Jerusalem Letter / Viewpoints

No. 405   16 Iyar 5759 / 2 May 1999


Eliyahu Kanovsky

The Underlying Causes of the Current Recession / Large and Growing Balance of Payments Deficits - 1993-96 / Positive and Negative Economic Developments in 1997-98 / Arms Exports and Israel's Defense Burden / Foreign Private Investment and Privatization / Education and Economic Development / The Impact of External Events / The Economic Dividends of Peace

Blaming "the other guy" for current problems is a human frailty, but there are cases where there is substance to the allegation. I believe that the widespread criticism of Netanyahu's economic record lacks, at the very least, a sense of fairness and balance. On the economic front, the Netanyahu administration is faulted for the slow rate of economic growth since 1997, and, as a consequence, the rising rate of unemployment. The opposition contends that in 1996, Netanyahu inherited from the previous administration (Rabin-Peres) a thriving, prosperous, and stable economy, and then proceeded to "mess things up." What are the facts and figures? What is the larger picture?

In March 1999 the Bank of Israel published its Annual Report 1998, with its usual abundance of data and economic analyses. The research division of the central bank is widely regarded as highly professional and reasonably objective. Unless otherwise stated, the data and analyses reported here are taken from this report as well as earlier reports of the bank.

The Underlying Causes of the Current Recession

Since 1996 there has been a sharp slowdown in economic activity, with the Gross Domestic Product rising by 2.4 percent in 1997-98 as compared with 5.4 percent in 1992-96 (annual averages). Consequently there was rising unemployment. "These developments reflected the correction (emphasis added) of the path followed from 1994 to 1996" (i.e., by the Rabin-Peres administration). In the Bank of Israel report for 1997, the bank noted that "The economic trends in Israel were very different in 1997 (and again in 1998) from those in the three preceding years, when there was rapid growth and declining unemployment. However, those years were also marked by a marked expansion of the current account deficit...and two digit inflation....[M]any of the developments of1997 (and again in 1998) can be regarded as corrections of the previous trends which...embodied a growing risk of a balance of payments crisis and the undermining of economic stability (emphasis added).

In short, the Bank of Israel researchers are telling us that the harsh measures taken by the Netanyahu administration were a necessary evil in view of the state of the economy in 1996 when the new administration took over the reins of government. The Netanyahu administration made considerable progress towards achieving a smaller budgetary deficit and lower inflation. This, in turn, made the Israeli economy "less vulnerable to shocks in the global economy." This policy was pursued despite its possible short-term effect of prolonging the slowdown in economic activity (i.e., the recession) and rising unemployment. The Bank of Israel report concludes that "the prevention of an economic crisis was aided by progress towards macro-economic stability, beginning in 1997, and the (consequent) decline in Israel's economic vulnerability (to external shocks) in recent years." The bank is referring to the economic crisis in a number of East and South Asian countries, as well as in Japan, Russia, and Brazil, and other buyers of Israeli exports. The recession in these countries in 1997-98 meant reduced demand for imports generally, including imports from Israel.

Budgetary policy had to contend with "the dilemma of...attaining the government's long-term budget and inflation targets, on the one hand, and refraining from exacerbating the economic slowdown in the short run, on the other. The dilemma was caused to a great extent by the expansionary fiscal policy which was adopted in the 1994 supplementary budget and persisted until the end of 1996," a tactful reference to the loose spending policies practiced during the Rabin-Peres administration.

Large and Growing Balance of Payments Deficits - 1993-96

Budgetary profligacy soon led to large and growing current account deficits in Israel's international balance of payments. The Rabin-Peres administration's agreement to much higher public sector wages, far beyond the growth in productivity, as well as generous subsidies to favored groups (kibbutzim, moshavim, and various Histadrut affiliates including the Histadrut pension funds), were soon followed by rapidly rising consumer spending. Inevitably, much of the consumer spending was on imported goods and services. Moreover, even increased consumption of Israeli-made products also raises imports, because of the import content of these products. Israelis in growing numbers were to be found touring in all parts of the globe and public spending on expanding and improving Israel's roads and highways could not keep up with the growing number of vehicles (all imported) on the roads. Though exports continued to rise, they were outpaced by the growth in imports of goods and services. The deficit in the current account balance soared. This deficit rose annually from about $1.5 billion in 1991 and again in 1992 to $3.1 billion in 1993, $4.1 billion in 1994, $6.4 billion in 1995, and an all-time peak of $6.6 billion in 1996.

In an article published a few weeks before the 1996 elections ("Is the Economy Doing So Well?," Jerusalem Post International Edition, 11 May 1996), I noted that these high and rising current account deficits were not sustainable, and that no matter which government took over, an austerity program was inevitable. The Bank of Israel report for 1995 concluded that the "current (Rabin-Peres administration's) path of economic development could not persist." Sharp cutbacks in government spending were required in order to ensure longer-lasting, high-level economic growth. An austerity program sounds innocuous, but it implies an economic slowdown, rising unemployment, curtailed personal incomes, and other hardships for many citizens. Austerity measures can and do cause pain, especially for the poorer sectors of society. Israel's elaborate social welfare programs may cushion the impact of these austerity measures, but do not eliminate them.

