For the latest thinking about the international financial system, monetary policy, economic development, poverty reduction, and other critical issues, subscribe to Finance & Development (F&D). This lively quarterly magazine brings you in-depth analyses of these and other subjects by the IMF’s own staff as well as by prominent international experts. Articles are written for lay readers who want to enrich their understanding of the workings of the global economy and the policies and activities of the IMF.


For the latest thinking about the international financial system, monetary policy, economic development, poverty reduction, and other critical issues, subscribe to Finance & Development (F&D). This lively quarterly magazine brings you in-depth analyses of these and other subjects by the IMF’s own staff as well as by prominent international experts. Articles are written for lay readers who want to enrich their understanding of the workings of the global economy and the policies and activities of the IMF.

Jacob A. Frenkel, Governor of the Bank of Israel, shares with Finance & Development his reflections on the new opening for peace in the Middle East, disruptions in the exchange markets, and other events in the world economy.

Middle East

What will be the overall economic ramifications of the recent peace agreement with the Palestinians?

I believe that the peace process and the agreement with the Palestinians will have significant positive implications for the economies of both Israel and the territories. Of course, I am hopeful that this process will extend beyond the agreement, so that the entire region will benefit once the peace process becomes more comprehensive.

As far as the territories are concerned, I expect to see a multiyear effort of a fundamental nature to rehabilitate the economic infrastructure in the territories—roads, transportation systems, electricity, water, solid waste disposal, sewerage, health, social services, and the like. This will be essential to attract private investment. As for Israel, the main benefit will be the creation of an atmosphere that projects more stability, in the geopolitical sense. I expect investment to increase significantly within Israel, emanating both from domestic and foreign investors.

Do you think the Palestinians should introduce their own currency?

The negotiations on these technical matters have not yet started. But if I were asked for my professional advice—speaking now as an economist—I would advise them to continue using during the “transitional phase” either the [Jordanian] dinar or the [Israeli] shekel, or both, as legal tenders. I say this because time and again we have seen examples of entities that were eager to introduce their own currency as a political symbol, but with disastrous results, because they lose monetary stability, which is essential for the promotion of growth.

What will be the scope for regional arrangements in trade and finance?

Since the two economies have been intertwined for many years—for example, a very large fraction of the Palestinian labor force in the territories [about one third] finds employment within Israel—I would expect a significant number of Palestinian workers to continue to find employment within Israel and Israel to continue to provide them with employment during the 5-year transitional phase.

By the same token, most goods and services should be exchangeable on the basis of free trade principles subject to compliance with the conventional standards of safety, health, and the like. Of course, there might be some areas that require special arrangements and negotiations, such as agriculture, in order to manage trade during the transitional period, but by and large the philosophy should be one of relying oil free market mechanisms. I assume that the Palestinian authorities will develop their own tax code for income taxes, and if they decide to develop their own banking and other financial institutions, the responsibility for supervision should of course rest with them.

We should also remember that there are broader regional issues to consider and that there is a multilateral track to the peace process. As chairman of the Israeli delegation to the multilateral peace talks dealing with regional economic development, I can tell you that there are quite a lot of promising projects of a regional nature. Some examples include projects in the area of tourism, where the region has a lot to offer—antiquities, religious sites, climate, and the like. And there is no question in my mind that the potential is far from being exhausted.

By the same token, there are some other more ambitious regional projects under discussion—linking electricity grids, the construction of regional highway transportation systems, the digging of canals linking the Red Sea and the Dead Sea as well as the Mediterranean and the Dead Sea, and making good use of our limited water resources. This last item recognizes the advanced technology Israel has developed in drip irrigation, a technology that Israel will be more than delighted to share with its neighbors. It also recognizes the fact that we have both arid and semi-arid zones in a region with limited water supply, meaning a more effective and efficient use of water would provide high social returns to all inhabitants.

Are we talking about joint ventures in infrastructure?

I think these economic activities—which will be a major engine of development in the territories—will be initiated, administered, and managed by the Palestinians themselves. Of course, I can envisage a situation in which cooperation with Israel would take place, whether it is in terms of joint ventures or subcontracting. The key thing to remember is that Israel is genuinely interested in seeing the economic situation in the territories improve significantly, because everyone recognizes that economic stability is necessary to secure the fruits of the political track of the peace process.

What do you see as the virtues of a customs union versus a free trade area?

Serious consideration should be given to the possibility of forming a customs union between Israel and the territories. The economies are closely intertwined at the present time, and I can envisage a situation in which there is practically free trade between the two economies with identical and unified external tariffs to the extent needed.

How about institution building?

One of the most important efforts in the early phases should be institution building—like tax administration and financial intermediation, which help transform savings into investment. If the Palestinian authorities wish to have the capacity to manage their public finances without having to resort to and be dependent upon foreign aid, they will need to have their own functioning tax system. In these areas, technical assistance from the IMF and the World Bank would be essential.

