Defending the Bank of Israel

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 economies.

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 hi-tech.

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.

In the 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 markets.

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.

Housing would 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 estate.

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 levels.

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 spending.

Israeli savers would have enjoyed high returns on their financial assets rather than the feeble returns available now in their near-zero rate universe.

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 International.