The Israeli economy was in good shape before October 7, 2023, and the subsequent war. The foreign currency reserves were high (about $200 billion). The balance of payments was good (a surfeit of about $20 billion). Israel was lending (net) about $200 billion to the world. There was full employment, a low debt-to-GDP ratio (61 percent), and a reasonable expected budget deficit for 2023 without the war (less than 2 percent).
The Israeli economy is strong thanks to good foundations, especially in the years after the 1985 stabilization plan. The condition was the fruit of the hard and ongoing work of a responsible economic policy, reforms, openness to the world, and the building of a superb high-tech industry as a growth engine and source of foreign currency. Good institutions were built at the Finance Ministry, at the Bank of Israel, in the judicial system, in regulation, and in a robust financial system. At the beginning of 2023, attempts were made to damage some institutional achievements that formed the basis of economic stability, but the economy remained strong.
The Hamas war intensified the security, social, and international risks. The macroeconomic level appears “reasonable,” but this is an illusion in the short time that has elapsed. The lack of an appropriate economic and budgetary policy for the new reality and a preference for nonproductive sectors while avoiding cuts in political and coalition funding have increased economic uncertainty. Because of the economy’s strength, the financial crisis is not immediately apparent. There is a lag until the changes affect the economic trend. The processes are not linear, but they are not at all robust.
A Different Kind of War
The Gaza war was completely different from previous rounds in Gaza or from the Second Lebanon War. In terms of reserve call-ups, it resembles the Yom Kippur War; in terms of its length, it resembles the War of Independence. The goals set for the military—to dismantle Hamas’s military and governmental capabilities—require an intensive and ongoing military effort. The duration of the war increases the economic damage. The fact that the war began as a great surprise, similar to the Yom Kippur War, need not in itself lead to economic outcomes like those that followed the Yom Kippur War—”the lost decade.” At the same time, the current war will have a significant long-term impact on the Israeli economy that depends primarily on the conduct of the government, which has not excelled at economic policy and devising a suitable state budget.
A large-scale security crisis, alongside a failed economic policy and management, worsens the dangers and the situation. The direct expenses of the war, military and civilian, are assessed at about NIS 180 billion from the last quarter of 2023 to the end of 2024 (without American aid). A large deficit was created in the 2024 budget (about 8 percent of GDP), public debt grew, and so did interest expenses. The crisis was not exploited to make significant cuts in the coalition funding and the unnecessary expenses of the government ministries. The 2024 budget was a disappointment: it did not include growth engines, economic and public reforms, or an orderly plan to emerge from the crisis. Faulty management will result in a lengthy recovery and high public debt.
Precisely because of the continuation of the war and its heavy costs, the government needed to formulate a responsible budget for 2025. A budget is the work plan for the government and the economy. Lax budgetary management harms growth and employment. The problems and the issues that roiled the Israeli economy—socially and politically—before October 7 were not resolved after the war began. On the contrary, some of them were exacerbated and grew more complex, such as the shortage of infrastructure, low productivity, the high-tech crisis, and housing prices. In addition to these, new problems such as damage to the functioning of institutions, appointments of unqualified persons to public positions, and harm to the quality of the public service are also present. The damage to Israel’s diplomatic standing affected foreign investment in high tech, trade relations, Israel’s image, especially in light of a lowered credit rating, and specifically its image as attractive and stable.
The war raised new issues that require serious attention: agriculture and food security, local production versus defense imports, maintenance of military and civilian inventories in light of problems with supply chains (involving Turkey and the Houthis), and disruptions in the labor market caused by the lack of Palestinian and foreign workers.
A complex problem threatening the economy and the country is the high growth rate of the Haredi (ultra-Orthodox) population and its lack of integration in the labor market and the military. This situation endangers the Israeli economy and society, including the Haredi society itself. The Haredi issue has been aggravated by its resistance to military recruitment and the entrenchment of its autonomy, which is detached from the state. The manpower needs of the army and the civilian economy have become acute, and haredi conscription has become an operational problem, not only a moral one.