What is the role and potential for capital flows to the region from both public and private sources? Will there be aid creation or aid diversion?

Recently, we have seen a variety of estimates of the financing needs of the region, but I am most familiar with the serious, highly professional study done by the World Bank. The Bank’s estimate is that over the next decade, we will need to see an increase of about $3 billion in public sector investment needs, primarily in areas related to infrastructure.

As these resources are mobilized, it is important that they catalyze, more than crowd out, private sector investments. We must also make sure that the territories have an institutional infrastructure capable of properly receiving, disbursing, monitoring, and allocating these resources. One note of caution, however, on the absorptive capacity of the territories. I have also heard much larger estimates on the financing needs, and we should keep in mind that it is much easier to throw numbers in the air than to substantiate them.

Since the IMF normally provides a complete range of services only for countries with full membership, what can be done in the special case of the territories during the 5-year transitional period?

Israel is keen to see that the autonomy in the territories is associated with the relevant institution building and independent capacity to manage the economy of the territories. We expect that for the transitional phase the links between the IMF and the territories would be coordinated with Israel, and Israel, on its part will, of course, cooperate to facilitate this endeavor.

States of the former USSR

What are the key lessons to be learned in light of the recent turmoil?

First, that economic transformation is an extremely long journey and that one should not expect immediate results. One of the tragedies has been that the courageous populations of these countries have not always been told clearly that the process is going to be lengthy and that there will be hardship during the transitional period. There were unrealistic expectations for an immediate turnaround.

Second, that the process of transformation needs broad-based political support. For this, the process must be transparent. The public must understand the objectives and accept that the alternatives are worse.

Third, no country these days can operate as an isolated island. It is important that as we launch these reform efforts, the products of these countries are given broad access to foreign markets. This is clearly the responsibility of the industrialized countries.

Fourth, it is essential that early on, a functioning tax system is put in place. It will contribute to responsible budgetary policies, rather than ones that resort to inflationary finance, or rely excessively on foreign aid, which will undercut the entire process.

Fifth, currency convertibility has become a symbol. It is critical that economic measures like currency convertibility for capital movements are motivated by economic needs and considerations, not by the urge to undertake political symbolism.

Sixth, one must ensure that an environment of macroeconomic stability is in place within the context of free trade before opening up completely the capital account of the balance of payments, or stability may be undercut.

Seventh, it is very difficult to begin a multiyear effort to restructure in an environment of price instability. It is therefore imperative that early on, macroeconomic stability is restored and inflation brought under control.

Eighth, many of these economies have not had the basic institutions needed to support a market regime: well-defined property rights, bankruptcy laws to enable money-losing enterprises to go out of business, a functioning tax system, and operational goals that encourage hard budget constraints rather than soft budget constraints and inflation.

In short, the process of transformation, which is a long-term process, must be based on broad political support that, in turn, can only be generated if there is a high degree of understanding of the process itself. We must also remember that it is the weak members of the population who are likely to be most heavily burdened. Thus, it is essential that society provide the appropriate safety nets to safeguard the very poor from excessive hardship. But while doing so, it should make sure that these safety nets are budgeted properly.

European Exchange Rate Mechanism

What have we learned about the ERM from the crises of the past year or so?

When there is a high degree of integration of world capital markets, one should be ready to see huge flows of money that move very rapidly from one currency into another. This means that intervening in the foreign exchange market can be like standing in the way of an avalanche: it can be extremely difficult to resist market pressure if the market believes that this is where things should go. As a result, if you really have a high degree of capital mobility, and you also want to maintain an ERM with a narrow band, you must make sure that there is a very high degree of convergence of economic performance, especially in the area of prices.

Does this mean the old ERM structure—with much tighter bands than currently exist—is necessary for European economic integration?

We should recognize that there are two parallel objectives. One is to achieve the benefits of an integrated market—benefits that are maximized in the context of free trade, benefits that in and of themselves do not require a single currency. They require freedom of trade. The other objective is stability—convergence of price developments and the like. Such developments can indeed be aided by (and lead to) exchange rate stability. And if there is no convergence of price developments, budgetary developments, and the like, then it will be very difficult to maintain a single currency or a very tight band around the reference rate.

How will the ERM turmoil of the past year affect developing countries?

Here the link is not immediate except to note that there is a grave danger of protectionism that emanates from the frustration of policymakers at their inability to bring about exchange rate stability. If indeed protectionism is on the rise, it will be a disaster for the developing countries. The greatest contribution that the industrial world can make is to open up their own markets to the products of developing countries. Doing this will not impose any budgetary cost on the industrial countries, and it will facilitate integration of the world economic system.

