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Jerusalem Letter / Viewpoints

No. 488     10-26 Kislev 5763 / 15 November-1 December 2002

NEEDED: LEADERSHIP FOR GROWTH

Yitzhak Klein


Israel's Current Recession / The Causes of Slow Growth / Constraints on Israel's Economic Growth Strategy / Israeli Policymakers Get It Wrong / Interest and Exchange Rate Policy / Outline of a Macroeconomic Recovery Plan / Cutting the Budget / Loan Guarantees: A Non-Solution / Conclusion


Israel's economy has contracted for two consecutive years, and a third such year may well be in prospect.1 Savings and investment are down, unemployment has risen sharply,2 and Israelis' standard of living has dropped sharply since the end of 2000. Poverty and welfare payments are on the rise, together with defense expenditures occasioned by war with the Palestinians. Foreign investment has declined; Israelis are investing more abroad, and some of this investment may be flight capital. As the recession has deepened steadily, international rating agencies have shifted their view of Israel's economic prospects to negative, lowering the rating of Israel's chief financial institutions and its sovereign domestic debt. These prophecies tend to be self-fulfilling; as Israel's borrowing costs rise, the stability of its banking system declines and the threat of a crisis of capital flight looms, deterring investors. It is thus no paradox to say that, if nothing changes, Israelis can confidently expect things to get worse.

Though the recession began with the outbreak of war with the Palestinians and the onset of the global growth slowdown in 2001, its underlying causes lie deeper, in the fundamentals of Israeli macroeconomic policy dating well before these events. Had the war and the growth slowdown never happened, these fundamentals would eventually have produced a crisis like the present one; perhaps not as severe, certainly not as rapid, but essentially no different. Escape from the recession requires Israel's government to adopt a medium-term fiscal strategy that will balance its budget and reduce taxes, expenditure, and public debt significantly. It is incorrect to assume that the ongoing war with the Palestinians prevents the adoption of such a strategy; indeed, the war and its economic consequences make such a strategy imperative.

Hitherto, unfortunately, Israeli authorities have not taken the steps necessary to create a reasonable likelihood that economic conditions will improve. Rather, they have focused on the short-term, ad hoc management of Israel's economic crisis rather than trying to change the economic fundamentals that underlie it. This failure on the part of Israeli authorities has become a chief factor in prolonging and deepening the recession. As long as businesses and investors at home and abroad continue to feel that the Israeli government does not know how to extricate the economy from recession, confidence in the economy will continue to deteriorate and the economic outlook will remain bleak.


Israel's Current Recession

Between 1996 and 2001 Israel's economy grew at the historically low average rate of 3% annually. This period includes sharp variations in the annual growth rate. In 2000, riding high on the international high-technology bubble, the Israeli economy grew 6.4%. In 2001, growth crashed to a 1% decline in GDP, a dismal performance repeated in 2002.3

The occasion, but not the fundamental underlying cause, of Israel's prolonged recession was the confluence of two events: the initiation of hostilities by the Palestinian Authority in October 2000 and the implosion of the global high-technology and telecommunications industry bubble in 2000-2001, that affected Israel's high-technology sector severely. More traditional sectors such as tourism, agriculture, and construction were also savaged; all depended heavily on Palestinian labor, and tourism was depressed by the war. Spillover effects into the rest of the economy undermined business confidence and led to a general contraction of economic activity.

Unemployment during this period rose significantly, from 8.4% in the last quarter of 2000 to 10.6% in the first quarter of 2002. Later, unemployment seemed to stabilize at the 10.3-10.4% level.4 This "stabilization" was deceptive, however, signaling the exit of many people from the active labor force after having given up on finding jobs. Figure 1 shows the percentage of the working age population actually employed, and gives a truer picture. Even those who retain their jobs are suffering. The average wage declined in real terms by 5.3% from September 2000 to August 2002,5 and private consumption in 2002 is below that of 2001.6

Figure 1
Source: CBS, Chart K-1, and author's calculations.

The misery of ordinary Israelis occasioned by economic contraction was compounded by rising in inflation, taxes, and interest rates. Recession might have been expected to bring about price stability. This principle held true through 2001, but in 2002 inflation rose from the 2-3% annual rate of the last several years to nearly 8%, occasioned by a slide in the value of the shekel. Taxes were raised by 0.8% of GDP in the middle of 2002 and were slated to rise by another 0.7% of GDP in 2003. Interest rates rose by over 5% in the latter half of 2002. All this indicates serious policy errors; in the midst of the most serious recession in Israeli history, policymakers have treated the economy as if it were in the midst of a torrid expansion that needed quenching.

