Institute for Contemporary Affairs
founded jointly at the Jerusalem Center for Public Affairs
with the Wechsler Family Foundation
Vol. 7, No. 4 18 June 2007
Maintaining a Thriving Economy in the Shadow of Terror
Professor Zvi Eckstein
Deputy Governor of the Bank of Israel
Despite terror and war, the Israeli economy has one of the highest per capita growth rates in the Western world among all the states established between 1948 and 1974. If there had been no terror in 2000-2005, the economy would have continued to grow and would have almost reached where it is today as early as 2003.
Public expenditure has declined from 65-70 percent of the GDP after the 1973 war to 47 percent - below the EU average and similar to the level in the Netherlands and the UK, but higher than the United States.
Before the Second Lebanon War, the economy was producing a budget surplus and growing at a level of 6 percent in annual terms. During the 3rd quarter of 2006 there was a decrease in the rate of GDP growth, but after the war, in the 4th quarter, GDP growth was higher than 7 percent in annual terms. Industrial managers and other employers in the north of Israel understood the importance of exports and of the continuance of economic activity, and worked day and night, during and after the war, to fill orders from abroad.
Inflation in Israel in the last twelve months has been almost minus 1 percent. The strengthening of the Israeli shekel against the dollar was the major factor affecting inflationary developments, and was a result of both local and global factors. Since 2000, total exports have equaled imports. In 2006 the current account surplus totaled $6.8 billion, an exceptionally high level both from the historical and international perspectives. The current account surplus is expected to be even higher in 2007.
There was substantial direct foreign investment in Israel during 2006. This trend, which began in 2002, is a manifestation of Israel's integration within the global economy and is a result of both global and domestic factors. The Israeli economy is open and diversified. Nevertheless, Israel should open up even more by improving and regulating the financial sectors and by adopting international standards.
An Economic Perspective on Zionist History
Data on the Israeli economy is available since 1922. Per capita GDP has grown from NIS 3,000 in 1922 to just below NIS 80,000 in 2006 (in constant 2000 prices). Thus, despite terror and war, the Israeli economy has prospered and has one of the highest per capita growth rates in the Western world, together with Japan, among all the states established between 1948 and 1974.
The 1973 war caused a major change in Israel's macroeconomic picture, with the defense budget growing to about 25 percent of GDP, and total government expenditure rising to 65-70 percent of GDP. The Israeli economy has struggled with this burden for a long time.
The Cost of Terror
Almost every decline in the Israeli economy has correlated with defense problems. This can be seen in the effects that the terror-ridden years of 2000-2005 had on the economy. Running an economy with the threat of terror is part of life in Israel. When fear was substantial, it affected local as well as foreign investment decisions. GDP declined, and defense expenditure, including the cost of building the security fence to deal with the new threats, rose substantially.
The 1990s was a decade of sustained growth. The first half of the decade saw the beginning of the peace process and the collapse of the first intifada, and was a period with a large influx of immigrants. With a high rate of terror in 2003, private consumption declined significantly. In times of terror and fear, there was a major decrease in GDP and in private consumption activity. It is estimated that without the terror in 2000-2003, Israeli per capita GDP and private consumption would have been much higher than they were in the first half of 2003.
In 2003, the government took several actions to stabilize the macroeconomy which, together with monetary stability, enabled the economy to reach a growth rate of 5 percent and achieve a stable budgetary framework. Public expenditure declined from 65-70 percent of the GDP to 47 percent - below the EU average and similar to the level in the Netherlands and the UK, but higher than the United States.
Before the Second Lebanon War, the economy was producing a budget surplus and growing at a level of 6 percent in annual terms. During the 3rd quarter of 2006, there was a decrease in the GDP growth rate, but after the war, in the 4th quarter, it was higher than 7 percent. Industrial managers and other employers in the north of Israel understood the importance of exports and of the continuance of economic activity, and worked day and night, during and after the war, to fill orders from abroad.
The success of the Israeli army and political activities in reducing terror in Israel's urban centers - together with changes in policies to stabilize the macroeconomy - were essential factors in moving the economy onto a new path.
