ToI podcast'We have seen the shekel weaken against all currencies'

What Matters Now to former Bank of Israel governor Karnit Flug: The economy, stupid

Leading economist offers data on the current effects of the controversial judicial overhaul legislation and projections for more ripples as the high-tech industry begins to unravel

Deputy Editor Amanda Borschel-Dan is the host of The Times of Israel's Daily Briefing and What Matters Now podcasts and heads up The Times of Israel's Jewish World and Archaeology coverage.

Welcome to What Matters Now, a weekly podcast exploration into one key issue shaping Israel and the Jewish World — right now.

Over 30 years ago, American political consultant James Carville quipped during former US president Bill Clinton’s successful 1992 presidential campaign, “It’s the economy, stupid.”

Today, a growing chorus of Israeli economists are echoing this phrase while attempting to pause the government’s judicial overhaul legislation in the hopes of maintaining Israel’s flourishing growth.

“We are now at a crossroads and I’m extremely concerned. But when I look back I think we’ve done tremendously well and that’s why I think we have so much to lose,” Prof. Karnit Flug, a former governor of the Bank of Israel, told The Times of Israel this week.

Today, Flug is a vice president of Research and the William Davidson senior fellow for Economic Policy at the Israel Democracy Institute and a professor in the Department of Economics at the Hebrew University.

Flug is hardly alone in her concerns: This week, the Bank of Israel issued its Financial Stability Report for the first half of 2023. It warned that growing and prolonged uncertainty around the implications of the controversial legislation poses a threat to the country’s financial system and economy.

In our talk, Flug gives concrete examples of what she and other analysts are seeing, right now.

So this week, we ask Prof. Karnit Flug, what matters now?

This podcast interview has been very lightly edited.

The Times of Israel: Karnit, thank you so much for joining me here today in the Nomi Studios in Jerusalem.

Prof. Karnit Flug: Thank you for inviting me.

Such a pleasure to meet you. In this week, in which a series of somewhat, I would say, dire financial reports are being issued — I wonder, and I ask you, what matters now?

What I really think matters is that an announcement must be made that no more legislation affecting the judiciary will be advanced without a broad consensus. And it’s important to start the journey toward restoring trust, and toward healing the deep divisions in Israeli society.

Okay, we are going to dive into all of that, especially the issues of trust and the psychology of finances here. But first of all, could you tell me, what is Israel’s economy made up of, in a very general way?

The Israeli economy is an advanced economy. We always used to say that it’s a small, open economy. It’s still open, but it’s not that small. And when you look at the composition of the economy, it’s quite similar in general terms to most advanced economies, where more than half of the GDP of the business sector is commerce and services, about 18% is communication and transportation, about 18% is industry and 7% is construction. So it’s not atypical.

Illustrative: Prime Minister Benjamin Netanyahu receives a copy of the Bank of Israel’s annual report for 2015 from bank governor Karnit Flug at the Prime Minister’s Office in Jerusalem, April 3, 2016. (Kobi Gideon/GPO)

But what is in some way distinct about the Israeli economy is the importance of the high-tech sector, which has both services and industry, but mostly services. And that accounts for about 18% — that was the number for 2022 — of the GDP, which is really very extreme. It’s the highest of any advanced economy. So that’s a very important feature of the Israeli economy. It’s not only that it has a high share of the GDP, it’s also the most dynamic sector. It’s a sector that has been responsible for about 40% of our growth in the last five years. It accounts for about 56% of our exports and 25% of our direct taxes. So it’s an extremely important sector.

We have a relatively small tourism sector. It’s quite surprising because Israel has so much to offer in terms of—

It’s the Holy Land!

Right, in terms of history and in terms of culture and in terms of religion. But tourism accounts for less than 3% of GDP. And if you compare it to countries like Spain or Italy or Greece, it’s less than a third of the weight in these countries. By the way, this was something that sort of shielded us from a much worse crisis during COVID, because in all these countries that are very dependent on tourism, where it accounts for a lot of their output, employment suffered a terrible blow during COVID, and Israel was protected because of the two sectors — because of the importance of the high tech sector, which continued to flourish during COVID, and the very small tourism sector that got hit. But it’s a very small sector. We went through the COVID crisis with relatively mild and very short-lived fallout.

