Bank of Israel 370.
(photo credit: Wikimedia Commons)
Counterfactual history is a difficult and treacherous subject, not least in the
area of monetary affairs. Yet sometimes it is essential to making a big point
otherwise hidden from view. And so it is with the failure of the Bank of Israel
to defend this country from the forces of monetary chaos emanating from the US
Federal Reserve in recent years.
The “Grand Experiment” which the
Obama/Bernanke Fed unleashed – taking the form of zero interest rates, massive
monetary base expansion (qualitative easing or QE) and long-term interest rate
manipulation – has created a powerful virus of asset price inflation in our
global village, which attacks, somewhat paradoxically, the most dynamic
Asset price inflation is a condition where investors out of
desperation at low yields available on the world’s principle currency (the US
dollar) chase apparent high returns from risk-assets and in doing so become
subject to flawed mental processes which Nobel Prize winner Robert Shiller
identified in his work on irrational exuberance.
Where did these
desperate investors turn to in the first years of the Grand Experiment? It was
the high yields obtainable in a group of dynamic emerging and small advanced
economies, of which Israel is an example on account of its startling success in
The central banks of all these economies – including South
Korea, Taiwan and Canada – faced a common dilemma. Would they stand firm in the
face of this torrent of foreign money and allow their currencies to appreciate
temporarily to a sky-high level while sticking to orthodox monetary policy? The
grounds for choosing this approach would have been to prevent the fueling of a
domestic credit and real estate inflation. The disadvantage would be pain
inflicted on the export industries.
The alternative was to submit to US
monetary force, lower domestic rates to far below the equilibrium level
appropriate to a dynamic economy, and thereby prevent the national currency from
appreciating too much. This would please exporters, but sow the seeds of a
powerful domestic asset price inflation of which inflated real estate prices
would be a principle symptom.
In the long run this real estate inflation
would turn to deflation. The national economy would encounter the torments of
bubble-bursting and these would include the sheer waste of resources related to
the violent cycle in the construction and related industries.
meantime a large part of the population would suffer from the extremely high
price of housing.
In practice, the central bank of every dynamic economy
in the world exposed to the US monetary virus has chosen to cave in and abandon
prudence. Almost every one of these economies is now smitten with a virulent
form of asset price inflation spanning credit and real estate
Unfortunately, in the monetary sphere Israel has proven not to
be the exception. It could have been. The Bank of Israel, with its highly
talented leadership, could have alerted its government and public to the
monetary danger from the US and come up with a plan for how to defend the
economy against its consequences. Instead the Bank of Israel sung the praises of
the Obama Federal Reserve’s Grand Experiment.
What would have been the
best strategy of defense against the forces of US monetary chaos? The main
elements would have been first, a continuing free float of the currency; second,
piloting domestic monetary variables along an unchanged path consistent with
long-run stability rather than deviating far from this path so as prevent a
powerful appreciation of the national currency; third, initiating emergency
coordination with the government so as to lift any regulatory or other frictions
which would prevented the export industries from temporarily lowering nominal
wages in terms of the shekel on the understanding that they would be raised
promptly once the national currency started to fall; fourth, drawing up a
general program of information for the public to explain why such a draconian
appreciation of the currency had taken place and why Israel would gain from
mobilizing its powers of economic flexibility in response.
This policy of
strenuous defense against US monetary chaos would have brought considerable
benefits compared to the alternative policy of submission.
have remained affordable. Yes, there would still have been strong luxury demand
from outside Israel, but a shekel at 2.50, say, rather than 3.50 to the US
dollar would have reined this back from influencing the shekel price of real
Import prices would have fallen sharply during the period of the
super-strong shekel. In turn this fall could have empowered the forces of
economic and market liberalism in the Israel economy to destroy the cartels and
other restrictive prices which are holding so many domestic prices at high
Israeli businesses and investors would have enjoyed a unique
opportunity to buy up foreign assets on the cheap.
(Instead, the Bank of
Israel’s loss-making currency interventions have been subsidizing in effect
foreign purchases of Israeli assets).
Many Israeli businesses would have
taken advantage of temporarily cheap imports to boost their capital
Israeli savers would have enjoyed high returns on their
financial assets rather than the feeble returns available now in their near-zero
Some of the shekel return from foreign assets would have
been in the form of a long-run expected fall of the Israeli currency from its
temporarily lofty level.
Is it too late for the Bank of Israel to change
course? There comes a point in asset price inflations where monetary tightening
is a worse option than allowing the disease to burn itself out. That might now
unfortunately be the situation in the Israeli economy. But it is not too late to
hold a debate on the subject and make accountable to history those who left
Israel defenseless against the forces of US monetary chaos as unleashed by the
Obama Federal Reserve.The writer is author of The Global Curse of the
Federal Reserve (Palgrave 2013), associate scholar of the Mises Institute and
head of economic research/executive director at Mitsubishi UFJ Securities