The new governor of the Bank of Israel, Karnit Flug, may not have noticed it, but she is riding on the back of a running tiger that threatens her and the entire economy.
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The tiger in question is the Bank of Israel’s interest and exchange rate policy, which has reached a dead end and requires radical change. But such a change is hard to implement. It requires getting off the running tiger.
The policy of negative real interest rates, and the effort to keep the exchange rate high by buying tens of billions of dollars, began in 2008, following the subprime mortgage crisis in the United States and the global crisis it sparked. At that time, the exchange rate fell to the level of NIS 3.2 to the dollar. But since this was due to the global storm, temporary, limited intervention in the foreign exchange market was justified during this difficult time.
Indeed, when the campaign began, the central bank’s then governor, Stanley Fischer, said he was only increasing the reserves to a level of $38 billion and wasn’t trying to influence the exchange rate over the long run. But Fischer was gradually dragged into capitulating to the pressures of the exporters. Thus, instead of a temporary policy during a time of crisis, he gradually adopted a permanent policy of negative real interest rates and buying enormous quantities of dollars – and these measures have now been in place for five years.
As a result, the reserves have ballooned to the excessive sum of $80 billion, which in turn has resulted in heavy losses on both interest and principal. Yet the exchange rate has stubbornly refused to stop falling - it’s already nudging the level of NIS 3.5 to the dollar.
This once again proves that any attempt to influence the exchange rate over the long-term is doomed to failure.
In the beginning, during the crisis, Fischer cut interest rates to bolster growth. But later the reason changed, and the goal was to stop the influx of foreign currency into the country so as to prevent an appreciation of the shekel. The Bank of Israel’s policy was subordinated to the exchange rate and exports, without taking into account that, meanwhile, the negative real interest rates were causing a worrying inflation of two enormous bubbles – real estate prices and share prices – that would someday burst, resulting in bankruptcies, recession and unemployment, and endangering the stability of the banks.
Today, Fischer is considered a success story, the “responsible adult” who prevented Israel from falling into recession in 2008-09. But when the real estate and stock exchange bubbles eventually burst with a loud bang, the same people who applauded him will throw him contemptuously off his pedestal and vilify him wholeheartedly. That’s exactly what Americans did to the legendary chairman of the Federal Reserve, Alan Greenspan, when the crisis erupted in 2008.
Flug must therefore recognize the fact that Fischer’s policy (and her own) has gone on far too long (she has been in temporary charge of the central bank since June) and is now causing only harm. The time has come to change it from the ground up, and she should start right away. She must gradually raise interest rates to a positive real level, while completely halting intervention in the foreign exchange market. In other words, she must stop buying dollars.
If she does, we won’t see a sharp appreciation of the shekel, because what matters to investors is not only the interest rate spread between the dollar and the shekel, but also the risk inherent in the investment. The moment everyone understands that the Bank of Israel has changed direction and is allowing the exchange rate to float freely, the risk of converting dollars to shekels will grow, and the influx of dollars into the economy will shrink. The shekel’s appreciation will therefore actually be halted.
Similarly, positive real interest rates will lead to a significant decline in the demand for mortgages. As a result, the real estate bubble will stop inflating. The stock exchange bubble will also stop inflating, due to that same rise in interest rates, and the economy will return to normal.
This is a change necessitated by reality. It’s a painful one, because it’s hard to straighten a huge hump that has been growing for years. The change is also dangerous, because it’s not easy to get off the back of a running tiger. But it’s clear that if Flug doesn’t get off now, the tiger will quicken his pace until everything ends in a huge economic crisis.