C. Peter McColough Roundtable Series on International Economics: The Israeli Economy - Thriving in a Complicated Environment

Thursday, October 18, 2007

JACOB FRENKEL: Good morning, ladies and gentlemen. Good morning. Welcome to today's Council on Foreign Relations meeting. I'll start with some words from the sponsor. The meeting is part of the Peter McColough Series on International Economics, which is presented by the Council Corporate Program and the Maurice R. Greenberg Center for Geoeconomic Studies.

Our next McColough meeting will be with Christine Lagarde, the French minister for Economy and Finance and Employment, on Monday, October 22nd. And finally, please remember to turn off your cell phones, BlackBerries and all wireless devices. And I would like to remind the audience that this meeting is on the record.

We will divide the period into two, as is customary in this event. The first one is a spontaneous, stage-managed conversation -- (laughter) -- between the two of us, and then it will be open for the floor.

Our guest is Professor Stanley Fischer, and I'm tempted to say that he needs no introduction, because it is true; on the other hand, he would be insulted if he was not introduced. (Laughter.) And then the problem is that -- the time that we have. So all of you have the details, resume, on your chairs or tables.

Enough is to say that Stan is the governor of the Bank of Israel, which is the central bank of Israel. He has been in this job since May 2005. He has had enough achievements, and some of them may come in the conversation. He has served with -- during this whole period with four ministers of Finance, and you will decide whether it puts some color on the questions that you want to ask. He is a very distinguished economist with public sector-private sector credentials; has been, immediately before his appointment, the vice chairman of Citigroup; and prior to this, he was the first deputy managing director of the International Monetary Fund, a task that he carried between 1994 and 2001.

He's a man of the globe, a man of academia that has had a distinguished career at MIT, the University of Chicago. He was born in a developing country, and you will trace his Zambian accent in his Hebrew when he speaks. (Laughter.) He is a Ph.D. from MIT, wrote many, many books -- some of you or your children have been educated on his textbooks; a very elaborate and illustrious list of distinctions.

But this is the excuse for you being here, Stanley. You choose -- as you know, the speakers in this event -- that's a secret -- choose their own title. So in order to know what is the speaker -- what does he have in mind, one better look at the title; it is a message. And the title is, "The Israeli Economy: Thriving in a Complicated Environment." So a thriving Israeli economy, complicated environment, something which is outside -- tell us a little bit about the title and whatever you want to elaborate on this.

STANLEY FISCHER: Well, thanks very much, Jacob. And before I talk about the title and try to elaborate on it, let me thank the council for arranging this breakfast, and particularly let me thank the people, the many friends and even some people I don't know -- there are probably one or two here -- who have come to this event. And I'd particularly like to thank my boss -- my previous boss, Sandy Weill, for coming. I learned a great deal from Sandy. We also had some nice experiences together, and one day Sandy will tell you what it was that really impressed him in the Ngorongoro Crater in Tanzania, when we spent a couple of days there together looking at the animals and their anatomies. (Laughter.)

SANFORD WEILL (Former Chairman of Citigroup): There was a monkey.

FISCHER: (Laughs.) As Sandy says, there was a monkey; okay, you can figure it out from there on out. (Laughter.)

The Israeli economy has been growing at over 5 percent for the last four years; that includes last year, a year in which there was a war and one quarter of negative growth. Nonetheless, growth came out at 5.1 percent in 2006. And the data we see at the moment, including the very latest data we looked at just this week from a survey of companies, suggests that we're growing possibly even a bit faster than that at the moment. The official forecast is for growth at 5.2 percent. We always try to be cautious; it wouldn't be surprising if we do quite a bit better than that.

We -- many of you probably think of Israel as having been an economy with very high inflation, and you would be right; we had inflation in 1985 of 400 percent in that year.

Many of you may continue to think of Israel as a country with high inflation. That would be absolutely wrong. We have struggled in the last few years to -- in the Bank of Israel to get the inflation rate within the target zone, which is 1 to 3 percent inflation. And the struggle has been to get it above 1 (percent), because it's been around 0 (percent) for the past three or four years -- remarkable stability of prices, a complete change in the way people relate to the currency. And the shekel has been remarkably stable and increasingly strong against the dollar.

I am trying to train our press not to say "the strength of the shekel" but to say "the weakness of the dollar" -- (laughter) -- whenever the exchange rate changes, because they seem to think there's something we could do about it when that happens.

