The Economic Implications of the Coalition’s Legislative Initiatives

This paper seeks to elucidate the economic consequences of the judicial overhaul. It approaches the topic through the lens of the new institutional literature in economics, which has extensively addressed the link between democratic institutions and the economy in recent decades.​

Photo by Tomer Neuberg/Flash90

In January 2023, approximately one week after Israel's 37th government took office, it introduced a comprehensive set of bills to bring about significant and fundamental changes to Israel's judicial system and the relations between its branches of the state. These bills sought to reduce the powers of the judicial system and the office of the Attorney General, thereby removing restrictions on the executive branch both in theory and in practice. Additionally, the coalition proposed other legislative initiatives and policy actions with similar goals. Throughout the process, referred to as "the coalition's initiatives" or "the legislative initiatives," Israel has experienced a period of unprecedented uncertainty. This period has disrupted Israeli society and raised essential questions about power dynamics, the structure of political rule, and the essence of democracy. The coalition's initiatives have faced strong opposition from various sectors of the Israeli public, leading to fierce criticism from senior figures in the business, legal, academic, and political communities. However, those favoring the initiatives enjoy broad public support and hold a majority in the Knesset following the November 1, 2022 elections.

Economists in Israel and other countries have censured these initiatives, warning about their negative impact on Israel's economy. On January 22, former Governors of the Bank of Israel, Karnit Flug and Jacob Frenkel, published an article cautioning that curtailing the judicial system's independence would likely hinder growth and result in a lower international credit rating for Israel. [1] On January 25, a letter known as the "economists' letter" was published, signed by hundreds of economics experts. It warned of the potential damage to the Israeli economy if the legislative initiatives were enacted into law, particularly emphasizing the long-term harm to economic welfare and growth.[2] Nobel laureates in economics and former director-general of Israel's economic government ministries were among the signatories. Following this, investment banks, international organizations, credit rating agencies, heads of state, and senior economists worldwide called on the Israeli government to reconsider the legislative initiatives, highlighting the potential damage to Israel's economy if implemented. In March and early April, reports from the Budget Division of the Ministry of Finance, the Chief Economist, and the Bank of Israel also projected significant economic harm from adopting these initiatives. On March 7, 2023, [3] after issuing an extraordinary warning against the industry proposals, the international credit rating agency Moody announced on April 14 that it was downgrading Israel's credit rating outlook from positive to stable. [4]

The main objective of this paper is to provide a detailed and well-reasoned explanation for these multiple warnings, aiming to help the public in Israel understand the economists' claims thoroughly. The consensus regarding the link between political institutions and long-term economic prosperity revolves around the notion that "good" institutions, which support economic development and growth, are characterized by a system of checks and balances restricting the government's power. Monitoring and oversight mechanisms such as constitutional boundaries, an independent judiciary, the supremacy of the rule of law, and a professional and independent bureaucracy are deemed particularly important. These characteristics are closely intertwined with the current legislative initiatives and lie at the heart of the ongoing public debate in Israel. Thus, this paper seeks to elucidate this connection and examine the anticipated economic consequences of implementing the coalition's initiatives. It approaches the topic through the lens of the new institutional literature in economics, which has extensively addressed this link in recent decades. [5]

After providing an overview of the research literature and theoretical frameworks, we present empirical evidence that supports the connection between checks and balances and long-term economic development. Acknowledging the limitations in making precise economic forecasts spanning several decades and the challenge of identifying causal relationships is essential. Therefore, the empirical evidence we present aims to demonstrate the general direction and potential magnitude of the effects of the coalition's initiatives on the economy. [6]

Considering the extensive knowledge accumulated in economic research regarding the significance of checks and balances for economic development and the expected damage to this system in Israel, we view these indicators as indicators of potential financial harm. While precise and reliable forecasts are challenging to create, it is crucial to make the public and elected representatives aware of the extent of this damage to facilitate informed decision-making, mainly when the consequences are so significant.

To quantify institutional characteristics, we utilize established measures of checks and balances, particularly indicators of judicial oversight of the executive branch across various countries over several decades. In line with previous research in this field, our analysis demonstrates a positive statistical correlation between measures of judicial oversight and long-term economic development, as measured by per capita GDP adjusted for purchasing power parity (PPP). Additionally, we estimate the correlation between institutional indicators and other economic indicators, such as fixed capital investment per capita, innovation levels, and corruption in the public sector.

