Macroeconomic status assessment: The Israeli economy is suffering from a crisis in the real sphere and from unrest in the sphere of product and property prices. 2002 will be the second consecutive year in which the per capita product is expected to shrink in conjunction with a raise in prices that exceeds the target for 2002. In 2001 economic activity was diminished as a result of three factors operating simultaneously: an increase in terror in Israeli cities, a recession in the world economy, and a slump in the high technology industry.
At the beginning of the recession, the damage to economic activity was focused in industries that were directly affected by the security situation, such as the tourism industry, or affected by the world recession, which damaged the high technology industry. It would seem, however, that during 2001 the damage to economic activity gradually spread towards all the industries in the economy.
The causes of the current economic recession, which began in the last quarter of 2000, are unlike the factors responsible for the low growth rates in the years 1997 to 1999. The current recession is a result of external upheavals (the terror attack and world recession), whereas the previous one resulted from a mix of a policy of monetary restraint with a policy of fiscal restraint (along with the influence of the dwindling of the wave of immigration and financial crises in various parts of the world).
The detrimental effect of the security situation increased progressively towards the end of 2001, whereas the influence of world economic activity is showing initial signs of changing from negative to neutral or even somewhat positive. Global recovery might shed a negative light on the Israeli economy if Israel does not manage to ride the wave of recovery worldwide. At the beginning of 2001 the recession in Israel’s economic activity could be attributed to the global depression. It would appear that in 2002 the security situation has a notably negative effect on the level of economic activity, and this affects the perceptions of investors abroad.
Social stability: The crisis in the real sphere has struck Israel at one of its low points in terms of indices of social stability. Decision makers must take into account the effects of policy on the level of social stability. An unemployment rate of over 10 percent of the workforce is one manifestation of the country’s economic crisis. An unemployment rate this high also reflects social malaise that threatens stability. The unemployment rate in certain Arab localities and a number of development towns in the south is particularly high.
The poverty rate, which is relatively high in international terms, coupled with an exaggerated poverty rate among specific population groups (especially Arabs), arouses concern as to the health of Israeli society. The high level of economic inequality and poverty relative to countries around the world is partially explained by the low rate of participation of Israeli men who are of the main working ages (25 to 54).
The world environment: There is an increasing number of signs indicating that global economy is recovering from the recession from which it has been enmeshed since mid-2000. The composition of this recovery in the US economy is less favorable from the standpoint of the Israeli economy, since the development of Israeli export is more sensitive to investments in machinery, software and equipment and less so to consumption.
The four new industrial countries in Asia (Hong Kong, Korea, Singapore and Taiwan) are also showing signs of becoming extricated from the 2001 recession. In view of Israel’s similarity to these countries (which also went from high growth rates in 2000 to negative growth rates in 2001, in an even more pronounced manner), the International Monetary Fund forecast which anticipates a relatively quick recovery in these economies can be perceived as encouraging.
At this stage, Israel’s current crisis is unlike crises the country’s economy has suffered in the past. The expected world recovery, the low deficit in the balance of payments, the low external debt and the high foreign currency balances are some of the strengths that help to safeguard the stability of the local economy.
The forecast: According to the team’s assessments, the gross domestic product in 2002 will be one percent lower than that of 2001. In 2003 the level of per capita product will remain the same. The growth forecast for the economy was based on the premise that a financial crisis will not occur. This does not mean that the probability, in the team’s assessment, of a financial crisis is non-existent. Naturally, the team chose not make predictions as to the growth forecast should there be a financial crisis.
Fiscal
picture: In the fiscal sphere, a regression has taken place in all dimensions, both with respect to the trends that characterized the Israeli economy in the past and with respect to global developments. This regression in fiscal policy, which is affected by the shrinkage of the product, is approaching the danger zone and poses question marks regarding financial stability and price stability.
The proportion of debt in Israel’s product is expected to rise significantly in the years 2001 and 2002, and this is a regression from the trend that characterized the Israeli economy until the past two years, as was mentioned above.
Even after the Knesset’s approval of the emergency economic plan, the government deficit target for 2002 is too high – 4.4 percent of the product (or 3.9 percent of the product, according to the official target). The actual deficit is expected to be even higher. The deficit ceiling for 2003 was also set at a level unparalleled since 1992, the year when the deficit reduction law was first enacted.
The budget deficit of Israel’s broad government is unusually high in international terms at the beginning of the 21st century. The convergence of many countries in a low budget deficit region reflects the effectiveness of the operating rules set out in the Maastricht Treaty. These rules impose restrictions on policy makers in Israel, due to the policy of integration in world capital markets.
Public expenditure in Israel is relatively high level by international standards. However, Israel’s geo-political location necessitates security expenditure that is significantly larger than that of the countries to which Israel is compared. Public expenditure in Israel, after the subtraction of extraordinary expenditure for security needs and interest payments, is not among the highest in comparison with the OECD countries.
Deducting the extraordinary security expenditure from Israel’s total public expenditure for purposes of international comparison is a technical operation that evades an important social question: How should Israeli society distribute the security burden? An extraordinary security expenditure seems to be an existential necessity in the foreseeable future.
The welfare state’s expenditure for public support allocations, which has grown significantly over the past two decades, is still low in comparison with developed countries around the world (and countries in southern Europe with a per capita income similar to Israel). The cuts in the welfare budget (especially unemployment payments) within the 2002 budget distance us even further from the level of social security that prevails in developed countries around the world.
The tax burden in Israel rose from 38 percent of the product in 1990 to 41 percent of the product in 2001. After this rise, the tax rate (in proportion to the product) is relatively high in international terms, but not unusual. The tax rate is expected to continue to increase, in view of a number of tax raises included in the 2002 budget.
