HOW DOES ONE HANDLE A potential housing bubble? The answer, according to Stanley Fischer: Very, very carefully. This is how Fischer describes his approach to what is perhaps the most vexing issue he is facing early in his second five-year term as governor of the Bank of Israel (BOI): the real estate boom that stubbornly continues to defy all attempts to rein it in.
“If you try to burst a bubble with a hammer, the result can be a spectacular mess,” says Fischer. “When dealing with a bubble, don’t try to be a hero if that means hurting a lot of people.”
On the surface, this might seem to be a relatively calm time to serve in one of the most stressful jobs in the Israeli economic leadership. The economy is growing at the second fastest pace among nations in the Organization for Economic Cooperation and Development (the OECD, considered the club of the industrially advanced economies), trailing only Sweden.
Everyone, including Fischer himself, gives Israel high marks for weathering the international economic crisis in very good form. Trade and exports, on which the Israeli economy relies for survival, are relatively healthy. Inflationary pressures, both international and domestic, are at tolerable levels.
No bond vigilantes threaten the Israeli government’s ability to borrow, in contrast to the economies of Europe’s periphery, such as Ireland, Portugal and Greece. There is no specter of either a fiscal or a banking crisis emerging to perturb the deliberations on the state of the economy regularly conducted on the top floors of the BOI’s imposing structure in Jerusalem across the street from the Prime Minister’s Office.
But all this good news has brought Fischer problems, too. The growth in the Israeli economy is out of step with continued economic doldrums in the US and Europe, and in response, the BOI has raised the prime interest rate much faster than many other central banks. Staving off appreciation pressures on the shekel has forced the BOI to buy foreign reserves at an unprecedented rate, and that cannot continue forever. The ongoing economic problems among Israel’s main export markets in Europe and the US are casting long shadows.
And tracking the effects of the housing boom – and worrying about what happens if it is a bubble and if that bubble bursts – is taking up a good deal of the attention of the BOI.
These were the topics that Fischer discussed in a lecture to participants in the Hebrew University’s prestigious Summer School in Economics in the last week of June, to which The Jerusalem Report was invited. In this impressively broad, deep and comprehensive lecture, Fischer also provided a rare view of the way he thinks and operates.
IT WOULD BE A GROSS EXAGGERation to describe Stanley Fischer’s speaking style as rousing. His manner is relatively subdued and his voice is quiet, with the Northern Rhodesian accent of his childhood emerging clearly in his English, especially in words with long vowels.
Despite the reserved style, his erudition and depth of thought are evident in every sentence, punctuated with his dry but very sharp sense of humor. He keeps his listeners focused and attentive.
Getting Fischer to agree to serve as governor of the Bank of Israel in 2005 was one of Prime Minister Benjamin Netanyahu’s most impressive results when he was minister of Finance in Ariel Sharon’s government.
With extensive experience in theoretical macroeconomics as an MIT professor, practical banking as vice chairman of Citigroup, and international monetary policy as vice president of the World Bank, and deputy managing director of the International Monetary Fund (IMF), Fischer brought a rare combination of first-class real-world and theoretical understanding to his job.
Perhaps just as importantly, he has over the years cultivated deep personal connections with all of the leading economic and financial agents around the globe – including the current Chairman of the Federal Reserve Bank of the United States, Ben Bernanke, who was one of his star students at MIT.
Fischer’s performance as BOI governor (he began his second five-year term in May 2010) has earned him praise from many financial observers. His management of the BOI put it in first place among central banks in the 2010 rankings of the International Institute for Management Development’s “World Competiveness Yearbook,” he got an A rating for two consecutive years on the Central Banker Report Card published by “Global Finance Magazine,” in 2009 and 2010, and was declared the best central bank governor in the world by “Euromoney” magazine in 2010.
