On Monday, August 26, Bank of Israel governor David Klein announced interest rates, for the last time in Jewish year 5762. The lending rates on the central bank sources were t stay at 9.1%, he said.

Almost exactly a year ago, on August 27, 2001, Klein announced the rates for September: 6.3%.

Klein plays a central role in today's high interest rates, which have widened the interest gaining between the shekel and dollar from 2.8% in August 2001, to 7.35% in August 2002.

The year 5762 was a bad one for the governor, maybe the worst in his long central bank career, which began in the late 1980s. There was his misguided decision to lower key rates by 2% in December 2001. There was his belated response to the consequent rapid devaluation of the shekel, his fights with the finance minister, and his straining to torpedo any efforts to reform the Bank of Israel.

For almost two years, Klein had insisted that despite the economy's condition, the central bank couldn't lower interest rates by more than 0.2% at a time, or at most, 0.3%. No learned explanations from academia or business or the prime minister, arguing that the economy needed faster rate cuts, could persuade him otherwise.

And then, on December 23, 2001, the governor unexpectedly announced a sharp deviation from his track: he cut interest by a whopping 2%. A month later he wrote in his annual inflation report that the move had been enabled by a combination of three causes, the third being - "assessments that the pace of inflation and interest rates are moderating, after acceleration in the third quarter, and that the slowdown in real activity is worsening".

Incredible. And that was written seven months ago by the man defined under law economic adviser to the government.

Thus, key lending rates on central bank sources stood at just 3.8% in January and February.

Didn't learn from Frenkel's mistakes

The subsequent events after Klein's ill-fated rate cut, and a series of mistakes by the government, have already been described ad nauseum, including the shekel's dive toward NIS 5 to the dollar and growing fears of financial crisis.

The deal Klein made with the government, resulting in his 2% cut, was especially amazing. First of all, because he had always opposed such deals. Secondly, because he was partner to the equally ill-fated deal of August 1998, between then-Bank of Israel governor Jacob Frenkel and prime minister Benjamin Netanyahu, and then-finance minister Yaakov Ne'eman. That resulted in a 1.5% rate cut. It cost the economy dearly, in the form of a subsequent escalation of lending rates by 4% in two months.

Klein has not, insofar as is known, accepted responsibility for his mistake of December 2001, despite its bad effect on the economy, on the shekel-dollar market, on inflation, and on financial stability. On the contrary, he has repeatedly placed the blame on other shoulders the prime minister's office, the Finance Ministry, the Knesset - for reneging on their part of the deal. And, on the worsening security situation.

In his inflation report for the first half of 2002, Klein wrote:

"At the end of February and the beginning of March, however, it transpired that fiscal policy had not been adjusted so as to restore the deficit to the agreed path, private legislation was not revoked and, in addition, at the beginning of March an amendment to the Bank of Israel Law was proposed which would impair its independence and its ability to adhere to the objective of maintaining price stability.

"Against the backdrop of the exacerbation of the security situation, these developments towards the end of March led to the renewal of rapid local-currency depreciation, a rapid rise in actual and expected inflation, and to indications that financial stability was being undermined, among them a sharp rise in government bond yields.

"In this context, the Bank of Israel raised its key interest rate by a cumulative 5.3 percent over the period as a whole, and by 4.5 percent in June, in three stages."


This Monday, the governor was back to normal ultra-cautious, foot glued to the brakes. For the third month running, interest stayed at a high nominal 9.1%, leaving real interest at a high 7.6%, in an environment of rampant unemployment and recession.

Last August, September and October the governor also kept the nominal rates fixed at 6.3%. Then too the marketplace badly wanted a rate cut, but the governor wouldn't budge, and could name his reasons. Two months later he slashed the rate by 2%.

In August 2001 the real rate was 3.6%. It bears saying that under the Bank of Israel Law, it is the governor's duty to factor in price stability, growth, and employment.

Undermining the Finance Ministry

The governor spent the last half-year trying to undermine every effort by the treasury to change the Bank of Israel law, and to set up a monetary council. His efforts were not in vain: the proposed legislation has been shelved.

Twice the government approved treasury proposals to change the Bank of Israel Law, which dates from 1954. The first proposal, from March 17, 2002, was terrible. The one passed on April 9, 2002 was much better, and could have served as the basis for a modern law. The uppermost echelon at the Bank of Israel also concurred.

Many agree that the Bank of Israel Law needs reupholstering. Moreover, the central bank itself has been contravening the law for some time. Many also agree that it's time to establish a monetary council, which would share responsibility with the governor for setting interest rates. Nowhere else in the developed world is a single man in charge of the nation's interest rates, by his lonesome.

Very possibly, a council would have nixed that 2% rate cut last December, after throwing out the proposed deal with the government. Possibly, Frenkel's retirement package would have been tailored according to the measurements of the law, not outside it. Possibly, the collapses of Trade Bank and Industrial Development Bank could have been prevented.

The Bank of Israel is delighted that the amendment has been shelved. Even before the Finance Ministry raised its proposal, Klein had hired consultants and lobbyists to torpedo the treasury's moves in that direction. He himself entered the fray and fought with vigor.

The main conflict centered on the roles of the national bank. The Bank of Israel, Klein claimed, could not agree to a law that unambiguously stated that its main goal was to maintain stable prices (low inflation) and that all other goals would be secondary to that one.

The ministerial legislation committee was given a compromise proposal penned by six economics professors, including Avi Ben-Bassat (former director-general of the Finance Ministry).

The compromise proposal stated that the central bank's main role would be to act to achieve price stability and maintain it over time, while helping to moderate cyclical fluctuations in growth. Klein refused to comment to the ministers on the proposal.

However, the central bank's official stance and that means Klein's is to support the establishment of a monetary council. The central bank is also prepared to accept the proposals of a public committee, headed by Dov Levine, on amending the Bank of Israel law. With a few changes, though.