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Jacob Frenkel and Free Markets

ANNOUNCER: Funding for THINK TANK is provided by the Bernard and Irene Schwartz Foundation; the Smith Richardson Foundation; the [unintelligible] and Harry Bradley Foundation; and, by Marilyn Ware.
BEN WATTENBERG: Hello, this is Ben Wattenberg. Recently THINK TANK traveled to Israel to attend the renowned Herzliah Conference. There we spoke to Jacob Frenkel, the former Governor of the Bank of Israel, roughly the equivalent of the American Federal Reserve Bank.
While serving as Governor, he helped transform the Israeli economy. The topic before the house: Jacob Frenkel, Israel, the free market this week on THINK TANK.
BEN WATTENBERG: Shalom, Jacob Frenkel.
BEN WATTENBERG: Could you give us sort of a short biography of your life and times here in Israel and in the United States.
JACOB FRENKEL: Well, I was born in Tel Aviv, in Israel. I did my graduate work in economics at Hebrew University. I went to the University of Chicago to do my PHD. I then returned to Tel Aviv University and subsequently returned to the University of Chicago.
And I was a professor of economics at the University of Chicago in the Department of Economics and ultimately became the David Rockefeller professor there, all together about 17 years.
In 1987 I was invited by the then managing director of the [unintelligible] to come and join the IMF as the economic counselor and the head of research, which I did until 91.
In 91, I was invited to become the Governor of the Bank of Israel which is the head of -- itís like the Federal Reserve System.
BEN WATTENBERG: An Alan Greenspan or Ben Bernanke job.
JACOB FRENKEL: Indeed. In a smaller scale as it is in Israel. Inflation at the time was very high, it was a very large influx of immigrants from the former Soviet Union.
JACOB FRENKEL: It was about 18 percent and it was sitting there for a while. Large influx of immigrants from the former Soviet Union, which meant a huge change in the labor force of Israel, with tremendous challenges as to how to provide them with employment.
And the key drastic dramatic decision that the government had to take, and fortunately took the right decision, was that it was not the government job to bloat the public sector and provide with employment.
But rather the government is to create the conditions for the growth of the private sector that will provide employment to the new immigrants.
BEN WATTENBERG: Which party was in power then?
JACOB FRENKEL: Prime Minister Shamir, the Lekud, was then the Prime Minister. And at that time I was invited because Israel really did not have any financial system that was commensurate with the challenges that Israel faced.
At the same time, Israel had not only high inflation it had foreign exchange control, it had an extremely unionized labor market and, therefore, you have to ask yourself how would the private sector thrive when their hands are tied, when there are no markets, when inflation is high, when you cannot bring foreign investment because there is foreign exchange controls. You cannot really lift yourself on your shoestrings.
BEN WATTENBERG: Isnít the basic answer to that is do nothing? And if you do nothing, markets develop.
JACOB FRENKEL: But you need to first of all undo the damage that was done there. Donít forget you have huge numbers, very strong groups that stood to lose a lot by removing their hold on the economy.
BEN WATTENBERG: So, what happened?
JACOB FRENKEL: Oh, unbelievable textbook story. Foreign investment into Israel came dramatically. Inflation went down. Growth accelerated.
BEN WATTENBERG: Hold on, it started out at 18 percent inflation and when you left?
JACOB FRENKEL: One percent.
BEN WATTENBERG: Now, is the Israeli economy doing now. The state is approaching its 60th birthday.
JACOB FRENKEL: The Israeli economy I would define it as a success story. Whether it is economic growth, whether it is the absorption of immigrants, whether it is exports, whether it is investments, whether it is domestic investments of foreign investment, Israel is doing very well.
It has price stability. It is growing at about five percent per annum, investment is thriving. And foreign investors are coming into Israel in vengeance. Of course, itís not only --
BEN WATTENBERG: Who are the American companies that are here?
JACOB FRENKEL: Well, we have had traditionally a lot of the high tech companies. And Israel has been a pioneer in the high tech areas, so most of the computer systems company have had the --
[speaking over each other]
JACOB FRENKEL: -- whether it is IBM or Intel or companies of that type. But we -- more recently we saw major investors like Buffet, who bought a major Israeli company that has operations all over the world.
To make a long story short, Israeli economy is doing very well. But letís understand we believed in miracles, but miracles must be earned. And the truth of the matter is that I give great credit to the range of economic policies that have been undertaken.
BEN WATTENBERG: What percent of the Israeli economy goes to defense?
