Remarks by Bank of Israel Governor Dr. Karnit Flug at the press conference marking the publication of the Bank of Israel Annual Report for 2017

We are submitting this Annual Report just prior to the State of Israel’s 70th Independence Day.  Before getting into current developments or the policy challenges looking forward, I thought it would be proper to take the opportunity to also mention the amazing achievements made by the Israeli economy in the 70 years of the State’s existence.  The economic growth the country has experienced has led to an impressive improvement in the standard of living.  Per capita GDP when the State was established was about $5000, just 30 percent of the level in the US, for instance.  Today, per capita GDP is $40,000, about 60 percent of the level in the US, and close to the median among the OECD countries.  All of this was accomplished while successfully absorbing numerous major waves of immigration.  Where we were once a country whose ultimate pride was in the export of oranges, and which suffered from a chronic balance of payments deficit and then from huge public debt and runaway inflation, we have become a country with a balance of payments surplus, a surplus of assets over liabilities, and inflation that we would like to be a little higher.  In our routine work as the economic advisor to the government, we naturally focus on the challenges, and what must be corrected and improved so that the economy can continue to grow during the next 70 years and so that all parts of the population can enjoy the fruits of our growth.  That is also what we have done in this report.  But at least for a moment, we can stop and look back with satisfaction.

 

In the Annual Report that we submitted today to the President, the Prime Minister and the Minister of Finance, the Research Department provides a summary and analysis of the developments in the past year.  It also deals with a number of major issues that have an impact on the development and the economy and society over time.  Among those issues, there are a number of chapters in the Report that analyze various aspects of the developments in the labor market, the changes that have taken place in it, and the policy challenges of improving productivity, and as a direct result the quality of employment.  I will focus today on the labor market.

 

The labor market in Israel is close to full employment, and is tight according to a long series of indicators.  The unemployment rate is the lowest it has been in a number of decades, and the participation rate is high, at 80 percent.  This is thanks to the prolonged growth created by demand for workers at all levels and in all areas, and is reflected in an unprecedented employment rate of 77 percent.  The decline in unemployment encompasses all population groups and all areas of the country.  The gaps that remain between various areas in the unemployment rate are lower than in the past, and represent structural gaps between the areas.  These are a result of the gaps in skills and in employment opportunities, as well as the distance from major employment centers, which is relevant as long as public transit solutions are insufficient.

 

Another reflect of the tight labor market is the prolonged increase in wages in all sectors, which also encompasses all types of workers and all wage levels.

 

There has been a prolonged decline in the return on labor as a share of GDP, which was even stronger in Israel than the trend among other advanced economies.  But in the past two years, there has been a turnaround, and the return on labor as a share of GDP increased, due to the tightening of the labor market.

 

The Beveridge Curve examines the link between the job vacancy rate and the unemployment rate.  Over the years, we have moved to the upper left end of the curve, which represents the point where the job vacancy rate is high and unemployment is low. This is an indication that the labor market is close to full employment and at a high point in the business cycle, and there is a shortage of workers in various places and industries.  But an examination of the curve over time also indicates movement toward the top of the axes—meaning that for each job vacancy rate, unemployment is lower than in the past.  This movement of the curve represents a decline in structural unemployment, or the unemployment rate at full employment.  This phenomenon reflects the increasing elasticity of the labor market, which is apparently reflected in improvement and greater efficiency in the job search process, alongside an increase in the relative attractiveness of employment compared with reliance on benefits or unemployment payments.

 

In view of the decline in structural unemployment to levels lower than we have known, we can ask whether unemployment can decline further.  A look at the unemployment rates in various countries over various periods indicates that various countries experienced periods of unemployment rates that were lower than our current rate, and it is certainly possible that structural reforms and improved worker skills can lead to a further decline in the structural unemployment rate in Israel.

 

With that in the background, I will now discuss the long-term structural processes in the Israeli labor market.

 

The most prominent phenomenon in the labor market in the past 15 years has been the increase in the employment rates.  The employment rates increase over time in all population groups, including those with employment rates that are still low.  The increase in the past 15 years is most impressive among ultra-Orthodox women, and is more moderate among Arab women and ultra-Orthodox men, among whom there has even been a worrying halt in the increase in the past two years.  There is no doubt that policy must focus on these population groups and on removing barriers and encouraging them to continue integrating into the labor market.

 

This trend is also noticeable if the population is divided into income quintiles, particularly in the lowest income quintile.  The number of breadwinners per household (and the number of work hours per household) increased persistently, although the hourly wage gaps remain very high and have not narrowed, mainly reflecting skill gaps as I shall show later.  These gaps are also high by international comparison.

 

These developments have led to the fact that income from labor has increased from about 40 percent of household income in the lowest quintile in 2000 to about 60 percent in recent years.

 

The increase in income from labor in the lowest quintile, as a result of the increase in the number of breadwinners per household, is reflected in a continuing decline in inequality in economic income, which in recent years, with the stabilization of government activity in income redistribution (after reducing progressive income taxes and lowering benefit payments until 2008), was also translated into a decline in inequality in disposable income.