The recent decision in June by the IMF to reject his bid to take over the top spot at the agency, following Dominique Strauss- Kahn’s resignation, on the grounds that at age 67 he is too old for the job, raised eyebrows around the world given that France’s Christine Lagarde, who was selected for the position and has a background mainly in law, has less experience than Fischer in economics and financial crisis management.
THE EXTENT TO WHICH FISCHER is involved in highest-level ongoing global discussions on how to contend with the prolonged economic slump becomes evident when he speaks about the active role that monetary policy, and central banks in particular, can play even as interest rates fall towards zero, the lowest possible rate. As he himself notes, many hold the opinion that once the interest rate gets to zero, that’s the end of monetary policy, and then the only tools left to policy makers are fiscal. Contrary to that opinion, Fischer makes a strong case for active monetary policy in several different ways, even when interest rates effectively hit zero.
The technical term for the quandary that central banks around the world have faced since late 2008 is “liquidity trap.” In a liquidity trap, which is often associated with massive deleveraging, aggregate savings far outruns aggregate desired investment. People and corporations prefer sitting on cash to spending and investing. With demand for borrowing down, the interest rate, which may be thought of as the price one pays for borrowing, plummets. As it comes towards the zero interest lower bound, central banks find themselves bereft of the main tool they normally wield to attain policy goals, which consists of raising or lowering interest rates.
“In Israel, interest rates went down to their lowest ever levels, half a percent,” notes Fischer. “The United States and Japan came closest to zero. The Fed’s declared interest rate now, still lies between 0 and 0.25 basis points.”
In contrast, the interest rate in Israel is currently 3.25 percent.
Fischer is quick to note, however, that “zero is not the end of the story. There is quantitative easing and credit easing. The zero-interest lower bound is a bound on only one asset. But central banks can buy and sell other assets, while playing the role of ‘market- maker of last resort.’” Quantitative easing is a familiar term to readers of financial sections. Central banks implement quantitative easing by purchasing financial assets from commercial banks, thereby increasing the excess reserves of those banks and enabling them to make more money available for loans. The US Federal Reserve has famously implemented two large rounds of quantitative easing, injecting liquidity into the system. The BOI under Fischer also turned to quantitative easing at the height of the economic crisis, buying government bonds on the secondary market in 2009 BUT FISCHER RECOMMENDS very careful analysis of the right amount of liquidity to put into a financial system before reaching for quantitative easing, saying that “if you put liquidity in, then you are likely to need to take it out eventually.”
Under what has been termed credit easing, central banks expand the portfolio of assets that they purchase beyond bonds. “With credit easing, central banks can fix markets, such as the markets for commercial paper and mortgage-based instruments. The commercial paper market just dried up,” explains Fischer. “The Fed went and bought enough commercial paper to get the market active again.” That alone was enough to get the markets moving again, because people knew that there was a buyer for the instruments, and it is in this sense that Fischer calls central banks the “market-maker of last resort.”
Fischer adds that he could not understand why so many people considered the quantitative and credit easing implemented by central banks to be “absolutely outrageous actions.” “It was,” he says, “in fact not a revolution, but a return to the way central banks used to operate. All this was spelled out long ago” in macroeconomics textbooks.
The earliest editions in the 1980s of a well-known textbook, simply titled “Macroeconomics,” which Fischer wrote with co-author Rudiger Dornbusch, contained five pages on the subject of liquidity traps. That dropped to one and a half pages in later editions, as the threat of liquidity traps seemed increasingly remote. The number of pages on contending with liquidity traps has crept up to two and a half pages in current versions of the book, after Japan suffered a liquidity trap. “Now it will be up to five, maybe ten pages,” promises Fischer.
IN ISRAEL, THE PERIOD OF QUANtitative easing was very brief. GDP growth slipped to only 0.2 percent in 2009, a significant slowdown after 4 percent growth in 2008, but when measured against the contraction most countries experienced in 2009, this could be regarded as an accomplishment.
Growth resumed at a 3.4 percent rate in 2010, as exports rebounded. The BOI resorted once again to raising interest rates, much earlier than other central banks in the OECD.
