Is Stanley Fischer giving our economy the medicine he repeatedly dispensed at the IMF??F
By JONATHAN LIPOW
Over the past three months, Bank of Israel Governor Stanley Fischer has engineered a sharp tightening of interest rates. In much anticipated moves, rates were raised by 0.25 percent in October and November. In December, Fischer surprised the markets by raising rates by a further 0.5%.
While the economy is growing, the rate of growth is rather tepid for this stage of an economic recovery and unemployment, though coming down, remains too high at 9%. So why is Fischer trying to "cool off" the economy?
The press is full of speculation regarding Fischer's motives. One argument is that he is concerned that recent price increases suggest that Israel is returning to its inflationary ways.
This doesn't make sense. Recent price increases are the result of high e nergy prices and the US dollar's temporary rally versus the euro and yen. These developments represent real changes in the economic environment in which Israel operates, and hence they are not "inflation." Why?
To make a long story short, inflation is wh en prices go up because there is too much money circulating in the economy. If prices rise, however, because key goods, such as oil, are more expensive, then all you have is the efficient operation of a market economy. This is what Milton Friedman was try ing to explain when he made his famous observation that inflation is always a monetary phenomenon.
Of course, the quantity of money circulating in Israel's economy actually has also been rising rapidly, so a case can be made that future inflationary pres sure may be building up. The problem is that the case doesn't hold water.
If unemployment was 4% and the banking system was responding to low interest rates by creating a credit boom, then inflation would be on its way.
But with 9% unemployment and on ly modest growth in credit, there is every reason to believe that inflationary pressure in Israel is under control.
SO WHAT is Fischer actually doing? We cannot know for sure, but it is possible to make an educated guess by looking at his prescriptions f or other economies over the years. During his sojourn at the International Monetary Fund, Fischer's policy prescriptions repeatedly erred on the side of setting rates too high - sometimes with disastrous consequences.
Take, for example, the Thai financi al crisis of 1997. After years of spectacular success, Thailand faced a genuine problem that year. The economy had slid into a recession which was beginning to destabilize the banking system.
To deal with recession, Thailand had printed a lot of its cu rrency, the baht. The baht's value was linked to the US dollar, and so many baht were now in circulation that the government could not possibly honor the link. Speculators smelled blood, and began to borrow baht and buy US dollars in order to exhaust Thai land's currency reserves and force a devaluation.
At this point, Fischer and the IMF offered Thailand foreign currency loans in order to rebuild reserves, but demanded that Thailand sharply raise interest rates in order to reduce the supply of baht and f end off the speculators.
While the Thais protested that high interest rates were contraindicated, eventually they gave in. High interest rates really did defeat the speculators, who could not afford to keep their baht loans open any more. There was, however, a minor side effect. The Thai economy collapsed and the baht went into a free fall devaluation.
While the high interest rate thwarted the speculators, it also exacerbated the Thai recession and the local banks really began to edge toward failure. Not surprisingly, Thais responded to the weakening of the banking system by shifting their checking accounts from local to international banks like Citigroup, HSBC, and Standard Chartered.
Since foreign banks don't accept baht, as Thais raced to withdraw funds from local banks, they were forced to convert baht to dollars. The result was that the baht's value collapsed even though Thai interest rates - and hence the financial returns from holding Baht - were high. Meanwhile, the local banks, faced with runs on their deposit bases, went out of business.
One would have hoped that Fischer would have learned from what happened in this and other, no less painful, experiences. Disappointingly, this does not appear to be the case. Even if Fischer is not plann ing to impose the full IMF "treatment" here, after only a few months in his current job, he is already shown signs of his old tendency to push interest rates above the level justified by economic conditions.
To be sure, current Israeli interest rates a re not alarmingly high, but they are indeed a bit higher they should be, and if Fischer continues on his present course, a renewed economic slowdown or even another recession will be the inevitable result.
The writer, a senior lecturer in economics at t he Academic College of Judea and Samaria, is chief economist of Forum FIE, the Israeli distributor of Vanguard Mutual Funds.Ωa
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