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BANK OF ISRAEL Office of the Spokesman and Economic Information PRESS RELEASE June 6, 2011 Abstract of Speech by the Governor of the Bank of Israel at the Israel Economic Association Conference The Governor of the Bank of Israel, Prof. Stanley Fischer, spoke today (June 6) at 27th annual conference of the Israel Economic Association in Ma'ale Hachamisha. The following is an abstract of his speech. Four years have passed since the sub-prime crisis began, and two and half years have passed since Lehman Brothers declared bankruptcy. In this lecture I will attempt to focus on developments in the global economy since the crisis, and also to touch on questions and lessons that the crisis presented to the economics profession. In their 2009 article "The Aftermath of Financial Crises", Reinhart and Rogoff describe the damage which financial crises have brought with them over the course of history, which is always expressed in a sharp drop in employment and economic output, and in a sharp rise in deficits and government debt. In their book, "This Time is Different", they describe how the dynamic in which crises occur once in several decades results in policy makers making the mistake of thinking that each time the crisis is different than its predecessor. I'll begin with a reference to the global economy. The International Monetary Fund estimated about two months ago that the global recovery is stabilizing and that the pace of growth is expected to increase. With that, the recovery is not uniform: Japan, England, and the euro bloc have not returned, as of the end of 2010, to the level of GDP which their economies had reached on the eve of the crisis; as of the end of 2010, US GDP surpassed by only 2 percent its record level from before the crisis. In emerging markets, growth is relatively high, and unemployment levels are low. All in all, the global economy is expected to grow around 4-5 percent, which is the average growth rate of the economy since World War II. World trade is also expected to grow at its long term average of 7-8 percent. The large economies in Asia are expected to reach within several decades the income levels of Middle Income Countries, even as inequality in those countries is growing. In South America as well there are extremely high growth rates. The global imbalances, which are expressed primarily in China's surplus with the US, continue, and it is expected that in the long term there will be a continued process of weakening of the currencies of developed markets vis-à-vis the currencies of emerging markets. At the same time, it is important to emphasize that one cannot draw conclusions from this about the short term, since it is very difficult to forecast trends in the exchange rates. Financial crises occur, and apparently will continue to occur. However, different countries dealt with, for example, the last crisis in different ways. It can be seen that countries such as Sweden, Germany, and Switzerland succeeded in getting out of the crisis in much better form than other countries. It is up to us, the economists, to understand what the factors are that lead to certain countries suffering the crisis differently, and what the policy tools are that allowed certain countries to deal in a better way. The first lesson that came out of the current crisis is the issue of macro-prudential supervision. It means that we must oversee the stability of the financial system as a whole, and not to settle for supervising each institution separately. In various countries they are now dealing with the proper approach to supervising financial institutions and with the structure of regulatory authorities. Another question deals with the role of the central bank. In the past, it was customary to think that since the central bank only has one instrument–the interest rate–it can only have one target, which is to manage inflation. Today we understand that a central bank has additional tools, and even if using them involves a cost, that cost must be weighed against the benefit that they can bring in reducing the impact on the economy during a crisis. A strong fiscal situation is a prime characteristic of the countries which made it through the crisis in a good position. During a crisis, governments need to choose between increasing government expenditure in order to motivate the economy during the crisis, and the need to watch the deficit and debt. In Israel, as is known, there was an inability to change the government's budget at the onset of the crisis because of the political situation at that time. Thus, from a fiscal perspective only the automatic stabilizers operated, and these alone brought the deficit to a level of over 5 percent of GDP. We should give thanks that the fiscal policy in Israel is stable and responsible, and aims to achieve long term goals for the deficit and the debt. If in the future we again find ourselves in a crisis, it is certainly quite likely that we will need to utilize fiscal policy as well in order to accelerate the exit from the crisis. In Australia, for example, the fiscal situation before the crisis was such that the debt to GDP ratio was very low, a situation which allowed Australia's government to adopt an aggressive fiscal policy which allowed it to exit the crisis relatively quickly. A current account surplus is a great advantage for a country during a crisis. Countries which are in a deficit must go through a painful process of adapting trade trends and their consumption to the new reality, in which they will find it difficult to provide their foreign currency requirements. Limitations such as these are nearly nonexistent for countries in surplus. This was the basis of Keynes's thinking at the time when the IMF was established. As proof, we are witness today to the strength of China in the international economy, a strength which relies in large part on the huge foreign currency reserves it has accumulated. So how, then, are we to relate to the short term capital flows which are entering the economy now, which stem mainly from interest rate gaps between the Israeli economy and the large economies abroad? Do these flows represent an optimal situation for the economy? In my opinion, the existing models today, which support those who claim we should allow these capital movements to flow freely, do not represent well enough the fact that financial intermediaries today have a significant role in the economy. It is customary to think that the Israeli economy endured the crisis "easily". That is no small matter – the economy was managed in the years before the crisis precisely in the way the international institutions such as the IMF and OECD preach – a current account surplus, responsible and balanced fiscal policy, a stable banking system, and also monetary policy and a banking supervision system that responded quickly to developments at the onset of the crisis. We must continue to adopt the correct policy in the future as well, so that we will be able to continue to grow at an annual rate of 5 percent and more. When will we need to begin to worry? We'll need to worry when we begin to hear people say the sentence which was the title of Reinhart and Rogoff's book – "This Time is Different". But primarily we will need to worry when people say, "It's different for us" – because for us it is not different.