Bretton Woods

If the IMF were created now, as opposed to 50 years ago, what form would you have it take?

Having moved to the other side of the fence, namely the position of governor of a member country rather than that of a Fund staffer who deals with a member country, I have learned to appreciate more and more the unique role that IMF surveillance [consultation] plays in improving the professional climate within which national economic policy debates take place. In Israel we have found the Article IV [annual consultation] visits of the Fund to be extremely useful.

If I can extrapolate from our own experience, I only hope that we can find a way to strengthen the role of the Fund as the major source of surveillance and policy advice to member countries. In recent years, some commentators have increasingly viewed the Fund’s role as a provider of financial resources. Of course, I believe this is a very important function, but in my judgement, it should not be viewed as the main function. The provision of financial resources is important to the extent that it catalyzes other private resources and strengthens the Fund’s ability to implement its surveillance functions and offer effective policy advice.

Now that you are on the other side of the fence, what do you think about the criticisms sometimes made of the IMF’s adjustment programs?

Nobody on the outside fully realizes the immense task the IMF is undertaking, and the amount of professionalism, dedication, and knowledge of the IMF staff. But the fact is that in many cases programs go off track. And when you look at the reasons why, it is often that the economic policies prescribed were not fully implemented. But in recent years, there have been additional reasons, especially in Eastern Europe. Certainly, the external environment facing the countries undergoing economic reforms has changed dramatically. The collapse of the trading system is a key element that program designers could not have taken fully into account.

Highlights of Governor Frenkel’s career

  • Appointed Governor of the Bank of Israel (1991)

  • Current Co-Chairman of the Israeli delegation to the multilateral peace talks on regional economic development

  • IMF Economic Counsellor and Director of Research (1987–91)

  • Prior to joining the IMF, taught for many years at the University of Chicago, where he was the David Rockefeller Professor of International Economics, and recently rejoined the faculty of Tel-Aviv University

  • Holds a BA in economics and political science from the Hebrew University of Jerusalem, and an MA and PhD in Economics from the University of Chicago

So if we have learned one important thing, it is that one should never have overoptimistic expectations. I would always start by saying that things will probably be worse than they are, rather than being more optimistic, because then the cost of a mistake is less. When you launch an adjustment program, you need to have political support, which is essential for staying power. But to have staying power, you need to avoid frustrations, and to avoid frustrations, you need to make sure that expectations are not excessive.

What about the case of Israel and its budget deficit? The IMF has long advocated reducing budget deficits, and now you are advocating a modest deficit because of all the Soviet immigrants?

For me, it is much more important to have information about the structure of the deficit, the composition of government spending, and the composition of taxation than just information about the difference between government expenditures and government revenues.

This does not mean that I am sanguine or relaxed about the budget deficit. I definitely would like to see a credible path of budgetary control. However, what matters to me is that people do not just talk about the deficit, but that they also talk about the composition of expenditures and revenues. If governments are taught to cut spending, and they cut from transfer payments, that is one thing; if they cut from infrastructure investment, that could be disastrous. As far as Israel is concerned, we have adopted a multiyear trajectory of budget deficit reduction—in this context, the budget deficit for 1993 should not exceed 3.2 percent of GDP.

Overall, how is the Israeli economy doing?

I am very pleased with the overall development of the Israeli economy. In 1991, real GDP grew by 6.2 percent, and in 1992, by 6.6 percent. Business sector growth was even higher, reaching 7.6 percent in 1991 and 7.9 percent in 1992. This year, 1993, is a year of transition, reflecting a drastic shift of government spending from construction toward education and infrastructure investment. While growth of our housing sector will decline, our business sector, excluding housing, will continue expanding at about 8 percent. Population will continue to grow in 1993 by about 3 percent, while the growth of the number of jobs will be higher. As a result, the unemployment rate will decline from 11.2 percent in 1992 to 10 percent this year. This positive development will take place against the background of a reduced inflation rate, a stable foreign exchange market, a continuation of the double-digit growth of exports, a further reduction in the budget deficit, a continuation of the multiyear trade liberalization program, and an acceleration of privatization.

Israel’s growth performance is especially noteworthy compared with the rate of growth in industrial countries, currently projected to be about 1.1 percent in 1993, while the European Community is projected to decline by 0.2 percent. Also, the new momentum to the peace process should give an added boost to the Israeli economy.

What advice do you have for the Bretton Woods institutions in the 1990s?