Investment declined from 22% of GDP in the last quarter of 2000 to about 19% in 2002.7 Just a few years ago Israel attracted a significant proportion of its investment capital from abroad. With the onset of recession, foreign investment declined sharply, though declining international investment has been a problem worldwide. Taking into account as well the export of capital from the economy by Israeli residents, the flow of capital from the economy has on the whole been negative since the recession started (see Figure 2).

Figure 2

Source: Bank of Israel, table, "Investment in Israel by Nonresidents and Abroad by Residents," www.bankisrael.gov.il, and author's calculations.

During the latter half of 2002 there were some indications that the steady decline in Israel's economic performance was bottoming out and that, at least, things might get no worse. This apparent stability should not be relied upon, however. One important indication of economic expectations is the government's ability to fund its debt, and here the auguries are not good. It has long been government policy to favor issuing long-term, fixed-interest, debt instruments in order to decrease the volatility of its domestic debt portfolio and combat inflationary expectations. By the fall of 2002, the market was forcing the Finance Ministry to issue more short-term, inflation-linked debt, a symptom of economic uncertainty and rising inflationary expectations.8

Late in 2002, Standard & Poor's degraded the ratings of most of Israel's chief commercial banks and, a few weeks later, of Israel's sovereign domestic debt. This further reduces the attractiveness of Israel as a place to invest, while increasing capital costs for an economy already saddled with high tax and interest rates. The primary cause of the downgrade was, apparently, S&P's evaluation that Israel's future growth prospects are not good. As a result of the downgrade, the perceived risks involved in keeping one's capital invested in the Israeli economy have risen, even as the prospect of a return on investment that might justify that risk, in the form of more rapid growth, has diminished.


The Causes of Slow Growth

During the first half of the 1990s, Israel's economy grew rapidly and created 600,000 new jobs. This expansion was caused by efficiency gains in the aftermath of the macroeconomic stabilization program of 1985 and the massive inflow of immigrants from the former Soviet Union in the early 1990s. Since 1996, however, the Israeli economy's performance has been unimpressive (see Figure 3). Economic growth has slowed considerably. In consequence, the economy no longer creates enough jobs. Unemployment rose steadily even before the onset of the current recession.

Figure 3

* First three quarters, annualized. 1991 and 1992 were years of massive immigration. Unemployment rates rose, though far less than feared due to rapid job creation.
Sources: Unemployment, CBS; Growth, Bank of Israel, various sources.

Figures 4 and 5 are central to understanding the reasons for Israel's slow economic growth since the middle of the 1990s. Figure 4 displays the level of general government expenditure9 as a percentage of GDP since 1990. At first glance the figures show a moderate decline since the beginning of the 1990s. However, if one controls for immigrant-absorption expenditure, which was high at the start of the 1990s, one finds that residual public expenditure was pretty steady at about 52% of GDP or more -- a very high level by international standards.10 Tax receipts have been rising steadily as well and stand now at over 40% of current GDP. Given these aspects of macroeconomic policy, it is not surprising that investment and job creation (refer to Figure 3) declined since the middle of the 1990s. Investment, of course, is the engine of economic growth.

Figure 4

Sources: Expenditure, Bank of Israel, Din Ve-Heshbon Li-Shenat 1999 [Hebrew; "1999 Annual Report," henceforth DV 1999], Jerusalem, Appendix table V-A-5, p. 325; Din Ve-Heshbon Li-Shenat 2001: "Taktziv Ha-Memshala Veha-Memshala Harehava," [Hebrew; "2001 Annual Report: Budget of the Government and the General Government," henceforth DV 2001], Table G-5, p. 158 (for years 1994-2001). Tax burden and Investment: DV 1999, appendix Table II-A-16, p. 267, and DV 2001, Ibid., p. 157.


Figure 5

Sources: Bank of Israel, DV 1999, Appendix Table V-A-5, p. 325; DV 2001, Table G-3, p. 158; Ibid., p. 157. The data in these two sources are defined slightly differently, and data with the nearest possible equivalence have been used to construct the figure.

With government expenditure so high, even a tax burden of over 40% of GDP does not suffice to cover costs. Israel's government runs an annual deficit. Official Israeli sources calculate this deficit in a number of ways; the figures we present here have their source in the Bank of Israel, which accounts for all official expenditure and employs internationally accepted standards of national accounts. Figure 5 shows that, except for the unusual year 2000 (the year of the high-tech bubble), Israel's public sector has consistently run a deficit of between 3 and 6 percent of GDP, which is high by international standards.

