The Governor of the Bank of Israel spoke today at the Institute for National Security Studies conference. The following are the main points of his remarks:
The Israeli economy is in very good condition but not in excellent condition, as it had been in previous years. The thing that has changed is the budget situation.
The economy exports around 40 percent of its GDP; it is therefore acutely affected by the state of the global economy. A week ago, we received the IMF’s forecasts. All the forecasts for 2014—for the US, Europe, and even the emerging markets—project a better situation than in 2013, which is actually an indication that the situation today is not good. Global trade is expected to grow by 3.6 percent in 2013, about half the long term average in recent years. This is not good news for Israeli exports.
In Israel, we forecast 3.8 percent growth in 2013. When I meet with central bank governors in advanced economy countries, I see that this number makes them very envious of us. Indeed, the forecasts for most of these countries are much lower. Our forecast, however, is affected by the beginning of the flow of natural gas from the Tamar reservoir, which will replace much more expensive imports of diesel fuel. If so, the increase in growth will originate not only in the existence of a more efficient source of energy but also in a decline in imports. The growth forecast excluding the gas is 2.8 percent. We at the Bank of Israel continue to cite this figure because unemployment will be affected mainly by economic growth excluding the effects of the gas.
The labor market is in excellent condition. The unemployment rate is the lowest in the past thirty years. This is a significant achievement. Admittedly, it isn’t mentioned too much, but even in the newspapers there are only few complaints about the state of unemployment, and in Israel, when there are no complaints, it means things are excellent…When I came to Israel eight years ago, we spoke about having a problem of low labor force participation. In recent years, the employment rate among those in the 25–64 age group has jumped from 70 percent to 74 percent. We do not understand everything about this leap. Some of it is due to the decrease in the unemployment rate; another part traces to people’s decision to join the labor force. We hope the change is taking place in the two sectors that we tend to regard as having low employment rates—the ultra-Orthodox and the Arabs. We still have no sectorial data that would support this hypothesis, but it’s good news no matter what.
The inflation rate is near the midpoint of the target range. The Bank of Israel interest rate is 1.75 percent—very low, but high in terms of international investment. The result is that many investors are interested in buying Israel government bonds, which pay higher interest than is available abroad even for short terms. This, together with the current account surplus, has generated appreciation pressure in the exchange rate, a factor that may negatively impact exports. Yet in contrast, the low interest creates an incentive to buy housing. If so, we have a problem: in terms of exports, we would like to reduce the interest rate, and in terms of home prices, we would rather increase it. What we have to do, then, is find a way to balance our policy and determine other ways to balance the exchange rate as well as home housing prices. Occasionally, of course, the Bank of Israel buys dollars and alleviates the appreciation pressure. In the housing market, we’re trying to affect the cost of mortgage loans by limiting loan-to-value ratios, setting capital requirements, etc. This is a protracted process and it’s what we should do. The value added in exports is nearly 30 percent whereas that of construction is 8 percent. Therefore, if we had to choose, we think exports are more important than the housing industry; furthermore, we have many more tools to impact exports than to influence housing.
The main problem for the Israeli economy is the government deficit. In 2003, we were in trouble with the budget, with the deficit exceeding 5 percent of GDP, and Israel found it hard to issue bonds in the markets at reasonable interest rates. The government, led by then-Minister of Finance Netanyahu and with strong support from Prime Minister Sharon, spearheaded a program that today we would call “austerity.” The program reduced the deficit to zero within four years—an important achievement. One of the reasons the Israeli economy weathered the international crisis in relatively good shape is that we entered it with a zero deficit, a good place at which to enter a period of global crisis. After the crisis, however, in 2010–11, we were unable to reduce the deficit in a similar way to what had been done in the middle of the previous decade. The global crisis impaired domestic growth and, in turn, tax revenues, exacerbating the deficit. In 2012, the government overspent its program, something that had hardly happened in many years.
Many ask, what’s the matter with a deficit of 4 percent of GDP—isn’t it just 1 percent more than 3 percent? The answer is very simple. The problem with a 4 percent deficit is that the economy is not in a state of unemployment, something that would allow us to assume that growth would accelerate in coming years, as one assumes will happen in the US and Europe in response to the policy measures being applied there. We currently have a high level of employment and do not have the luxury of expecting an imminent steep increase in growth; therefore, we have to deal with the budget deficit. In a meeting held yesterday, the Minister of Finance stated that the deficit target would be 3 percent. In my opinion, this is a courageous and important decision; if we manage to carry it out, it will help domestic growth to recover. The increase in the deficit between 2007 and 2009 was induced not by an upturn in expenditure but by the collapse of tax revenues due to the slowing of growth. If we enter a recession in the next few years—an unexpected but nonetheless possible development—the deficit will increase by another 4 percent, attaining the highest levels that we will have seen in the twenty-first century. Therefore, I am very pleased that the Minister of Finance and the Prime Minister decided that a 3 percent target is both good and attainable.
The production of Israeli natural gas places the country at risk of contracting the so-called Dutch disease—a phenomenon that acquired its name after the Dutch discovered gas deposits in the North Sea, triggering currency appreciation that impaired domestic manufacturing. Our program for the treatment of this problem is based on the establishment of a wealth fund—which will receive some of the government’s receipts from the production of gas and invest them abroad, keeping pressure off the exchange rate. Several days ago, the government endorsed a bill in this context and it’s important that we activate the fund promptly.
A historical view of the defense budget shows a protracted decrease in the share of defense expenditure in GDP since the Yom Kippur War, to historically low rates today. It is very hard to conduct a budget policy when more than 20 percent of GDP is spent on defense, as was the case in Israel in the 1970s and 1980s. What usually happens in such circumstances is that the government prints money and creates inflation, and indeed, it happened in Israel. The decrease in the defense burden had a favorable effect on growth in the 1990s and still does, albeit to a lesser extent. In the US, this phenomenon was called a “peace dividend.” In real terms, however, defense spending has been growing steadily and now exceeds NIS 50 billion, the largest chunk of the state budget. Every Israeli who has served in the army knows that there is waste in the defense system. Although no army is free of waste and inefficiency, the question is how to deal with it. Given the budget situation in Israel, the defense budget faces special pressure. Some claim that the short term threats have waned because the neighboring countries no longer threaten us. Other argue, conversely, that threats from more distant enemies have actually increased. Even if one takes into account the cost of a conscript army that is not fully remunerated, the share of the defense budget in GDP has been falling in historical terms, as stated. However, we have ample reason in economic terms to look for ways to economize on defense expenditure. What happens with this budget will affect the economy’s ability to return to the kind of budget stability that we had in 2003–11. As an economist, I have nothing to contribute to the debate over the defense budget except to say that while it is important to maintain national security, it is also important not to overspend on it