Why did the Israeli economy manage to emerge so well and so quickly from the world economic storm? Fischer answers that what made the difference between one country’s rapid recovery and another country’s continued struggle with a prolonged recession in the recent crisis is the strength and robustness of its financial system. “Recessions accompanied by financial crises are far worse than those that are not,” he says. “Israel came through the recession quickly, as did Australia, China, and Norway – because we did not have any financial systems that collapsed.”
He is quick to add, however, that “it is not true that we got through the crisis easily.”
Fischer certainly remembers many worrying times during the crisis. “The newspapers did their best to make people nervous, by coming and asking, ‘Can you promise us that no bank [in Israel] will fail,’” he recalls. “Well, that’s that sort of thing you have no answer to, because you don’t know which rogue trader is going to show up tomorrow at which bank.
You have to say things that are true rather than things which are reassuring. Eventually I issued a statement that ‘no Israeli depositor has ever lost money in a bank.’We didn’t actually make any promise, but it was understood. We did come through it.”
The Israeli financial system, which was always much more conservative than the financial institutions in New York and London, was not involved in sub-prime lending and did not partake of credit default swaps. That kept it relatively immune to the infections that struck the international financial system. Nevertheless, at the height of the crisis, Israel’s regulator of banks at the BOI imposed higher bank capitalization requirements on the nation’s banks. “The banks were furious at that,” says Fischer. “But they came out of this in better shape than they came in.”
With no Israeli banks close to tottering, Fischer was spared the agony of needing to save a financial institutions that is “too big to fail,” an action that is rife with what is termed “moral hazard” – if banks come to believe that they will always be saved without consequences they may be more likely to undertake precisely the risky behavior that endangers the system. That does not mean that he hasn’t pondered the issue. He distinguishes between a liquidity crunch, which is a situation in which a bank temporarily needs a large loan of money to meet its obligations but is fundamentally sound, and a solvency crisis, in which a bank is not solvent in its fundamental bottom line and teetering on bankruptcy. A central bank, Fischer explains, is the lender of last resort, and should provide liquidity to banks undergoing a temporary liquidity crunch. An insolvent bank is in a different category, however, and that is when questions of “too big to fail” become relevant.
“There is a need to know whether what a bank is going through is a liquidity crunch or a solvency problem, but often one does not really know,” says Fischer. “This has fiscal consequences. Too big to fail can also mean too interconnected to fail. There is a need for macroprudential supervision (a method of analysis that evaluates the soundness, health and threats to a financial system), including regulation of the financial system at a broad level, with an emphasis on systemic interactions.
Regulation usually looks at each bank individually. But what is the overall rate of the expansion of credit?” Nor is the issue of moral hazard one that can be taken lightly. “Allowing banks to go around believing that they will be saved without consequences is not a good thing,” Fischer continues. “But I thought about it for a long time. Here is a simple rule: If you are going to make a bank fail to teach its 100 senior managers [a lesson] and you’re going to cause a major recession that will affect millions of people, then you are too late. Just save the damned thing. You should have done something earlier. Accept by this stage you have lost the round. Get the thing right next time.
Don’t be a hero. Being a hero in this case is likely to be the stupidest thing.”
THE ADVICE FISCHER DISPENSES with regard to saving large failing banks is characteristic of the caution he recommends when facing crises in general.
It is also evident in his approach to handling the current Israeli housing bubble.
“Real estate is ‘going great guns,’” is how Fischer picturesquely describes the situation.
“Housing prices have risen more than 50 percent in two and a half years, and they continue to rise. These things look terrific as long as everyone is playing the game. But housing prices cannot keep rising at 15 or 20 percent.
At some point that will stop. The question is, how will it stop? We want to avoid a messy bursting of a bubble. We don’t want to overdo it and bring about a sudden collapse of the housing market.”