The war highlighted the great strength of the civilian society, the third sector, and many nonprofit associations that compensated for the government’s weakness. The wartime behavior of the civilian society was encouraging and impressive, but it cannot replace an efficient and functioning public service. The war allowed tens of thousands of volunteers to act upon their desire to help and soften the harsh blows that many families and communities suffered in the war. The business and private sectors contributed funds, and Israel was also blessed with contributions from world Jewry.
The war combined the front and the home front. Damages were caused to communities in the western Negev and in the north, and branches of the economy were hit hard by the extensive reserve mobilization and the barring of Palestinian and foreign workers (in the construction and agriculture branches). Damages were also caused in branches other than construction—tourism, aviation, and recreation. Rehabilitating the western Negev and northern communities will require rebuilding homes, production facilities, and infrastructure so that the veteran residents can return and new residents can be absorbed.
Costs of the War
Israel’s security concept was that wars should be short in light of international factors, reserve mobilization, and the functioning of the national economy. The current war caused a loss of the sense of security along the borders, affecting the defense budget’s size. A new and updated reference scenario will be needed for the use of force, the crafting of the order of battle, and technological developments while internalizing the latest lessons and threats. Israel can withstand a one-time heavy burden of a war, but a permanent high increase in the defense burden will entail the raising of taxes, the cutting of educational, health, welfare, and infrastructure services, or a deficit and public debt. A mistaken policy could create phenomena, as in the aftermath of the Yom Kippur War, of an ongoing loss of output.
The prolongation of the war raised the expenses of reserve mobilization, the consumption of ammunition, fuel, food, spare parts, and the wear and tear on operational tools and supplies. The generous American aid of $14 billion softened the impact on the state budget. Still, the local defense burden grew significantly. It will cast a heavy shadow in the future on the return to serviceability of damaged weapons, the renewal and reinforcement of inventories, and military equipment in the aftermath of the war. The war highlighted the need for military manpower, affecting the length of military service, reserve mobilization, and pressures for recruiting marginalized groups. The increase in the burden of reserve duty for a relatively small but productive group over the long term will harm the economy. This is another reason why greater equality is needed in sharing the burden of military service, both in the standing army and the reserves.
The assessment is that the GDP loss from the start of the war to the end of 2024 will come to about $17 billion. To this must be added ongoing defense and civilian expenditures of about $45 billion (beyond the special American aid), as well as additional budgets for rehabilitating buildings, equipment, infrastructure, forests, and small businesses at a cost of about $20 billion. Restoring military equipment and renewing and reinforcing supplies will cost about $15 billion. The war exacted (up to September 2024) human damages with the deaths of 1,630 soldiers and civilians, and about 6,000 who have been physically and psychologically injured. Rehabilitation of the injured and compensation to bereaved families are assessed at about $15 billion. That is, the war has cost, so far, about $95 billion—or about 18 percent of Israel’s annual GDP.
Budget
The updated state budget for 2023 included a supplement of about NIS 30 billion beyond the internal changes in the budget, for both defense and civilian expenditures, and the deficit came to 4.2 percent of GDP. The deficit planned for the 2024 budget was 6.6 percent of GDP. In actuality, it will be higher, about 8 percent, increasing government debt to about 70 percent of GDP (compared to about 60 percent before the war). The defense aid from the United States (about $14 billion) helped to fund part of the high expenses of the war.
In 2023 and 2024, an addition to the debt resulting from the deficit growth due to the war came to about NIS 175 billion. In 2025, Israel will be forced to pay another NIS 7 billion in interest expenses (including recycled debt) compared to 2024, and in 2026, the sum will reach NIS 10 billion. High deficits and rising debt affect the trust of investors and rating agencies while also accelerating inflation and lowering the shekel’s value.
The war was an opportunity to correct distortions created by coalition pressures for expenses whose contribution to the economy and society was minimal and even harmful. A temporary rise in the deficit and public debt is inevitable. Still, the finance minister increased both expenses and the deficit in the 2024 budget, which will raise the deficit to about 8 percent of GDP. The composition of the 2024 budget did not take the war into account, weakening the credibility of fiscal policy and the ability to contend with future challenges. In wartime, a budget requires prioritization, which the government avoided because of a political fear of unpopular measures. For 2025, a deficit without restraining measures will result in a debt-to-GDP ratio of 80 percent of GDP and raise the risk for Israel of a financial crisis.