The relationship between institutional indicators and long-term GDP per capita is assessed using two empirical approaches. The first approach relies on short panel data, identifying controlled variation across different states. This approach considers long-term variation in institutional quality among countries and aligns with the known consequences from the research literature regarding institutional characteristics' impact on economic development. However, it is challenging to isolate the influence of individual and institutional factors reliably.

The second approach follows the empirical strategy that Acemoglu et al. (2019) proposed, which identifies changes in institutional characteristics within a specific country over time. This approach offers more reliable identification of the institutional impact, isolating it from other influences and accounting for dynamic trends in GDP. However, it does not leverage the variation between countries, and the GDP data used are not adjusted for PPP.

These two approaches complement each other. Generally, the first approach yields a higher estimate of the impact. Still, both indicate that judicial restrictions on the government significantly and primarily affect long-term economic development.

To apply these correlations to the anticipated changes in Israel resulting from implementing the coalition's initiatives, we employ two methods to quantify institutional changes. First, we estimate the expected changes in Israel based on similar changes in Hungary and Poland, assuming similarities in the democratic decline between those countries and what is anticipated in Israel. Second, we utilize a simulation conducted by political scientists in Israel to evaluate the change in the judicial review indicator resulting from the initiatives' implementation. Alongside the statistical correlations described earlier, these approaches provide estimations that reflect the potential long-term damage to Israel's economy.

Based on the calculations presented, the estimated damage to long-term per capita GDP ranges from tens of percent. The different simulation and specification estimations indicate a decline of 9% in the most optimistic scenario to a drop of around 45% in the most pessimistic scenario, relative to an alternative method without implementing the legislative initiatives. In terms of real-world impact and using figures from 2022, a 10% reduction translates to an annual income loss of approximately 175 billion NIS, equivalent to around 92,000 NIS for a household of five each year. [7] Moreover, implementing the legislative initiatives is expected to elevate public corruption levels in Israel to a range comparable to countries such as Cuba and China in the more negative scenario or Slovakia and Fiji in the less harmful method. While not definitive, these estimates portray an unprecedented potential danger on a substantial scale that could significantly hinder Israel's economic development for many years, potentially placing it at the bottom among developed countries.

It is important to note that several characteristics of Israel's economy raise concerns about the potential for rapid and severe economic damage. Firstly, the high-tech industry in Israel is susceptible to changes in the judicial and governmental environment. It heavily relies on foreign direct investments, which can quickly and easily be redirected to other markets if the domestic climate deteriorates. Additionally, there is a long-term risk of a significant "brain drain" as highly skilled workers, crucial to the local high-tech industry, possess high mobility and may choose to leave the country due to unfavorable conditions. [8]

Another significant concern in the Israeli context is the sectorial structure of Israeli society. Existing literature highlights that institutions enabling smaller population groups to rule with minimal restrictions can impede long-term growth. These institutions prioritize sectorial interests over national economic resources, hindering efficient resource allocation and adverse conditions conducive to innovation. In Israel, sectorial budgets have particularly severe implications due to factors such as the high birth rate and educational challenges faced by the Haredi community and their low workforce participation. Many economists view these factors as the most severe threat to Israel's long-term economic future. [9]

It is also crucial to consider the damage that has already been inflicted on Israel's economy in recent months. The paper briefly describes and documents the significant economic harm from increased business environment risks, negative market sentiment, and growing expectations of future damage. Among the issues examined are the development of disparities in share prices between Israel and other countries, the depreciation of the shekel relative to the US dollar, and the decline in investment volume in the local high-tech industry, surpassing the global trend of decreasing high-tech investments.

