Karnit Flug has been deputy governor of the Bank of Israel since July 2011. Flug worked with the International Monetary Fund before joining the Israeli central bank, where she is completing a quarter century. In this interview from December with Israel Knowledge@Wharton, Flug — said to be among the front-runners to replace Bank of Israel Governor Stanley Fischer, who steps down at the end of June — talks about a wide range of issues, including the Israeli economy; why the ‘start-up nation’ hasn’t been able to produce large companies, the serious social problems that lie ahead if currently unproductive segments of the population are not brought into the economic and labor mainstream. “Diversity is the key,” she says, and that principle applies equally to the sectors of innovation, export markets and the labor force.
An edited transcript of the conversation appears below.
Knowledge@Wharton: I wanted to start by asking you about the Israeli economy. How would you rate the performance of the economy in 2012 and what does it look like for 2013?
Flug: Overall, the economy performed reasonably well in 2012 given global circumstances. Growth slowed down since the second quarter with the slowdown in the global economy. But we grew at roughly 3%. That’s more or less what we expect in 2013. And the slowdown is basically the result of slowdown in demand for our exports. Israel is a very open economy and our exports are about 40% of GDP. About one-third is to Europe. So when Europe is in a recession, it is reflected in the demand for our exports. Actually two-thirds of our exports are to Europe and to the U.S., so we are affected by [uncertain conditions there.]
The result is a growth rate of around 3%. Unemployment is still low — around 7%. So we’re doing reasonably well, but it’s not the growth rates we saw in 2009 and 2010, which were closer to 5%.
Knowledge@Wharton: Are you taking any steps to increase the rate of growth to 5%?
Flug: Increasing it to 5% would take more than our doing. The growth rate of 5% was based on relatively strong global demand. What we are doing is trying to support growth by, for example, fairly expansionary monetary policy. We have reduced our interest rate from 3.25% [it is now 1.5%] because we saw the slowdown. As inflation is well within our target, we could support growth by reducing interest rates.
Knowledge@Wharton: On the other hand, there are obviously problems on the fiscal side. Fiscal policy is going to be contractionary. Tax rates have risen and they’re going to rise further. Spending is going to be cut to some degree.
Flug: Let me clarify something about the fiscal policy, especially on the spending side. When we talk about cutting 15 billion shekels ($4.20 billion), what are we cutting from? We’re actually talking about a cut from budget commitments that now exceed the 2012 budget by 30 billion shekels. So we’re talking about 15 billion shekels from a 10% increased expenditure. After the cut, we’re talking about an increase of 5% in real terms. I would not characterize that as contractionary fiscal policy, at least on the spending side.
Yes, taxes have been raised. The government is attempting to meet the 3% of GDP deficit target that it has set. But if you have a deficit of 3% and growth of 3%, I wouldn’t characterize that as a very contractionary fiscal policy.
Knowledge@Wharton: So, if we have an expansionary monetary policy and an expansionary fiscal policy, we’re going to have inflationary pressures. The Bank of Israel says there are no inflationary pressures. But they’re showing up on the housing front.
Flug: About the fiscal, it would probably be fair to characterize it as closer to neutral than contractionary. In terms of the [consumer price index], which is our target, I don’t see inflationary pressures. The markets don’t expect that as well.
On housing prices, distinct from the housing component of the CPI, we have seen some increase in the past few months. This is something that is a concern to us. We’ve taken some steps. We — specifically the banking supervisor — have instructed banks to limit the [loan-to-value ratio] of mortgages to 70% for the general public, 75% for the first-time homebuyer and 50% for investors. It’s too early to say what exactly the effect of these steps will be. But I expect them to have some effect. I’m not sure that that’s the end of the story. Other measures could be taken if needed.
One issue that should be addressed is the release of land by the land authority so that the supply of houses can be increased. There were some positive developments in this respect earlier on. But the release of land has actually fallen, especially in the central area. Efforts will have to be made to increase the supply of land, to solve the housing market problems in a more fundamental way.
Knowledge@Wharton: Is it fair to say the Bank of Israel views the problem as one in the real market, a problem of supply and demand? And the measures that you’ve taken can maybe work, in the short term, to put a cap on the demand, but they can’t change the fundamentals?
Flug: It’s fair to say that there is an issue of fundamentals here. But it’s also fair to say that when the yields in alternative investments are not very attractive, some investors also find themselves in the housing market. So there is a component of that as well.
Knowledge@Wharton: Do you think you’ll be able to block that flow of funds into the market?
Flug: The long-term solution is the release of land. In the short run, you can affect behavior; the steps we took earlier were actually quite effective. You saw a very sharp deceleration of the rise in housing prices.
Knowledge@Wharton: But in any event, from a narrow monetary policy point of view, the housing market doesn’t impact inflation as you measure it. So it’s not your problem.
Flug: I wouldn’t want to use that phrasing.
Knowledge@Wharton: It’s outside your purview.
Flug: Well, it is very important in terms of financial stability, which is also something that the Bank of Israel is looking at. It’s not within the narrow definition of price stability on the basis of the CPI, which doesn’t have the prices of homes as a component.
Knowledge@Wharton: Is there at this stage a threat to the banks? There’s a big fuss being made about the size of mortgages being taken, several billion shekels monthly.
Flug: I would say that the mortgage market in Israel is quite conservative. And I think that the banks are checking the ability to repay.
Knowledge@Wharton: Going on to another issue, from the long-term point of view, how would you promote the capital market?
Flug: One important development that took place in 2004 or so was to reduce the dominance of banks in the market and the development of the corporate bond market. I think it may have developed a little bit too fast. Some of the problems that emerged during the global crisis in that market were partly the result of very rapid development. In 2008, about half the credit to the business sector came from the issuance of corporate bonds.
