The Region

Interview with Jacob Frenkel

Melvin L. Burstein | Senior Vice President and General Counsel

Published December 1, 1993  | December 1993 issue

He could have stayed at the University of Chicago and continued his productive career within the halls of American academe, as colleagues encouraged him to do. But in 1987 Jacob Frenkel, 44 years old, took the job as chief economist at the International Monetary Fund (I.M.F.) in Washington where he was credited with reviving the I.M.F.'s research department.

Four years later, in 1991, Frenkel took another career leap when he accepted the position of governor of Israel's central bank, the Bank of Israel. Born in Tel Aviv, Frenkel has returned to his homeland to address the pressing issues of inflation, privatization, immigration and the nuances of developing economic ties with neighboring countries that are historical enemies.

Melvin L. Burstein, Minneapolis Fed executive vice president and general counsel, conducted this interview this fall at a symposium sponsored by the Kansas City Fed. Earlier this year Burstein and Arthur J. Rolnick, Minneapolis Fed senior vice president and director of research, were invited by the Bank of Israel to provide counsel on matters relating to banking reform.

Region: What is the major issue facing Israel's economy today?

Frenkel: The key issue facing Israel today is absorption of the massive flow of immigrants from the former Soviet Union. During the past three years or so, immigration to Israel has increased the labor force by about 15 percent. It's a huge increase. It's a very unique group of immigrants. Very well and highly educated. Over 5O percent of them have had more than 13 years of schooling. Many of them, a majority, have had this education in technical vocations. And, in short, this is probably the most precious human capital that a country could have.

There is a consensus about the strategy of absorbing them in the economy. Everyone understands that they must be absorbed by the private sector, in the private sector and not through bloating the public sector. What it means is that the government has to speed up its structured adjustment—the structured policies, all the policies that remove distortions from the economic system, that increase the flexibility of the labor market, so as to be able to absorb these immigrants in a relatively rapid way.

In order to perform this task, Israel has cast its economic policy in a multi-year context. Our budget policy is set in a three-year perspective—a multiyear budget reduction scheme. We are somewhat ahead of schedule so that our budget deficit for 1994 will be about 3 percent of GDP (gross domestic product). In 1993 it is about 3.2 percent of GDP. We are planning to cut down the budget deficit during each of the subsequent two or three years. This process has credibility because our budget deficit has been reduced year-in and year-out during the past two to three years.

Likewise, our trade liberalization program is cast in a multiyear setting. We do have a free trade agreement with the United States, and we are now negotiating an update of our agreement with the European Community. As far as countries that are outside of Europe and the United States, we have a multiyear tariff reduction scheme according to which each year we reduce our projection by a prespecified percentage, and we are on schedule in this regard.

We have set a multiyear target for inflation reduction. Our exchange rate policy is also set in a long-term perspective. We also have started this year a tax reform system that is spread over several years, all in a preannounced fashion. This multiyear setting of economic policy helps to, on the one hand, lend credibility to the program, but on the other hand, spread over time as the current burden is just too high to impose all of it at one point. These efforts have produced some good results. Our growth in each of the preceding two years has been about 6 percent or 6.5 percent in real terms.

I should also say that these growths emanated from the business sectors. As a matter of fact, GDP growth—the business sector GDP growth—was closer to 8 percent per annum. All of this was done while cutting inflation by half, while exports have increased in 1992 by about 14 percent, profitability of exports has increased and with it also massive investments have taken place. In short, the main objective is the appropriate absorption of the immigrants, and so far so good.

Region: Have attempts to privatize Israel's nationalized banking system proved successful?

Frenkel: For about 10 years, very little was done in privatizing the Israeli banking system. More recently, the government undertook upon itself to start moving the process in a more serious manner. The important point was, and this was a subject of debate which was resolved in a satisfactory way in my judgment, the economists believed that it was essential that structural changes in the banking system—those measures that increase competition, those measures that reorganize our banking system and minimize potential for conflicts of interest—it was believed that all of these measures must be undertaken prior to privatization so that once the bank shares are sold in the marketplace that the process of structural changes will already have been underway.

Fortunately, the government has adopted a very impressive set of changes in legislation concerning the banking system. These changes should contribute to increased competition in the marketplace, and several banks have already been sold. I believe this is a very high priority item. During the past few months we have seen very significant progress. Two of our major banks have floated 20 percent of their stocks in the stock market that has absorbed them very, very well. And, I expect to see further movement on this front.

