The senior economist: “When interest rates rise, the cracks in the financial system are exposed”

The new government is formed, and in less than two weeks announces an economic plan that includes a significant increase in spending as well as lowering taxes. Within a few hours, the interest rates in the markets soar, and the devil’s sand opens. During this time, the country’s pension system approaches the brink of crisis, and the central bank is forced to intervene.

Pretty soon, heads start butting. The Minister of Finance, who is participating in an international conference, is called back to the capital – and is fired. But the fire also reaches the top. After an internal party rebellion, a new prime minister is appointed, who together with the new finance minister changes the policy.

All this happened in the UK, just two and a half months ago. The government of Liz Truss lasted less than a month, from the presentation of the new budget on September 23, until her resignation on October 20.

In this episode, Prof. Eitan Ilzetzky explains, there are hidden important lessons for the new government in Israel. For example, the insight that times change, and the economic policy needs to be changed accordingly. This is a time when you also have to approach the budget increase with caution. But mainly you can learn how important it is to maintain the independence of the central bank.

The interview with Ilzetzky was conducted during a visit to his homeland, last month. A few hours after that, the Chairman of the Finance Committee, Moshe Gafni, announces his intention to initiate a law according to which an interest rate increase by the Bank of Israel will not be translated into the mortgage interest rate of first home buyers. It turns out that this is not just a theoretical discussion.

Prof. Eitan Ilzetzky

personal: 50 years old, married and father of two
professional: He teaches economics at the London School of Economics (LSE), has a bachelor’s degree in electrical engineering from the Technion, and a PhD in economics from the University of Maryland. Previously served in policy, research and consulting positions at the US Treasury Department, the International Monetary Fund, the World Bank, the Federal Reserve, and the Bank of England
Something else: Plays guitar and piano

“Any economist will say that the plan was bad”

Prof. Eitan Ilzetzky, originally from Israel, is a macroeconomist who teaches at the London School of Economics. In the past, he served in policy, research and consulting positions at the US Treasury, the International Monetary Fund, the World Bank, the Federal Reserve, and the Bank of England. Ilzetzky specializes in budgetary policy and the global monetary system. In August, he even participated in the Fed’s annual conference in Jackson Hole, an exclusive and very important event in the central bankers’ calendar.

What happened in September?
“Liz Truss entered the Prime Ministership with old-new budgetary ideas: tax cuts, regulatory changes for a freer economy, and insisting that Britain stand firm against the European Union on the issue of Brexit. What is relevant for us is the budgetary issue – she proposed a program to support households to purchase energy.

“It was a program to the extent of 4% of GDP to limit energy prices, and to subsidize the purchase of energy by households. Almost every economist will say that this is a bad program. You pay people to buy a product in short supply, thus pushing them to buy more expensive energy.

“The plan was accompanied by a lot of uncertainty, so it was particularly bad. It guaranteed prices for two years, and who knows what’s going to happen.”

And there were more steps.
“The trigger for the crisis was that Strass not only promoted a very radical subsidy program in the budget, but also added to it tax cuts amounting to 1.5% of GDP. Mainly for the rich, which does not greatly stimulate the economy (rich households tend to save the freed up money, rather than spend it, a” f).

“Within hours of the budget announcement, the interest rates that the British government is required to pay increased by almost 1%. And from there things started to fall apart.” When the yield on bonds rises, their price falls. “This led to problems in the pension funds, which saw the value of their bonds decrease, and all of this brought the government to an unsustainable budgetary situation.”

Not only the government paid the price of the crisis, but also the households, and especially the mortgage takers, whose cost soared. Banks withdrew their mortgage offers, and buyers who had already submitted an offer found themselves without financing.

“Great confidence of UK investors”

According to a common interpretation of the crisis in the United Kingdom, interest rates in the markets rose because investors feared that the government might not meet the repayment of debts in the future. Ilzetzky thinks that is not where the main explanation lies.

“Budget actions need to be examined in the context in which they are proposed,” he says. “If they had proposed such a plan, no matter how bad it was, in 2010, the markets would not have reacted at all. In 2010, Britain was an economy in recession, with unemployment. Such a plan, with a tax cut however ineffective, could have reduced unemployment somewhat.” .

And what is the different situation today?
“Today there is a massive shortage of workers, and you feel it every day, everywhere. The queues at the train station are longer. This is an economy with 10% inflation.

“I mean, it’s incredibly bad timing to add a 5.5% of GDP stimulus to a ‘tight’ economy. And that was, I think, the reason for the markets’ reaction.”

According to this interpretation, the rise in interest rates did not reflect fear of a debt crisis, but an expectation that the government’s measures would push inflation up, and lead the bank to raise interest rates more than expected.

