18th Caesarea Economic Policy Planning Forum - Macroeconomic Policy

A few months ago, it seemed that Israel’s economy had emerged relatively unscathed from one of the worst economic crises of the last hundred years. Recently, however, apprehension has grown in view of the persistence of the global slowdown in the wake of the debt crisis in Greece and several other Eurozone countries. One concern is that in order to reduce government deficits and debts, the countries of Europe will have to raise taxes and reduce public expenditure – measures that are liable to impair their economic recovery. The slowdown of demand in Europe could harm Israel’s exports and retard the pace of the country’s recovery. In addition, recent quarterly National Accounts data indicate that there has been some slowdown in the pace of Israel’s economic recovery.

As far as macroeconomic stability is concerned, the starting point of the Israeli economy prior to the crisis was better than it had been in the past. The budget deficit and the debt/GDP ratio were on a downward track, the unemployment rate was lower than it had been in the previous decade, and the inflation rate remained within the target range. There was a trend towards easing the tax burden, with the attendant reduction in the government’s share of GDP. Israel’s economy is currently at a point where government spending and the tax burden as a share of GDP are close to – and even slightly below – the OECD average. The process of reducing the tax burden and the extent of government involvement has led, inter alia, to the contraction of expenditures on education relative to GDP growth. The budget for higher education has been adversely affected, and the economic expansion of recent years has been accompanied by increased inequality and poverty rates. The OECD report on Israel notes that despite the tax cuts and the lower share of public expenditures in GDP, the income and productivity differentials between Israel and the leading OECD countries are still evident.

The main impact of the global crisis has been on exports. The damage has been significant and in line with the decline in world trade. However, since Israel’s banking system was less exposed to mortgage-backed assets abroad, the domestic housing market was conservative and balanced, and Israel’s exports were affected to a lesser extent than small open economies in Europe. The economic slowdown was also less severe than in other small, open economies that were also not exposed to mortgage-backed assets. In retrospect, government policy appears to have been neutral vis-à-vis the business cycle, the principal activity being that of the automatic stabilizers and restraint, when it came to implementing the deficit ceiling. Most of the counter-cyclical policy was implemented by the Bank of Israel, which reduced the key interest rate to its lowest level ever in line with central banks in other developed countries. The Bank of Israel also adopted an expansionary policy, purchasing government bonds and also supporting the exchange rate against the dollar by buying foreign currency, as manifested by an exceptional rise in the foreign reserves. A brief comparison of the macroeconomic policy mix during the crisis with that of several small European countries shows that Israel’s fiscal policy was atypical. In countries not in the Eurozone that were able to conduct expansionary monetary policy, the policy mix was more balanced, involving the combined deployment of fiscal and monetary measures. Note, however, that as regards the debt/GDP ratio, those countries started off in a better position than Israel. The global crisis exposed once again the importance of aiming for a low debt/GDP ratio, thereby providing a greater extent of freedom in deploying counter-cyclical policy. Countries in the Eurozone were obliged to implement fiscal policy, as this was the only possibility open to them. These countries, which started from a weaker position, were in danger of rapidly descending into insolvency. In the final event, it can be said that even though Israel’s fiscal policy could have been more expansionary, placing less emphasis on monetary policy, the policy implemented helped to moderate the adverse effect on the economy. However, according to an analysis of the impact of the PIGS policy in terms of fiscal stability, given the various countries’ diverse structural compositions, it is not the size of the government or the share of the tax burden in GDP that explains the extent to which they were affected, but the debt/GDP ratio and the government deficit.

As previously stated, a few months ago it seemed that the policy dilemmas would be linked with the measures to be taken following the rapid emergence from the crisis. On the fiscal side, the government prepared to introduce legislation. The new expenditure rule was intended to balance the desire to cease reducing the government’s share in GDP, while recognizing that resources should be directed to education, the infrastructure, and stimulation of economic growth, on one hand, and the desire to aspire for a debt/GDP ratio of 60%, on the other. The fiscal rule was intended to join existing legislation regarding the deficit target and the easing of the tax burden. The government even presented the Knesset with a proposal for a two-year budget. The dilemma of monetary policy was connected to the policy of emerging from a low interest-rate level, while endeavoring to avoid the rapid strengthening of the NIS.

Using a dynamic macroeconomic model developed in the Bank of Israel’s Research Department, the team examined the implications of the new fiscal instruments. Two scenarios were examined: rapid recovery from the crisis and slow recovery. Both scenarios indicated that it will not be possible to combine the three fiscal instruments. If the expenditure and tax reduction rule is used, it will not be possible to attain the deficit path and the reduction of the debt. Alternatively, by adhering to the deficit ceiling and the reduction of the debt, the proportion of public expenditures as a share of GDP will continue to contract, despite the recognition that it has fallen adequately. In a pessimistic scenario, which is not unlikely given recent developments, there is a possibility that expenditures will decline sharply or that the debt/GDP ratio will rise. Neither of these two possibilities is desirable and would not be welcomed by the team.

