The Governor of the Bank of Israel spoke today at the Calcalist newspaper’s National Economic Conference. The following are her remarks.

Good morning.
For about the past week we have been in a ceasefire, after a long military confrontation which presented the state’s leadership with many challenges requiring courageous decisions.
Operation Protective Edge led to a negative economic impact felt by, among others, small business owners, exporters, and employees. Now the economic leadership’s mission is to deal with the challenges and risks facing the economy and to work to fully utilize the chances for inclusive growth—growth which will benefit all citizens. 
Challenging periods such as these are also an opportunities to reassess previous decisions. We are at the point of making decisions on the state budget for 2015, and we must make those decisions with the responsibility required by the circumstances. Before I present my recommendations on the state budget, I will begin, with your permission, with a short survey of the economic reality we are facing.
Israel’s economy is very influenced by global economic developments, and so, with the beginning of the European debt crisis in mid-2011, a decline in the growth rate began here as well. Due to the support from monetary policy, which was reflected in interest rate reductions and foreign currency purchases, the decline in growth was relatively moderate; we declined to a rate of 3 percent per year, which is higher than that in most advanced economies. Likewise, despite the decline in the rate of growth, we saw in the labor market, until recently, a continued decline in the unemployment rate and increase in the employment rate—these, too, in contrast to most advanced economies.
Since the beginning of the year, a further slowdown in growth has been apparent, and the security events are expected to be reflected in an additional slowdown in the third quarter. The experience from previous security-related events teaches that most of the effect is temporary, and after the fighting ends the economy recovers rapidly. An exception is the tourism industry, which generally only returns to pre-hostilities levels after about a year.
Against the background of the moderate growth environment, the Bank of Israel’s Monetary Committee decided it was correct to adopt a policy that will provide additional support to the economy at this time, and therefore reduced the interest rate twice, over two consecutive months. One of the results of reducing the interest rate is the depreciation we saw in recent weeks, which facilitates the industries exposed to foreign competition in dealing with an environment of global demand which is essentially holding still, and this prevents production lines being moved abroad, factories being closed, and layoffs. Interest rate policy does not operate in a vacuum, and it has ramifications on demand for housing as well. However, the fundamental solution to the housing problem has to come from an increase in supply. In this regard, the decline in building starts that we have seen in recent months is especially disconcerting.
The discussions on the 2015 budget present us with challenges that are not simple. We must approach the budget decisions while taking into account current needs, but at the same time we must be responsible and consider the results of these decisions over the longer term. The decisions that the government needs to take are on the extent of expenditure, priorities in allocation of expenditure, and the required level of revenues. The gap between revenue and expenditure is the government deficit.
So where do we stand? The structural deficit—that which is not dependent on one-time or cyclical shocks to the economy—is already among the greatest in the OECD. After the deficit framework was breached in 2012, the government committed to a new deficit path, one which was higher than what had been previously planned. Based on that path, the deficit target for 2015 is 2.5 percent of GDP. However, even before the shocks that have been buffeting the economy recently—the additional slowdown in growth, and Operation Protective Edge and the increase in defense expenditure—in light of government decisions which included inter alia the zero VAT for homes plan and the cancellation of tax increases for 2014, it was already apparent that the structural deficit would increase to around 3 percent, which means an increase in Israel’s debt to GDP ratio.
There are those who claim that current needs require an increase in the deficit in order to support economic activity, beyond the support from the very accommodative monetary policy. In my assessment, some increase in the deficit, compared with what was planned, can be justified due to the need to cover the expenses of the fighting in Operation Protective Edge, which were of a one-time nature, and in light of the slowdown apparent in growth which is acting to increase the deficit by reducing tax revenues. However, a deviation beyond that level—that is, a deficit that reaches over 3 percent of GDP—much greater than what is incorporated in in the automatic stabilizers, will clearly signal a stepping back from the commitment to maintain fiscal discipline, and increases the risk of losing credibility.
Not only will such a deficit not allow the reduction of the debt to GDP ratio, but it will in fact increase it, and lead in the future to an increase in the economy’s interest payments (which in the past year, for example, reached NIS 38 billion) and will reduce the budget resources available to the education, health, and welfare systems, as well as to the other budget items, and will require all of us to fund them, ultimately, through a sharp increase in taxes in the future.
This summer we received a painful reminder that the Israeli economy is exposed to shocks, in addition to the global shocks that other economies are exposed to. The fighting in the south ended about a week ago, and it is still too early to estimate its overall effect on the economy and on the budget. Nonetheless, past experience teaches us that the ability to deal with such shocks depends on our conduct during routine times. The fact that financial markets continue to display confidence in Israel’s economy, and the economy’s ability to absorb the costs of the operation, are the result of responsible conduct by the government in the past two years, which contributed to the economic resilience.