During the first half of the 1990s, when Israel's economic growth was rapid, public debt calculated as a percentage of GDP fell rapidly from about 145% of GDP in 1990 to about 93% in 2000. The burden of annual interest payments on this debt fell as well. Slow growth and high government deficits retarded this progress, and the onset of a shrinking economy has reversed it. Today Israel's public debt is once again over 100% of annual GDP.11

Throughout the 1990s and till 2000 Israel's macroeconomic profile was not very encouraging: High taxes, high government expenditures, high annual deficits, a public debt of just under 100% of GDP, and domestic interest rates generally much higher than the global average, required to ensure the stability of the shekel. It is not to be wondered at that the economy grew slowly, or failed to provide the jobs required by a young and growing population exhibiting demographic characteristics closer to the third world than to Europe or North America.


Constraints on Israel's Economic Growth Strategy

Israel has an open economy. At one time, foreign investment and commercial credits made up only a small part of the flow of foreign capital into Israel. Since the mid-1990s this has no longer been true. In the years prior to the onset of the global recession in 2001, Israel became one of the world's most successful economies at attracting foreign capital, drawing in nearly 10% of its GDP in foreign investment during 2000. This foreign capital plays a crucial role in Israel's economic growth.

In a global environment in which Israel potentially can attract between 4 and 10 percent of its GDP in foreign investment, foreign investment can become the primary fuel of growth.12 In order for such investment to take place, however, the Israeli economy has to be attractive to foreign investors and provide a low-risk environment for foreign lenders. This means low taxes, low interest rates, and a stable currency. The key to all these things is low government expenditure, a small government debt, and low or no deficit spending. In other words, the policies that would most conduce to growth and job creation, were the Israeli economy not exposed to the international financial system, are the policies that make accelerated growth possible by attracting foreign capital.

As a small, open economy, Israel is especially vulnerable to high government debt and large government deficits. Every increase in indebtedness implies higher taxes, lower growth, and greater risk of default. When Israel's debt increases, both foreign and local owners of capital redo their sums: What is the likelihood that the Israeli economy will grow and investment in Israel will pay off? What is the likelihood that Israeli assets will lose their value compared to other economies? Investors start to move assets out of Israel. The exchange rate of the shekel versus foreign currencies starts to decline, turning fears of a devaluation of Israeli assets into a self-fulfilling prophecy. Higher interest rates can help stabilize the shekel's value for a while, offsetting the effect of increasing indebtedness, but this stability is fragile. High interest rates further depress growth prospects and increase the risk of financial instability. As the example of Russia and East Asia in 1998 and Argentina in 2001 show, international confidence in a problematic economy can vanish quickly, in a manner that no interest-rate adjustment can halt.

For Israel, therefore, an increase in the domestic budget deficit with the object of re-inflating a depressed economy is simply not an option. It will not produce growth but rather capital flight and higher interest rates. The only real solution is to create an economy that is "fiscally fit": one characterized by low taxes, no deficit, and declining public debt. Israel is, in fact, in competition for foreign investment with all the other small, potentially attractive economies in the world, and the competition is about the quality of domestic economic policy, especially macroeconomic fundamentals.


Israeli Policymakers Get It Wrong

Israeli policymakers failed to realize that what happened to their economy in 2001 and 2002 was not solely the effect of temporary economic "shocks," i.e., war and global recession, but the consequences of poor macroeconomic policies coming home to roost.13 The Finance Ministry consistently failed to foresee economic developments during the past two years. The Ministry's budget for 2001 projected growth of 4.5%;14 in fact, growth was negative. The Ministry made the same mistake in preparing the 2002 budget. This was presented to the Knesset with a projection of 4% growth, at a time (November 2001) when any informed observer knew that the projection was quite unrealistic.

Both budgets created unsustainable expectations regarding the resources the government would have to spend. As a result of the recession, tax receipts were far below the levels projected in the budgets, even though they remained quite high as a percentage of (reduced) GDP. Due to this "revenue shortfall,"15 the public sector deficit threatened to spin out of control. The general government deficit for 2001 was 4.6% of GDP and 4.5% in 2002, against projections of 3% for both years. These large deficits have reversed the trend of recent years toward reducing the government's debt burden.

The Ministry's efforts have been confined largely to attempts to manage the deficit on an ad-hoc basis. On three occasions between February 2001 and February 2002 it cut the government's budget by a total of about NIS 8 billion, or some 1.6% of GDP.16 On a fourth occasion, in June 2002, confronted by a sliding currency, rising inflation, and the threat of capital flight, the Ministry spoke of cutting NIS 13 billion from the budget. This proved beyond the government's political strength.