The team’s fiscal policy recommendations follow:

1. Since the three fiscal instruments are liable to clash with one another, it is necessary to pay attention to the limitations entailed in the attempt to meet the three fiscal targets. In view of the fiscal crises in some European countries, which indicate that the process of fiscal deterioration can be very rapid, extreme caution should be exercised in order to avoid increasing the deficit beyond the track determined by law.
   
   
2. It is necessary to review the tax-reduction trajectory. If it transpires that the deficit trajectory is about to be disturbed, policy-makers will have to decide whether to make adjustments in the income side or the expenditure side, or in their mix. Some team members recommend making adjustments in the income side; that is, considering the discrepancy between the targets, tax reductions should be discontinued. Doing this when the growth path in the near future is uncertain will enable the government to maintain expenditures, without jeopardizing convergence to the target of the debt/GDP ratio. Since the tax burden in Israel is one of the lowest in the OECD countries, and in light of the fact that many countries are expected to increase their taxes, the team does not think that terminating tax reductions will have a grave economic effect. However, the continued reduction of taxes and sharp spending cuts, given the Brodet trajectory regarding the defense budget and debt-servicing payments, will lead to low levels of civilian expenditures, which are perceived by most of the team members as endangering future, growth given the expected adverse effect on Israel’s human capital and physical infrastructure. Some team members think that if there are concerns regarding Israel’s ability to meet its deficit target, it will be necessary to abandon the expenditure rule and aim at making changes in the composition of expenditures, while maintaining the tax reductions to which the government is committed. Freezing tax reductions could have an impact on the government’s credibility and on incentives in the business sector. These incentives could boost competition in this sector, especially in the context of Israel’s low position on the scale of business transactions. Thus, top priority should be given to expanding the tax base, inter alia by canceling tax exemptions. In a situation in which revenues from measures of this kind are not practicable or adequate for attaining the deficit ceiling, the dispersal of the tax reductions over several years should be considered.
   
   
3. Long-term budget planning should be encouraged, although the two-year budget should be reconsidered. Most of the team members think that the goal should be to extend the planning horizon of the national budget in strategic spheres, such as education, along the lines of the long-term plan outlined in the Brodet trajectory for the defense budget. However, in light of macroeconomic uncertainty, most of the members of the team think that a two-year budget enhances the government’s flexibility and enables the democratic discussion of budgetary alternatives, since adjustments will have to be made to the budget should the growth rate differ from the expected rate. Nevertheless, if the two-year budget is approved, it will be necessary to build into it mechanisms for the second year that will provide expenditure frameworks and will indicate the income changes, which are dependent on macroeconomic performance and will become clear at the end of the first year of the two-year budget.
   
   Monetary policy is currently in a predicament. Israel’s inflation rate has overshot the target as a result of several factors: the relatively moderate impact of the recession on Israel; the highly expansionary monetary policy; the unanticipated increase in V.A.T. and other taxes in mid-2009. In addition, there is real apprehension that Israel’s low interest rates will lead to a property bubble, and certainly to a rise in the consumer price index. The policy predicament is embodied in the possible effect of an interest-rate hike – in an attempt to deal with inflation and prevent an asset bubble – on the exchange rate and exports. The dilemma could worsen if the negative scenario is realized, as global demand is expected to expand at a slower rate than anticipated. In that case, exports will be adversely affected should local currency appreciation persist concurrently.

The team calls on the Bank of Israel to make the inflation target its top policy priority. The team recognizes the complexity of the monetary predicament, but feels that in the framework of the new Bank of Israel Law, the inflation target should be the central bank’s chief policy concern. The team also recognizes the importance of policy regarding the foreign currency market, and the Bank of Israel’s contribution to exports. According to the team’s assessment, it will not be possible to support the real exchange rate over time. Nevertheless, the team feels that it is possible and desirable to find other tools for checking local currency appreciation in the short term, especially during the initial emergence from the economic crisis. The appendix contains a proposal for supporting the exchange rate based on stimulating capital outflow from Israel, subject to the existence of surpluses on the current account of the balance of payments.

The team calls for the adoption of plans to lower the hurdles confronting businesses. In view of the existence of a restricted budgetary sphere of action, the team recommends that initiatives be introduced to reduce the bureaucratic barriers confronting Israeli businesses. International reports place Israel in a relatively low position among the developed countries in indices of business transactions. Improving the regulatory and administrative infrastructure could contribute substantially to Israel’s economic growth rate at a relatively low cost.

 Read the full report on Macroeconomic Policy in the Wake of the Global Financial Crisis (Hebrew)

 See the PowerPoint presentation that accompanied this session (Hebrew)

 Read the Hebrew summary of the session on Israel's Macroeconomic Policy  (Hebrew) 

 Read all the English summaries of the recommendations of the working groups (English)

View all the proceedings of the 18th Caesarea Forum (with simultaneous English translation)

See the interview with research team leader Dr. Nathan Sussman (Hebrew)

 Go to the main page of the 18th Caesarea Forum (English)