We know how it appears in reality when a shock hits the economy after a period of irresponsible fiscal conduct. We felt that in 2002–03, when the combination of a security-related shock and moderation in global growth led to a recession and to concern of a negative impact to financial stability. We had to sharply cut the budget then in a manner that deepened the recession and negatively impacted civilian budget expenditures. In contrast, the responsible conduct of the years preceding the current global crisis, which led to an extended decline in the structural deficit and in the debt burden, was one of the main factors in the impact of the crisis on Israel’s economy being minimal. We were able to allow the cyclical deficit to increase, without feeling a marked increase in the cost of funding the deficit, or a loss of credibility from the financial markets.
Deviating from the deficit target, to greater than 3 percent, will expose the economy to significant risk, and thus is liable to negatively impact the economy—that is, the citizens, each and every one of us.
Operation Protective Edge also sharpened the budget dilemmas related to the size and distribution of the pie:
I very much would have wanted to stand here today and tell you that the government can do this, and this, and this—now; and that the projected revenue is enough to fund all the defense needs in a manner that will make it possible to ensure an appropriate response to all threats, and also to avoid cuts in the education, health, and welfare budgets.
I very much would have liked to tell you that the Israeli government will be able this year already to increase the education budget and promise the long school day, afternoon day care, education in technology, acclaimed higher education with cutting edge research in all subjects, and it will also be able to provide enough to the health system so that the public system will be able to retain the best doctors and shorten the lines, and that the government will also be able to pave roads and lay down train tracks that will bring the peripheral areas closer to the center, and to finally provide us with suitable public transportation.
I would very much have liked to say that not only is it necessary, but it is also already possible, to lessen the poverty of those who cannot help themselves, and also to increase the earned income tax credit in order to support those who work hard but nonetheless remain behind.
I would have wanted to promise that we will be able to broaden the support for research and development, and other growth engines in the economy, which will allow the full utilization of our comparative advantages and to produce the maximum from Israeli innovation and creativity, with a reputation that precedes it in the most advanced industries around the world.
And most of all, I would have wanted to tell you that all these deserving additions to the budget can be made without a single one of us paying for it. Not us, and not our children, and that despite not increasing taxes and not cancelling exemptions we will be able to protect the economy from unexpected shocks, so that if we do again face a storm, domestic or global, one that hits all the ships around us, we will again be able to steer the Israeli economy’s ship to a safe haven, due to the credibility we accumulated and the responsible policy we led, like in the previous storm.
But it is clear to you that to think that it is possible to do all that, here and now, is an illusion.
It is my duty to present the government and the public an analysis of the reality as it is, and to suggest to the government a measured and responsible budget policy, which points to a horizon of economic growth.
Don’t misunderstand me: the decisions facing the government are difficult, and the challenge that the Minister of Finance and the Prime Minister must deal with is not simple. The government must decide on a framework for the defense budget, in a manner that provides a response to the reference scenarios, takes into account the need to increase efficiency, and brings about an informed level of risk management.
The government must provide a solution to civilian expenditure which is very low in international comparison, which makes it difficult to provide an appropriate response to the main economic and social challenge of reducing the gaps in Israeli society. Low civilian expenditure means allocating resources that are too small to support growth that will reach all parts of the population. The process of reducing civilian expenditure to the lowest level in the OECD has led us to a point where we find it difficult to provide public services in a manner that will allow us to deal with the social challenges ahead of us. Therefore, a thought-out and responsible increase in the budget is required. We must be wise enough to divide the resources between short term needs and the factors that will assist in increasing welfare over the long term, and we must determine what tax exemptions ought to be cancelled and what taxes can in fact be increased.
Civilian expenditure has many supporters. We all want to appear like the leading countries in the world—we want education that will return us to the top of tables in international comparisons, healthcare that we will be able to continue being proud of, public transportation and a network of roads like in Europe, academic institutions like in the US, and welfare like in Scandinavia. Yet at the same time, there is considerable support for low taxes, as is known, among the public and among policy makers. But the result of these conflicting desires is a large deficit. We must recognize the cost of the economic choices we are making, and as the Governor of the Bank of Israel it is my obligation to warn of the development of extraordinary deficits, which are liable to endanger the economic resilience of us all.
Israeli society displayed impressive resilience and solidarity during Operation Protective Edge. Our resilience, both as a society and a state, is contingent and depends on our ability to enlist for the economic and social battle in order to promote sustainable and inclusive growth which will lead us to a more fair society.
I believe and know that we have what it takes to create this while protecting our security: we have to allow our creativity and innovation to reach their full expression; to invest in growth drivers, to know how to create a supportive business environment, through reducing bureaucracy and adopting smart regulation; to determinedly advance a list of structural reforms that will support the full utilization of the economy’s potential, such as in electricity, ports, and all that is related to increasing efficiency of public service. We must judiciously utilize the natural resources we recently discovered, for example by shortly connecting energy intensive industries to the gas pipeline; we must educate and train the workforce, from all population sectors, and ensure a high level of infrastructure.
We must understand that there is no one who will finance the achieving of these goals instead of us, because the responsibility and the obligation to reach these targets are only ours.
If we steer our ship so that we will be durable and stable in the face of storms and shocks, with productive and tight cooperation between all the captains of the ship, we will together be able to lead the economy to growth, and to entrench our economic and social resilience.