Instead, the government adopted an "emergency plan." Some NIS 3 billion were in fact cut from the budget in April 2002; further cuts were postponed until the 2003 budget, when NIS 8.7 billion would be cut from projected spending levels.17 In addition, taxes were raised. VAT went up by 1%, from 17% to 18%. Significant additional taxes were laid on income, an area in which taxation is already crushingly high. National Insurance Institute (NII) taxes were raised across the board by about 1% of income, and a surcharge was levied on large incomes. The excise on fuel, tobacco, transportation, and liquor (a small item in Israel) were increased.18 Together, these taxes were expected to yield 0.8% of GDP in 2002 and an additional 0.7% of GDP in 2003 -- a cumulative additional 1.5% of GDP.19 As noted above, these harsh measures failed to hold the line of the budget deficit in 2002.


The State Budget for 2003

Once again the Finance Ministry has chosen a deficit target for the central government budget of 3% of GDP. The overall deficit of the public sector will be higher, even assuming the central government's deficit target is met. Even this large deficit is only to be met by imposing a tax burden 1.5% of GDP higher than it would otherwise have been had the "emergency program" of June 2002 not been adopted. In addition, NIS 8.7 billion will be cut from programmed spending.

This budget cut is curiously designed. NIS 3 billion is to be cut from the wage benefits of career army personnel, and another NIS 3 billion from National Insurance Institute payments. The balance of the cut is to be achieved by an across-the-board freeze in the government's expenditure, except where statutory obligations mandate an increase. Israel's welfare policies, as well as the compensation of armed forces personnel, are generous and these cuts are understandable. Simply freezing the rest of expenditure, however, means not making any genuine policy decisions about where further cuts ought to be made.

The growth rate assumed in the budget, 1%, shows that the Finance Ministry does not anticipate a return to rapid growth anytime soon. Its efforts are still confined to containing the fiscal deficit, without considering the fundamental problem of how to make the economy grow. The tax rises and budget cuts planned in the 2003 budget are harsh enough to inflict real social pain, without promising real gain in the form of significantly higher growth and job creation.


The Rabinovitch Commission Reform

The Rabinovitch Commission was appointed in the spring of 2002 to consider reform of direct taxes. Its report, delivered in June 2002, recommended a 15% tax on capital gains (hitherto exempt under Israeli tax law), in order to fund gradual reductions in income taxes. The reform itself was well-conceived, in the sense that taxes on labor are very high in Israel, and a shift in the tax base from labor to almost anything else -- in this case capital gains -- would tend to stimulate growth and job creation.

The best part of the Rabinovitch report was that its proposals are not revenue-neutral; they provide for income-tax cuts of NIS 10.4 billion (in 2002 shekels), offset by capital gains taxes of only NIS 3.9 billion. Implementing the report fully implies a NIS 6.5 billion tax cut, or 1.3% of GDP, which would be a good thing if actually done.20 However, the report provides for the gradual phasing in of the reform over six years, i.e., by 2008. It does not provide much in the way of tax relief now -- only NIS 1 billion (0.2% of GDP) in tax relief is planned for 2003. The Rabinovitch report's provisions were passed into law in July 2002. Nevertheless, many observers regard the new law as nothing but a statement of good intentions, liable to remain a dead letter until the government undertakes the budget cuts that will make its implementation plausible.


Interest and Exchange Rate Policy

Fiscal policy, which affects taxation, the deficit, and the government's debt burden, has crucial influence on the attractiveness of the Israeli economy to investors, and thus on capital flows to or from the economy, on the exchange rate, and on interest rates. Nevertheless, policy decisions regarding interest and exchange rates are the province of the Bank of Israel.

During 2000 and 2001 the Bank gradually relaxed the high interest rates that characterized Israel in the 1990s. As recession took hold and deepened in 2001, policymakers at the Bank rated the danger of inflation low, while the economy's need for interest rate relief seemed obvious. In December 2001 the Bank offered the Finance Ministry a deal: a sharp interest-rate cut in return for a cut in the fiscal deficit. In principle, the deal was struck; the 2002 budget, then before the Knesset, was cut by NIS 6 billion, and the Bank dropped its discount rate from 5.8% to 3.8% in December. Nevertheless, this moderate fiscal adjustment proved insufficient to keep the central government's deficit within 3% of GDP, as the Bank had required. With interest rates low and the fiscal deficit growing, the shekel began to slide against other currencies.

As the shekel devalued, inflation took off, reaching the 8% level. The more unstable the shekel seemed, the more its slide seemed to increase the risk of massive capital flight -- which of course would only serve to accelerate devaluation. Figure 6 shows the sharp increase in the shekel's rate of devaluation after December 2001. In order to arrest this deterioration, the Bank had to yank on the interest-rate handbrakes in the second quarter of 2002, which reversed the trend of the exchange rate and is expected to slow inflation -- at the expense of ruinously high interest rates in the midst of a recession. Had the Bank not tried earlier to manipulate fiscal policy by using its interest-rate mechanism as a stick and carrot, this outcome may have been avoided.

