Dr. Karnit Flug (Photo: Reuters)
Photo: Reuters
Bank of Israel is stuck in the past
Analysis: By encouraging inflation in an attempt to spark growth, the Bank of Israel is repeating past mistakes and refusing to accept the current global reality.

Bank of Israel Governor Dr. Karnit Flug has been ranked among the top eight central bank governors in the world for a second year in a row, but the question remains: Are the banks making the right decisions?



Inflation has always been viewed as the most important issue with which all central banks had to contend. Banks ranging from the US Federal Reserve to the Bank of Japan have battled inflation for decades, but how is it that inflation is no longer an issue for them? Since the beginning of the 21st century, inflation has all but disappeared from the developed world, with an extremely low annual average.


The current policy followed by the central banks is “inflation encouragement,” in complete contrast to policies which have been in place since the banks’ inception. This encouragement is created by lowering interest rates in an attempt to create growth. But this method does not always achieve its purpose. Since the 2008 financial crisis, not one ofb the 34 OECD member states has managed to reach growth goals through encouraging inflation.


Dr. Karnit Flug (Photo: Reuters)
Dr. Karnit Flug (Photo: Reuters)


Under the current circumstances, it’s difficult to justify such a concerted effort to use inflation in order to drive growth. But the central banks are prisoners to a system of regulations, and are limited to using tools derived for the last decade’s needs. These tools are no longer relevant for the current global situation.


Did Japan’s case drive home the point?


Since freeing itself from the grip of a serious financial crisis in the early 1990s, Japan's economy has yet to return to growth, despite efforts by its central bank.


The Bank of Japan also sought to encourage inflation, but failed to achieve its goals, for which it fought for over 20 years.


The growth rate stood at a mere 0.5% per year.


Why didn’t the other banks learn from the Japanese case? The answer is so severe that no one wants to talk about it: They are left with no solutions. Just like the Japan case, the central banks have run out of options, as interest rates are already nearing zero.


Barking up the wrong tree


Luckily, Israel has achieved some of the higher growth figures of all the OECD states, despite last quarter’s weak figures.


Israel’s collective growth in the last five years has outpaced every country in the OECD except for Turkey and Chile. This collective growth figure of 20% is even more impressive when compared to the OECD’s collective growth of 7.6%.


There are many reasons for this success, but the Bank of Israel played an important role in the achievement, and as such Flug and her predecessor Fischer deserve the accolades. But some of the things the bank is currently doing can be summed up as barking up the wrong tree. Flug has resisted recent attempts by Finance Minister Kahlon to lower tax rates in an attempt to encourage growth, while suggesting a concerted effort to lower the government deficit instead.


But Israel is in relatively goodplace in terms of consistently lowering the public deficit in relation to GDP (in contrast to the global trend). As such, taking care of the public debt is in no way an urgent issue.


Flug and Kahlon (Photo: Gil Yochanan)
Flug and Kahlon (Photo: Gil Yochanan)


The bank claims that the “burden of the interest payments on the debt represent a heavy burden on the government budget.”


This is where the bank really starts to exaggerate – the burden on budget is the lowest its been since the establishment of Israel, and this is due to two main reasons: The size of the debt in comparison to the GDP is at a very acceptable level of 67%, and interest rates on the debt are in a steady decline. This is a direct result of recycling debt on attractive interest rates.


There are people in the bank who would have us believe that if the debt is not taken care of, Israel’s credit rating will suffer. But Israel only needs a credit rating in order for Israeli companies and the government to garner external debt. But external debt has not been built up in recent years, because most companies build on domestic credit, or receive large-scale foreign investment.


The foreign investors are not interested in Israel’s credit rating. That’s a fact. Even the the government is no longer accumulating major foreign debt. So what is there to be afraid of? The Bank of Israel is fighting the wars of the past on an issue that is no longer relevant.


Dr. Adam Reuter is the chairman of the Reuter Maydan investment house and the CEO of the Financial Immunities consulting firm


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