Israel’s economy: The day after the reform

By the end of July, the Israeli Supreme Court will be stripped of its power to strike down laws they consider extremely unreasonable.

I will not be discussing the ethical, social, or philosophical issues of this bill. I won’t be discussing security risks, nor the legal risk to Israelis travelling abroad. I will only be outlining the economic implications once this billed is passed

I’ve maintained a 20+ year career in the capital market, despite no formal education. It forced me to reason economics from first principles. So, I’d like to explain first why money is like fish!

Money is like fish
Imagine you’re a fisherman on the Thames in the late 1800s (I doubt there were any fisherwomen at the time!). You catch 10 fish and go to the riverside market early morning to sell your catch. If 10 customers arrive, you can charge x for the fish. If more than 10 customers show up, you can charge more than x. If less than 10 customers show up (the others went to a competitor), you charge less than x. This is the dynamic of supply and demand.

The historical geography of London was built around the fishing industry. Bankers saw the opportunity to lend to fishermen and set up their industry close to the river. Next, fishermen realized they need lawyers (as protection from the bankers) – the legal centres in London grew up around the banking system. Then bankers realized they needed insurance, and thus the insurance industry developed adjacent to the lawyers. Indeed, supply-demand dynamics in the fishing industry had an impact on money flows through all these industries, and a knock-on impact to the wider economy related to salaries taken home by employees of this eco-system.

The reason Jews became central to European money lending was not simply antisemitism locking them out of industry. Jews, unlike many others, understood that money works like fish. So, it’s ironic that today’s Israeli government either lacks such understanding, or simply doesn’t care.

In what way is money like fish?
Just like fish, currencies increase and decrease in value based on their supply and demand, and the knock on effects are diffuse. If more people want USD than NIS, then you must spend more NIS to get the USD e.g., the value of a USD1 would move from NIS3.5 to NIS3.7 – it now costs NIS0.2 more to buy the same dollar. The Shekel has weakened i.e., it has less purchasing power.

But what makes a currency more-or-less interesting to investors? Potential returns – the more one can make in assets denominated in said currency, the greater the demand. Interest rates are one such driver – higher interest rates mean higher returns, which leads to more currency demand, which strengthens the currency. Yet, the key word is POTENITAL returns. Investors are in the business of buying low and selling high – the difference being the forecast potential in returns.

The Israeli government is making decisions that over the medium to long term will continue make the shekel progressively less attractive when global investors make their forecasts.

Rating Agencies
Moody’s made it clear that they will downgrade Israeli debt should they see decreases in transparency and governance. By definition, removing the reasonable test lowers the bar, and the market will not react kindly when the government fires the attorney general and chief of police, transfers more security power to an unchecked Ben Gvir, and gives the purse strings of the country to Deri (on a suspended sentence for fraud). Once a country’s debt is downgraded, not only do its borrowing costs jump, but capital leaves the country, and the local currency weakens. Without strong governance, global investors will be concerned about the strength of the Israeli economy, as well as the risks to the rights of individual property ownership – it would no longer be unreasonable for the government to nationalize Israel Chemicals for example.

A country’s budget is like a home’s budget. Let’s say a family just about makes its bills every month, but suddenly one of the children requires a brace for his or her teeth. The parents have several choices. One is to borrow the money; the other is to cut back on spending elsewhere. Borrowing must be paid back, and we said the family only just make their bills, so instead they decide to stop eating out. Multiply this across many families, one will see a decline in restaurant profits, and the manager will eventually have to fire employees… and a vicious downward cycle begins.

On the country wide level, everything we consume is either imported (meat, white goods) or sourced locally (fertilizers, vegetables). That which is sourced locally is either consumed domestically or exported. Once capital starts leaving a country its trade deficit expands. In other words, there is more being imported than exported. Eventually the gap must be paid for – the country can either borrow, reduce import led consumption, or build new industries to export.

Israel has a large concentration of exports in the tech industry, which rely on foreign investors to keep functioning and growing. Yet as explained above, without a reasonability test, global investors will stop investing in Israel. The immediate impact will be increased unemployment, collapse in corporate real estate, and of course a material reduction in tax receipts.

Reduced tax receipts eventually create a budget deficit, which gives the government a number of choices. Borrow – can’t do so forever. Increase tax rates – which reduces consumer spending and business growth. Cut spending – we’ve just passed the most expansionary (inflationary) multi-year budget in decades. Eventually the gap must be closed somehow, or the country defaults and quickly looks like Argentina.

Independence of the Bank of Israel
The rhetoric against the current governor has been popularist. No doubt, the speed of rate increases has been crippling for borrowers. It has been particularly hard for the Haredi community who have a disproportionately high exposure to floating rate mortgages (partially explaining the pressure for the expansionary budgetary).

Currently, Israel’s central bank is run by professionals with no political interference. Central banks take a long-term view – politicians must take care of their constituents in upcoming election cycles. Therefore, when politicians set interest rate policy it creates gross distortions in the stability and long-term prospects for an economy.

The current governor’s tenure ends later in 2023. It’s a no brainer that the prime minister will appoint Avi Simhon as his successor; Simhon is a Likud man through and through! With less clarity on the long-term outlook, more capital will leave Israel. Simultaneously, the local banking sector will have less information to forecast and budget, and will give out less loans. That will lead to further shrinkage of the Israeli economy, and most likely higher interest rates.

1 August 2023
The sun will rise. Bibi will tell us that the economists were scare mongering.

The Bank of Israel sits on USD200bn of reserves (interestingly the same nominal figure the Turkish Central Bank had when Erdogan was first elected). With a yes man at the helm of the Bank of Israel, the government will gradually spend these USD reserves to buy NIS, ensuring the Shekel does not weaken dramatically at least until after the following election. I’ve no doubt Israel’s next election will be deemed democratic. But the tagline will be “leftie elite economists” who got it wrong, and we got it right.

During this period, the government is likely to cut expenditure. The first to go will be long-term projects where the public will not feel the pain for many years: infrastructure. Israel already requires an additional NIS 50bn infrastructure spend a year until 2040 to keep within OECD norms. Poor infrastructure, especially transport, leads to lower economic productivity. Imagine how much time you’ll waste on the Ayalon in 2035. The tag line about taxes will be the same: “leftie elite economists” who got it wrong, and we got it right.

The current coalition will win again, and only then the economic woes will set in. By this time, it is very hard to reset the economic clock. This is exactly what happened in Turkey. With no more reserves, high borrowing costs, and no more long term programs to cut, the Shekel will begin to weaken dramatically.

A weak currency is a major driver for domestic inflation. How? That Chevrolet you were going to buy was NIS100,000. Really, it was USD28,571 at an exchange rate of 3.5. But now the exchange rate is 4.0, so the car is NIS114,285. The price of the car for Israelis has increased 14% in an environment of high interest rates, and higher unemployment. Multiply that across all imports, including oil.

The best tool for tackling inflation is interest rates…. I think you understand the vicious cycle here.

Wrapping Up
My thoughts are not theoretical – over my 20+ year career in the capital market I’ve witnessed what happened in Russia, Turkey, Hungary and Poland. There is a reason why Hungary’s interest rates are 13%, and inflation is 21.9%.

These dynamics are all interlinked and complex. It is not easy to encapsulate them in a blog post. As such I’ve tried to simplify them, which I’m sure leaves my opinions more easily open to attack. But I would be so relieved for someone to tell me why I am wrong.

At the end of the day, it doesn’t matter what one’s beliefs, creed, race, gender, or the size of one’s peyot (side curls) – to quote James Carville… “It’s the economy stupid!”