Current State of the Israeli Economy 03.04.13

Current State of the Israeli Economy 03.04.13

by

Howard Adelman

One of the most prominent issues in the run up to the election was the cost of living in general and the cost of housing in particular. Yair Lapid vowed to tackle that issue. Let me offer some examples.

Thus, a cheap restaurant in Israel is more expensive than in Toronto but a good restaurant costs about the same. Basics, like milk and bread, are cheaper in Israel, but eggs and cheese are surprisingly more expensive. Fruit and vegetables are much cheaper in Israel and so is transportation even though a litre of gasoline is 60% dearer in Israel. Brand clothes are much more money in Israel but apartments are almost 20% less to rent but more than 20% more to purchase. The latter figure is astonishing but I am somewhat sceptical of its accuracy for in my experience in Toronto the rents are higher and the costs of purchasing apartments I believe is also about 20% higher. But the most important revelation is that salaries in Israel are about 40% less when the cost of living overall, except for the cost of purchasing an apartment, is about the same.

Inexpensive restaurants are a bit more costly in Israel but good restaurants cost about the same.

The real issue in Israel is that salaries are not comparable to the cost of living. Other than the cost of housing, which I will deal with in a separate blog, it is not clear how Lapid can tackle this problem. Lapid raised several other issues in the campaign concerning government expenditures. He provocatively asked: “How dare they sit there with 34 ministers and deputies and then come to the middle class and tell them they’re taking another NIS 1,800?” He claimed that ministers without portfolio cost the taxpayers NIS 60 million, the same amount parents of autistic children requested in social aid. Lapid in negotiating with Netanyahu did succeeded in reducing the number of ministers and deputy ministers, but at the cost of clout for his party.

On another issue of what are called entitlements or tax loopholes in American political parlance, Lapid called for an end to the annual practice of “Hok Hasederim”, the distribution of large sums of money not provided for or allocated within the budget. Yet Lapid`s first action as Finance Minister on 21 March was to order $13 million transferred to the foundation to assist Holocaust survivors – the Foundation for the Benefit of Holocaust Victims. It is very hard for anyone to object to directing funds to meet quality-of-life needs for aging survivors, including at-home nursing care, especially since it was an integral part of the coalition agreement, but the process appears to me as a naïve outsider to be a continuation of “Hok Hasederim”. At least the cut of three hours of nursing services per week can be restored and no one surely begrudges that expenditure.

But these are small potatoes. One deep historic fear in Israel is of runaway inflation, the rise in prices based on the Consumer Price Index (CPI) indicating how much less you can purchase with the same number of dollars as the year before.. However, the fear seems exaggerated. Both in terms of historic inflation figures (the overall increase from the year before) and average inflation (the average rate of increase in each month over the full year), the rate of inflation in Israel is not that much higher than Canada`s.

Since interest rates are so low, those on fixed incomes who depend on interest from deposited monies to earn income are effectively earning no money since inflation wipes out the value of anything earned. In fact, deposit income in the current period is even less than the rate of inflation. So pensioners and others on fixed incomes suffer.

Israel also suffered from the global economic slump when its growth rate was only 2.4% in the final quarter of 2013, the slowest rate of increase in three years but one that many industrialized countries might envy in these perilous economic times. Israel has had a spectacular rate of growth and is a model of convergence for a country that not very long ago was poor and now has caught up and passed a number of developed countries. Economists long ago dispensed with the Solow model in which economic growth depended on physical and human capital. Total factor productivity (TFP), the measure of an economy’s long-term technological change or technological dynamism, is now perceived as the main agent for stimulating growth. Israel has and continues to excel in this area, particularly with respect to improving innovations along quality ladders more than simply expanding the variety of products made and sold. Further, productivity improvement also accelerates capital accumulation thereby multiplying the positive effects.

Further, Israel continues to expand its free trade regions that also may help stimulate growth since Israeli economists pioneered in the nineties in the research that demonstrated that a country gains more from another country in proportion to the R&D of the other country if you trade with this country more. Israeli institutions have also evolved to reinforce and enhance technological change, but there is a general fear that the institutions that foster the accumulation of knowledge are too underfunded, an issue that will be discussed in the blog on education. This is important because there exists a robust relationship between the quality of institutions and economic performance. Further, though economic incentives are widely in place to enhance knowledge accumulation, a side effect has been a growing disparity between those in the knowledge economy and those outside of it, a topic that will be discussed in the blog on disparities in the Haredim and Israeli-Arab sector.