Israel's total government expenditure is getting closer to international standards. It is very important this year to keep expenditure low in order to reduce the public sector debt. The public sector debt in the early and mid-1980s was around 160 percent of the GDP. Decreasing this ratio to around 60 percent is a key goal for sustained growth. If the forecast 5 percent growth rate for 2007 is realized, this debt is expected to be around 85 percent of the GDP.
Most studies show that if there is more stability and sustained peace in the area, such that defense expenditure can go down even more and people see the economy as stable, the Israeli economy could maintain a higher growth rate.
The short-term interest rate is the main monetary tool to reach the annual inflation rate target of 1-3 percent. Inflation targets exist in most of the countries which are Israel's key trading partners. Inflation in the last twelve months was below the target - almost at minus 1 percent. The exchange rate had the largest impact on the development of the Consumer Price Index during 2006. Prices in the Israeli economy are highly sensitive to changes in the dollar exchange rate because prices of services and non-tradable goods such as housing, and lawyers' and accountants' fees, are still indexed to the U.S. dollar, even though the U.S. dollar is dropping relative to the shekel and the euro.
One key pillar for the stability of the economy is the huge change in the nature of exports and imports. Since 2000, total exports have equaled imports. 2006 was the third consecutive year in which the goods and services account was in surplus, and in 2007 it is also expected to be in surplus. In addition, Israel's current account surplus has risen steeply, with more foreign currency coming in and more foreigners seeing the country as attractive for investment.
Israel has an income tax rate close to the EU average at high income levels. It is lower than Sweden and Norway, but higher than the U.S. Income tax has been reduced substantially since 2003. By international comparison, the income tax rate is relatively low for the average income level of most workers, and close to the European level in the upper income levels. Total tax revenues have increased substantially in recent years.
Reforms Still Needed
The economy looks good, but even without the desired peace it could be excellent. To be excellent, some reforms need to be implemented.
Israel's biggest weakness, compared to other countries, is in the labor market, and especially in the participation rate of men. In most countries, about 92 percent of men aged 25-55 are working or looking for work. In Israel it is about 83 percent. Israel should maintain policies that encourage people to go to work.
One of the causes for the low participation is the entrance of low-skilled foreign workers from the poorest areas of the world such as Thailand, the Philippines, and China. No other industrial country has Chinese construction workers who pay thousands of dollars to get work. That pushes the wages of low-skilled individuals in Israel down, such as in construction. Many countries bring in seasonal workers for the agricultural sector, but no other developed country has a high rate of legal low-skilled foreign workers in agriculture, as in Israel. There are nearly 200,000 legal and illegal foreign workers in Israel (most of them work in construction and agriculture or as personal long-term care-givers).
High-tech in Israel is among the most developed sectors, which attracts people from all over the world. Many Israeli high-tech companies were extremely successful and this helps the economy to grow, but it affects only a segment of the population. In fact, the traditional sectors - construction, agriculture, food production, and others - have much lower productivity per worker than in other developed countries. The implementation of new technologies has been neglected in those sectors.
Development in the peripheral areas has been neglected, particularly in the Arab sector, which needs to move from a village environment to an urban one with urban occupations and urban standards of living. The traditional family structure in these villages, which has to a great extent been ignored by the Israeli political system, has resulted in a real problem and created a bottleneck for the development of the economy.
In 1983, most economic activity was in the hands of the government. Nowadays, the capital market is larger and more competitive, more companies are involved in it, and the economy is more open. The amount of direct foreign investment in Israel has been substantial. The Israeli economy is open and diversified, and direct government involvement in financial activity has been substantially reduced, which is a positive trend. Israel should open up even more by improving and regulating the financial sectors and by adopting international standards.
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Prof. Zvi Eckstein is the Deputy Governor of the Bank of Israel. This Jerusalem Issue Brief is based on Prof. Eckstein's presentation at the Institute for Contemporary Affairs in Jerusalem on March 26, 2007.
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