A couple of weeks ago that the media exaggerated some statements by the Ministry of Finance and the Bank of Israel to make it look like a full blown brawl was about to erupt.  In summary, the Bank of Israel raised interest rates and the Ministry of Finance wanted to make sure that foreign currency was still being bought on a regular basis.  No one even threw a chair.  So why all the hullabaloo?

Right now we are in the middle of a double edged crisis – on one side we have a housing bubble and on the other side a looming export crisis.  According to many economists, the Bank of Israel and the Ministry of Finance were disagreeing about which problem to tackle and which to ignore, assuming both are mutually exclusive.

Before passing judgment, it is worth taking a closer look at these two problems and how they impact our lives.

Let’s begin with the housing bubble, or as I call it, “The Jon Degani will never be able to afford an apartment crisis.”  Prices are rising for a couple of reasons:

(a) Investors – two types of people generally buy property, people looking for a home in which to live and investors.  When we have a bad market (and low interest rates abound), then investing in an apartment is a pretty good deal.  If an apartment costs ₪ 800,000 and it receives rent of ₪ 3,000 per month, then investing in an apartment is a solid investment with a return of 4.5%.  I know it doesn’t look like much, but it makes for a nice piece in the portfolio, especially when other investments perform so poorly.

(b)  Everyone else – when money is cheap to borrow, people tend to borrow more of it.  So when interest rates stay low, soon-to-be homeowners are able to borrow larger sums and pay more for housing, driving up prices.

(c) People leaving the periphery –As more people migrate toward the center of Israel, the demand for housing increases and the prices rise.

It would seem that the simple solution here would be to just raise the interest rate.  When the interest rate is higher, less money is borrowed, less money is put into the economy and inflation is curbed.  Also, with higher interest rates, investors will leave the real estate market and move toward government securities.  Unfortunately, not every solution is so simple.  Increasing the rate of interest would worsen our looming export crisis.

Our export crisis: 

Israel is an exporting country.  Correction, Israel is a country that imports a lot of goods, fixes them up and exports them for a profit (if you look at Israel’s major imports and exports in the CIA factbook, you’ll notice that our imports and exports are mostly the same).  In fact, over 40% of our economic activity comes from exporting (source) and if the shekel were to be too strong, exporters would loose a tremendous amount of money.  How so?

Let’s say that $1 = ₪4 and diamonds are $1 a kilo raw, $1.50 per kilo polished.  Israel imports one kilo for $1 worth of diamonds for ₪4, polishes them and resells them for $1.5 = ₪6.  This would earn Israel a ₪2 profit.

Now let’s say the shekel gets stronger and $1 is worth ₪3.  Israel imports one kilo worth of diamonds for $1 (₪3), polishes them and sells them for $1.50 = ₪4.50.  This would only earn Israel a profit of only ₪1.50

When the shekel gets stronger, imports and consumer prices drop causing customers to pay less and sellers to profit less.  Since Israel is the seller, Israel prefers for the cost to be higher so that it can profit more.

As the dollar plummets, Israel risks the shekel getting too strong, hurting not only exports, but all businesses tied to them (for example, the diamond polishers mentioned above).

So how can Israel solve this problem?

1 – Israel’s central bank can lower interest rates, driving down the value of the currency.  But of course, this would worsen the housing crisis so the Israel’s central bank chooses to…

2 –Buy dollars every day.  By buying dollars, Israel adds more to the supply of shekels, driving down the value of the shekel compared to the dollar.

“Hold on a second” you may ask.  “If we artificially inflate the exchange rate, then exporters profit at the expense of private citizens who have to pay higher prices for consumer goods.  Why should the producers be allowed to profit at the expense of the consumers?  If the prices have legitimately dropped, then let them get used to the new economic reality!”

Good question (thank you).  The truth is that if the dollar were to permanently fall, then the Bank of Israel would be stupid to try to maintain an artificial exchange rate; it would only end in another bubble bursting eventually.  But the Bank of Israel does not think the dollar will fall, at least not permanently.  The Bank of Israel is afraid of what will happen when the exchange rate, whatever it is, becomes too volatile.

Austrian Economist Eugen von Böhm-Bawerk explained this problem in his capital theory.  He explained that one of the problems with capital is its inability to be easily transferred.  This inability can spell disaster to a business in a volatile economic environment. 

Now in English:

Let’s say I decide to invest in building boats.  I invest thousands in machinery, raw materials, and manpower hoping to get a profit.  Now, after I spent millions trying to build boats, someone invents tiny hovercrafts that hover above water.  No one wants to get wet anymore and my boats become completely useless.  So I default on my loans, file for bankruptcy and end up penniless looking for a new business venture.  Maybe I’ll make tiny hovering plains.  But then the next year I find out that using small hovercrafts causes cancer.  The hovering system used a terrible chemical and the entire system becomes illegal.  Now boats are in high demand.  Unfortunately for me, I had to break all the ones I made into scrap to try to repay my debt.  Now I’m broke again.

Imagine that we decide to tell the exporters to go fly a kite and let the market work it out for them.  They become less profitable and investors move their money to other businesses such as pharmaceuticals where they can get a better return on investment.  The import / export companies fire thousands of workers and the pharmaceutical company begins hiring and training.  Now, a year later, the dollar gets stronger and investors move their money back.  The pharmaceutical companies have to fire thousands of workers and the import / export businesses begin rehiring and training.  Both firms wasted millions, if not billions, due to the turnover they suffered because of the fluctuation in the dollar.  In a few years, both of these industries will be considered too unstable and no one will want to invest in either of them.

And so, our government is doing what it can to try to make these businesses a bit more stable.  They cannot stop all fluctuation, but by using a couple of monetary tricks, they can help the import / export companies ride out the boom – bust – boom they expect to see in the American economy and the dollar.

So that’s our financial crisis in a nutshell.  In some of the coming posts I plan to discuss some of the repercussions of this crisis and how it affects our everyday lives.

What do you think?

PS – If you’re wondering, Eugen von Böhm-Bawerk is pronounced Oygen Bom Boverk