What are these achievements based on? They're based, in the first instance, on a government which got its act together around 2003 and started putting its fiscal house in order. At that point, the government was spending 52 percent of GDP. A high number is understandable because we have very large defense spending. Nonetheless, within four years, that number's been reduced from 52 to 44 percent of GDP. The government has really squeezed very hard.

The budget deficit this year we say will be around half a percent of GDP. That is very close to balance. It may well end up in fact in balance. Last year, the year of the war, with large military spending, the budget deficit was below 1 percent of GDP.

The government has announced in 2003 a program of reducing taxes, corporate and personal, by 1 percent a year through 2010, to numbers which people think of as high, but they're not people who have lived in New York City. Maximum rate will be 44 percent, including all taxes, by 2010, and the corporate rate will be around 20 percent.

All these changes have taken place, remarkably, at a time when everyone says we have a weak government. Well, I don't know whether we have a weak government or not. What I do know is that on the economy they've been extraordinarily strong and have not let the fiscal situation get out of hand, despite the war and despite many pressures to increase spending.

As a result of that, we have -- as a result of the budget situation, as a result of the remarkable strength of the private sector in Israel, we have a large surplus in the current account of our balance of payments, about 5 percent of GDP. It was around five-and-a-half (percent) last year. It'll probably be four-and-a-half (percent) this year.

There are many things -- I worked on the Israeli economy in 1985 as an adviser to George Shultz and later, when Joan Spero was undersecretary, as a member of the Joint Economic Development Group. There are many things that have happened that I would never have expected. Surplus in the current account of balance of payments is very high on the list.

That is due to a spectacular export performance. Share of exports in GDP has gone up from 30 percent a decade ago to close to 45 (percent) this year, at a time when growth has been pretty reasonable. They've been growing much faster than GDP. And it's largely high-tech exports, to account for about 60 percent of exports, that are the dynamic element.

How do we get to low inflation? Well, you've seen one of the main reasons that we got to low inflation on the sitting -- sitting on the dais here. There was a long fight in the 1990s over what monetary policy in Israel would look like, over what sort of capital markets and capital controls we have. Jacob, who was governor from -- 1991? -- 1991 to 1999 or 2000 -- 2000 -- fought a very strong and successful fight to get rid of capital controls -- there are no Israeli capital controls, neither on outflows nor on inflows -- to float the exchange rate, and to change monetary policy to have an inflation target, which we now have. And during his period in office, inflation rate came down from about 20 percent to single digits, and the subsequent governor and I have had the benefit of being able to take it from there.

We have not intervened in the foreign exchange markets since 1997, since they were liberalized. Bank of Israel has not bought and sold foreign currency since then. And I used to say "yet" the market is very stable. I'm now inclined to say "and therefore" the market is very stable because nobody thinks we're going to intervene. And if they want to buy and sell foreign currency, they've got to figure out what's going on in the market, not which side of bed the governor got out of that particular morning.

We never say never. If there's a national crisis, we'll intervene -- we've got reserves -- if we have to. But we have no intention of doing so in foreseeable circumstances.

I don't want to go on too long, Jacob, because we've got to leave time for other questions, but that basically is the story of an economy which is very heavily controlled from the center, with a a massive government, with pervasive controls, which in the last 15 years has reformed itself remarkably. Not totally; there are still things we'd like to get done. There are still more reforms to be done. But overall, the change is close to revolutionary, and the results are very evident in the data.

FRENKEL: Thank you.

I see Paul Volcker that just came in, and I just wanted you to know, Paul, there is a seat which is reserved for you here, just in case you want to move on.

MR. : (Off mike) -- back here. (Laughter.)

FRENKEL: That's perfectly fine. It's a free option. (Laughter.)

MR. : (Off mike) -- sure. (Laughter.)

FRENKEL: A bit more confidence. (Laughter.)

Let me ask you, Stanley, as you described the economy, it became clear that it became -- it is now part of the integral -- of the world capital market. And it has been argued that, in a way, the opening up of the markets have marginalized the role of domestic policymakers because really they cannot -- that's not the relevant point where action takes place.

But if that's the case, here, when you ask people what -- well, what bothers you today, they will tell you subprime, capital markets, credit markets are getting dry, banks do not lend to each other. Reading the Israeli press, I don't see it yet there. Is it yet, or what? Tell us a little bit.

FISCHER: Well, first of all, it's certainly true that the future -- the fortunes of our economy are very dependent on what happens in the world economy. We export 45 percent of GDP. We must be dependent. And we've got open capital markets, so we must be dependent.