Positive and Negative Economic Developments in 1997-98

For the most part, the Netanyahu administration followed the macro-economic guidelines indicated in the Bank of Israel reports and the results - both good and bad - were predictable. The negative developments were mainly a much slower economic growth rate and rising unemployment. As a direct consequence of the slowdown in economic growth, unemployment rose from 6.9 percent of the labor force in 1995 to 8.6 percent in 1998 (annual averages).

But there were also important pluses, including a resumption of the downward trend in inflation. Between 1992 and 1996 the average annual rate of increase in the consumer price index ranged between 10 and 12 percent, showing no distinct trend. In 1998 it was down sharply to 5.4 percent. Inflation in the current year (1999) may be even lower. In the first quarter of 1999 there was deflation - overall price declines. The attainment of inflation rates comparable to those prevailing in the advanced Western countries - 2 or 3 percent per annum - would be a major plus for Israel's future economic development.

The deficit in the current account balance has been drastically reduced from a peak of $6.6 billion in 1996 to $4.9 billion in 1997 and a far more tolerable $2.3 billion in 1998. Israel's foreign exchange reserves climbed to unprecedented levels from $8.8 billion in mid-1993 to $22.7 billion at the end of 1998.

A sharp reduction in the budgetary deficit was a prime goal, and the record shows very considerable improvement. The measure of a budgetary deficit is its size in relation to the gross domestic product (GDP) of that year. In 1995 and again in 1996 the budgetary deficit was 4.1 percent of GDP. In 1997 it fell strongly to 2.8 percent and fell again to 2.4 percent in 1998. The change in fiscal policy (government taxation and spending) contributed greatly to the abatement of inflationary pressures and to the vast improvement in the balance of payments. The other important partner in these positive changes was the central bank which controls the money supply and interest rates, and also encouraged the government to pursue fiscal policies which would favor long-run macroeconomic stability.

Arms Exports and Israel's Defense Burden

Since the early 1980s there has been a marked decline in Israel's defense burden from about 25 percent of GNP to 10 percent since 1994-95. Measured in dollars it is about $10-11 billion per annum in recent years, not taking into account implicit costs, such as the loss of civilian production during the period of army service. Israel's arms imports - almost all from the U.S. - range between $1.5 and $2 billion per annum. Since the mid-1980s these arms purchases are financed by U.S. grants.

At the same time, Israel has developed its own defense industries. Reduced domestic orders for Israel-made arms (due to budgetary cutbacks) have induced the defense industries to seek markets abroad. The exports of the defense industries make it possible to take some advantage of economies of scale and reduce the costs per unit. In 1997 these exports reached $1.5 billion, the fifth largest in the world, following the U.S., the United Kingdom, France, and Russia. Over the last few years Israel has been particularly successful in developing a special relationship with Turkey. An agreement was signed last year for Israel to upgrade Turkey's fleet of F4 fighters, at a cost of $630 million. Of course, the importance of this agreement goes far beyond the economic realm.

The sharp reduction in the deficit in the current account balance helped to reduce the burden of the external debt. The measure is the ratio of payments on account of principal and interest in a given year to export earnings of Israel in the same year. This ratio fell sharply from 13.6 percent in 1996 to 10.2 percent in 1998. In other words, only ten cents of every dollar earned from exports was needed for carrying Israel's external debt, a relatively light burden when compared both with Israel's past and with other emerging economies today. Unlike some of its neighbors, Israel has not requested nor has it received from other countries either debt forgiveness or easing of the burden of payments.

Foreign Private Investment and Privatization

Conceptually, privatization and attracting foreign private investment are separate issues. In the Israeli context they are intertwined. Both major political parties advocate, at least verbally, both privatization of state-owned enterprises and attracting foreign private investment. In reality, the Labor party did little during its four years in office (1992-96) to advance privatization (The Economist, London, 14 December 1996).

In an increasing number of cases there are mergers or acquisitions of Israeli firms by much larger foreign firms, most often American. The high tech firms are special targets for acquisitions by foreign firms. According to one report, the value of mergers and acquisitions among Israeli and foreign technology groups has been large and rising strongly even in the midst of the current economic crisis in many emerging economies. The value of these mergers and acquisitions rose from an estimated $1.5 billion in 1997, to $2.2 billion in 1998, and $1.1 billion in the first two months of 1999. Aside from that, the Tel Aviv stock exchange has been attracting foreign investors. The investment of the latter group is more often short term. In 1998 there was a sharp fall in financial investment, mainly through the stock exchange. However, direct foreign private investment continued to rise. Currently, some 120 Israeli companies trade on the U.S. stock exchanges, second only to Canada.

At one time, most foreign private investment in Israel - leaving aside the purchase of second homes by some rich Jews abroad - contained an element of sentiment. It was not purely a business proposition. Today's investors, especially in the high tech companies, contain "some of America's best known Establishment names: AT&T's Pension Fund, MIT's Endowment Fund, Boston's Hancock Venture, and Chase Capital" (Business Week, 13 October 1997). These are sophisticated investors and their goal and their expectation is high rates of return on their investment.