The finance minister announced the outline for the 2025 budget, albeit belatedly.1 It included a deficit target of 4 percent of GDP and a plan for fiscal measures amounting to about NIS 35 billion involving the freezing of National Insurance benefits, tax rates, and the minimum wage and wages in the public sector. These measures will mainly harm the middle class, the weak strata, and consumption, and there is doubt about their political feasibility. The fiscal framework is important (with its deficit of 4 percent of GDP), but its contents are no less important. In the Finance Ministry itself, some cast doubt on implementing the budget proposal in light of “unrealistic hopes.” Deficit reduction is necessary to stabilize the debt-to-GDP ratio by 2025. Also needed is an announcement on a plan for the deficit to decline, beginning in 2026, to about 2.5 percent of GDP.
GDP and Economic Activity
In 2023, growth came to only about 2 percent. The growth forecast for 2024 will be lower at 0.5–1 percent,2 entailing a decrease in GDP per capita. The Israeli economy coped well with the COVID-19 crisis thanks to the dominance of the high-tech branch (10 percent of GDP), which was not harmed, and the low weight of the hospitality and food (tourism) branches, accounting for only 2.6 percent of GDP. The current war, however, is not similar to the COVID-19 crisis because its economic ramifications are ongoing rather than temporary. Moreover, a significant escalation in the fighting in the north, or, God forbid, an expansion to a regional conflict, will create shockwaves and could slow down even worldwide growth (as oil prices rise). The lengthening of the war is likely to cause additional weak quarters in which Israel will fail to exhaust its growth potential, and the gap between Israel’s GDP and its growth potential only widens. The risk to growth will also stem from a sharp rise in debt and interest expenses.
Before the war, the inflation rate was about 4 percent per annum. Inflation has somewhat moderated to 3.25–3.5 percent; in the great uncertainty, the Bank of Israel’s high interest rate of 4.5 percent hampers growth and makes household debts (mortgage payments) hard to meet. The uncertainty surrounding the 2025 budget, which concerns the adjustments needed to reduce the deficit continuously, has contributed to a rise in the risk premium and will make it difficult for inflation to return to its target. The risk of stagflation—recession and inflation—has grown, and this combination poses a difficult challenge for economic policy.
The Labor Market
At the war’s inception, the reserve call-up of about 8 percent of the labor force harmed local manufacturing. The callup, consisting mainly of young men (aged 21 to 45), affected the industry, high-tech, and agriculture branches. A significant mobilization of drivers caused disruptions in supply and logistics chains. The most significant impact was in the construction branch because of Palestinian laborers’ barring and foreign laborers’ departure. Working at home is more feasible in the high-tech and financial branches, and many businesses increased the proportion of those working at home during the war.
Seemingly, there is an anomaly in the labor market: a low unemployment rate and slow growth. The reason for this disparity is the shortage of about a hundred thousand Palestinian workers, which affects GDP growth. In addition, the Israelis uprooted from their homes and the reserve soldiers are not considered unemployed—though, nonetheless, they contribute little to growth. Unemployment is at a minimum, not because the economy is growing, but mainly because of the shortage of workers.
The construction branch includes a large number of Palestinian and foreign workers. Numerous construction projects for dwellings, infrastructure, public buildings, and commercial projects have been delayed, affecting housing prices. In the agriculture branch, the shortage of workers has affected the consumption yields and the prices of agricultural products. The war has highlighted the economy’s significant dependence on Palestinian workers. The quantity of these workers, with or without permits, from the West Bank and Gaza came before the war to about 170,000, or about 4 percent of the total of employed Israelis—and at a high rate in the construction and agriculture branches. This dependence will require Israel to rethink the matter. At the same time, the Palestinian Authority is dependent to a large extent on Palestinians’ salaries from work in Israel. Despite political declarations over the years about wanting to reduce this dependence, nothing has been done. This is an issue with broad ramifications for the economic relations between, on the one hand, the Palestinian Authority and Gaza and, on the other, Israel, which will not be discussed in this article. Closing the gates to the Palestinian workers has sparked internal unrest and created a pressure cooker in the Palestinian Authority, with a rise in terror that, for its part, increases risks for the economy.