Figure 6

Source: Bank of Israel, "Main Israeli Economic Data," www.bankisrael.gov.il, and author's calculations. Note how the sharp cut in interest rates in December 2001 had an immediate effect upon the exchange rate, reversed after the sharp reversal of interest rate policy in April-June.

The shekel's slide resulted in a real devaluation which should improve Israel's export performance, depressed by the global recession. Another unanticipated dividend from higher inflation was that the Finance Ministry found it easier to reduce real government spending,21 since the budget was denominated in (inflated) shekels.


Outline of a Macroeconomic Recovery Plan

Israeli policymakers have failed to respond adequately to Israel's deepest and longest recession. This was most evident in fiscal policy. Finance Ministry officials consistently failed to assess economic trends realistically, or to make timely adjustments to their assessments in the light of emerging developments. More seriously, there has been a failure of vision. Policymakers have concentrated their attention on one limited policy issue, containing the fiscal deficit. They seem unaware of the larger macroeconomic picture: that high government expenditure, high taxes and high deficits, and heavy government indebtedness all act together to choke off growth and prevent job creation. While the Bank of Israel understands the macroeconomic fundamentals and argues for change, it overreached itself in its attempts to "bribe" the Finance Ministry to make budget cuts in return for interest-rate cuts, thus jeopardizing the shekel's stability and leaving the economy worse off than before.

Israel requires a fundamental correction in macroeconomic policy, in the form of an ambitious plan to balance the budget while driving taxes, expenditure, and government debt significantly lower. Such a policy does not merely require an understanding of macroeconomic fundamentals; it requires political courage as well. Israeli leaders need to explain to their people the need to give up cherished budgetary programs in return for the prospect of long-term, steady growth and job creation. This they have manifestly failed to do.

What the Israeli economy needs in order to grow and create jobs is simply stated. Taxes need to come down. The fiscal deficit needs to be reduced, preferably eliminated. Public debt, currently at a level that threatens the stability of the government's finances and the stability of the shekel, needs to be reduced.

A sharp reduction in taxes and, consequently, expenditure is needed right away to start the economy growing again. In the longer run, taxes, expenditure, and debt need to stabilize at new and significantly lower levels. In order for an initial tax cut to stimulate investment and growth, investors and businesses must believe it to be the first part of an ongoing program of deep macroeconomic adjustment.


Essentials of a Macroeconomic Program for the Rest of the Decade

  1. Cut taxes sharply in 2003 to stimulate growth. Since the fiscal deficit cannot be allowed to grow, expenditure must be cut by at least as much.
  2. Control growth of the budget until the deficit is eliminated.
  3. As economic growth accelerates past the rate of budget growth, additional tax receipts will be available. They should be divided more or less equally between deficit reduction and tax reduction.
  4. Use privatization aggressively, first, to limit the government's borrowing requirements while the budget is still in deficit, and later to accelerate the reduction of Israel's public debt burden.
  5. Aim to cut the tax burden by 5% of GDP, and government expenditure by 10% of GDP, by the end of the decade. As growth should revive well before then, this need not require actual cuts in spending programs after 2005/6, as long as no large new spending programs are added.

The crucial year is 2003. For this year we recommend more than doubling the budget cut from NIS 8.7 billion (1.75% of GDP) to NIS 18.7 billion (3.75% of GDP). This is a very significant and politically difficult cut, but not more so than that implemented by other countries (such as Ireland) when faced by less severe crises. Where and what to cut is discussed in Appendix A. The additional taxes imposed in the "emergency program" of June 2002 should be rescinded entirely, excepting reduced tax exemptions for certain geographic areas of the country. This would provide tax relief of about 1.5% of GDP. Tax relief under the Rabinovich income-tax reform should be increased by 50% to NIS 1.5 billion, as part of a program to implement the reform fully by 2006.

For 2004, expenditure should be frozen at the 2003 level. Since budgetary expenses usually increase about 2% a year (due mainly to population growth) even if no new spending programs are adopted, this involves a de facto budget cut of 2% of general government expenditures, or about 1% of GDP.

Budget growth should be restrained in 2005 and 2006. By this point, however, growth should have revived to about 4% per annum, making it possible to reduce the deficit as well as the tax burden. Fiscal balance should be achieved around 2006. From then on, reasonably prudent fiscal policy should suffice to permit ongoing tax reduction and reduction of the tax burden.

Privatization during the last few years has been nugatory. Nevertheless Israel's government has great reserves of "privatizable" resources. The aim should be to increase privatization goals by 1% of GDP in 2003, and to aim to privatize 1% of GDP's worth annually till the end of the decade. Other publications of the Jerusalem Center deal extensively with ways and means of privatization.