But we still have the capacity to affect the economy for good or ill, and if our domestic policies were not as good as they have been, growth would slow. There have been a couple of episodes in the past when monetary policy did strange things and you saw the impact immediately, when fiscal policy did strange things and you saw the impact immediately. So to put negative spin on it, we could mess it up domestically if we wanted to, and we haven't.

Now, as to what's going on in the world economy now and its impacts on us, the Bank of Israel is the bank examiner, the banking supervisor. We've spent a lot of effort trying to see what exposure our banks may have to the subprime market or to related markets which have been affected in the subprime crisis. We see no impact on our banks. They reported back nothing. Our examiners have seen nothing. It may just be that they weren't taking enough risks, but at this moment we're very glad they weren't taking those particular risks.

The interest rate effects have come to us; that is, the spread between Israel 10-year government bonds and U.S. 10-year bonds has opened. There was a moment in April/May -- there were a couple of moments in April/May when, to my total amazement -- but I couldn't say it -- the 10-year rate in Israel was below the 10-year rate in the United States. Only by six or seven basis points, but still.

There was a big change. It's no longer there. The gap is now about 100 basis points, partly because the U.S. went down, partly because we went up. I think those are sort of risk premium which are understandable. So we've had a little bit of effect.

And then we've had the other phenomenon which we all know and probably all the private-sector people here understand perfectly. Stock markets think the world is wonderful and there's nothing to worry about, and the policymakers I know kind of walk around with long faces, wondering what's going to happen next. So somebody here probably knows who's right, the people who worry or the stock markets. Our stock market has behaved just like the other stock markets, and it's reached new peaks several times in the last few weeks.

In many economies that opened up and liberalized, foreign banks came in and changed the local scene, for good or bad. In Israel, the presence of foreign banks, except for, of course, a very major bank in the U.S., that I remember when Sandy came and inaugurated it, we don't have, or you don't have now a significant presence of foreign banks. Can you say something about it?

FISCHER: Well, we have a significant presence of foreign banks on the corporate side -- (inaudible) -- Citigroup and some of its competitors, whose names I won't mention --

FRENKEL: You mean you forgot. (Laughter.)

FISCHER: -- right -- you know, because of the delicacy of the situation. We have three or four of the major investment banks there, and a lot of activity from others. Harvey Krueger pioneered, in many ways, the connection between American investment banks and the Israeli economy. I think you've been -- (inaudible) -- 50 years or something, Harvey, if I got that right.

So they're there, and large corporations have a choice of financing themselves wherever they want, and these guys are very active in our financial markets. What we don't have is competition on the -- from foreign banks on the consumer side. And we have a lot of private banking, but I mean the ordinary consumer side.

We would be delighted if a foreign bank would come in. We analyzed why that hasn't happened. I think a part of the reason is that the Israeli banks are technologically pretty advanced. So a foreign bank couldn't really come in and bring in new technology, even new products. They can bring some new products, but it's not that they would be able to dominate that easily.

Our economy is relatively small. It's the biggest in the region outside Saudi Arabia and Turkey, but we are about 1.3 percent the size of the U.S. economy. We're bigger than Chile, where foreign banks are present. I think though there is room for a foreign bank, a large foreign bank, to come in, or a small -- medium-size foreign bank to come in, because the level of service from the banks in Israel is relatively low.

We have two very large banks that dominate the system, and we are trying to encourage it. We have a bank up for sale now, bank that the government is selling its residual shares in. And the government will sell a controlling interest in the second largest bank in Israel -- Bank Leumi. So we hope through that way to bring in some foreign competition for our domestic banks, but that's the situation.

FRENKEL: Well, this was a very impressive description of the economy. And yet I bet if you met individuals in this room and asked them, Israel, what comes to your mind, they will tell you maybe security; they will tell you political instability; they will tell you maybe terrorism. Obviously you made a good story why the economy is immune from all of that, but I'm sure many people would like to hear a little bit more also on that front. Can you say something?

FISCHER: Well, I -- you didn't -- I thought you were going to ask me, what's the complicated environment? It all sounds --

FRENKEL: You're right. What's the complicated environment? (Laughter.)

FISCHER: The complicated environment is the environment you've just described. (Laughter.)

FRENKEL: Can you elaborate? (Laughter.)