Region: A related problem to nationalization of banks is that when Israel bailed out the bank stock market in 1983, it probably left an implicit notion that all depositors would be protected in the event of a bank failure, and some of the kibbutzim have recently been bailed out. Would you give me your observations on the moral hazard that is created by those events.

Frenkel: Well, I think that one of the great tragedies in various places, the United States, Israel and other places, has been the situation that the governments provided insurance services without charging the appropriate insurance premium. The assumption, typically correct, that the government will stand behind and bail banks out in times of crisis, has stimulated excessive risk-taking by the private sector. When such bailouts occur, they breed the expectations that the next time around will be the same.

Therefore, I believe that the governments should announce in a very clear and credible way that it does not provide insurance policies without charging the appropriate insurance premium and that some entities will be allowed to fail if, indeed, economic conditions warrant it. But, speeches are not enough. Some concrete examples should be happening. Once one, two or three such examples occur, I believe that those statements will gain credibility and thereby the likelihood that such crises will reemerge will be diminished.

Region: One of the comments you made at the conference was about the importance of proper supervision and regulation in terms of risk management. Do you see that as a substitute for market discipline, even in banking?

Frenkel: There is no substitute for market discipline, but whenever you are liberalizing the economic system and deregulating it is very important that you protect the system by appropriate supervision so that the rules of the game can indeed be carried out and the system operates smoothly. We have seen a lot of examples in which countries have liberalized their economic system, their financial system, they opened up their current capital account of the balance of payments just to see foreign exchange crisis emerging or to see failures taking place.

The reason for the negative effects is not the fault of the liberalization process itself, but rather the failure to realize that if you liberalize you should reinforce this process by appropriate supervision. I think that prior to undertaking any significant liberalization, one should develop the supervisory and regulatory systems sufficiently concretely so that they can be fully operational on day one.

Region: Inflation in Israel has declined from over 500 percent in the mid-1980s to its present level of about 10 percent. How was this stabilization accomplished?

Frenkel: After the mid-1980s, Israel suffered a very high inflation rate, which distorted the entire price mechanism and upset the productive structure of the economy. In 1985, the decision was made to undertake a very massive and drastic stabilization effort which had two basic elements: first, budgetary responsibility and, second, the introduction of the nominal anchor.

On the budget, the government undertook a very, very drastic expenditure cut which brought about, or reduced the budget deficit practically to zero. At the same time, it adopted an exchange policy which served as the nominal anchor. The importance of using a nominal anchor in a very dramatic and drastic way was to break expectations that were old and built upon the habit of inflation. The announcement of a commitment toward a nominal exchange rate target enabled existing contracts to be reopened and renegotiated, and a system that was otherwise highly indexed started to adjust itself toward a lower inflation.

After a relatively short time, inflation went down to the rate of about l8 percent per annum. Like in many other successful stabilization examples like Mexico and Argentina, we got stuck at that inflation of about 18 percent. Over time, the exchange rate policy of Israel has adopted itself to various changes. Israel moved towards an exchanging system of a band in which there is a center parity and a band around it. But, obviously, this meant that about twice a year an adjustment of the exchange rate had to take place because, after all, Israeli inflation was still much, much higher than the one prevailing in its trading partners.

At the end of 1991, Israel adopted a new exchange policy which serves us successfully up to the present. And what it amounts to is finding a mechanism that can be referred to as a crawling band.

The idea of our exchange rate system is that we have a system that has both the anchor properties as well as the flexibility that is needed to allow for exchange rate changes as long as our inflation rate is higher than in our trading partners.

Region: Donning your University of Chicago hat for a moment, the Federal Reserve System has aimed its policy at the stabilization of prices. What are your thoughts on the Fed's efforts?

Frenkel: Well, I cannot remove all my hats at the same time, so therefore, I will not comment specifically on the performance of the Fed, except to say that I have no doubt that the primary responsibility of the monetary authority should be the attainment of price stability. The greatest contribution that monetary policy can make to growth, the standard of living, employment and the like, is by ensuring that there is an environment in which stability prevails and inflation is as low as possible.

Region: As chief economist of the International Monetary Fund before your move to the Bank of Israel, much of your work revolved around stabilization programs as well as economic coordination efforts among the G7 countries. What are the main lessons from this experience?

