Globalization and World Financial Turmoil -A Test for Israel's Economic Policy
By Daniel Gottlieb, Senior Economic Adviser to the Governor, Bank of Israel (The full article is available in Zipped Doc file)
The World financial turmoil, that beset emerging economies during much of 1997 and
culminated after the Russian crisis in the second half of 1998, presents an interesting
test case for economic policy in an open economy. Israel's policy response was
radical, and - with the benefit of hindsight - successful in maintaining and reinforcing
stability, when the odds of many emerging economies, such as Israel, were clearly at
risk. Indeed several emerging markets suffered a severe setback in output, a deep
and sometimes contagious fall in the value of stocks and a sharp depreciation in their
exchange rates, when the world financial crisis evolved. National policy mistakes
were punished by rapid capital flight, spearheaded by foreign investors and
accompanied by a loss of these countries' international creditworthiness.
The first section sets the background for open economies at the end of the 1990s: a
precipitation of globalization in financial markets, led by the rapid advance in
information technology. The integration of world capital markets has brought about a
rapid change in the rules of the game for national economies that seek to increase
their share of financial and direct investment in the international financial market.
The second section focuses on Israel's economic developments preceding the World
financial crisis. This section emphasizes the importance of timeliness of policy
actions. Economic fundamentals can be changed by economic policy, but only in a
slowly breeding process, whereas financial crises by their very nature can hit
economies sharply, instantly and typically unprepared. If the economies, which
suffered from the crisis, had expected it, the crisis would probably never have
developed in the first place.
The third section describes the shock of world financial turmoil on the Israeli foreign
exchange market and its immediate impact on the inflationary process on the
background of Israel's exchange rate regime
The section ends by a discussion of the policy reaction and some short and long
term economic consequences.
In the last section lessons for economic policy are drawn from Israel's experience
during world financial turmoil:
Lesson #1: Macroeconomic stability must be maintained continually
Globalization is an irreversible process. The attempt to close the economy artificially
from that process is doomed to failure. The question for economic policy is therefore,
how the economy can prepare efficiently to the challenges posed by globalization.
Globalization reduces frictions of international capital movements. This tends to
amplify shocks both positively (rewards) and negatively (penalties). The major
challenge is therefore to secure international investors' confidence in the domestic
economy. That requires the domestic policy makers' knowledge of the rules
governing the conduct of international investment funds. The focus on international
investors' behavior derives not only from the size of the current international
investment but mainly from the potential future investment and from the access to the
domestic and international borrowing market. Furthermore, domestic investors'
behavior (and consumers, who behave according their expected permanent income)
is similar to investor behavior anywhere. Globalization therefore greatly intensifies the
necessity for economic policy makers to adhere to international standards of sound
economic policy making. International rating agencies' sovereign risk ratings have
thus greatly gained in importance in recent years. Their country reports have become
an indispensable monitoring device for international private investors. Consequently,
economic policy makers need to orient themselves according to the criteria, which
govern the rating industry. Economic decisions by policy makers and market
participants in general must be geared at absorbing external shocks.
The best way for economic policy makers to assure this capability is to pursue a
macroeconomic policy aimed at stability. This is a fundamental precondition for
shielding the economy from "contagion". The strategy of insulation (reversal of the
liberalization process), as has been suggested at some stages by a number of
economists1, actually intensifies financial vulnerability from globalization because
they leave the private sector unprepared to deal with risks arising from external
shocks. The private sector remains artificially shielded from objective risks, inherent
in the integration of the domestic economy into the world economy. This situation
eventually becomes unsustainable. Businesses are thus induced to take risks, which
they are not aware of at the time of their decision. Eventually risks might materialize
at an unpredictable timing and at a high cost to the economy as a whole. The major
goal of macroeconomic policy must therefore be to minimize vulnerability from global
shocks. This lesson was learnt the hard way by several emerging economies, which
were hit by crises in the 1990s.
Of course, each country's output loss had its own idiosyncrasy, which probably
explains some of the variance in the depth of their output losses. These losses varied
between a total "loss" of 37 percent of GDP and 11 percent in the least severe case.
The highest yearly loss (in midst of the crisis) varied between 21 percent and 6
percent. (see chart in the full text).
In that comparison Israel has clearly made a better choice than the countries in the
sample. A comparable rough calculation for Israel yields only a loss of 2 to 3 percent
(the difference between potential output growth of, say, 4 to 5 percent and the lowest
growth rate (in 1999) of 2 percent. The comparable cumulative "loss" for Israel was in
the vicinity of 6 percent, well below the "loss" of the best case (Philippines). This
rough calculation suggests that a disciplined macroeconomic policy pays off also
from the point of view of potential GDP loss minimization.
Foreign direct investment into Israel has continued unhampered throughout world
financial turmoil. Even foreign financial investment recovered quickly after the shock.
Total foreign investment in Israel's business sector surged in 1999 to 4.8 billion
US-dollars and in January 2000 alone foreign investment already reached nearly one
billion US-dollars.
Despite these facts many have argued that the simultaneous application of tight
monetary and fiscal policy in the course of 1994 to mid 1996 has been detrimental to
the economy's welfare, adding unnecessarily to the slowdown in growth rates in 1997
to 1999 and to the rise in the rate of unemployment during 1997 to 1999. Domestic
critics of Israel's macroeconomic policy observed that the inflation target throughout
much of 1998 and again in 1999 had been undershot. They argued in favor of an
"optimal policy mix" which - according to that view should have led to a more rapid
relaxation of fiscal and monetary policy in view of output growing below potential2.