FISCHER: I should add, I'm not trying to avoid this question. The security situation is obviously something that foreigners tend to focus on, and there's a lot to be said. I'd like to say one thing first.

When I was leaving Citigroup, I used to get taken into a corner -- it was always in a corner; I'm not sure why -- by some senior head of some business and say -- who'd say to me, Stan, I hope you're going to have very good security when you're there.

And truth is, I've got a guy who's a policeman who takes me to work and brings me back. Cabinet ministers have security, but I don't feel any need -- I don't feel less comfortable walking around Tel Aviv or Jerusalem at night than I felt walking around the Upper East Side, and I felt very comfortable walking around the Upper East Side. It does not feel that way when you're in the center of Israel, and daily life does not feel like you would think it is from CNN. I think that's the objective situation, but, you know, we may be fooling ourselves. I don't think we're fooling ourselves.

In terms of the threats, Israel during -- after -- after the second intifada broke out, Israel developed a means of dealing with it. It's very tough, but there basically are very few terrorist incidents now. It's not because they don't try, it's because they don't succeed. And Israel's defense department has figured out by and large how to deal with this. None of this is foolproof, but as I said, there are very few incidents.

In terms of threats to the overall economy, larger threats, there was the war last year. I think the significant fact about the war is -- what impressed me, never being in a situation like that, was just how people understood what they were supposed to do. I thought it was my duty as governor to call various major exporters and tell them they had to keep on exporting no matter what. Well, after speaking to about two or three of them, I understood that they understood that.

One of the companies that you know -- probably won't know, Tel Aviv's largest -- large pharmaceutical company, said: "Yeah, we understand that. In the 1973 war, when a lot of people were called up" -- which was not the situation this time -- "we called every pensioner we had back and we didn't miss any orders. We just kept on producing." I visited places in the north during the war. They kept on producing and their exports did not go down very much.

One could say unfortunately, Israelis know how to deal with these situation. The capital markets -- stock market went down for a week, then came back to some sort of normal. I, during the war, raised the interest rate not sooner than I was scheduled to make a decision, just to make it clear to everybody that we were going to defend the stability of prices and defend the stability of the currency, if there's a need to do so, and the shekel ended the war stronger than it started. And there were no signs of panic that I saw.

I think even in those circumstances, one saw people understanding what had to be done and doing it -- doing it very well. I don't think -- and I speak to defense people all the time -- I don't think that, aside from Iran, there are threats that are -- that couldn't be dealt with by the defense forces. And that includes the rocket threats, which are complicated but not as dangerous as the Iran threat. And that, as Israel keeps pointing out to everyone, is a global problem. I'm not an expert on that. I have my guesses as to how it will end up. But that aside, I don't think that we are subject now to the sorts of pressures on the economy that would come from where we are.

Now, there's argument which I used to have with former Finance Minister Netanyahu, who said all the time: "Look, we can grow, as soon as you guys" -- I think he meant me -- "always say we can't grow without peace. And here we are, growing without peace." I think we can grow very respectably without a peace agreement. I think we could grow more rapidly with a peace agreement.

There is nothing very much about the Israeli economy that says it couldn't grow at 6 or 7 percent for a decade. It has almost everything that is needed. Our income level is about half that of the United States -- about $22(000), $23,000 per capita. A lot of catching up we could do. We have very good businessmen. We have a very highly trained labor force enormously strengthened by the immigration from the Soviet Union in the 1990s. And I think all the ingredients are there for very -- for much more rapid growth if the security situation -- if the situation vis-a-vis our neighbors were to improve, mainly because of what it would do to the image of -- to the risk assessment of others about the Israeli economy, not because we would have large amounts of trade with our neighbors. They are much smaller than we are. And there will be trade benefits, but they're not the major factor.

FRENKEL: Thank you.

Let me open the floor now for brief questions. As I said, brief. Please state your name, affiliation, and wait for the microphone, and a brief question please. The floor is yours.

QUESTIONER: Thank you. I'm Glen Lewy from Hudson Ventures. Very good to see you.

The Dubai/Abu Dhabi/Oman are different kinds of economies than we've generally seen in the Arab world, and getting more modern all the time. What challenges do you see from that to the Israeli economy, and what opportunities do you see from that to the Israeli economy?

FISCHER: I don't think there are a lot of challenges. I think it's very good for us. It's doing -- they're doing very well, and that they're modernizing. I think the more the Arab economies modernize, the better it will be for us in the longer run. It's also good for us because in fact, a lot of Israeli companies are somehow involved and welcome, if they don't make a noise about it, in at least one of the three economies you mentioned. So I see no problems for us in what's happening there, only opportunities.