Actually, according to Ilzetzky, the investors were not afraid of losing control, but the opposite. They believed that the bank would do what was necessary to control inflation. “I have been following financial and fiscal crises for many years. When things get completely out of control, there is nothing the government can do. In fact, my conclusion is that there was great investor confidence in the British economy. Otherwise we would have seen a bigger spiral.”

Still, the government fell.
“At higher interest rates, the budget gets tighter, it’s just a mathematical fact. Truss had to make a change to avoid higher interest rates for the government and households. She started to reverse the plans, but at this point she had already lost so much credibility.”

To this analysis, Ilzetzky adds an important reminder. “The pound is overweight in the reserves of central banks in the world, it is overweight in international trade, and London is one of the two largest financial centers in the world. It will take a lot to make the British financial system fall apart.”

Therefore, one should not rush into comparisons between the British economy “to economies like Brazil – or Israel”. Britain, in other words, “has a bigger security cushion than other countries”.

In the Israeli equivalent of the occurrence you describe, the government pushes inflation up, the Bank of Israel responds, and this translates into mortgages.
“True. And there is also a reverse risk. In fact, this was the best of the two possible outcomes. The worst outcome would have been if the Bank of England had folded, and not raised interest rates, or the markets would not have believed it. Then we were really in danger of getting out of control.

“The Bank of England has a lot of credibility, but if it had gone on for months, I don’t know who would have won the game of chicken between the government and the Bank of England. In a country like Israel, with a history and an institutional framework that is less chained to the independence of the central bank… I trust the Bank Israel, but it does not have the same length of history and credibility of fighting inflation.

“So that in fact an equally dangerous scenario is not that the Bank of Israel raises interest rates, but that the Bank of Israel does not raise interest rates and is perceived as being controlled by the budgetary authority.”

“The danger: the loss of independence of the central banks”

So what can be taken from the upheaval that Britain has experienced in Israel? “First of all,” says Ilzetzky, “in the current period, of high inflation, of supply limitations, one must be very, very careful with budget expansions.

“The big danger is the loss of independence of central banks. And if that doesn’t happen, then there is another danger of huge damage – to households and the housing market due to the increase in mortgage interest.”

Taras and her finance minister, Kwazi Kwartang, believed in lowering taxes, reducing the state’s weight in the economy, and reducing regulation. “We tried Reaganism and Thatcherism. From a budgetary point of view, this is not successful and I think in Israel it is even more relevant than elsewhere. Every now and then in some country we get a government that says ‘we will cut taxes, and we will cut the size of the government’. As soon as the government reaches the stage of cutting its expenses in 3% of GDP, she discovers that the government cannot be made more efficient with 3% of GDP. What she wants to cut are popular things.

“In the end, what happens is that the taxes are cut and the government expenditures are not cut at the same time. Because there is no majority for a concrete cut. Tax cuts increase the government debt and we do not cut the size of the expenditures.”

I pause Ilzetzky to mention that some argue that lowering taxes will lead to more tax collection, and will pay for itself. Ilzetzky rejects it outright. “We know empirically that this is completely untrue. I don’t think there is a serious economist today who still believes that.

“And it’s the same in Israel. Where can it be cut? I don’t know the Israeli budget as well, but in Britain they said ‘we will cut’ and then look: you can’t cut teachers’ salaries and nurses’ salaries, and that’s already half the budget. And in Israel it’s the same. It’s either Cut back on popular things or on defense spending, which no one is capable of doing in the State of Israel.”

It is still unknown what the new government’s economic policy will be, but there are commitments to increase allowances, and promises to lower taxes.
“Like in the UK, there is the danger that it will stimulate the economy. Inflation in Israel is not as bad as in the UK, maybe there is still a little room to do it here. But any reasonable government should do it with extreme caution.”

What else can be learned from Britain?
“I don’t know the financial situation of the banks and the pensions here. In the UK, no one thought or understood that the entire pension system might be on the verge of bankruptcy. According to some estimates, these are balance sheets worth 1.5 trillion pounds that were at risk. This could have had global systemic consequences.

“Israel will not have global systemic consequences, but Israel also has pensions, it has a very developed financial system. And we know that when interest rates rise, the cracks in the system begin to be exposed. I am sure that the regulators and the Bank of Israel know where the potential cracks are, and we need to be prepared.

“This is another reason to leave some budgetary space, because usually, the actions of the central bank are not enough to rescue a financial system that has gotten into trouble, and budgetary help is needed. The government should be prepared for the fact that it may face liabilities if interest rates continue to rise.”

Meaning that she will have to borrow, increase a deficit, to support the system.
“Right”.

By Editor

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