Remarks by Bank of Israel Governor Dr.
Karnit Flug at the Conference of the Aaron Institute for Economic Policy –
Macroeconomic Policy Challenges in the Short-Term and the Long-Term
The Bank of Israel Governor delivered a lecture at the conference of
the Aaron Institute for Economic Policy at the Herzliya Interdisciplinary
The various sessions of the conference deal with the global economy’s
effect on the Israeli economy, the question of the strategy of economic policy,
and the reforms necessary to increase labor productivity. These issues are not isolated from each
other, and I would like to address the links between them.
In the years since the economic crisis, the global economic environment
has become more challenging for economic policy makers in Israel, both due to
the fact that world trade increased at a much slower rate than in the past, and
due to the ultra-accommodative monetary policy adopted by some of the central
banks in our major trading partners.
These conditions obviously have implications for the required
macroeconomic policy in the short term—over the course of the business
cycle. The not-so-good news is that even
in the long term, according to many assessments, global growth, and even more
importantly world trade—which is the global economic variable with the largest
effect on Israeli exports—are expected to remain more moderate than in the
past. Various experts are divided over
the reasons for the pessimistic outlook, as well as the strength of the
moderation, but the widespread assessment all relate to a significant slowdown
compared with the years prior to the crisis.
These forecasts of the future global environment make it more necessary
to act to increase productivity in the Israeli economy, as part of the economic
strategy, of which dealing with the quality of human capital is a main
Since the crisis, world trade has increased at an average rate of about
3 percent per year, less than half of its pre-crisis growth rate (7.5
percent). According to an analysis by
the International Monetary Fund, the fact that investments as a share of GDP
declined is responsible for 75 percent of the slowdown in world trade. At the same time, we also see a slowdown in
the trend of policy measures intended to lead to a liberalization of trade,
alongside an acceleration in the imposition of restrictive measures on
international trade. This basically
amounts to a retreat of sorts from the trend of globalization that took place
in past decades, even before the effect of the most recent political changes is
felt. All of this contributed to a
further slowdown in the growth of world trade, the significance of which from Israel’s
point of view is that demand for Israeli exports in recent years has increased
more slowly than in the past.
Alongside this, several of the central banks of Israel’s major trading
partners, adopted unusual monetary accommodation, including low and even
negative interest rates and quantitative easing, reflected in the fact that
some of the government’s debt is traded at negative yields. These create upward
pressure on the shekel beyond the appreciation derived from the fundamental
economic forces—the forces that are reflected in the strong performance of the
Israeli economy, including the current account surplus. Against this background, the shekel has
appreciated significantly in terms of the nominal effective exchange
rate—almost 20 percent since 2012, and 11.5 percent in the past two years. The
appreciation led to the fact that Israeli exports increased at an even lower
rate than the growth of world trade.
This has all made it necessary for the Bank of Israel to engage in
monetary accommodation – lowering the
interest rate and keeping it at the low level of 0.1 percent for more than 2
years, alongside foreign exchange purchases to prevent some of the
over-appreciation. This policy,
alongside budgetary policy that is quite accommodative, has helped support a
return of inflation to within the inflation target range, as well as economic growth,
which, in Israel as well, has been led by private consumption in recent years
given the weakness of exports.
Looking at the long term, the global environment is expected to remain
moderate. In particular, world trade is
expected to increase moderately. As
such, increasing labor productivity, which is a main element in the ability to
remain internationally competitive and is a necessary condition of economic
growth at a rate that will contribute to reducing the gap in per capita GDP
between Israel and the most advanced economies, has become more important.
The growth rate of GDP per worker in Israel is low given the level of
per capita GDP, which means that we are not closing the gap between Israel and
the other advanced economies. As we have
shown at various opportunities, Israel’s export industries actually have a
higher level of productivity than those industries in other countries. In contrast, in the domestic-oriented
industries, where most of the business sector workers are employed, GDP per
work hour is much lower in Israel. Against this background, the decline in
exports as a share of GDP is not good news.
The export industries, which reflect the relative advantages of the
economy and the advantages of scale in production, are leading in innovation
and productivity. A lower share of those
in GDP is correlated with a slowdown in the growth of GDP per work hour.
I have discussed the varied reasons for the productivity gaps between Israel
and the other advanced economies at other opportunities. I have described the surplus bureaucracy that
is reflected, for instance, in our low ranking on the World Bank’s Doing-Business
index, and in a variety of trade barriers (mainly non-tariff) that are
relatively high in Israel according to the OECD. Insufficient government
investment in physical infrastructure also affects the relatively low
investment in physical capital by the business sector. The skills of Israeli workers are also low in
all areas (with particularly large gaps), and achievements by Israeli students
in standardized tests do not provide good news in relation to the preparation
Israeli students receive for the labor market of the 21st century.
So what strategy for economic policy is needed in order to change the
trend and in order to support sustainable and inclusive growth that relies on a
continuing increase in productivity? The
strategy must include three main elements: improved quality of human capital,
improved business/regulatory environment, and higher level of physical
infrastructure that will also contribute to an increase in investment in
physical capital. As shown by a long
series of empirical studies around the world (a few primary examples are Barro
and Lee, 2013; Hall and Jones, 1999; Hanushek and Woessmann, 2012), the quality
of human capital and workers’ skills is a main element of growth. The OECD conducted an analysis of various
countries, which shows that in contrast to past years, improvement in human
capital by increasing the number of years of schooling is not expected to
contribute to productivity growth in Israel in the coming years. We must therefore focus policy on improving
the quality of education.
In terms of the contribution of an improvement in the regulatory
environment, the OECD found that if regulation of the authorities in Israel
will be "as friendly" as in the average OECD country, this will lead
to an increase of about 3.75 percent in GDP after 5 years, and about 5.75
percent after 10 years. In other words, an addition of between 0.5 and 0.75
percent to annual growth in Israel over the period.
In terms of physical infrastructure, the IMF’s World Economic Outlook in
April 2014 found that, on average, an increase of one percent of GDP in
infrastructure investment leads to an average increase of 1.5 percent in GDP
over 4 years. Assuming that marginal
output declines, we can assume that in a country like Israel, in which the infrastructure
is at a lower than average level, the contribution will be even higher.
Later today, various elements of the strategic plan will be discussed in
greater detail. It is important to say
that precisely now, when the macroeconomic state of the economy is good, we
must focus our efforts on dealing with the long-term challenges.