Netanyahu can only save Israel's economy only if judicial reform stops - opinion

By maintaining Israel’s rating, the credit rating agencies gave us an opportunity to avoid the worst of possible economic outcomes – it is critical that we do not miss it.

 PRIME MINISTER Benjamin Netanyahu and then-incoming Bank of Israel governor Jacob Frenkel attend a news conference in the Knesset in 2013.  (photo credit: MIRIAM ALSTER/FLASH90)
PRIME MINISTER Benjamin Netanyahu and then-incoming Bank of Israel governor Jacob Frenkel attend a news conference in the Knesset in 2013.
(photo credit: MIRIAM ALSTER/FLASH90)

Earlier this year, we published an article warning against the dangers of the judicial reforms, after they were proposed by the justice minister, for Israel’s economy. We warned about a potential decline in foreign investment; a rise in the country’s borrowing costs; damage to Israel’s credit rating; and long-term harm to economic growth in Israel, particularly its main growth engine – the hi-tech industry. 

The Reasonableness Amendment, passed last month, which limits the High Court’s oversight of government decisions, is the first stage of the comprehensive judicial overhaul. Merely the concern that legislation of this sort would be passed had already caused a sharp drop in investment and activity in Israeli hi-tech, a decline in the value of the shekel, a rise in Israel’s risk indicators, and poor performance of Israel’s stock markets. The passage of this amendment along narrow partisan lines changed the situation. What, until now, had been a negative scenario that might come to pass, has become a negative scenario that is now being realized. Indeed, the market reacted immediately with a sharp devaluation of the shekel, alongside a decline in stock market indices. 

The Reasonableness Amendment adopts the most extreme form of restriction under consideration. It was passed in the most heavy-handed way possible – without a comprehensive discussion of the law’s consequences for the economy or for Israel’s security and foreign relations, and with complete disregard for the recommendations and warnings issued by experts in Israel and abroad.

This legislative process was also in blatant contrast to Prime Minister Benjamin Netanyahu’s commitment to the credit rating agencies that he would not advance legislation without broad consensus. In a recent interview with Bloomberg, he announced his plans to “only” enact one more law from the judicial overhaul package concerning the Judicial Selection Committee. It should be noted that this law is in fact at the heart of the judicial overhaul debate, so the announcement did not alleviate concerns. All of this has severely damaged his credibility while harming Israel’s international standing.

Israel and Netanyahu are harmed by judicial reform's economic impact

The economic outcomes of this are expected to be severely damaging, as indicated by the prompt negative response of Citibank and Morgan Stanley, in addition to the rating agencies Moody’s, S&P, and Fitch. The consequences are serious, as can be learned from events in Hungary, Turkey, and other countries that have followed a similar path. 

The Fitch Ratings building is seen in New York (credit: REUTERS)
The Fitch Ratings building is seen in New York (credit: REUTERS)

As of today, investment in hi-tech, the growth engine of Israel’s economy in recent years, continues to fall. This sector is seeing a decline even as the hi-tech industry globally is showing signs of recovery. Moreover, over the last six months, almost no new hi-tech companies have registered in Israel. Instead, they are registering abroad, which means Israel will lose out on a large share of their future economic activity and the tax revenue they generate. In parallel, there has been a sharp decline in employment and number of jobs available in the hi-tech sector. 

Furthermore, the value of the shekel has fallen considerably, and according to the Bank of Israel’s assessment, it has depreciated by about 10% due to the market reaction to the mere intention to pass the judicial overhaul. This has contributed approximately 1.5 percentage points to the rise in inflation and worsened the already high cost of living in Israel.

The stock markets in Israel have seen significantly inferior performance compared to that of the main stock markets in developed countries over recent months. For example, the “Tel Aviv 35” (which tracks the share prices of the most important 35 companies listed on the Tel Aviv Stock Exchange) has risen by only 4% through the end of July 2023, compared with rises of about 19% for the S&P 500 and 44% for NASDAQ. The risk premium for Israeli bonds has also increased, resulting in higher borrowing costs for the government. Furthermore, in the time since the judicial overhaul was announced, pension funds and other savings accounts have increased their investments abroad at an unprecedented scale. 

In terms of Israel’s credit rating, Moody’s has downgraded its outlook from positive to stable. Fortunately, all the other agencies refrained from lowering their rating outlooks, though they unequivocally state that the judicial overhaul legislation is harming the country’s institutional resilience and system of checks and balances. They further note that if the judicial overhaul legislation continues to move forward without broad consensus, there will be negative economic consequences that could damage Israel’s credit rating.

It would be irresponsible to ignore these warnings. By maintaining Israel’s rating, the credit rating agencies gave us an opportunity to avoid the worst of possible economic outcomes – it is critical that we do not miss it.

Although the credit ratings remain unchanged, economic damage is already evident in the short term, and this has an impact on all Israelis: the devaluation of the shekel contributes to higher inflation, which is likely to induce the Bank of Israel to raise interest rates further, placing an even greater burden on households and businesses in the form of higher mortgage and credit payments. It will also contribute to a relative reduction of the value of the public’s asset portfolios; harm pension funds and other forms of savings; increase borrowing costs for the government (and consequently for the business sector); and lead to a fall in tax revenue. These last two outcomes will force the government either to raise taxes or cut its expenditure, thereby harming the well-being of Israelis through cuts to public services. They could also increase the deficit, which would simply transfer the burden onto our children and grandchildren.

As for long-term growth, all professional assessments have predicted severe declines in economic growth in the next few years, and empirical studies show that countries with low levels of judicial oversight of the executive branch have a much lower GDP per capita than those with strong judicial oversight. Thus, the long-term effect could be a sharp decline in the standard of living of all Israeli citizens.

The damage will be exacerbated by the expected exodus of hi-tech entrepreneurs and cyber experts, who are being courted by many other countries; doctors who are considering emigration, leaving an already strained health system worse off; and departing academics, whose contribution to Israel’s continuing scientific excellence is absolutely vital for the country’s innovation ecosystem.

TO OUR regret, many of the negative developments about which we warned at the beginning of the year have already come to pass. Every day that goes by without corrective steps reinforces the negative image of Israel’s economy and deters investors.

Unfortunately, there is no easy way out of this self-inflicted crisis. There is, however, a course of action that, if taken, promises to staunch the bleeding, halt the economic decline, and prevent the realization of the most pessimistic scenarios for Israel’s economy and society. That is to halt all legislation of a constitutional nature, and to declare that no law affecting the checks and balances between Israel’s branches of government, the independence of the judiciary, or the weakening of judicial review will henceforth be passed without broad consensus.

Absent such action, we fear that Israel will become more isolated internationally, more divided internally, and that the economic damage will become potentially irreversible. 

Prof. Jacob Frenkel, Israel Prize laureate in economics, is the chairman of the Jacob A. Frenkel and Mortimer B. Zuckerman Center for Global Economics at Tel Aviv University and was governor of the Bank of Israel from 1991 to 2000.

Prof. Karnit Flug, vice president for research and William Davidson Senior Fellow for Economic Policy at the Israel Democracy Institute, is a professor in economics at the Hebrew University of Jerusalem, and was governor of the Bank of Israel from 2013 to 2018. 

This is an adaptation of a Hebrew article first published in Yediot Aharonot.