JACOB FRENKEL: Oh, this is something which is extraordinary. We started with a very very large number, where 50 percent -- then it went down, then it went down, then it went down.
And I must say that -- when I said about miracle -- I said that in spite of all the military building that Israel had to incur -- yet, it was able to excel in the economic scene.
BEN WATTENBERG: Hold on a minute. As wealth increased and as population increased, the percentage to produce a fixed amount of military goods and services goes down.
JACOB FRENKEL: That is correct. But I want you to know also that some of the benefits from the spending on defense are spread all over the economy.
Itís not just providing employment or demand, the technology that hasnít been developed even in the Air Force or in other units in the electronics field laid the foundation to much of our high tech economy.
BEN WATTENBERG: We came here with THINK TANK about nine or ten years ago and we interviewed a young man and two partners from the IDF. A guy named Bill Schwade [phonetic] who started Check Point.
BEN WATTENBERG: And I asked him about the revenue stream and he said it was going up and up and up and up. And I went back to the United States and bought some of the shares and they went from 10 to 120, then they came down a little bit, but it was all from the army. It was the Checkpoint with a fire wall system.
JACOB FRENKEL: Indeed, indeed. And this is only one of many. The fire wall systems, many of the electronics that were developed in artillery or in the Air Force have now been diverted towards more civilian use, major export industries. And it was the high tech that was developed.
Therefore, when we looked at defense spending -- you know the tendency is to say itís always -- if we only had peace, we would have had so much more.
But letís recognize that, yes, I wish we all had peace, but given that youíre invested in defense in the modern era -- defense means know-how technology.
BEN WATTENBERG: In your talk today at the Herzliah Conference, you indicated that the balance of trade was very important and that the United States was in a negative situation.
Your old friend, and my old colleague, Herb Stein, used to say it doesnít matter. It just doesnít matter. Because -- particularly in the case of the United States, where sell goods and they donít redeem the dollars, they keep them.
From our point of view it is a cheap dollar, they invest in the United States and when we buy their goods they put them in the bank. And the reason he -- you said, oh -- one of the other speakers said, isnít wonderful China has such a high savings rate.
They need a high savings rate. The United States and Israel have Social Security, they Medicare, they have Medicaid, they have AIDS education. China doesnít have very much of that. They better have a high savings rate.
JACOB FRENKEL: When our good friend, Herb Stein -- he was probably one of the wisest economists I ever met and a dear friend of Israel, had a lot of wise remarks. Of course if itís not [unintelligible] we know all of that.
The reality is that if we could be sure that when the US saves so little and has to rely on foreign capital to finance its deficit --
BEN WATTENBERG: Hold on a minute. The deficit in the United States is about one percent of GDP which is about a half to a third the historical average. It is a drop in the bucket.
JACOB FRENKEL: Iím talking about the deficit in the balance of payments, which is a bit larger. But the important point is --
BEN WATTENBERG: Iím talking government spending.
[speaking over each other]
JACOB FRENKEL: Iím not worried about the budget at this stage. Iím much more worried about the current deficit in the balance of payments.
Because what happens is that year in and year we are incurring debt not just to the rest of the world, but to two major groups in the rest of the world. And I would not choose them to be my bankers.
BEN WATTENBERG: When you say we youíre talking about Israel?
JACOB FRENKEL: The United States, Iím sorry.
BEN WATTENBERG: And who are they?
JACOB FRENKEL: The first are the Asians countries, particularly Asian central banks. They run surpluses in the current accounts to a very high degree reflecting the high saving rate.
There is another group which is more recent and thatís the oil exporting countries, primarily from the Middle East and the Soviet Union.
If they were willing to keep it up forever all the best. I will get goods, they will get papers and letís give a party. The fact of the matter is that we do not know if they will do it like that.
They can now generate a sovereign wealth fund and do something and do something else. Now they are --
BEN WATTENBERG: Now, wait a minute, not something and something else, what could they do with that money that would hurt the United States.
JACOB FRENKEL: Iíll tell you, two things. First we already now see a reduction in the external value of the dollar. We see a significant depreciation of the US dollar -- if you allow me just to finish the sentence -- you see depreciation in the value of the dollar.
This stimulates US exports. At the same time, those heavy holders of US dollars may say to themselves, you know, what itís not a great deal to hold this depreciated currency. Why donít I shift slowly to holding other currencies. And after they think about it aloud, the market will be destabilized. Itís not in our interest that the market gets destabilized. They can also use it as a political weapon which is not in the interest of the US either.