Frenkel: As far as stabilization efforts are concerned, the main lesson that emerges is the importance of restoring budgetary balance. One cannot have any serious stabilization effort without fiscal responsibility. All attempts at stabilization that have failed in various countries, especially in Latin America, have failed because of the inability of governments to restore fiscal balance. As far as the economic coordination among the G7 countries, there again I must say that if there is a lesson, it is how difficult it is to coordinate economic policies among industrial countries and how difficult it is to bring about fiscal responsibility and restoration of fiscal balance when there is less than complete commitment on the part of each individual country.

I do not believe that international coordination efforts in and of themselves can substitute for the truly difficult decisions that governments must undertake at home. Of course, good economic policy starts at home. If the commitment is in place, then economic coordination at the international level can improve the picture—it can serve as the frosting on the cake. But the cake itself must be baked at home.

Region: What are your views on international efforts to reduce or eliminate trade barriers such as NAFTA and GATT?

Frenkel: As far as I am concerned, I believe that any activity that brings about freer trade in the world economy is, in and of itself, a welcome activity—a blessed one. There are so many interest groups that are pressing governments to slow down trade liberalization. Each one with allegedly good reason—that it is essential that the process of trade liberalization is done in a very determined, vigilant way at the world level. GATT must be strengthened. We have seen extraordinary difficulties in the completion of the Uruguay Round, the most recent round for tariff reductions and agreements on services and the like. And, I very much hope that the most recent G7 meeting that was held in Tokyo and came with a concrete statement to bring about a successful resolution of the Uruguay Round will indeed materialize. Although, I must say that experience over the past few years has taught me to be a bit skeptical about such announcements, and I will believe it when I see it.

Region: What are the key features of your exchange rate system?

Frenkel: Our crawling band system is a system in which we use the exchange rates path as the anchor patio for our target inflation path. For example, if in 1991 we had an inflation rate of about 18 percent, we decided to have a very significant reduction in our inflation rate for 1992. So, we chose the nominal inflation rate which we believe could be obtained in 1992. We subtracted from this target inflation, the inflation prevailing in our trading partners, and this determined the rate of change of our central parity exchange rate around which the reserve band of plus or minus 5 percent.

Indeed, it proved to be very successful. Expectations adjusted themselves toward this preannounced crawling band. And, inflation in 1992 was cut almost by half. It reached the single digit of about 9.5 percent. In 1993, we have solidified this achievement, and inflation in 1993 will be of similar magnitude—around 10 percent. We are now adopting a multi-year inflation reduction program.

So, therefore, in 1994 we will have an 8 percent inflation target and it will successfully go forward. And, hopefully, within three years we should obtain the inflation rate prevailing in our trading partners. This, by the way, all was achieved while maintaining a very rapid growth rate of about 6.5 percent in real terms.

Region: I would like your views on the various exchange rate regimes. Our bank has expressed a considerable interest in fixed exchange rates.

Frenkel: Well, I think that the debate about the choice of the exchange rate regime has been with us for many, many years and it will continue to be with us for many, many years. The real issue is not so much the choice of the exchange rate regime, but the choice of the policies that are capable of sustaining whatever regime one chooses to adopt. My gut feeling is that we will continue to have a relative degree of flexibility of exchange rates between the three major poles, namely the U.S. dollar, the European currencies, call it the Deutsche mark, and the Japanese yen. The other smaller countries will probably find it useful to hook themselves to one of these blocks.

So, within Europe we saw the exchange rate mechanism design, but we also saw how it has faced significant difficulties during the past few months. These difficulties have taught us an important lesson, which is exchange rate intervention in and of itself cannot be a substitute for fundamental conversions of economic performance and economic policies. It makes no sense to try to peg the wrong exchange rates because in the present as we have huge capital markets and very well integrated capital markets, there is no way the authorities through foreign exchange intervention can overcome the flows that are determined in the marketplace. Therefore, what we are probably going to see is the European exchange rate mechanism learning some lessons concerning the need to have conversions on the inflation front before they solidify again their exchange rate into a more rigid formula.

I think that the real issue is what exchange rate mechanism is capable of generating the inflation path that each country wishes to have. There is no way that a country that does not have its own house in order can in a sustainable way import this stability through the exchange rate. The exchange rate is a manifestation of policies rather than the policies themselves.