The essentials of the plan are summarized in Table 1. Note that the plan is very conservative in its growth projections. It adopts the Finance Ministry's projection of 1% growth in 2003 (though that goal is likely to be reached only if taxes are cut), and assumes growth will not rise above 4% per year, starting in 2005. If the economy returns to growth, it is quite likely that this rate will be exceeded during part of this decade. The plan projects a reduction of the tax burden to 37.5% of GDP by 2010, public sector spending to 44% of GDP, and the gross national debt to 75% of GDP.


What Do We Mean by "Eliminating the Deficit"?

There are a number of ways to define the deficit.22 Here the term is used for the deficit of the entire public sector -- the "general government" -- net of the influence of the business cycle. When the economy is in recession, government revenues decline and the deficit increases. In growth years revenues rise. This is normal and does not in itself constitute a serious problem. The question is, what is the average deficit, taking good and bad years together? If it is negative, that means the government consistently spends more than its revenues, guaranteeing that the national debt will continue to grow. Our objective is to reduce this deficit, the "noncyclical deficit of the general government," to zero. We assume that if a serious macroeconomic adjustment plan is adopted, the deficit can be eliminated around 2006. For years after 2008 the plan assumes a very slight budget surplus, to aid in retiring government debt and bringing interest rates in the Israeli economy down.


Cutting the Budget

The budget cut for 2003 proposed by the Ministry of Finance includes NIS 3 billion cut from the compensation of career soldiers and another NIS 3 billion from National Insurance Institute payments. The rate at which both these payments have grown in recent years justifies cutting them back. There remains to dispose of NIS 12.7 billion in cuts. The point of distributing these cuts is precisely to eliminate or reduce counterproductive government intervention in the economy and, to a lesser extent, reduce expenditure on nonessential activities. A possible list of things to cut is presented in Appendix A, and is intended for illustrative purposes rather than as a hard and fast recommendation.

Two subsidy programs should be cut entirely: government-subsidized mortgages and subsidies to foodstuffs and transportation. At the same time, restrictions on the free marketing of foodstuffs and constraints on the financial sources of mortgage lending should be eliminated. Regarding mortgages, it should be assumed that a growing economy and a program of debt reduction will result in lower free-market mortgage rates than those eligible for government mortgage subsidies can get today with subsidies.

For 2004, planned spending programs of another 1% of GDP, or about NIS 5 billion, will be necessary. If 2003 is used to plan a program of social services privatization, a substantial part of this additional reduction could be achieved by making social services more efficient rather than less effective.

Further, smaller cuts are required in 2005 and 2006. By this time, however, renewed growth and the reduction of interest rates occasioned by a substantial contraction of the general government deficit could mean that the entire "cut" originates in the reduction of interest charges. By achieving fiscal balance and privatizing aggressively, Israel can achieve growth, tax relief, and a reasonable rate of public sector expenditure growth -- in real terms, not as a percentage of GDP.


Table 1
Summary Table: Hypothetical Medium-Term Macroeconomic Plan for Israel

  20022003-MoF* 2003-This Plan2004 2005
Assumed Growth Rate (%)-1 1 1 34
GDP (2002=100)100101101104108.2
Growth Rate of General Government Expenditure (%)-0.8-1.101
Budget Reduction (% Current GDP)-1.753.7510.5
G. Gov't as % of 2003 GDP 54.552.5 52.5 53.025
General Government as % of Current GDP54.5 54.552.551 49.5
Reduction of Tax Burden (% Current GDP)-0.21.8 0.30.3
Cumulative Tax Reduction (% Current GDP)   0.21.82.12.4
Actual Tax Receipts (% Current GDP)40.541.339.740.2 40.3
Noncyclical Deficit (% Current GDP)-3 -3-2.7-1.7-0.9
Actual Deficit (% Current GDP)-5-4.2-3.9 -2.1-0.9
Privatization Receipts (% Current GDP)  0.31.311
Change in Gross Government Debt (% of 2003 GDP) 3.92.6 1.1 -0.1
Gross Government Debt (% of Current GDP)101103.9102.6100.796.7
* Ministry of Finance Budget, 2003