BEN WATTENBERG: Now, hold it. Letís say that you are the head of a pension fund in China or India, Russia or Israel, Europe or Brazil, you have hundreds of billions of dollars.
Youíre going to say I have to invest it. And I -- so, where do you invest. I say, I want to find a big country, stable country, a respected country and a free country. Is there more than one.
JACOB FRENKEL: I would say that this is a fantastic case, if the decision maker in this pension fund was a man who is guided by the principles that would guide you or me as a responsible head of a pension fund.
But if he is a political appointee of the government that is not completely known for its liberal attitude or a government that is not completely running the best democracy in the world, of a government that is capable of using the resources at its disposal for other objectives, I would just say I want to have additional bankers as a fall back position.
BEN WATTENBERG: You also spoke today -- and this is for our American audience -- you were very concerned about the housing situation, the sub prime rates. And I talked to you about demographics. Now, in the next 40 years America is going to grow by 40 million people.
Now, there are two possibilities. Youíre either going to have a very strong rebound in the housing market or youíre going to have 30 million people sleeping in the streets. Those are the only two possibilities that I can think of.
[speaking over each other]
BEN WATTENBERG: -- people -- new 40 million people have to live somewhere. Where are they going to live? Is that going to create -- is that going to recreate a housing boom?
JACOB FRENKEL: Iím a great believer in the American economy. But letís face it we need also to address the current situation and to draw the lessons.
There have been a lot of excesses that need to be taken care of and we will not take care of -- we will not take care of it [unintelligible] America [unintelligible] unless we recognize where it came from.
Let me give you an example. There was a dream, a house for everyone and many unregulated mortgage companies provided no documentation mortgages to everyone, with teaser rates, without checking even if the borrower is credit worthy or not. And the borrower took it, because his home went up in price and the celebration went up.
The banks that issued the mortgages never had it on their balance sheet. They sold it under the rating of the rating agency who said those are reasonably good --
BEN WATTENBERG: They sold it under what?
JACOB FRENKEL: Under the rating of the rating agency --
[speaking over each other]
BEN WATTENBERG: Right, right.
JACOB FRENKEL: -- described as a good law, but who pays the rating agency. The issuer, not the investor. Look at the messed up, screwed up incentive system. The rating agency is hired by the issuer that wants a higher rating.
BEN WATTENBERG: All right, now, hold --
JACOB FRENKEL: Wait Iím telling you that this is the main lesson to be learned from it. A main lesson. We need to change the way in which the rated agency market works.
We need to increase competition in this market, we must increase transparency so you and I and the bank and the borrower and the regulator know who holds the bag. Once a loan is given, it is being sold off, off balance sheet, who owns this bank.
BEN WATTENBERG: Okay. All right.
JACOB FRENKEL: The decline today in the financial markets, to a large extent, reflect the extraordinary confusion about risk, the pricing of risk and how it all settles.
BEN WATTENBERG: I accept your argument. Now, will you listen to my argument.
BEN WATTENBERG: A lot of poor people -- lower middle class people -- who would not have been able to buy houses bought houses. Letís say 100 of them bought houses that they would not have been able to -- a certain percentage of them -- they didnít have jobs. They lost their jobs. Their wives lost their jobs, had to give back their houses.
So, theyíre back where they were. The others -- and I think the figure must be 50 - 60 - 70 percent. I donít have the numbers, they still have the house.
They got raises, they got two people working, so it may have been financial policy, but the home ownership rate in the United States now -- and weíre talking principally single family houses, not condos. I mean, weíre talking real American Dream houses is about 70 percent.
So, can it be that it was bad financial policy and good social policy?
JACOB FRENKEL: No, and I will tell you why. Very clear. Sounds like a free lunch and you know there is no such thing as a free lunch. There is nothing more expensive than a free lunch.
The situation is that once the house prices started to decline and the banks had to write off their assets, what they thought were good assets to write them off -- they needed to cut down the credit they give because their capital has declined.
And who do they cut down the credit to? To the corporate sector, to those investors who would have liked to invest. So, basically in the morning after, you have a situation where -- what we call in the jargon -- spread in the market or put in a more normal language, the interest rates that an investor has to pay for a loan from the bank is now higher than what it would have been because it is now viewed as a riskier situation.
And thatís one of the results of fulfilling the American Dream of giving to those who are not credit worthy loans. So, let me tell you the damage is spread much beyond the housing market.