Specifically, the study examines the performance of the Tel Aviv TA-125 and TA-35 stock market indexes compared to the American S&P 500 index. The analysis reveals that these indexes exhibited nearly identical trends until November 2022, coinciding with the most recent Knesset elections. Subsequently, a significant divergence occurred, with the Israeli indexes performing significantly worse than their American counterpart. As of early May 2023, the Tel Aviv indexes were underperforming the S&P 500 by approximately 20 percent. According to estimates, this underperformance reflects an alternative scenario without the shocks experienced in recent months, resulting in a loss of value of around 12-14 percent in dollar terms, compared to an 8 percent rise in the value of the American index. The underperformance is not solely attributed to the decline of the shekel in the Israeli indexes but also the shekel's devaluation. In other words, an investor who purchased Israeli shares on election day would currently possess a dollar value 20 percent lower than an investor who chose to invest the same monetary value in American shares. Consequently, Israeli households' wealth has suffered damage in tens of billions of shekels.

Furthermore, it is observed that since the end of January 2023, there has been a rapid and unusual decline in the value of the shekel relative to the forecast based on a well-ordered pattern that had been carefully maintained over a long period about the S&P 500. This divergence commenced following the publication of the coalition's legislative initiatives and intensified as the extent and expected risks associated with the proposed legislation became clearer. It is essential to approach these results skeptically, considering the pace of recent developments and the limited availability of up-to-date data. Nonetheless, these results indicate the prospects of the Israeli economy in the long term rather than the problem itself. The seriousness of these results highlights the high level of pessimism in the financial markets regarding the future of the Israeli economy.

Naturally, each piece of evidence presented in this selection constitutes only partial proof or precise quantification of the expected economic damage. However, collectively, they all point to the same conclusion. The existing knowledge from the literature, the empirical findings presented, and concerns about the structure of Israel's economy and society collectively indicate that the danger is accurate, and the potential scope of the damage is a significant, warranting grave concern.

 

Footnotes:

[1] Karnit Flug and Jacob Frenkel, “Governors’ Warning: This is How the Judicial Revolution Can Damage Israel’s Credit Rating—and its Economy,” Ynet, January 22, 2023 https://www.ynet.co.il/economy/article/sydcvb9io. See also Porat Hirsh, Flug, & Kenneth Portal (2023), published the same day, on the possible impact of the legislative initiatives on Israel’s credit rating and foreign investment.

[2] The initial economists’ letter—which the authors of this paper helped organize and draft— can be found (along with other documents relating to the economic impact of the legislative initiatives) at the following website: https://economists-for-israeli-democracy.com/.

[3] Moody’s Investors Service (2023a).

[4] Moody’s Investors Service (2023b). Reports from the other two major credit rating agencies, Fitch and S&P, also warned of the negative effects of the legislative initiatives on Israel’s future credit rating, or of an attempt to force through such measures without broad consensus. See also the announcement issued by Fitch Ratings on March 1, 2023, and the announcement from S&P Global Ratings on May 12, 2023.

[5] Some view the principled confrontation between the camp that supports the legislative initiatives and the camp opposed to them as an argument about the essence of democracy: Is democracy a system that first and foremost implements the principle of decision by the majority, or one that uses this principle to resolve disagreements while also maintaining and advancing other important principles, such as the rule of law and the defense of minority rights. This paper does not presume to address this question, at least not in the accepted sense, but rather takes as its premise that the intended result of the coalition’s initiatives is to remove checks and balances from the ruling groups in the political system, and thus make it more difficult to carry out effective oversight of the executive branch.

[6] In general, economic analyses struggle to provide unequivocal forecasts for the short term, and even more so for a horizon of decades. There are (at least) two main reasons for this: First, quantifying the impact of the coalition’s initiatives on the indicators that assess the system of political rule is difficult, and entails a degree of uncertainty. And second, the inherent complexity of economic systems, such as states, makes any attempt to create precise numerical forecasts for a period of decades in the future a highly ambitious undertaking. In addition to these two reasons, there are challenges relating to empirical identification, which can be partially overcome in this instance.

[7] In 2022, Israel’s GDP was around NIS 1,765 billion—equivalent to approximately NIS 184,000 per capita (in current prices; Bank of Israel, Annual Report, 2022).

[8] A document produced by the Aharon Institute (2023) details various scenarios for the impact on growth of the global high-tech crisis and the judicial revolution. See also Section 2 of this paper regarding the importance of high-tech for Israel’s economy.

[9] On the significance of the coalition’s budgetary allocations to Haredi education, see the economic professional opinion provided for the government resolution by the Budget Department on May 12, 2023 (Ministry of Finance, 2023).