  20062007200820092010
Assumed Growth Rate (%) 44444
GDP (2002=100)112.5117121.7126.5131.6
Growth Rate of General Government Expenditure (%)1 1.81.81.81.8
Budget Reduction (% Current GDP)0.50.10.10.10.1
G. Gov't as % of 2003 GDP53.55554.5255.556.557.5
General Government as % of Current GDP48.1 47.146.145.144.2
Reduction of Tax Burden (% Current GDP)0.40.50.60.6 0.7
Cumulative Tax Reduction (% Current GDP)2.83.33.94.55.2
Actual Tax Receipts (% Current GDP)39.939.438.838.237.5
Noncyclical Deficit (% Current GDP)-0.200.10.2 0.2
Actual Deficit (% Current GDP) -0.2 00.10.20.2
Privatization Receipts (% Current GDP)11111
Change in Gross Government Debt (% of 2003 GDP)-0.9-1.2-1.3-1.5-1.6
Gross Government Debt (% of Current GDP)92 87.48378.774.4

Loan Guarantees: A Non-Solution

Loan guarantees from the United States will not extract the Israeli economy from its recession. They will retard rather than accelerate a return to long-term, rapid growth. The purpose of loan guarantees is to make it easier for the Israeli economy to take on new debts. This is exactly the opposite of what Israel needs to do now; the object should be to regain fiscal balance and reduce debt, not increase it.

The previous time Israel received loan guarantees, in the early 1990s, was in order to fund the imports of capital goods needed to absorb mass immigration from the Soviet Union, with the expectation of turning them into productive workers. No equivalent special need justifies loan guarantees now.

Loan guarantees will create the illusion that the urgent task of correcting the fundamentals of macroeconomic policy can be deferred. They may make it easier for some of Israel's commercial banks to put off dealing with their problematic loan books. However, they will not do anything substantial to promote growth or jobs. They will not reduce the tax burden, especially the crushing burden of taxes on labor, reduce government expenditure, nor reduce government debt -- rather the reverse. They ought not to have been requested and, if offered, they should be declined.


Conclusion

Israel's current economic recession is the greatest economic challenge the country has faced since the macroeconomic stabilization program of 1985. It is the product of long-standing macroeconomic imbalances, in fact, of the unfinished business left over from the 1985 stabilization plan: high taxes, high government expenditure, large deficits, and burdensome government debt. These factors, taken together, made Israel a slow-growth economy even before the double shock -- war and global recession -- of 2001. They are also the factors that retard recovery from the recession.

Persistence in current policies is likely to increase Israel's economic instability and prolong its economic decline. Bold leadership, informed by an understanding of economic fundamentals and able to convey to the people a vision of what the Israeli economy could yet achieve, is needed in order to turn things around.

Appendix A
Hypothetical Budget Cuts, 2003
(Millions of Current NIS)
ItemAmount    Notes
Foreign Ministry
Culture and Sport
Local Authorities
Ministry of Finance
Education
Higher Education
Health System–Rationalization
Religious Affairs
Labor and Welfare
National Insurance Institute
  Across-the-board cut - 2%
  Taxation of child allowance for richest families
  "Mothers' Subsidies"
  Welfare: weeding out the ineligible
Consumer Subsidies
Agricultural Subsidies
Tourism-Development Subsidies
Industrial Subsidies
Government Mortgages
Government Premises–Development
Inflation Reserves

TOTAL

150
100
200
180
250
100
480
100
250
1250
900
100
100
150
3232
400
100
677
5100
63
100

