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

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 up-till-now 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 should be made that no more legislation affecting the judiciary will be advanced without a broad consensus. And I think it’s important to start the journey towards restoring trust, and towards 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, actually. 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 I think 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 also 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 or something that describes the Israeli economy. It’s not only the share in 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. Actually, it’s quite, I think, 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 all these countries that are very dependent on tourism and that it accounts for a lot of their output and employment actually suffered a terrible blow during COVID, and Israel, because of the two sectors — actually 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. Actually, we went through the COVID crisis with a relatively mild effect and very short-lived effect.

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, it’s 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 of a central bank. But the governor of the central bank has also a relatively unique role as the economic advisor to the government, and that’s something that is atypical, and 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 advisor to the government. Therefore, he not only is responsible directly for monetary policy but he also presents the analysis of economic processes, he brings his 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 law that was changed, a new law, 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. I think their political views were never actually a factor, nor were they known. And I have to say, I very much hope that this will continue because I think being a highly-regarded institution, and independent, is very important for the economic stability and economic prosperity of Israel. If you see the comments made for example by rating agencies, they always mention the strengths of the bank, its 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 that they are a source of concern. I think, 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 advisor. He would not fulfill his duty as the economic advisor if he would not voice his views, his concern, his analysis about 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 — actually, I still do — but I viewed myself always as a public servant. And I think this is how people at the Bank, from the most junior to the most senior position, view themselves — as public servants. Definitely. And I think that 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. And I think 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 I think that you have to maybe make a distinction between short-term effects that we’ve already seen and projections of what may happen based on sort of a scenario that looks at what is happening if this kind of process goes on, based on the experience of other countries, and of research that has actually 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. I think what has changed between a week ago and now, when the first pillar of the legislation actually went through, is a difference between legislation that was considered 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, but at least it has begun to materialize. And I think 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 to actually go through this legislation without broad agreement.

So what have we seen? And here I think, 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 actually 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 actually were quite good in predicting the short-term evolution of the shekel. So, when you play or use these models, you can see what is not explained and you see actually that there is a divergence towards the weakening of the shekel from that model. And the Bank of Israel did this work, and it was published and they showed that about 10% of the depreciation of the shekel vis-a-vis a basket of currencies is related to the legislation.

10% of depreciation also means between 1-2% of additional inflation. So we’ve been talking about inflation moving up, and in some countries, we’ve already seen the decline of inflation. 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 actually apply because of the 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. So if you look at the graph you can see that 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 something between 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. So this is another example that you can actually 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. Now there was a drop everywhere, and people say that and that’s true, but when you see the extent or the percentage of the decline, you can see that it was much sharper here. And while you start seeing recovery in investment in the high-tech sector 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 explained in the beginning 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 actually listing themselves in the US and not here. If before all of this started, there was about 80% of the listing of Israeli companies were in Israel and 20% listed themselves 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 also to our resilience. We’ve gone through some very severe global shocks and the Israeli economy actually performed quite well. The effects were relatively not that severe. And it’s partly because of this sector. I think it’s also because of the institutions that were actually able to deal with these shocks. So I think 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, it’s 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. I think that even if we do, or if the government does, and if the Prime Minister actually does what I think should be done, which is the announcement that I said before, and take some other actions, I think the fact that the rift in society, the divisions in the society will be much harder to heal. I think trust has been lost, and that’s true between the government and a big part of the population, but also between the government and some, for example, the rating agencies or some other external. I’m not putting it on the same footing, but I think the issue of trust is so difficult to actually 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?

Well, I think that there are some parts of the economy that are, and again, I’m going back to the most dynamic part, that are very mobile and they can choose, 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 will have the ability to go to court if a decision seems to you by the government or by any governmental body, that it’s arbitrary, it doesn’t make sense. You had, normally, the protection of the courts. If you do not have that, you’ll think twice whether you want to really invest your money, your abilities, in a place like that.

I think there are some parts of the economy, of society that are less mobile and that will always be here. But I think it’s the parts that are very dependent on investment from abroad and on the decisions of very bright entrepreneurs and people in technology and so on. They can choose. And I very much hope that we will restore in some way their trust and their will to actually 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 before. It’s very important. And actually, these kinds of committees were set up in many places as a lesson from the global financial crisis of 2008, when I think the realization was that risks can move from one part of the financial system to another part. And if you’re not looking at the entire system as one, and exchanging information, for example, between the different regulators, you may actually have some blind spots. And I think 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 what, 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?

I think that 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 foresee, or 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 actually provide all the wrong incentives, in terms of trying to actually incentivize people from the Haredi community to get the right skills, to get the basic skills that will allow them to be in the labor market and to get a decent income from that. So the fact that we are actually expanding the budgets to these institutions that don’t teach any basic skills, and the fact that we provide further incentives to actually stay outside of the labor market, I think 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 change, 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, 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, actually, in many aspects. I have to say that we’re 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. 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 seen really a lot of achievements in terms of growth, in terms of resilience in the Israeli economy with, in a very impressive way, the last two global crises because of the things that we talked about. So I think there is a lot to be very impressed with, and I think that’s why we have so much to lose, and that’s why I try in all my ways 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 was asked before. Actually, it gave me some kind of pride, 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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