I think some of the issues that came up during the crisis were addressed by the Hodak Committee which imposed some restrictions and regulated this market to some extent. In the transition period with the new rules and regulations, some companies may find it difficult to refinance or reissue or roll over these debts. But it’s not a macro problem.
Knowledge@Wharton: Can we come back to the monetary policy? The big change in the past two or three years is, of course, the monetary committee. What is your feeling? Is it working? Is the formulation of policy richer as a result of having this wider discussion, having outside inputs?
Flug: Yes. What you’re describing is exactly right. I think having a discussion that involves outside experts who didn’t grow up in the Bank of Israel certainly enriches the process. More questions are asked. Some of the discussions are longer, but issues that we took for granted are sometimes debated. It does enrich the discussion. You have to also look at these changes over the long run.
Knowledge@Wharton: Do you feel that there is a give and take? Are you prepared to hear ideas or criticism from outside people?
Flug: It’s hard to say whether it changes the actual policy, but it does enrich the discussion. I’m not sure if your question implies that it’s the internal members versus the external members. That’s not how the discussion takes place. Different views are not divided by affiliation lines.
Knowledge@Wharton: So what you’re saying is that more subjects are discussed, probably at greater length and with more ways of looking at them?
Flug: Yes. It does make the discussions more interesting. [In Israel, we are always critical about our policies.] We always thought that our debt to GDP ratio was very high. When it went down from 100% of GDP to 77% of GDP in 2008, we thought we had come a long way. But we were still [worse than others] in terms of our debt to GDP ratio. I still think it’s too high. But I can’t make that argument now because we are somewhere in the middle, probably a bit less than the average [Organisation for Economic Co-operation and Development] country. But when you look at how much we paid in interest — the debt service payments to GDP — it’s higher than the average OECD country because we have a risk premium. Things have changed. But we should move in the right direction even if things look, in comparative terms, better than they used to.
Knowledge@Wharton: You mentioned the weight of Israeli exports going to Europe and the U.S. But Europe is weak and unlikely to experience much growth. Growth in Israeli exports will have to come from expanding where there is growth, which is East Asia, perhaps South America. Do you think that the government is doing enough to help Israeli companies penetrate these new and difficult markets?
Flug: The government is doing something. If you look at the data of the past 12 years, you see a steady increase in the share of the Asian markets. It is happening with or without government support. Increased guarantees, like those provided by export insurance corporation ASHRA, could be enhanced and that could be very helpful. The process is underway and some shifting of exports toward nontraditional markets is happening.
Knowledge@Wharton: Yes, but the counterargument is that it’s only happening in a small group of large companies such as Teva, Israel Chemicals and Israel Aircraft Industries. Research by the Manufacturers Association shows that export growth of small or medium-sized companies has been nonexistent over recent years. Small companies are very oriented toward Europe. They haven’t got the resources to expand into the Far East. That’s a role for the government to play.
Flug: Yes, you’re right that the costs of penetrating these new markets are too high for small or medium-sized companies. There is a role for the government. Providing guarantees is one way. Technical assistance could be quite helpful.
Knowledge@Wharton: Do you feel that the government sees that problem and is addressing it?
Flug: I don’t know to what extent there is a focused effort to try to help these smaller companies.
Knowledge@Wharton: Ultimately that’s going to be critical. You can’t rely on the few big companies to pull the whole export sector along.
Flug: Well, they’re responsible for a very large share of exports globally, not only to nontraditional markets.
Knowledge@Wharton: Is that something you can be comfortable about?
Flug: If the large companies are in a broad enough set of sectors that are not correlated, it’s less of a concern. If they’re all in a very narrow area, which I don’t think is the case; it would be more of a concern. So it’s a question of how diverse they are.
Knowledge@Wharton: I want to jump to a different issue. As you know, a debate has been going on for years in the Israeli high-tech community: is it good or bad — or maybe it doesn’t matter — that Israel is just a production line of start-up companies. You sell a company and you start another. Is that desirable? Should Israel be trying to develop a group of large companies, maybe not Nokia, but perhaps Teva? Do you have a position on this?
Flug: If you judge by what has happened so far, it seems our comparative advantage lies in the early stages of developing ideas, of innovation. There is only one Teva and so many successful start-ups. I don’t know if this can be changed. I am not sure whether we can be efficient in the mass production stage. We used to say it would be nice to have a Nokia. Now, things are changing. When you are very dependent on one company, it can also be a problem. So I think diversity is the key. Lot of start-ups in different areas is the best utilization of our comparative advantage.
Knowledge@Wharton: Are there any questions that you wish we had asked that we haven’t?
Flug: Well, there are some interesting challenges for the Israeli economy and Israeli society over the longer term that we could discuss. These are issues that relate to demographic changes, the labor market and the interaction between these two.
Knowledge@Wharton: What concerns you the most?
Flug: What concerns me is the aging of the population combined with the fact that there are some groups in Israel that have very low rates of engagement in the labor market, specifically Arab women and ultra-Orthodox men. This makes these parts of society — and they are significant parts of society — much poorer and much less engaged in the economy. When you look forward, you see that these groups are growing in importance. I think it’s very important that we tackle these challenges. If we don’t, a larger and larger portion of the population will not be engaging in economic activity. That has very worrisome implications both in terms of economics and also in terms of social tensions in Israel.
I think there is recognition in Israel that these issues have to be tackled. There are some attempts, but they’re not at the scale that will produce the change that is necessary. I’m talking about changes in the education system, which are crucial. There is also a lot to do in the labor market in incentivizing these groups to engage.
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