Many venture capital firms have been set up. In 1998, venture capital funds invested $333 million in Israeli companies, 65 percent higher than in the previous year. According to one estimate, foreign investors own over 50 percent of Israel's twenty biggest conglomerates.

Education and Economic Development

The Bank of Israel's annual report also deals with the economic aspects of education. Israel's national expenditures on education as a ratio of GNP reached 10.4 percent in 1998, far higher than the average in Western countries where it was 6.2 percent. Eighty percent of these expenditures is by the public sector; the rest is financed by the individuals involved and/or their families - not the public purse. The Bank of Israel report emphasizes that though expenditures on education are included in the national accounts as part of public sector consumption (in accordance with accepted practice), they are more accurately defined as investment in human capital, rather than consumption. Much of the growth of the economy over the years, and in particular the high tech industries in recent years, must be attributed to education, as well as the immigration of many highly qualified professionals, mainly from the former Soviet Union and to some extent highly educated Jews from the Western countries, as well as the return of many Israelis. From an economic point of view, Israel's main asset is the quality of its manpower.

The Impact of External Events

While government policies are of crucial importance, external events can and do have a powerful impact on Israel, especially since its economy has become much more open. There are far fewer controls on international trade, cross-border move-ments of capital, and the like. Free trade agreements with the U.S. and with the European Union open up vast markets for Israeli products, but they also make Israel more sensitive and more vulnerable to adverse economic developments abroad. The Bank of Israel report notes that government policies helped to reduce Israel's vulnerability to events abroad, but their impact is still substantial.

Thus far, the U.S. and Europe have been affected only peripherally by the economic crisis which began in Asia in 1997. Since Israel does most of its trade with the Western countries, and foreign private investment in Israel is also from these countries, the impact of the crisis on Israel has been attenuated by increased trade with the West. Should the crisis affect the Western countries more severely, the economy of Israel would surely be in for some shocks. Barring major external shocks and assuming the continuation of the present administration's economic policies, at least for the most part, it appears likely that the economy of Israel will again achieve high levels of growth and low rates of unemployment. The Netanyahu administration has laid or strengthened the foundations for a turnaround and upturn. Israel's external accounts are greatly improved and its foreign exchange reserves are unprecedented. Inflation is at or near levels prevailing in the advanced industrialized countries, and the country is blessed with high-level manpower. The government has given encouragement to the private sector, its policies foster entrepreneurship, and many have responded. The very large number of start-ups of new high tech companies - about 300 a year according to the Office of the Chief Scientist - bodes well for the future.

The Economic Dividends of Peace

From time to time statements are made to the effect that if peace were concluded with the Palestinians and other Arabs, peace and prosperity would reign throughout the region, This is another case of wishful thinking. Following the Oslo agreements of 1993, I wrote a number of articles on this subject, arguing that peace is of great importance in its own right, if it is durable and prevents bloodshed, even if the economic dividends of peace are minuscule.

Twenty years have passed since the Egypt-Israel peace agreement was concluded at Camp David. Israelis, including this writer, were looking into the possibilities of joint projects, trade, technical cooperation (i.e., aid), and the like. The Egyptians demanded and received every inch of territory and Israel acceded to their wishes. Economic projects and trade were almost forgotten. The vituperation of the Egyptian media has not abated. Ehud Yaari, the well-known Israeli TV commentator, has noted that twenty years after Sadat's visit to Jerusalem, "The Egyptian media (controlled by the regime) have lapsed into the language of hate towards all Jews" (Jerusalem Report, 27 November 1997). Bernard Lewis, a foremost scholar of Islam, writes, "To an astonishing degree, the ideas, the literature, even the crudest inventions of the Nazis...have been internalized and Islamized....[T]he enemy is no longer the Israeli or the Zionist; he is simply the Jew" (Middle East Quarterly, June 1995).

It is hard to envision economic cooperation under the circumstances, and Egypt is the most influential Arab country. But, in truth, there are many other obstacles. The Arab economies lag far behind Israel's economy which, oil aside, leaves little room for trade. The Arab countries fear Israel's economic power and many believe that Israel is out to dominate them. From Israel's point of view, the Arab market is very small, even if their populations are large. The Arab countries as a whole import only 3 percent of total world imports. This leaves 97 percent of world trade open to Israel. Directly and indirectly, many Arab states are dependent on oil and, in my view, oil prices (inflation corrected) are in a long-term downward trend. Most of the Arab countries have failed to diversify and develop their economies. Economic failings in the Arab countries can lead to political instability. Israel must constantly be on guard. Peace for Israel, i.e., the absence of hostilities, is desirable, but Israel's economic salvation will not come from economic dealings with the Arab world. It will come from the pursuit of productive and wise economic and social policies accompanied by prayerful wishes for success.

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Eliyahu Kanovsky, a Fellow of the Jerusalem Center for Public Affairs, is Ludwig Jesselson Visiting Professor of Economics at Yeshiva University, New York, and Professor of Economics at Bar-Ilan University in Ramat Gan, Israel.

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The opinions expressed by the authors of Viewpoints do not necessarily reflect those of the Jerusalem Center for Public Affairs.