FRENKEL: Thank you.

Jeff Schafer (sp), please.

QUESTIONER: Jeff Schafer (sp) from Citi.

Since the Israeli economy is doing so well, I'm going to ask you about the rest of the world. You did allude to some concern as a central banker about an appreciating currency. It doesn't seem like a very deep problem with a 5 percent plus current account surplus, but there are other countries in the world who are coming under this pressure whose external accounts are in a much more precarious state, whose export growth is much more threatened. What do policymakers do, when pressures build up, to appreciate currencies very strongly and you're struggling to maintain your commitment to price stability? Are there any options for them?

FISCHER: Well -- I'm going to say something and then answer your question. In our case, we trade about a third with the United States, about a third with Europe, and a third with the rest of the world. Our effective exchange rate vis-a-vis our trading partners (is ?) actually not appreciated, it's depreciated. And it's -- the shekel against a trading basket is weak, by historical standards. I think that's consistent with our very good trade performance. So aside from the fact that the man in the street thinks the exchange rate in Israel is the exchange rate against the dollar, and you can't explain this complicated stuff about the euro, we don't actually have a problem with an appreciated currency at the moment.

As to others, well, you've read the text books. I have read the text books. They say you can't do very much through monetary policy about an appreciating exchange rate. You've got to make the adjustment elsewhere, which is to increase national saving, which means tighten fiscal policy. It's a hard thing to explain to finance ministers, but that's what the answer is.

The solution doesn't come through monetary policy if you're worried about inflation. You can try what the Russians tried, which is to run at about 10 percent inflation forever, but there's a recent IMF paper which says that all these attempts to use monetary policy to deal with an appreciating currency have failed after a few years.

FRENKEL: (Inaudible.) Do you have a question?

QUESTIONER: Thank you, Jacob. Governor Fischer, if 45 percent of the GDP is sort of export-driven and technology is one of the key factors, how do you see, between Israel and India, since you're talking about technology and that being one of the key drivers going forward, I'd be interested in your thoughts on the collaborations between, in this particular sector and also in the -- (inaudible) -- sector, and its impact for Israel's overall growth. Thank you.

FISCHER: Well, thanks very much for that question. The -- we're not an incredibly disciplined society, those of you who've ever been there. We had a management consultant in who -- to the Bank of Israel to help us improve our corporate culture, and he explained the basic problem in Israel. He said if you ask, say, Koreans to line up in order of hierarchy and if you ask Israelis to line up in order of hierarchy, they'll each be in a line. The Koreans will be one behind the other; the Israelis will be shoulder to shoulder. (Laughter.) Everybody's certain that he knows better than everybody else what needs to be done in every circumstance.

This leads to a great deal of originality, and -- (laughter) -- but I mean that in a positive sense. Israeli high tech is very innovative, and lots of things I carry around simply for convenience, my thing that in Israel it's called a Disk-on-Key. It's a flash disc. This is an Israeli invention, the thing that all of you use, (those of you who ?) use computers. And there are just lots and lots of things.

At this point in the -- there are a lot of companies, American companies that have research facilities in Israel and in India. I've asked them how they differentiate, and they said at this stage, when the problem basically requires a lot of ingenuity and it's not clear where the solution lies, they use the Israelis. They say India's much more disciplined; the people who have learned computation in India are much more disciplined. You give them a well-defined problem and they'll solve it. Now, obviously, that's going to change over time, but Israel is simply going to have to, in that competition, being 7 million people against your billion, is going to have to maintain its quantitative edge in that relationship.

The other thing you pointed out which is very, very clear is there's a lot of community of interest between Israel and India. Trade ties are developing very fast. They used to be in the diamond sector and, in fact, one of the few retails branches of the foreign bank we have is of the State Bank of India, which is opened a retail branch in the diamond exchange, where Jacob's father used to work.

There are military -- not direct military links, but military equipment sales between the two countries, and, as you say, the pharmaceutical link. And as I listen to Israeli businessmen and so some Indian businessmen, I think those ties are simply going to continue to strengthen pretty rapidly.

QUESTIONER: My name is Fred Broda with Oxford Analytica. And my question is would you elaborate on some of your comments regarding defense in Israel, particularly the effectiveness of the wall. Is that what you were referring to? And then could you elaborate on the Syrian situation which occurred several weeks ago?