Tourists walk near the Tower of David in the Old City of Jerusalem on June 23, 2022. (Olivier Fitoussi/Flash90)

This puts a lot of context into the very explosive comments and protest movement coming out from the high-tech sector because as you’re saying, they get a really big vote in terms of our financial stability and our economy. Now I want to also just hear a little bit about the Bank of Israel — what it is and what it does.

Well, the Bank of Israel is, first of all, the central bank that is responsible for monetary policy, for setting the interest rate, for maintaining our foreign exchange reserves. It also has a role as the regulator of banks and that’s something that’s not in all central banks, [where] the banking supervision sits within the central bank. It’s responsible for all the payment systems which is, again, a typical job for a central bank. But the governor of the central bank has also a relatively unique role as the economic adviser to the government; normally these roles are separated. But in the case of Israel, since the establishment of the Bank of Israel, the governor has been the economic adviser to the government. Therefore, he not only is responsible directly for monetary policy but he also presents the analysis of economic processes, he puts forward recommendations and he is expected to have a very clear view and voice regarding what’s affecting the economy and where the economy is going.

And is this an independent opinion, or is this some kind of politically swayed appointment?

No, it has always been an independent institution. The Bank of Israel law, which was enacted in 2010, formally establishes its independence. And in practice, the governors were always professionals, not affiliated politically, and were all very highly regarded experts in the economy. Their political views were never a factor, nor were they known. And I have to say, I very much hope that this will continue because being a highly regarded independent institution is very important for Israel’s economic stability and prosperity. In the comments made, for example, by rating agencies, they always mention the bank’s professional strengths as an important element in the functioning of the economy.

Jacob Frenkel, a former governor of the Bank of Israel, speaks during a protest against the government’s judicial overhaul, in Tel Aviv, on July 29, 2023. (Avshalom Sassoni/Flash90)

There are some who are saying that the current judicial overhaul legislation could affect the independence of the Bank of Israel. Do you see that happening?

Well, it’s not part of what was announced as the judicial overhaul. However, in parallel, and maybe it’s related and maybe it’s not related, you hear a lot of comments regarding the Bank of Israel that I would say are a source of concern. For example, when some members of the parliament, of the coalition, or some people in the government comment about the mere fact that the governor is voicing his view about the economic consequences of the judicial overhaul. The kind of comments that we’ve heard are certainly a source of concern because it seems that they don’t really understand the importance and the role of the governor as the economic adviser. He would not be fulfill his duty as the economic adviser if he did not voice his views, his concern, his analysis of the consequences of this overhaul.

For most of your career, you were inside the Bank of Israel. This is in a way, a public service job, is it not?

Yes, it is. I viewed myself — I still do — always as a public servant. And this is how people at the Bank, from the most junior to the most senior position, view themselves — as public servants. Definitely. And people who care about Israel and about the Israeli economy have a duty to voice their views based on their most in-depth analysis and based on their professional judgment. That’s what is expected of every public servant.

Let’s talk about how one can analyze what could happen. Meaning the judicial overhaul. Only one piece of the legislation has gone through so far, which obviously has caused waves, not just ripples, waves, throughout our economy or at least the feeling of how it could affect our economy. But let’s talk about the really hard measures that we have, to actually analyze this through data, through science.

So you have to make a distinction between short-term effects that we’ve already seen and projections of what may happen based on a scenario that looks at what will happen if this kind of process continues, based on the experience of other countries and on research that has looked at these kinds of effects. And it’s important to make the distinction because some of the effects are relatively immediate or are already showing in the short term.

A worker stacks dairy products at a Shufersal supermarket in the Golan Heights town of Katzrin, on July 1, 2022. (Michael Giladi/ Flash90)

What are you seeing?

