Imagine a businessman who left Israel on Monday, June 24. In the plane he read the economics section of



The front page declared: "Bond market tumbles - Yields in shekel accounts reach 12%." The main financial indicators: The representative rate for the dollar soared to NIS 4.98, the Maof-25 index index plummeted to 348.11 points and the expected annual inflation rate was 7.88%. Hanging in the air was question of whether the mountain of shekels was about to collapse and whether a financial crisis lay ahead. The Bank of Israel issued a statement to the effect that "there are signs indicating shakiness in financial stability".

Returning to Israel at the end of last week, our imaginary businessman checks the front pages of the business section, and reads about a bid to buy Israel Discount Bank of New York. Yields on shekel accounts had gone down to 9.4%, the dollar had plunged to NIS 4.71, the Maof-25 index had climbed to 386 points and inflation expectations had shrunk to 2.42%.

The most recent publication from the Bank of Israel dealt with "Sustained Growth - Is it Around the Corner?"

He could be pardoned for scratching his head bald in confusion.

What lies behind a turnaround like this in 2.5 weeks? He left with the terrible impression of bloody attacks on buses near Gilo, the French Hill intersection and Itamar, and returns to shining sun and chirpy headlines?

The latest military campaign has almost entirely stopped terror attacks, but can that alone explain the descent of calm upon the financial markets, the appreciation of the shekel by 5.5% and the decline of 70% in inflation expectations in less than three weeks? No.

Could it be that Israel's financial situation changed? No. The real economy remains as it was: Unemployment is still high, retail sales are unchanged, production and exports are floundering and investments are way down. The speakers at the recent economic conferences lamented the state of the economy and the bleak horizon.

Maybe Israel's macro-economic management improved? Well, the governor of the Bank of Israel said that Israel tumbled into financial crisis because the government ignored its commitments. Has the government picked up its socks? No: The huge budget deficit remains; there is no certainty that the Finance Ministry will manage to cap it at 3.9% of the GDP this year, or cut the 2003 budget by NIS 8 to 9 billion to keep the deficit below 3%. In this respect, too, there has been no essential change.

What, then, explains the dramatic change?

Let's look at the nature of the crisis. The steep cut in the interest rate by 2% in December, 2001 and the narrowing of the gap in the shekel/dollar interest rate to only 2.05% created a tidal wave of demand for foreign currency.

According to Bank of Israel figures, the purchase of financial assets in foreign currency by individuals only (excluding businesses) in January-May 2002 was $2.4 billion (compared with $1.8 billion during all of 2001). Is it any wonder that the dollar galloped?

The Bank of Israel responded by raising interest four times, to 9.1%. Altogether between March and June 2002, interest was lifted by 5.3%.

The difference between the Bank of Israel interest rate and the U.S. Federal Reserve rate rose to 7.35%.

With the latest increase, at the end of June, it was as if an all-clear signal had been sounded: The dollar began to drop, bond yields and inflation expectations declined, stocks went up, shekel deposits regained their allure, there was a new dawn.

Conclusion? The situation of the economy remains as problematic as it was, the fears about the budget and the deficit are still in force. But the storm that blew through economy in the spring of 2002 has nothing to do with these distressing facts, but rather with the waves of dollars that flowed out of the country as a result of the sharp decrease in the interest rate in December, 2001, along with lively speculative activity and hysterical headlines in the electronic and print media.

All in all, this was a bubble, a product of hasty interest rate cuts coupled with speculation and hysteria, costing some people heavily, and generating handsome profits for others.