The Bretton Woods institutions today face an extraordinary challenge, because they have to reconcile two parallel trends that have emerged in the world since their creation. On the one hand, especially now with the states of the former USSR and countries in Eastern Europe having become members, they have become truly global and universal in their nature. Yet at the same time, a process of regionalization has taken place. Europe is more cohesive, notwithstanding last year’s currency crisis. We have groupings like the G-7 [Group of 7 major industrial countries]. We have other types of groupings. We have free trade arrangements within regions—for example, the move toward the adoption of NAFTA [North American Free Trade Agreement], Capital markets are global, requiring a global perspective. Yet interests are, on occasion, regional, encouraging regional perspectives. The challenge is how to make the best of both processes. In this regard, there can be no substitute for strengthened cooperation and coordination among economic policymakers.

Personal reflections

What views do you hold now as a central banker that are different from those you held as a research economist and an academic?

I would not say that there has been a dramatic change in my views, because over the years, particularly while I was at the IMF, I had a lot of contact with central bankers and, therefore, a good appreciation of their tasks. But you could say that my job as a central banker in Israel has meant my dealing with a much broader range of issues than I might have expected. As a result, I have come to realize that successful central banking requires strong support from fiscal policies and structural reform. In that sense I am fortunate, because in Israel, the Governor of the Bank of Israel is also the Chief Economic Advisor of the Government and in that capacity, he can contribute to the formation of a broad range of economic policy measures.

Have your views changed at all on the pros and cons of an independent central bank?

If anything, I have become much more extreme in insisting that it is essential to have an independent central bank, as we have in Israel. Time and time again, I see how important it is to have a long-term perspective in the conduct of monetary policy, as there are daily political pressures that may induce a central bank that is not independent to depart from this perspective. “Steady-as-you-go” and “no superficial fine-tuning” are two key principles essential for economic stability—principles that are hard to adopt unless you have an independent central bank. The bottom line is that countries that have managed to have independent central banks have generally shown a better inflation performance.

By taking on this new job, you have lost the comfort of having the time to research solutions. What is the balance now between intuition and rigor?

I do not want to sound too self-serving, but coming to this operational job after so many years of research makes intuition also rigorous. The issue is not so much a choice between rigor and intuition, but rather how well-founded on rigor is your intuition. By and large we do not have time to start reflecting on creation. We have to make fast decisions, especially if the foreign exchange market is involved. If policy is run correctly, there is less need for “stop-and-go” policies or for “fine-tuning.”

In academic circles, you were talking to your peers. Now you are talking to politicians. What types of difficulties are you running into in getting your messages across?

What has become clear and what some of my former academic colleagues may not always appreciate is that economic policy is not made in a political vacuum. What might be the optimal policy recommendation in the abstract may therefore not be the policy recommendation that is feasible and appropriate given other constraints.

I am not saying that economic policy recommendations should yield to political constraints. On the contrary, there has to be interaction. On the one hand, there are political realities within which you are trying to find the best policies. You have to remember all the time that the worst enemy of the second best policy may be the first best, and that if you persist in rigidly pressing for the first best, even when it is not feasible, you may end up with the third and fourth best outcomes. Moreover, you are engaged day-to-day in an educational task of explaining to the politicians the economic realities—that not everything can be legislated and that market forces are overwhelming. The effectiveness of this educational task hinges on the prestige and credibility of the “educator,” which in turn depends heavily on his own track record.

Looking back at your first two years as central bank governor, what do you see as your main successes?

Speaking as a central banker, my greatest area of success has been on the inflation front. For the six years (1986–91) following our stabilization program of 1985, Israel’s inflation had been around 18 percent per annum, and during my two years in office, it has been cut almost by half. However, I should indicate that as long as our inflation rate exceeds the one prevailing in our major trading partners, we will be at a disadvantage in international competition. Thus, we will continue in a vigilant way to fight inflation, and I hope that within two or three years we will be able to converge on the lower level prevailing in our trading partners. An additional source of satisfaction is the performance of the exchange rate policy that we adopted in December 1991. This policy of a “crawling band” enabled us to lower inflation while maintaining and even improving the competitiveness of our exports—an especially noteworthy achievement given the recent turmoil in the markets associated with the European ERM.

Speaking as a broader economic policymaker, I am pleased with our record on absorbing a major influx of immigrants into Israel—an influx that has increased our population by about 15 percent in less than three years—without increasing our unemployment rate significantly. The strategy has been to absorb these immigrants through the private sector without bloating the public sector.

Any disappointments?

The main disappointment is that I would like to have seen the process of privatization move much faster than it has, although in recent months a significant acceleration has taken place. My main hope is that we will continue along this more encouraging track.

Looking forward, what do you hope to accomplish in the next few years?

If I could single out several objectives, I would say: (1) further lowering the inflation rate; (2) sticking seriously to the goal of trade liberalization under the more general objective of internationalization of the Israeli economy—an objective that encompasses the notion of openness, transparency, and involvement in the world economic system; (3) an accelerated program of privatization, of both public enterprises and the banks; and (4) contributing in the best possible way to the development of an economic strategy commensurate with the peace process.