Management of monetary policy: 2001 was the third consecutive year in which the actual inflation rate was lower than the inflation target set by the government. Achieving an environment of price stability should be the main goal of monetary policy, but systematically missing the inflation target from below refthe fact that insufficient weight was afforded to the secondagoal of increasing economic activity during a recession.
A sharp change took place in Bank of Israel policy in December 2001. The Bank of Israel reduced the interest rate by two points (from 5.8 to 3.8 percent). This sharp reduction surprised the public, which had planned its moves on the basis of having experienced gradual policy steps in recent years. The public was forced to update its expectations regarding the Bank of Israel’s modus operandi from that date onwards. This is also because the Bank of Israel’s sharp reduction of the interest rate was accompanied by a raised budget deficit target. The reduction, which was carried out as part of a deal between the government and the Governor of the Bank of Israel, also showed the public that the government can participate almost directly in managing an expansive monetary policy. The sharp reduction in the interest rate was also surprising in light of the gradual climb of the risk premium due to the destabilization of the security situation.
The security escalation, the expansion of the budget deficit and the sharp interest reduction brought about a sharp rise in the exchange rate and the consumer price index. These developments constitute a threat to the establishment of price stability, and increase the uncertainty as to the financial stability of the Israeli economy. This uncertainty is reflected in foreign agencies threatening to lower Israel’s rating.
The policy of monetary restraint combined with fiscal discipline succeeded in creating a low-inflation environment, at a significant real cost. Maintaining this achievement should be the main goal of monetary policy.
Policy management during crisis – international experience: The shocks that hit the economy are extremely powerful and economic policy can only assist to a limited degree in attenuating the fluctuations in economic activity. However, even if the expected effect of such policy is moderate, this does not eliminate the question whether an anti-cyclical policy should be employed at such a time.
International experience shows that countries with a long tradition of fiscal discipline, such as East Asian countries, employed anti-cyclical policies in times of crisis, while countries lacking such a tradition, such as South American countries, were afraid to implement anti-cyclical policies. The effectiveness of an anti-cyclical policy is based on government credibility. During 2001, a number of decisions were made that compromised this credibility. The political instability, expressed in the high frequency of government turnover and the proliferation of private bills, does not contribute to creating credibility regarding budgetary discipline. Neither does the fiscal basis of the Israeli economy contribute to the implementation of an anti-cyclical policy. It would seem that in light of the Israeli economy’s vulnerability to financial shocks, the anticipated damage caused by anti-cyclical policy would exceed its benefit.
- Management of the macroeconomic policy in the short term must be guided by the observation that Israel’s economy is threatened by crisis. The overarching goal is to prevent deterioration.
- Crisis conditions impose restrictions on the employment of an anti-cyclical budget policy (automatic stabilizers) which might be desirable under other conditions.
- Social stability must be a consideration of the macroeconomic policy.
- The desired fiscal policy goal is convergence in an environment of operative rules determined in the Maastricht treaty:
1. The budget deficit target set for 2002 is too high. An exaggerated deficit target, which is expected to be even higher, is a dangerous deviation from these rules.
2. The composition of the budget cuts recently approved by the Knesset includes too many taxes, an unbalanced cut in transfer payments and an insufficient reduction in salary expenditure.
3. The permanent and extraordinary level of security expenditure must be funded by reducing other expenditures or raising the tax burden.
4. The government’s economic plan mainly addresses curbing the expansion in the budget deficit.
5. It is also important to take measures to address the fundamental problems of the Israeli economy as soon as possible (see below).
- Reforms are becoming increasingly necessary in the labor market, education, the capital market and the fiscal sphere, as is expansion of investment in infrastructure, in view of slowed productivity in the Israeli economy. For example, long term programs are required for the labor market in order to increase the rate of participation in the work force:
1. Reduction of the tax burden on income from labor, to be financed by taxation of income from capital.
2. Reduction of the number of foreign workers by making the cost of foreign workers equal to that of Israeli workers and increased enforcement of the law.
3. Long term programs for integrating the ultra-Orthodox sector into the work force.
4. Integration of recipients of income support payments into the work circle. Shifting the emphasis “from income support to employment support,” in the spirit of the Tamir Commission recommendations.
5. Establishment of a public committee to examine the effect of transfer payments and other support allocations on the incentive to work and the welfare of weak sectors in society in the long term, considering budget limitations. The committee will submit its recommendations to the government.
- Budget transparency should be increased. Mechanisms of fiscal control should established and policy management culture should be improved:
1. Quarterly reports to the government on the implementation of the budget.
2. A forecast for growth and government revenue from taxes (and other sources) should be prepared by an economic research institute and submitted to the government.
3. Implementation of the government action regulations regarding the date of submission of information to the ministers and relevant bodies (such as the Bank of Israel).
4. Reporting to the government and public on economic policy targets and their effect on the budget and important economic and social variables.
- The Knesset:
Private bills:
Either a special majority or government approval will be required to approve a private bill bearing significant budgetary cost. A private bill will only take effect in the following budget year.
The deciding date for dispersal of the Knesset:
December 31 should be the deciding date for approving the budget (instead of March 31).
- The central goal of monetary policy is to maintain price stability (and financial stability), which were achieved at a significant cost.
1. The independence of the Bank of Israel must be ensured.
2. A council of (impartial) governors should be established, while maintaining the independence of the Bank of Israel and setting price stability as a central goal, in addition to achieving other secondary goals such as a high level of economic activity.
3. The management of the exchange rate and foreign currency balances will be left in the hands of the Bank of Israel.
4. The transparency of the decisions made by the Bank of Israel should be increased. A report should be submitted to the public if the inflation target is exceeded by more than one percent. The Bank of Israel will present the factors leading to this deviation and the planned steps for returning inflation to its target rate to the government.