FRENKEL: In Israel, "wall" means the Western Wall -- (laughter) -- and the other one means a fence. (Laughter.) No politics.

FISCHER: In Israel, that's called a separation fence.

As to the Syrian situation, this is the first example in two and a half years I've seen where any Israeli politicians, you know, succeeded in staying -- keeping quiet about an issue for any length of time. And everything we know is what's reported through the foreign press. Our newspapers are allowed to report anything that's in a foreign newspaper, so these articles start, "According to The New York Times," or whatever. So I don't know more about it than you do.

What is clear on the separation fence, whether you like it or not, is that it has had a very -- it has been very effective in reducing the number of terrorist incidents. And more so, I think, than the opponents expected, probably more so than the proponents expected as well.

It's sometimes said, it was said before Hamas took over Gaza, there've been remarkably few terrorist incidents that originated in Gaza. That's because there's always been a fence between Gaza and Israel.

As to -- on the Syrian side, there are simply very divided views in Israel. There are many very hard-headed people who want to reach an agreement with Syria, despite all the things that are said about the Assad government. And there are others who hew to the other line, why reward them at a time when they're supporting Hezbollah in an alliance with Iran, et cetera, et cetera. So I think that's very much up in the air.

The prime minister has repeatedly said that he'd like to reach an agreement with Syria.

FRENKEL: I can see now excess hands. You will need to shorten your questions, and Stanley will shorten his answers.

Yes, please. Very quickly.

QUESTIONER: David Malthus (ph) with Bear Stearns. Thank you for talking with us this morning.

My question is on tax -- (word inaudible). Israel's lower tax rates have been successful. I'm interested in the budget way that you did that, and trying to get you to give advice to the U.S. We're stuck, because if we lower, say, corporate tax rates, which we desperately need to do, then it's charged against the budget. So did Israel avoid that bottleneck, and how did it get taxes cut?

FISCHER: The fundamental constraint that was effective in reducing the (Sharon ?) government in GDP was the constraint on the growth of government spending, an extraordinarily tough one. There was 1 percent a year in real terms for three years. And it's now, at the rate of population growth, 1.7 percent; in other words, keeping government spending per head constant. With that, you have a lot of room to keep the deficits small while cutting taxes.

FRENKEL: Thank you.

QUESTIONER: Ralph Buultjens, New York University.

What percentage of the economy is directly owned by the government? And to what level would you like to bring it?

FISCHER: I should know the answer to that, and I don't. Private-sector activity is somewhere over 70 percent. The government is the major owner of land as a result of historical developments, and so it's a little hard to say either what percentage of assets is owns, because most of the land is not marketed. But it is no longer in very major industries. The defense industries are owned by the government. There is talk about privatizing as much of them as possible. And for the rest the government has a minor share in one bank. It's out of that sector altogether. The oil refineries have been sold. So there's very little left on the -- in the active production that the government now owns.

FRENKEL: Thank you.

QUESTIONER: Karin Lissakers, the Revenue Watch Institute.

You describe this booming Israeli -- thriving Israeli economy which is next door to the abject poverty and I guess desperation of the Gaza and West Bank. Can you tell us a little more about what, if any, economic linkages there are now between Israel and those territories? And do you have a scenario whereby you could see the Israeli prosperity spilling over to those areas?

FISCHER: Well, the links between Gaza and Israel have been reduced after Hamas took over. The West Bank is still pretty open, and the vast majority of imports to the West Bank either come through Israel or are Israeli.

I think a scenario in which that prosperity spills over is a -- is a scenario in which there is no risk of terrorist incidents. That's what stops the -- that's what stops the free movement of goods at the moment.

At the moment there are no tariffs between Israel and the Palestinians. And ironically, the Palestinian economy was doing at its best on the eve of the second intifada. And that had to do with the fact that a lot of Palestinians were working in Israel and that there was free movement of goods at that point.

So we hope it happens. The Palestinian -- the shekel is used in the territories, so that's another link that we in the Bank of Israel are involved in. But obviously I would be a lot happier if it was possible to go back to the level of trade we had in 2001.

FRENKEL: Thank you.

Please.

QUESTIONER: Thank you. I'm Harrison Goldin.

You said you have a view as to how the Iranian situation is likely to play out. Can you tell us what impact, in your judgment, that scenario would likely have on the Israeli economy, and over what period of time?