Region: Milton Friedman reportedly discouraged you from leaving the University of Chicago to join the IMF, arguing that you could make more of an impact through research. Any regrets for having left?

Frenkel: Well, I obviously miss the academic career that I had at the University of Chicago. It was one of the most stimulating places that I could imagine. And, I owe practically all of my human capital, as far as understanding economic theory and developing my economic philosophy, to my colleagues and the atmosphere at the University of Chicago.

As for myself, I found the move from the University of Chicago to the International Monetary Fund a natural progression in the development of my own human capital. Having been involved many years in teaching and research, primarily in the field of international economics and international economic policy, it was very challenging and indeed natural to try to apply these concepts within the context of the International Monetary Fund, where I was asked to not only head its research department but also to be very directly involved in the policy coordination efforts of the G7 countries. I have found this experience rewarding. I have learned a lot about how economic theories feed into economic policy advice. I definitely do not regret having made this particular move. Needless to say, one always misses his good colleagues and the atmosphere at the University of Chicago, but I guess that is the way life goes on.

Region: Regarding your other major career change from the IMF to the Bank of Israel, how has the move to Israel changed your perspective on international economic issues?

Frenkel: Well, needless to say, in Israel I am primarily involved with Israeli economic policy. I am now experiencing a very big shift from being an adviser to policymaking to becoming a policymaker myself. I find it very challenging. The task is huge. And, of course, one always needs to find the best mechanism by which he can be effective.

The Central Bank of Israel is an independent central bank. The governor over the Bank of Israel serves also as the chief economic advisor of the government. And, here one needs always to find a delicate balance. On the one hand, one wishes to maintain distance from the government to ensure a maximum degree of independence.

On the other hand, one wishes to be as close as possible to the policy debate; otherwise, one would not be effective. Like always in such situations, one needs to find a middle ground. I believe that I have probably found the right balance. In Israel the governor of the central bank is involved in a broad range of economic policy much beyond the more narrow elements of monetary and exchange rate policies. He and his staff are involved in the debate on fiscal policies, on trade liberalization, on privatization, and for example in my own case, I am also chairing the Israeli delegation to the multilateral peace talks dealing with economic development and regional cooperation. I must confess that I find all of these tasks extremely rewarding and enriching, challenging. And, the most important thing, I believe that the Israeli economy is on the right track and I am very pleased and, in a way, happy to be able to participate in this endeavor.

Region: You mentioned your involvement in the peace talks. Would you care to comment on progress that is being made from your perspective? [This interview was held prior to the signing of the peace accord by Israel and the Palestine Liberation Organization in September.]

Frenkel: Well, as you look at the peace talks, and I am involved only in the multilateral committees dealing with economic development, but in general as you look at the peace process, I think it is important to gain a broad perspective. Jokingly, one can say that one should not read the newspapers every day but every three months, then one smooths out and averages out the ups and downs and one gains a more solid perspective of the actual trend. I believe the geopolitical situation of Israel is much improved. The discussions in the committee that I am involved in are very professional.

It is indeed fascinating to deal with 45 delegations from all over the world—industrial countries, developing countries, 10 Arab countries of which only one has diplomatic relations with Israel (Egypt)—and all of them are engaged in one unique effort, which is how to build the new Middle East. The working assumption of the multilateral peace process is that the bilateral talks are dealing with the problems of the past and the multilateral talks are trying to build the new Middle East.

The projects that have been presented to this committee are fascinating indeed. They range from massive tourist programs to regional highway systems, effective efficient use of water resources, irrigation programs, solar energy, transportation systems, and the like. I believe that as the debates and discussions go on, more and more participants realize that the stakes of losing momentum are extremely high, and that the benefits to the region stand to be so great with the successful completion of the talks.

Region: Let me return to the issues of immigration. Do you see parallels between the immigration issues facing Israel and those facing other countries such as Germany, France, and the United States?

Frenkel: Well, I would say the magnitudes in proportional terms of the immigration task or the absorption of the immigrants facing Israel probably exceeds any of the examples that you have mentioned. I would also add that when it comes to the Israeli case, especially as most of the immigrants come from the former Soviet Union, we are talking about immigrants who come without knowledge of the language, who come from economic systems that are very very different, who do not know what property rights mean and how an economic system of a thriving private market type operates—so, I believe that both quantitatively speaking as well as other objective issues make the absorption task facing Israel much more difficult.

