Needed: Leadership for Growth

, November 15, 2002

No. 488     November – December 2002

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

Dr. Yitzhak Klein

Dr. Yitzhak Klein is Director of Policy Research at the Foundation for Society and Liberty, a policy institute in Jerusalem devoted to a Jewish society, civil liberties and economic liberalism in Israel. Dr. Klein is former Director of the Israel Policy Institute in Jerusalem. He has published numerous articles on Israeli politics and economic policy.