The volunteering of tens of thousands from the civilian society replaced the missing workforce in many domains, which enabled the economy and the society to function, even in the first difficult days after the murderous attack. In some branches, the volunteers were full of good intentions but not sufficiently professional, and it was unclear how long they could continue in their tasks. The unemployment rate has remained stable throughout the war.
The Branches of the Economy
Small businesses—Small and tiny businesses have been especially hard hit by the war. In 2024, for the first time in years, the economy is expected to be in a negative balance, with the number of businesses that close exceeding the number that open, harming Israeli economic activity in general.
High tech—Since the 1990s, high tech has become a leading branch and the economy’s growth engine, accounting for about 50 percent of Israeli exports. The war has reduced foreign investment in high tech, causing companies to relocate abroad. Since the start of 2023, the state of Israeli high tech has worsened with the world crisis. Israeli high tech suffered further from the judicial overhaul and the war.
Agriculture—The war has depleted agriculture along the Gaza border, a chief source of potatoes, carrots, onions, and tomatoes. The same holds for communities along the border with Lebanon, which supply eggs and fruits. The ongoing problem in the branch is a shortage of workers. The war raised food security and Israeli imports to the agenda. Care must be taken to rehabilitate the farmers of the western Negev and the north so that they will continue to be Israel’s vegetable garden.
Construction—The direct weight of the output of the construction branch is 6.5 percent, and with the associated services, about 9 percent. Now that about a hundred thousand Palestinian laborers have been barred from Israel and about fifteen thousand foreign laborers have returned home to Turkey and Moldova, the branch’s activity has suffered.
Industry—Industry has been harmed by the shortage of workers caused by the reserve call-up. Demand has grown in the industry branches of food, security, medications, and health products. The factories that produce raw materials for the construction branch have suffered from the reduced demand for their products because of the stoppage of work at construction sites. In most industrial factories, the work continues as usual (despite the reserve call-ups).
Tourism—Tourism from abroad has sharply declined. Some of the hotels have dealt with the crisis in the short term by hosting Israelis evacuated from the Gaza border and the north, with state funding. The concern is that an ongoing crisis as the war continues will discourage tourism.
Air Travel—This branch is volatile amid the suspension of flights by many foreign companies, which has also affected cargo imports by air. Maritime cargo has grown more expensive because of the increased risk and the smaller number of vessels visiting the ports (the port of Eilat was paralyzed by the Houthis).
Energy—The beginning of the war saw a shutdown of the Tamar gas field, which is about 25 kilometers from Ashkelon, for fear of rocket attacks and risk to the workers. The shutdown caused damage amounting to about NIS 800 million per month. The Tamar field is the leading gas supplier to the Israel Electric Company. The company was forced to use coal and solar fuel, and air pollution grew. In the short time, the Leviathan gas field did not manage to supply the same quantity as Tamar. After a month, the energy supply stabilized and returned to the prewar level.
Private services—Recreation (restaurants, entertainment) declined due to reduced demand.