FRENKEL: In all of the previous -- and let me -- in all of the previous questions did not start by saying he has a view; he gave the answer. (Laughter.)

FISCHER: The --

QUESTIONER: You could stay with the view.

FISCHER: Well, I have a view, but I'm not an expert, and actually I wasn't an employee -- I wasn't brought to Israel to be the national security adviser, but I occasionally feel I'd be good at the job. But nobody else -- (laughter) -- nobody else thinks so. (Laughter.)

Let me just say that I think there are solutions that would not have -- that would not have a material impact -- negative impact on the Israeli economy, but I don't want to go --

FRENKEL: Thank you.

FISCHER: -- into things I'm not an expert on.

FRENKEL: Ladies first.

QUESTIONER: Rachel Robbins, NYSE Euronext.

Stan, building on Karen's question, given the innovation and Israel's high-tech industry, is there more that could be done and could facilitate building of the economies of Palestinian areas in particular and other Arab neighbors that wouldn't require the physical movement that raises the security issues you mentioned?

FISCHER: Well, Rachel, it's much more complicated than that. Shimon Peres in the early '90s after, after Oslo and all that, was very big on a new Middle East in which Israel was essentially going to explain to our neighbors how to do things.

They don't want that relationship. So there are lots of things that could be done, but they're going to have to be on a more equal basis than Israel doing things for the Palestinians and so forth. So there is technology that can be transferred. On the other hand, they can buy their technology from Europe or the United States or many other ways.

When I was in the World Bank I spoke to a Canadian who had arranged for Israeli irrigation equipment to be sold to the Syrians. So it could be done, and so forth.

There are lots of ways around it. I don't think that -- these are very small economies. The Palestinian economy is officially $5 billion. That's too low. Maybe it's 10 billion (dollars). We're 160 (billion dollars). And so they need to trade with us to grow. And we can suggest all sorts of things. But if they don't have that trade, it has a tremendous negative impact on them. And that's the fundamental point.

So you can transfer technology. You can say all sorts of things. But then they've got to sell their product. They're too small, much too small, to be inward looking; they have to be outward looking. And they've to do that trading with their neighbors. Jordan is also a very small economy, so it's not going to be the answer either.

FRENKEL: Thank you.

Gerry.

QUESTIONER: Gerald Cohen, Ziff Brothers.

As one of the foremost macroeconomists and also as a central banker, I wonder if you'd like to comment on the moral hazard question that central bankers are facing?

FISCHER: Well, I'll be very brief. I think the moral hazard problem is vastly exaggerated. I think the notion that central banks should go around not trying to prevent a recession so that they'll teach Wall Street a lesson is pretty perverse. And I thought that in the 1990s when the IMF was being told it shouldn't help countries so the speculators would learn a lesson.

I didn't think it would arise in this connection. The Fed was set up to prevent the sorts of recession that result from financial crises, and I think it's doing its job when it deals with that.

FRENKEL: Chris -- (last name inaudible) -- please. Wait a second, please.

QUESTIONER: (Off mike) -- International Organization of Employers.

Could you comment on the social issues and how they impact on the economy, especially the disparities in income and union power, which used to be very strong?

FISCHER: There's a -- there's a major poverty issue in Israel, which is accentuated as a political issue I believe by the definition of poverty that is used in Israel. In Israel you are poor if you are -- if your income is below 50 percent of the median income. This means it's a measure of social gaps. If you're halfway below the average, you're poor.

That means last year, for instance -- everybody got richer more or less -- the poverty line went up 4 percent in real -- in real terms. The line at which you can become, you needed to have 4 percent more income to not to be poor. And so the number of poor went down relatively little; it did go down. So the problem -- the problem will be there forever. It's just a question of whether the social gaps are reduced or not.

It's a complicated issue, and it's -- I'll explain the complication. At a discussion on poverty in Israel, somebody said, if we really want to reduce the poverty rate in Israel we should close down the high-tech sector. (Laughter.) That's where the high incomes were being earned; that's the problem. That explains why the problem is not a straightforward one.

Now, within the terms of when you do look at the poverty rates, they are very highly concentrated among the ultra-orthodox and the Arabs. Those two groups, which account for 30 percent of the population, account for 60 percent of the poverty, and the explanations are reasonably straightforward, really.

Ultra-orthodox men don't work; 15 percent of them are in the labor force and 85 percent study. Kind of hard to not be poor in those -- in those conditions.

In the Arab sector, women -- the female participation rate is very low. There are also data issues, which suggest in the Arab sector poverty is much less than the official data.