And the danger of a slowdown now spreading beyond the housing market --
[speaking over each other]
BEN WATTENBERG: Now, now, now, now, now, now wait a minute. Letís take things one at a time. There is a free lunch. Itís called liberty and innovation. If you have a democratic country with a free market and smart people and motivated people you got a free lunch.
And what youíve described in Israel is just that kind of free lunch.
JACOB FRENKEL: Well, when you --
BEN WATTENBERG: I mean, Milton Friedman notwithstanding, wonderfully brilliant statement, but it had to do with spending and government spending. The nature -- itís Adam Smith -- if you leave things alone and you let -- and you bring in a million Russian Jews, some of the smartest, best educated people in the world and you stay out -- you have to regulate, you have to give health care, you have to do all those nice things that we social democrats -- or once social democrats -- said you have to do -- and leave them alone, theyíre going to create great corporations. Got a lot of wealth.
JACOB FRENKEL: Thatís perfectly fine. And you donít have to quibble for words. I would not call it free lunch, I would call it an earned lunch, a lunch that is earned from a good policy of [unintelligible] of deregulation of liberation --
BEN WATTENBERG: I accept that. Okay. All right now, Iím going to make you briefly President of the world. And you want to create a maximum amount of wealth for a maximum amount of people -- Jeremy Benton, okay. What do you do?
JACOB FRENKEL: First of all I would recognize that in order to distribute a pie in whatever way I want to distribute, the size of the pie must be maximized.
So, the question therefore -- or the guidelines for me would be find where is there the largest potential growth in the world that you are ruling, shower resources there, do the right thing about it, maximize the size of the pie and then ask yourself how do I distribute in the best way that does not screw up incentives.
Probably Africa has about close half a billion people if we are able to give them the medical, the education, the water and all the rest -- and young population.
We have in China 200 million extra, we have in Indian 300 million extra. How can we make sure that they are producing the most for the world in which we are supposed to --
BEN WATTENBERG: No, but that wasnít the question -- well, that was part --
JACOB FRENKEL: That was --
BEN WATTENBERG: No, no, no -- the question --
[speaking over each other]
BEN WATTENBERG: Let me rephrase it. Letís say youíre not President of the whole world --
[speaking over each other]
BEN WATTENBERG: Well, I understand -- just a moment here -- youíre now President of the western world.
JACOB FRENKEL: Iím perfectly happy to go there.
BEN WATTENBERG: And you have this huge pot of money. And you want to invest it wisely and you donít want to put it just in the west, you want to put it elsewhere.
JACOB FRENKEL: If you want to be President of the United States -- of the west -- I would definitely try to get the part of the
***[GAP OF 11 SECONDS - 4:09 minutes remaining to 3:58 minutes remaining]
I donít need any favors, but I need to have playing level field.
If I have playing level field, then the size of the world will be so much bigger. You spoke about the world. The very definition of the world is that it is something that encompasses some moving parts that belong to the same machine.
At the present time there is a gulf, whether itís an ocean or a culture or political or traditional that makes some part of the world not part of the same machine; if you could only hook it and oil it and move it, suddenly the entire machine would be better.
BEN WATTENBERG: So, youíre very much for globalization.
BEN WATTENBERG: Now -- and I am too. You know Israel needs globalization, no question about that. But the United States is in a remarkably different -- you know de Tocqueville famous statement about American exceptionalism. All the rules donít hold for America.
JACOB FRENKEL: Well, I -- itís tempting but it is a slippery road. Itís tempting because you say, why do I need to mess up with all of these kind of things, I have a beautiful country of my own, 300 million people, etcetera, etcetera.
By the same token the reality is that openness, free trade, free movement of ideas, free movement of people and free movement of capital is benefiting everyone.
You know openness is a concept. Itís not just trade, itís openness of minds, itís openness to ideas and it is the playing level field of let the best win.
Once you define and confine yourself you really are endangering it.
BEN WATTENBERG: I agree with that. Itís not what I said. I said Iím in favor of all those things, but itís not as necessarily for the United States but it was a very eloquent summation of what in the United States would be regarded as right of center economics which I approve of and [foreign phrase]
JACOB FRENKEL: Youíre very welcome.
BEN WATTENBERG: Jacob Frenkel, thank you very much for joining us on THINK TANK. It is a -- was a most enlightening discussion. And thank you. Please remember to send us your comments by email. We think makes THINK TANK a better program. And from Israel for THINK TANK, Iím Ben Wattenberg.
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