No one is talking much about the first cause of the recent devaluation even though it is the most important. ¿Natural devaluation¿ that happens as the economy settles into price stability.

For the past seven years the shekel has posted real revaluation against the dollar ¿ shekel devaluation was much lower than the gaps between inflation in Israel and inflation in the countries with whom we do business.

Two forces powered the revaluation: the first was Bank of Israel¿s disinflation policy, maintaining significantly higher interest rates than abroad expressly to lower inflation. The interest rate led the public to divert assets from foreign currency to shekels and liabilities from shekels to foreign currency. The second force was the massive wave of foreign investment in Israel, motivated first by the peace process and later by the technology boom.

It was impossible to predict if and when foreign investment in Israel would weaken, stop or turn around, but it was clear as day that the disinflation policy would eventually run its natural course and Israeli interest rates would get in line with their foreign counterparts. And that is really what happened in the past year, first slowly and with great caution, and finally in a sharp drop.

Other side of the coin

The devaluation that heralded the end of the disinflation period is natural and necessary and is a mirror image of the inevitable revaluation that had preceded it for years. The interest rate drop leads companies and households to tailor their assets and financial liabilities to the new situation by increasing currency-linked assets and decreasing dollar loans.

That devaluation isn¿t just natural, but welcome. While the revaluation of the disinflation years hurt many sectors, the current real devaluation will improve profitability and bring color back to the cheeks of many companies hit by the transition from rapid inflation to price stability.

The second part of the devaluation is the devaluation in the Ministry of Finance and the Israeli government¿s status. After years in which the treasury was highly committed to responsible fiscal policy, which is accepted practice worldwide, the country fell into serious recession, catching the government off-guard ¿ and the government strayed from the path of fiscal discipline.

The first deviation, the prominent 4.6% budget deficit last year, was explained by the treasury as unavoidable due to the economy¿s dramatic deterioration at the beginning of the year and the ¿inheritance¿ from the previous government. But they won¿t be able to blame the expected leap in the 2002 budget deficit on the previous government, the global economy or the Nasdaq.

Against the backdrop of loss of control over the budget deficit, it is hardly surprising that some of the public prefers to transfer its assets to the currencies of stronger or more responsible governments ¿ the U.S. for instance.

That is the unnatural part of the devaluation, the destructive aspect. With every passing day that the deficit grows and the economic leadership doesn¿t show commitment to reigning it in, the circle of investors interested in increasing their currency exposure widens.

The third part of this shekel devaluation is what has happened to Bank of Israel¿s status in the past few months. In 2001, Bank of Israel demonstrated admirable caution in the pace of interest rate reductions despite public confidence in the shekel, the fast-dropping U.S. interest rate and the global slowdown.

The excessive caution was consistent with Bank of Israel¿s policy over the years, until one fine day the central governor decided after a meeting with the prime minister to slash interest rates by 2%. Even more surprising than the decision itself were its justifications. At first Klein said he was lowering interest ¿only¿ because of the removal of the short-term debt ceiling and expansion of the fluctuation band. He later changed his story, claiming he lowered interest rates based on government assurances it would return to fiscal discipline.

Stutter step

Since everyone knows Bank of Israel never based monetary policy on government promises, but on the budget deficit and real actions, some capital market players came to the conclusion that the central bank had weakened and been dragged into a political deal.

Klein now has to prove not only that the central bank is still committed to price stability but that he has the economic wisdom to raise and lower interest rates at the right time, as well as the street smarts to contend with the politicians.

If Minister of Finance Silvan Shalom shows his commitment to decreasing the deficit, and the central bank governor proves the deal with the prime minister was a one time slip up, price stability will be maintained, the economy will be left with only the first part of the devaluation and whether that is 10% or 5% or even 20% -- it will be nothing but welcome.