 

Another structural aspect analyzed in depth in the Report is employment by geographic district.  As we have already seen, the unemployment rate declined in all districts, but it remains higher in the peripheral districts.  Employment alternatives found by people who were unemployed depend on their residential area.  Those without a post-secondary degree who live in the peripheral districts will in many cases find employment at a lower scope than they would have preferred.  The option of traveling to more distant locations apparently does not provide an answer due to insufficient public transit (whether due to availability and/or quality).  For those who were unemployment and do have a post-secondary degree, and live in more distant districts, some will commute to work places outside their residential area, and some will compromise with employment that does not maximize their skills.  In this context, there is no doubt that improved quality of public transit, the level of which according to a series of indicators is not satisfactory, will effectively increase the relevant labor market, thereby contributing to a better fit between the worker’s skills and the demands of the workplace.  This will also have a positive impact on labor productivity.

 

The main challenge we face in the labor market is the need to upgrade the quality of skills of the labor force in Israel, which will obviously contribute to an increase in productivity, in wages, and in the standard of living of the workers.

 

Following the tremendous increase in the acquisition of higher education that began in the 1990s with the establishment of the colleges, which is reflected in a marked increase in the average number of years of schooling and the particularly high level among the younger population groups in Israel, the potential for further growth in the average number of years of schooling is not large.  Therefore, the increase in the years of schooling of the Israeli population is not expected to contribute much to growth in per capita GDP in the coming decades.

 

However, the level of skills relevant to the labor market (literacy, numeracy, and functioning in a digital environment) is relatively low in all education groups.  In other words, the quality of education, insofar as it concerns the acquisition of the skills required in the labor market, is insufficient, and improved skill quality may contribute much to an increase in labor productivity.  Beyond that, there are large gaps in the average skill level between the various population sectors, and among the Arab population, the skill level in all areas is particularly low.

 

Until the beginning of this decade, when high tech industries were increasing their share of exports, the quality of human capital involved in exports increased.  Since the beginning of this decade, the level of human capital involved in exports has remained stable, since the main transition in the composition of exports has been from high tech manufacturing to high tech services, while the level of human capital in each is similar.  This halt in the increase of human capital in exports apparently reflects supply restrictions of workers with the highest level of technological skills.  As such, the national program to increase skilled manpower for high tech manufacturing, which was approved by the government last year and includes Planning and Budget Committee measures to encourage study tracks in high technology subjects, is very important in supporting the continued expansion of technologically innovative industries.

 

The basis for acquiring skills and talents is in the education system, and as we have shown at various times, Israeli student achievement in standard international tests is relatively low, and the gaps between the achievements of students from different socioeconomic backgrounds is particularly high.  Studies indicate that the main favor in the quality of achievement in the education system has to do with the quality of the teachers.  One of the indicators that can serve to assess the level of the teachers is their own achievements in the psychometric test.  Teachers in localities from low socioeconomic clusters have significantly lower scores than those from strong localities.  While the gap has narrowed among young teachers, it remains significant.

 

One of the questions that is occasionally raised has to do with the efficiency of the education system, or whether the achievements of the education system are in line with per student expenditure, and whether it is possible to improve achievements by increasing expenditure.  The average expenditure per student in the education system is low by international comparison, and the average achievements are approximately in line with what could be expected given the average expenditure per student.  Therefore, it is reasonable to expect that an increase in expenditure that focuses on components that have been proven to be effective, will contribute to improved achievements.  Given the level of expenditure, the level of achievements of students in the top 5 percent of achievements is similar to what would be predicted by per student expenditure, while the level of the students in the lowest 5 percent is much lower than what would be predicted.  At least some of this can be attributed to the allocation of resources, which reflects an inadequate level of affirmative action and a lower average of teachers in the periphery.  There is a particular lack in the Arab sector, where students are given fewer hours, while the needs are higher, for instance to reinforce Hebrew studies that are essential for integration in the labor market.  The Ministry of Education’s “program to reduce gaps and promote equality” is supposed to increase the proportion of hours distributed through a clear affirmative action formula.  The program should contribute to a narrowing of the gap in achievement, but its implementation is lacking at this stage.  It is important to successfully implement the program, and even to expand it.

 

The Annual Report examined the relative effectiveness of the policy to improve achievement in the educational system, particularly among students from a weak socioeconomic background, based on a series of studies in Israel and abroad.  The examination shows that incentivizing high-quality teachers to move to weak schools, and adding teaching hours for students from weak socioeconomic backgrounds are relatively effective tools, particularly if implemented together.  Reducing the number of students per class is a relatively expensive and less effective way to achieve the goal.

 

In summation:

 

  • Government policy has led many households to join the labor market since the beginning of the 2000s, in a way that contributed to economic growth and a narrowing of gaps.
  • The positive business cycle in recent years has supported an increase in employment rates, increased wages, and increased income from labor, and has encompassed all population groups throughout the country.
  • With the support of accommodative monetary policy, the labor market has continued to tighten in the past year.  Employment rates increased, and the unemployment level declined to historically low levels.
  • The upward trend in the average number of years of schooling has been nearly maximized, and cannot continue contributing significantly to growth in the coming years.
  • Despite the many years of schooling, the level of skills in the economy is low by international comparison, and there are large gaps both between the population groups and within them.
  •  In order for the growth trend and the decline in inequality to continue, a policy must be formulated to deal with employment challenges, with an emphasis on increasing the skill level in the economy so that it will ensure improvement in productivity, wages, and the standard of living.​

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