Fischer makes dealing with the housing boom seem akin to conducting delicate surgery on a patient, with the surgeon striving to tackle the source of the illness without harming vital organs in the process. “We cannot do the obvious thing [to cool off the housing market], which would sharply raise the interest rate,” he says with a serious look on his face. “We export 45 percent of our GDP, and we do not want to price ourselves out of the export market.”
What Fischer has chosen to do so far is to attempt to assert some control over the housing market mainly by regulating housing loan terms, using the BOI’s regulation of banks.
This has included the imposition of restrictions on the loan-to-value ratios of mortgages issued by banks, meaning that Israelis cannot purchase real estate almost entirely on credit alone, without a significant down payment – in contrast to the state of affairs in the United States prior to the bursting of the housing market there, where in some cases buyers were able to borrow more than 100 percent of the amount of money they needed to purchase a house.
As can be expected, the increased regulation of mortgages was not universally popular, but it has also been praised by some economists as the right response to the situation.
John Geanakoplos, a Yale economist who was a lecturer at the Hebrew University’s Summer School on Economics, is persuaded that if the US Federal Reserve had had the foresight to regulate mortgages in the middle of the last decade, much of the economic pain resulting from the immense deleveraging America is going through as it winds down the immense amount of housing credit issued by the banks could have been avoided.
“I recently proposed that the Fed consider implementing loan-to-value regulation on mortgages,” says Geanakoplos to The Report. “The Federal Reserve governors didn’t seem to like the idea, but I pointed out to them that Stanley Fischer, the governor of the Bank of Israel, managed successfully [to regulate loan-to-value].”
In addition to the housing boom, the BOI has been struggling to hold down the appreciating shekel. “The exchange rate is extremely important for a small open economy,” says Fischer. “It is fashionable to say don’t intervene, that you don’t have enough resources. That is half true in a depreciation situation, when you don’t have enough dollars to stop the currency depreciating. You can’t make the foreign currency. When the money is pouring into your country, you can intervene. They want what you can make, shekels… Then the question is what are the consequences. You are creating liquidity, but you can get rid of that by buying other assets.
But then there is the question of how long you can keep doing that.”
Fischer leaves that last question open, apparently not wishing to get quoted as identifying a definite target beyond which the BOI will no longer buy foreign reserves in order to keep the shekel artificially weak. All he will say is that “this is a central question in the international system. Every country that emerged well from the crisis is growing, while the US and Europe continue to suffer economically. That has implications for exchange rates.”
IN ADDITION TO DETAILED ANALYses of the main issues being grappled with by the financial world’s leadership, the Governor of the Bank of Israel is happy to dispense general advice. For one thing, he strongly recommends that “in a crisis, do not panic.”
Fischer recalls that when he took the position of No. 2 at the IMF in September 1994, “Mexico was the star poster child of the IMF.” He had to undergo a medical procedure and chose December 20 for it, expecting things to be quiet during the Christmas period. “I was sitting at home the next day,” he relates, “when somebody called at 11 at night and said Mexico is going to devalue tomorrow… My wife asked, ‘What are you swearing about?’” But the memory that Fischer takes away most strongly from the experience is the manner in which the IMF’s managing director at the time, Michel Camdessus, reacted to the Mexican crisis. “He was as calm and cool as a cucumber,” Fischer says. Abailout package was put together for Mexico, which overcame its difficulties and eventually repaid all its loans.
Beyond “don’t panic,” Fischer promotes what he terms “the eternal verities.”
“It turns out that if you manage your budget well, and if you keep the inflation rate relatively low, and you do all the boring things that the IMF tells you to do and that your parents would tell you to do if you were a central banker, it works,” he says. “It is sometimes disappointing that these old-fashioned stories are true. You may prefer to be daring, or brave or innovative. But you need to keep the basics together. Then you can do innovative things.”
And after all that, there is still one more nugget of advice he has. “This is something I’ve learnt from dealing with many crises: You discover that what you have to do is something that you said you would never do.
So never say never!” •