The Financial System
The immediate response to October 7 was a considerable devaluation of the shekel to about four shekels per dollar. The Bank of Israel declared its willingness to intervene in the foreign currency market with an allocation of up to $30 billion from Israel’s large foreign currency reserves. This declaration stabilized the shekel rate. In October 2023, the Bank of Israel sold about $8 billion, ensuring the regular activity of the foreign exchange market and the financial system. Liquidity problems did not arise in the banks. The banks and the insurance and pension companies have large enough capital cushions. At the same time, the war affected the rise in Israel’s risk premium in the international capital market (CDS), in turn causing a rise in interest in the government’s raising of capital in the business sector both abroad and at home. Israel’s risk premium in the world increased sharply (from about 50 points to about 120) because of the prolongation of the war and the increase in both defense and civilian expenses. The international rating agencies—Standard and Poor, Fitch, and Moody’s—lowered Israel’s rating and left it on a negative-outlook list amid fear of a further reduction. The lowered rating stemmed from the war and the government’s incompetence in budget management. It reflects the decline in political and geopolitical stability, alongside the fear that the war will continue into 2025. In reality, the Israeli rating in the international capital market is lower than the reduced rating of the rating agencies (A+) and stands at BBB. The capital market in Israel responded, as expected, with significant volatility. The Israeli stock market, on average, rose less than its companies in the world, unlike in the past.
Eighty-five percent of the government debt is from the local market. The war was financed primarily by a sharp increase in the issuance of government bonds in the Tel Aviv stock market. Israel’s government debt before the war3 stood at about NIS 1,060 billion, with 52 percent of it being negotiable debt. The debt denominated in foreign currency came to about NIS 160 billion, about 15 percent of the debt balance and about 9 percent of the GDP. The accountant general has significantly accelerated debt financing since the war, and most of the issuances are in the local market—primarily for the institutional bodies that manage public savings. The larger the debt needs and the higher the risk, the greater the yield that the government is forced to pay. The option of significant financing at favorable prices in foreign currency is limited, so most financing comes from the tradable local market. The state must raise large sums, including the existing debt cycle, on the order of NIS 15–20 billion monthly.
The heightened debt financing makes the government debt more expensive and increases interest expenses. In such a situation, a responsible government would have hastened to implement a plan to reduce expenses or increase revenues and quickly present a responsible budget with a clear order of priorities that could accelerate growth. The growth of this debt poses the most significant risk of a financial crisis.
Challenges
The war in Gaza is substantially affecting the economy even before the expected escalation along the Lebanon border. The great unknown is the lack of an economic policy precisely in wartime, with the war’s expenses and their ramifications constantly growing. The lack of a policy, both economic and budgetary, lowers the confidence of people and companies both in Israel and abroad. The risk of stagflation—recession and inflation—has increased. That is the main reason the rating agencies have lowered Israel’s credit rating alongside a negative outlook. The war has produced a change in Israel’s security situation amid concern that Israel’s enemies will try to undermine the society’s resilience, which has been responsible for the economic prosperity and social cohesion during the decades of the Israeli economy’s growth.
The war has shown that Israel has difficulty sustaining a long war entailing a very large reserve call-up, with deleterious effects on high tech and tourism, a paucity of foreign workers in agriculture and construction, and growing difficulties in the international arena amid economic boycotts. The war has also revealed the dilemmas in the munitions economy, with the costs of Israel’s interceptors incomparably higher than the enemies’ cheap airborne munitions, something that can seriously damage the Israeli economy.
The lack of professional economic thinking and procrastination about an economic policy (as in the budget talks for 2025) harms national security. The political polarization and the coalitional, political, and sectoral needs have resulted in flawed government management, leading to long-term economic and national security damage. A responsible state budget requires investing in growth engines and infrastructure, cutting unnecessary expenses, rebuilding the fiscal reserves, and investing in the social needs that are growing because of the war. The shirking of conscription and absence from the labor market by many Haredim impose an intolerable burden on the economy and society. The Haredi population is the fastest growing in Israel today and will be in the future.
Instead of updating the orders of priority, the government has dealt with the economic challenge primarily with horizontal cuts that have harmed education, health, and welfare, impairing essential elements of national resilience and have not helped the economy. Israel’s challenges after the war will require a strong economy and firm social resilience. Israel faces an ongoing war of attrition against the Iranian axis with its proxies. It will need new thinking for security, economic, political, and diplomatic coping with a long war at different intensities. Among the practical necessities are increased sharing of the burden by the Haredi population and suitable compensation for reserve soldiers who carry the burden. Israeli resilience lies in finding the balance between the requirements of the war and the need to sustain a flourishing economy. The economy and the society must not be overly subordinated to security objectives.
* * *
Notes