Maybe one other comment before I talk about the exact indicators. What has changed between a week ago and now, when the first pillar of the legislation went through, is a difference between a scenario that could materialize and therefore, if it materializes, it’s a risk that we can talk about, and between the current situation where this scenario started to materialize. We don’t know yet exactly how [it will take shape], but at least it has begun to materialize. And that’s part of why the level of concern has been going up and we see that in the market.

Because it’s no longer theoretical, right?

Because it’s starting to materialize, and there is a realization that there is the will, and there is the power [on the part of the government], to go through with this legislation without broad agreement.

So what have we seen? One way is to look at what happened to the main indicators over the last six months or so, since the announcement of the intention to legislate this very extreme and controversial overhaul of the judicial system.

What we have seen is the weakening of the shekel against all currencies. And you can measure the excessive weakening of the shekel, because there are all kinds of things that are affecting the dollar and that are affecting the shekel beyond or regardless of the political developments. And there are models that were quite good in predicting the short-term evolution of the shekel. So, when you use these models, you can see that there is a divergence towards the weakening of the shekel from that model. And the Bank of Israel did this, and published it, and showed that about 10% of the depreciation of the shekel vis-a-vis a basket of currencies is related to the legislation.

Ten percent of depreciation also means one to two percent of additional inflation, so we’ve been talking about inflation moving up. In some countries, we’ve already seen inflation decline. So you can attribute about 1.5% of the current inflation, which stands at about 4.5%, to the legislation. That also means that some of the additional interest rate hikes that the Bank of Israel had to apply because of higher inflation can be attributed to the legislation, which means higher interest rates on our mortgages and all our credit. So these are the kinds of things that we’ve already seen.

Another element is the divergence between the stock exchange prices in Israel and for example, the S&P 500. For a long time, until the beginning of the year, the trends went together, and then all of a sudden you see this divergence. And there is a gap of 20-25% between the level of indices that represent the S&P 500 and the indices of Tel Aviv 125 or Tel Aviv 35. So, it’s a substantial loss in terms of the value of our assets and it affects pensions and it affects the value of all our financial assets. That’s another example you can quantify.

The Tel Aviv Stock Exchange, December 25, 2018. (Adam Shuldman/Flash90)

And the third element that you can see very clearly is the drop in investment in our high-tech sector. There was a drop everywhere, but it was much sharper here. And while  beginning of a recovery in investment in the high-tech sector has been seen in other places, we haven’t seen it here. So this is again an element that is crucial, because our high-tech sector — and I’ve explained how important it is for the economy, for employment, for prosperity, for taxes — if that sector really suffers a severe blow, it means a severe blow for the economy as a whole.

Another indicator of the effect of the legislation and the fear of where we’re going is the fact that Israeli startups are now listing themselves in the US and not here. Before all of this started, 80% of Israeli companies’ listings were in Israel and 20% were in the US. Now it’s the reverse.

Now, this is much harder to quantify, but it’s clearly affecting the sector that was the engine of growth in the last five years and was very important to our resilience as well. We’ve gone through some very severe global shocks and the Israeli economy performed quite well. The effects were not that severe, relatively. And it’s partly because of this sector. (It’s also because of the institutions that were able to deal with these shocks.) So we’re really weakening ourselves in many, many aspects.

Everything you’ve described has taken place in a relatively short period of time. Does that mean that it’s like a fresh stain, something we can easily wipe off of that white dress and get our economy back on its feet?

I wish I could say yes, but I am not sure. Even if the prime minister does what should be done, starting with an announcement that no more legislation affecting the judiciary will be advanced without a broad consensus, plus some other actions, the rift in society will still be hard to heal. Trust has been lost, and that’s true between the government and a big part of the population, as well as between the government and the rating agencies. Trust is so difficult to build and so easy to destroy.

So let’s talk a little bit about the psychology of the economy. Nobody can forget the scenes in, for example, “Mary Poppins” when the little boy is asking for his tuppence back and the bank crashes or in “It’s a Wonderful Life” and the same thing kind of happens. How much does the public’s psychology, the public’s perception of the stability of their country affect the economy?