However, there are two important elements that make things simpler in the Israeli case. First, there is in Israel a national consensus on the desire to absorb these immigrants into the Israeli society. As you know, in the various examples that you cited, there is no consensus on the desirability of allowing immigrants to come and be absorbed into the respective countries. Second, in Israel, there is also a consensus about a strategy of absorption. By the private market, in the private market and not through the public sector. All of this makes me optimistic even though, needless to say, in the short term there will be some difficulties, but Israel's economic history has already demonstrated that such difficulties can be overcome and growth can accelerate in a sustainable way.

Region: In view of the effect of immigration on unemployment, there have been calls for the government to use fiscal policy to undertake public works to absorb some of these people. What are your views?

Frenkel: My views are very negative on such proposals. It would be a great mistake for the government to step in to create superficial jobs and not allow the marketplace to operate in absorbing those immigrants in the most productive way. The best contribution that the government can make is to undertake those economic policy measures that increase the flexibility of the labor market so as to enable the private sector to operate. Israeli economic policy is based on the strategy of reducing the size of government, and any move in the wrong direction will be counterproductive.

Region: How about monetary policy—should Israel consider compromising somewhat its inflation fight to absorb some of the unemployment?

Frenkel: Definitely not. Israel understands very well that the Phillip's curve is dead, it was dead, too many mistakes have been undertaken all over the world in trying to play around alleged illusory trade-offs. There is no trade-off. As a matter of fact, if Israel was to compromise its inflation fighting, it will end up with higher inflation and with higher unemployment. The best way to reduce our unemployment in the most sustainable manner is to undertake more drastic measures to reduce inflation to bring about stability, because only under an atmosphere of stability will business sector investments accelerate and thereby unemployed people are absorbed into the labor force.

I think that if there are places where the notions of illusory trade- offs are very well understood, it is in countries that suffered from high inflation, from hyper inflations. These countries understand that governments cannot play on some tradeoffs that are really illusory, and, that basically steady as you go is the name of the game.

Region: I know you are involved in Israel's budget debate. Given the unemployment problems and other constraints on the economy, isn't this a time to perhaps ease up somewhat on the budget deficit constraints?

Frenkel: I must be very firm in dealing with this question. Let me state very clearly. A budget deficit does not create jobs, a budget deficit does not contribute to economic well-being—it increases debt, it distorts the economic system, it increases uncertainty about the way in which these debts will be repaid. By and large, budget deficits are a curse on societies. I truly believe that the best way the government can contribute to economic policymaking is by reducing the size of government on the one hand and, on the other hand, by reforming the tax system so as to remove various distortions that upset the economy by cutting down public spending on consumption.

Government spending should be directed toward infrastructure investment, toward education, research and development—these activities that are contributing to society and that the private sector left alone would produce too little of them because the private sector cannot capture all of the benefits. Otherwise, budget deficits really are negative and you will not find me an ally to justify a relaxation on this front. Israel has suffered dramatically during a full decade of budget irresponsibility. It took many many efforts and a lot of crises to bring some common sense in this regard. I don't think that our society wishes it and I think that any government that will attempt to do it will be penalized by the private sector.

Region: One final question. What do you foresee for yourself after your tenure at the central bank?

Frenkel: Well, a wise man once said that anyone who while on any given job plans the details of his next job is bound to fail in performing his present job. And, since I wish to succeed in my present job, I should only focus on this one. I do feel, however, that I assume I will be involved in one way or another with a university. I like teaching. I like research. I find the interaction between policymaking and economic research very stimulating, very productive, and I will probably continue in this direction.

Region: Thank you, Gov. Frenkel.

More about Jacob Frenkel

  • Governor, Bank of Israel, Tel Aviv

  • Former chief economist, International Monetary Fund, Washington, D.C.

  • Former professor of economics, University of Chicago

  • Wrote, collaborated on or edited more than 200 scholarly papers and 15 books during academic career, including:

  • International Economic Policy: Theory and Evidence, editor (with R. Dornbusch), Johns Hopkins University Press, 1978

  • The Economics of Exchange Rates: Selected Studies, editor (with H.G. Johnson) Addison-Wesley, 1978

  • "Flexible exchange rates, prices and the role of 'News': Lessons from the 1970s," Journal of Political Economy, 89(4), Aug. 1981