When the Central Bank chose to dampen the economy in the years 1994 to 1996,
that policy choice was highly unpopular. Politically it would have been very easy to
abandon or "postpone" the continuation towards long run stability. The advantage of
the "policy of permanent struggle for stability" became clear, when, during world
financial turmoil, the economy's macroeconomic fundamentals were stable. The
trouble with world financial turmoil is that it is inherently unpredictable and once it hits
an unprepared economy, stability takes too much time and effort to be achieved.
Furthermore, in such a situation the policy effort has to be much more ambitious, if it
has to be achieved in midst of a domestic crisis. The policy of a "permanent struggle
for stability" thus becomes the preferred strategy, whenever economic fundamentals
get out of line. Obviously this weakness is typical for emerging economies which are
characterized by a basic credibility problem of government policy.
A highly credible government may indeed use a policy mix, using one tool (say
monetary policy) temporarily in an expansionary fashion and the other (say fiscal
policy) in the opposite direction, with a focus on the overall effect of the policy3.
However, the problem in an emerging economy with eroded policy credibility is that a
policy mix with a combination of offsetting policies sends a mixed signal to the public.
The public will tend to give a larger, myopic weight to the expansionary part of the
policy, which will hamper policy credibility even more. The fact that inflation
expectations in Israel during the years 1994 to mid 1997 were consistently higher
than actual inflation indicates that market participants still perceive a latent danger for
future inflationary excesses. In such a case a premature relaxation of monetary policy
might therefore require an even more restrictive monetary policy in the future, to
counteract the inevitable loss of confidence in monetary policy that would occur.
This episode should serve as a lesson for emerging economies with limited policy
credibility: A crisis is very costly. Even with a low probability, the expected cost is
high, due to the high penalty inflicted by globalization. Stabilization is a time
consuming process. Therefore it is irresponsible to react excessively to the current
observed output gap. In Israel it took the authorities about two and a half years to
recognize the need for restrictive fiscal policy and implement it.
Lesson #2: Enhance the Flexibility of the Exchange Rate Regime
Or - How to find a suitable exit policy.
Flexibility is a sine qua non for foreign exchange markets. Any rigidity (fixed
exchange rate rule) will hit markets in areas, which are less fit to absorb external
shocks. The shocks will eventually need to be absorbed. Labor markets, which
inherently lack flexibility (due to the preponderance of long term wage contracts and
trade union power) are less suitable for that task. This does not mean that labor
markets are not affected by external shocks - they are - but increased flexibility in the
foreign exchange markets lets the business sector adjust more easily in the other
markets because the foreign exchange market can provide risk insurance more
easily than other markets. Israel's gradual and automatic widening of the exchange
rate band towards full flexibility has proved an optimal exit policy from the Central
Bank's official commitment to intervene and has strengthened its policy credibility,
and therefore allowed a lower interest rate than would otherwise have been
necessary.
Lesson #3: A nominal appreciation can be consistent with a real depreciation
The Israeli experience is a good example for the dichotomy between nominal and
real exchange rates. The real exchange rate is related - sometimes even in the short
term - with real phenomena, such as improved policy credibility, the development of
government deficits and expenditure and other real variables. What matters for
export profitability is the real, not the nominal exchange rate. The latter was managed
for many years with poor results concerning the real exchange rate. The sharp
depreciation in October 1998, being the result of market forces, proved to be much
more permanent than administered devaluations in the years of a managed
exchange rate.
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* Dr. Daniel Gottlieb is Senior Economic Adviser to the Governor of the Bank of Israel. This article is based on
a lecture given at the United Nations ECE meetings in Geneva on May 4-6 1999 and at the Second Budapest
Workshop of the EACES, held on the 3rd and 4th September, 1999, at the Department of Comparative Economics
at Budapest University. The article draws heavily on a forthcoming joint research with Professor Jacob A.
Frenkel, Governor of the Bank of Israel from 1991 till early 2000. Thanks to Mimi Cohen and Erez Kapitolnik
from the Bank of Israel for their excellent help. Of course the author bears sole responsibility for any possible
mistakes. The views expressed here are not necessarily those of the Bank of Israel.
See for example P. Krugman (1998), Bhagwati (1998) and D. Rodrik (1997).
While there exists no authoritative number for sustainable potential growth, the growth rate in the years 1997 to
1999 has probably been below "potential". When the growth rate is adjusted for the natural slowdown, the
exhaustion due to slowing immigration and the stalemate in the peace process from 1996 to 1998, the
exaggerated per capita growth of more than 4 percent in 1995 and 1996 would have been slowed down anyway.
The policy induced slowdown accounts thus only for a fraction of the observed growth decline.
1See for example P. Krugman (1998), Bhagwati (1998) and D. Rodrik (1997).
2While there exists no authoritative number for sustainable potential growth, the growth rate in the years 1997 to
1999 has probably been below "potential". When the growth rate is adjusted for the natural slowdown, the
exhaustion due to slowing immigration and the stalemate in the peace process from 1996 to 1998, the
exaggerated per capita growth of more than 4 percent in 1995 and 1996 would have been slowed down anyway.
The policy induced slowdown accounts thus only for a fraction of the observed growth decline.
3This is why an interest reduction during world financial turmoil in stable economies such as the US and UK was
justly met with complacency there.
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