In both those two cases it's going to take a lot of work to resolve those issues. They are not amenable to sort of any simple treatment. And growth will not necessarily solve them, and it hasn't.

As to -- sorry, what was the second issue?

QUESTIONER: Union power.

FISCHER: Union power. It's gone down a lot because the unions are now very -- continue to be powerful in the government sector, in the public sector, but -- and in companies which are recently privatized. But aside from that they're losing power and they're less important.

FRENKEL: Thank you very much.

Joan Spero.

QUESTIONER: Stan, could I ask you about the IMF where you spent some time? And I assume you'll be going to some meetings. Joan Spero from the Doris Duke Charitable Foundation.

From your perspective, what is the role of the IMF in today's global economy?

FRENKEL: In 20 seconds or less. (Laughter.)

FISCHER: Three things.

First, the charter of the IMF says there is a need to set up a central -- an institution for consultation on the international financial system. That's it; it's the IMF, it's the one that has all the legitimacy. All its members belong to it by treaty. All its -- it's the only place that has finance ministers and central banks involved. And it has a superb staff. So when they make a decision, the stuff gets done. It'll continue to be in that position, and they need to develop that in association with strengthening surveillance, which I won't -- don't have time to explain to you.

And if we thought, as we did a year ago -- did 10 years ago--

FRENKEL: "We" means?

FISCHER: "We," us, not the fund, the establishment. (Laughter.) If we think that financial crises are a matter of the past, I think 10 years ago the view was they're not going to happen in the industrialized economies any more. They do happen in the emerging markets. Well, now we know they do happen in industrialized economies as well, and they will happen at some point in the emerging markets, and the fund had better be there with the money to help the economies that get into trouble even if this time around, fortunately, the emerging markets have stayed out of this particular crisis.

FRENKEL: We have time for one last question, please. You won.

QUESTIONER: Would you be willing to comment on your -- recognizing it's not your area of responsibility -- oh, I'm sorry; John Watts, FAPW -- on your hopes or expectations from the current attempt to have a conference in the Middle East?

FISCHER: My hopes I can describe, and my expectations I won't. (Laughter.) My hopes are it'll be very successful and be an important step on the road to peace between Israel and the Palestinians.

FRENKEL: Thank you.

I am now torn between credibility of having said the last question and desire to satisfy the lady at the end. And the last one wins. Please.

QUESTIONER: Thank you very much. I've been waiting. It's Eva Sanchez with J.P. Morgan, and actually my question was on monetary policy challenges in Israel.

You mentioned that inflation has been at 1 percent over this year, especially recently, and one of the main factors is the -- (inaudible) -- sector of the economy, particularly housing. It means that the Central Bank of Israel has to cut rates many times, even if the economy is accelerating -- (inaudible) -- cap is closing, and even if educated part of the labor force, you know, that that sector is quite high.

So two questions. One is, what are the challenges and what is the debate on the priorities that -- you know, that you put when you're facing both questions -- the inflation target per se, given the impact of the exchange rate and the pressures for appreciation, the current account surplus and (other ?), and of growth? And the second one is, why maybe not change the inflation -- the inflation basket you are targeting?

FISCHER: On the second part first, I think if we were to define an index that wasn't affected by the exchange rate, we'd be left with about 30 percent of the Consumer Price Index. And I much prefer to be in a situation where our target is something that everybody knows, the CPI, and we have to explain to them why we don't hit it, rather than define something nobody knows what it is and say we hit it every month right on the nose, even though it's of no relevance to you. So that one is pretty straightforward.

On the first one, just so you all go home with an economics question, we have a very strange situation in which the prices of many non-traded goods like rent are specified in dollars and you pay them in shekels. This means that when the exchange rate changes next month, the price of -- the shekel price of housing changes, and we have a very very quick transmission between the exchange rate and the inflation rate. This complicates the task of monetary policy.

If I had to grade questions, I'd give you an A. But it'll take too long to answer it, so I hope you'll excuse me. (Laughter.)

FRENKEL: Thank you very much. (Applause.)

Ladies and gentlemen, you saved me from inviting you for a round of applause. You understand now -- just one minute, please; no free breakfast -- you understand now why Governor Fischer was among the very handful (of) governors who was graded an "A" by the magazine that will greet all of those who arrive to Washington today and for the next week of the IMF meetings.

So I really thank you very much, and thank you for your patience. (Applause.)

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