As Deloitte reported in 2011, Israel excels in the supply of financial and business services and in high tech manufacturing in electronics, software, communications and pharmaceuticals as well as low tech industries such as chemicals and plastics. Where it enjoys the greatest comparative advantage is in the high levels of investments in education and R&D, particularly through the military which creates not only basic innovation and knowledge but networks that subsequently go on to create businesses and new qualitative improvements in products.

Israel once offered a myriad array of investment incentives that may have attracted capital but, at the same time, created economic distortions and a bureaucratic nightmare for some. The Encouragement of Capital Investment Law that came into effect on 1 January 2011 has eliminated most of the previous incentives, rationalized the tax rate, reduced the number of development zones, and simply reduced corporate tax rates for those businesses that export at least 25% of production. Corresponding changes were made in the distribution of dividends. With the rationalization of the taxation system, Israel has experienced enhanced rates of investment. However, middle class savings rates have declined as incomes have not kept up with increased costs.

The biggest change in the Israeli economy is on the doorstep and will be the subject of a separate blog. In the Deloitte 2011 report, Israel was described a country with few natural resources. With the discovery of the huge gas fields offshore with one on the verge of coming on stream, this is no longer the case. Israel will save US$2-3 billion in imported energy bills. This will have a tremendous impact on the Israeli economy but requires a separate discussion. The reality is that Israel has become a country of the energy equivalent of a land of milk and honey that will enhance its great lead in its booming high-technology sector complemented by the structural reforms that reduced controls on foreign currency exchanges and profit remittances.

However, Israel faces the problem of many other developed countries – a stubborn unemployment and underemployment rate, particularly among young people. Further, the 2011 unemployment rate of 5.6% rose to 6.3% in 2012 and currently sits at 6.5%. Though not as high as the American rate of 8% with America still not quite over the great recession, or even Canada`s rate, unemployment in Israel did reach a thirty year low in 2011.

As the last remaining item on the overview of the Israeli economy as the lead up to understanding the budget that Lapid can be expected to introduce, we come to the budget deficit. On 1 July 2012, the Former Finance Minister, Yuval Steinitz, received approval from the Israeli cabinet to double the 2013 targeted budget deficit from the initially proposed 1.5% of GDP with an absolute ceiling of 2.5% to a new target of 3% of GDP, with the expectation that it would come in at 3.5-4%. The actual deficit came in at about 4.2% of GDP or a 39 billion shekel budget deficit or AM$10.8 billion. The cabinet was accused at the time of being reluctant to cut spending and raise taxes ahead of the then October 2013 scheduled elections. The Bank of Israel governor, Stanley Fischer, warned that both inflation and interest rates would increase. The bank’s base interest rate had fallen to 0.5% in 2009 at the height of the financial crisis, rose to 3.25% in the middle of 2011 as Israel’s economy recovered, but has since been cut to and hovers around 1.75%.

The shekel immediately dropped from almost 4 to the dollar to 3.9 and continued to drop to its current exchange rate of 3.56 after having remained steady for a number of years. In a final meaningless rhetorical flourish, the cabinet then voted to set a 2014 budget deficit target of 2.75%, of 2.5% in 2015, of 2% in 2016 and 1.5% in 2019. There was never any discussion of a balanced budget. However, Israel’s debt-to-GDP ratio remains relatively stable and less than that of many developed countries – though that is not saying a great deal these days. The country’s debt burden, however, is higher than most developed countries because the government pays a relatively high rate of interest on government debt. The Israeli government is undoubtedly banking on the shekel strengthening when natural gas begins to glow from its offshore wells.

Yesterday, Stanley Fischer, while praising Israel`s economic performance and the monetary policy maintained by the bank, stated in its report on 2012 that Israel`s budget deficit was the main economic problem. (Moti Bossok Outgoing Central Bank Chief: Israel`s fiscal situation economy`s main problem, Haaretz, 2 April 2013.) He also urged the government to create a sovereign wealth fund from its anticipated new found gas wealth. Lapid may increase taxes to cover part of the deficit but he will have to do so without inhibiting business and prospects for economic growth.

Lapid`s main problem will be how to increase government revenues and where to cut expenditures. Certainly, defense will be cut. Netanyahu and Lapid already have agreed that defence cuts will cover 4.5 billion shekels over the next 18 months. Where those cuts will be made is yet to be determined.

Current State of the Israeli Economy 03.04.13.doc

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