12732

     
Not scientific research

Miscellaneous industrial subsidies
Not classroom Instruction

Efficiency reforms in HMOs











Except new immigrants

*     *     *

Notes

* Note on sources: The following abbreviations have been used here:
Bank of Israel, Din Ve-Heshbon Li-Shenat 2001: Taktziv Ha-Memshala Ve-Hamemshala Harehava [Hebrew: Annual Report 2001: Budget of the Government and the General Government], abbreviated DV 2001.
Ibid., Statistical Annex, abbreviated DV 2001 Annex.
Ibid., Din Ve-Heshbon Li-Shenat 1999 [Hebrew; Annual Report 1999], abbreviated DV 1999.
Ibid., Main Israeli Economic Data, www.bankisrael.gov.il, abbreviated BOI.
Israel. Central Bureau of Statistics website, www.cbs.gov.il, abbreviated CBS.
Israel Ministry of Finance, Taktziv Li-Shenat 2003: Ikkarei Ha-Taktziv [Hebrew; 2003 Budget Summary], abbreviated Budget 2003.
1. The Bank of Israel warns growth in 2003 may be negative. See BOI, Recent Economic Developments #99, Jerusalem, November 2002, p. 5.
2. Times are so bad that ordinary statistics require careful interpretation to establish their true meaning. Thus, Israel's unemployment rate declined in the third quarter of 2002. This does not mean things are getting better but that they are getting worse. Employment is calculated as a percentage of people working or actively seeking work. In the third quarter of 2002, many jobless people quit the job market for good, resigned to finding no work. Unemployment declined as a percentage of the "workforce," i.e., those working or in the job market, but the percentage of the total working-age population employed continued to deteriorate. See Figure 1.
3. Israel Central Bureau of Statistics (henceforth: CBS), press release, November 18, 2002.
4. CBS, "Uchlusiyat Benei 15 U-Maala, Lefi Tchunot Koah Ha-Avoda Ha-Ezrahi Ulfi Min" [Hebrew; "Population of Age 15+, by Workforce Characteristics and Gender], www.cbs.gov.il.
5. CBS, Table, "Sachar Memutza Le-Misrat Sahir" [Hebrew; "Average Employee Wage"], www.cbs.gov.il.
6. CBS, Table, "Hotza'ah Le-Tzricha Pratit" [Hebrew; "Private Consumption Expenditure"], www.cbs.gov.il.
7. Source: Bank of Israel, chart, "GDP and its components at constant 2000 market prices," www.bankisrael.gov.il, and author's calculations.
8. Yoram Gabizon, "Mahnak Ha-Ashrai shel Misrad Ha-Otzar" [Hebrew; "The Finance Ministry's Credit Crunch"], Ha'aretz, October 6, 2002, p. C10.
9. "General Government" expenditure in Israel includes the expenditure of the central government, local authorities, and official nonprofit organizations such as the National Insurance Institute and the Israel Broadcast Authority that are funded by mandatory payments from the public.
10. In 2001 general government expenditure in Israel reached 54.9% of GDP, the highest among the developed market economies, topping even Sweden. See the Bank of Israel, Din Ve-Heshbon Li-Shenat 2001: Taktziv Ha-Memshala Veha-Memshala Harehava [Hebrew: 2001 Annual Report: Budget of the Government and the General Government], Jerusalem, 2002, Diagram G-3, p. 166.
11. Budget 2003, chart, p. 26.
12. The author wishes to thank Dr. Adi Brender of the Research Department at the Bank of Israel for stimulating conversations on this subject. Dr. Brender has done much to popularize the view that a "fiscally fit" economy can attract copious foreign investment and grow rapidly on the morrow of a macroeconomic adjustment program, even though government expenditure and the fiscal deficit have declined as a result. For a summary of Dr. Brender's arguments (based especially on the Irish example), see the record of a conference held at the Knesset, May 28, 2002, at www.israeleconomy.org.
13. For a trenchant statement of this argument, see Karnit Flug and Michel Strebczynski, "Tzemikha Bat Kaiyma -- Me'ever la-Pina?" [Hebrew; "Long-Term Growth -- Around the Corner?"], Bank of Israel Research Department Discussion Paper #5, June 2002.
14. Avi Lavon, "Hachnasot Ha-Medina Mi-Misim -- Gviah Bifoal Bi-Shenat 2001 Ve-Idkun Tahazit Li-Shenat 2002" [Hebrew; "Tax Receipts -- Actual Receipts in 2001 and Updated Projections Regarding 2002"]. Ministry of Finance, State Revenue Administration, Din Ve-Heshbon Shenati 51 [Annual Report #51], p. 18.
15. It would be more accurate to term it an "expenditure outburst." The central government's budget rose from 42% of GDP in 2000 to a projected 46.3% of GDP in 2002. See Budget 2003, p. 26.
16. See Ha'aretz, April 22, 2001, May 21, 2001, and December 17, 2001.
17. Budget planning in Israel is based on projections of the growth of next year's expenditure, assuming social and economic trends that affect budgetary expenditure do not change and legislation does not change expenditure levels. This is referred to by planners as the budget "on automatic pilot." The NIS 8.7 billion figure is a cut in hypothetical expenditure levels in 2003. It represents real pain for recipients of government funding, because ministries base their spending plans on the assumption that their statutory obligations to provide funds and services will be fully funded.
18. See Bank of Israel, "Recent Economic Developments," #97, Jerusalem, April 2002, p. 10; #98, August 2002, p. 9.
19. Conversation with Avi Lavon, Director, State Revenue Administration, Ministry of Finance, October 28, 2002.
20. Ministry of Finance, Reforma Be-Mas Hachnasa: Hamlatzot Ha-Va'ada Le-Reforma Bemas [Hebrew; "Tax Reform, Report of the Tax Reform Commission"], Jerusalem, June 2002. See Chapter 1, Table 11 [pagination uncertain] for a schedule of proposed tax cuts and revenue offsets.
21. See Bank of Israel, "Recent Economic Developments" #98, Jerusalem, August 2002, p. 9.
22. See DV 2001, pp. 142-48, 158, 162.

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Dr. Yitzhak Klein is Director of the Israel Policy Institute in Jerusalem. He has published numerous articles on Israeli politics and economic policy.


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