There are some parts of the economy that are very mobile and they are much more reactive to these kinds of developments. If you are an investor and you’re not sure that the rules of the game are stable, you’re not sure that you’ll be able to go to court if a decision by the government or by any governmental body seems arbitrary and doesn’t make sense. Normally, you had the protection of the courts. If you don’t have that, you’ll think twice whether you want to invest your money, your abilities, in a place like that.

There are some parts of the economy and of society that are less mobile and that will always be here. But the parts that are very dependent on investment from abroad and on the decisions of very bright entrepreneurs and people in technology —  they can choose [to go elsewhere]. And I very much hope that we restore their trust and their will to put all their abilities here, and not somewhere else.

A high-tech company that employs ultra-Orthodox women in Modiin Illit. August 17, 2009. (Abir Sultan/Flash 90/File)

One of the measures that you instituted as governor is the Financial Stability Committee. What is its role — and could it save us here?

The Financial Stability Committee was set up to coordinate between the financial regulators and to look at all the parts of the financial system in a more holistic way. I’m not sure it can save us from the things we talked about, though it’s very important. These kinds of committees were set up in many places as a lesson from the global financial crisis of 2008, when it was realized that risks can move from one part of the financial system to another. And if you’re not looking at the entire system as one, and exchanging information — for example, between the different regulators — you may have some blind spots. And the Financial Stability Committee is important for that. I’m not sure it can save us from ourselves.

Let’s talk about more of a long-term view: Israel is, of course, the startup nation, which plays into the 75-years-young mindset of Israelis in general, and the “yihiyeh beseder,” the “it’ll be okay” mentality. But long-term thinking — it appears to anyone who studies the demography of the country that a large chunk of our population in 20-30 years is not going to be employed. So how does that work into all the financial forecasting that people such as yourself do?

The demographics or the growing share of the Haredi population is certainly something that we have to analyze. Now, it’s hard for me to believe that the economy will continue to flourish if the Haredi community does not somehow get more engaged in economic activity in Israel. What worries me very much is that recent decisions by the government, and the coalition agreement, provide all the wrong incentives in terms of trying to incentivize people from the Haredi community to get the basic skills that will allow them to join the labor market and to get a decent income from that. So the fact that we are expanding the budgets for these institutions that don’t teach any basic skills, and the fact that we provide further incentives to stay outside of the labor market, is very worrisome. I don’t see how Israel can continue functioning in 30 or 40 years, when this part of the population will be about one-third up from about 13% that they are now, without a serious change in the way that they are engaged in economic activity.

Everything you said is extremely depressing, I have to say. But I feel like there is some kind of ray of hope that I can pull out of you somewhere. So perhaps in this direction: Your research was about labor markets. And are you seeing any kind of improvements in the labor markets over the past several decades?

Oh, yes, I’ve seen a lot of improvements in many aspects. I have to say that we’re now at a crossroads and I’m extremely concerned. But when I look back, we’ve done tremendously well. And that’s why we have so much to lose. If you look at participation in the labor market, there was a huge jump. And in spite of the fact that there is this part of society that is very modestly engaged in the labor market, when you look at the average, we are higher in terms of labor force participation or employment than most advanced economies.

We have seen quite a substantial decline in income inequality because of this process of more people getting into the labor market. We’ve really seen a lot of achievements in terms of growth, in terms of resilience in the Israeli economy during the last two global crises. So there is a lot to be very impressed with, and that’s why we have so much to lose, and that’s why I’m trying every way I can to explain why we should stop this madness and go back to a more constructive path.

A NIS 20 bill with former governor of the Bank of Israel Prof. Karnit Flug’s signature. (ToI Staff)

My final question for you is more personal in nature. How did you feel the first time that you saw your signature on the shekel bills?

Wow, that’s not a question that I’ve been asked before. It made me proud, I have to say. When I pay with bills with my signature [on them], I sort of chuckle and I say: “Wow, well, I did something.”

You definitely did. Thank you so much for joining me today.

Thank you.

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