Steady as she goes – but for how long?
25 January, 2016
Originally posted on Wharton university website- [email protected]
The Israeli economy turned in another solid performance in 2015. The country’s Central Bureau of Statistics (CBS) published on December 31 its traditional year-end preliminary estimate of economic growth, which showed GDP expanding at 2.3% — slightly down from the 2.6% recorded in 2014.
The main driver of growth is now consumption, with household expenditure rising by 4.5% and general government expenditure by 2.8% — the latter somewhat constrained by the absence of an approved state budget for most of 2015. On the other hand, investment contributed a meager 0.6% increase, while exports declined by 3%.
This estimate is in line with the most recent hard data which, for the third quarter of 2015 as for the first half of the year, show GDP growing at an annual rate of 2.5% — as it did in 2014, for the full year and in each half measured separately. The Israeli economy seems to have settled into a groove in which –despite considerable fluctuations from quarter to quarter – 2.5% is its equilibrium growth rate. That’s a rate that many developed economies, especially in Europe, would be happy to achieve — yet most Israeli economists, both in and out of government, are unsatisfied and believe a better performance is possible in 2016 and beyond.
However, there are strong headwinds preventing a significant improvement in Israel’s rate of growth. The Bank of Israel’s research department released on December 28 an updated economic forecast for 2016-17, in which the central bank’s economists cut their previous forecast for 2016 by half a percentage point, from 3.3% to 2.8%, citing the contraction in world trade and sluggishness in the global economy as the main factors behind this downward revision. Assuming an improvement in the world economy, the Bank of Israel expects Israeli growth to rise above 3% in 2017.
Zvi Eckstein, Dean of the Arison School of Business at the Interdisciplinary Center, Herzliya, and a leading Israeli academic economist, largely agrees with this assessment. “The economy is growing at an underlying rate of 2.5-3% per annum and this rate will remain in place for the foreseeable future”, he says. “In a ‘good year’, that could reach 3.25% or even 3.5%, but no more”.
Eckstein believes that the ‘duality’ of the Israeli economy remains a key feature and is actually intensifying. This refers to the dichotomy between Israel’s high-tech sectors, which are world-class, export-oriented and characterized by high profitability and high productivity, versus most of its domestic economy, which is sheltered from foreign competition and plagued by low productivity and very gradual improvement in that critical metric..
“Israel’s high-tech, which is the driver of its export growth, is doing well”, he observes, with the country’s renowned start-up sector continuing to attract considerable foreign investment flows. Yet, as the 2015 data cited above show, overall export growth is sluggish. This, Eckstein explains, is because of the strength of the Israeli currency, the shekel which, in turn, is the result of a growing current account surplus. In 2015, that surplus has posted new records, thanks to the sharp fall in the cost of imports, primarily of energy and commodity products.
“Because of the rise in the shekel’s value, especially vis-à-vis European currencies”, he continues, “many industries that used to export are no longer able to do so. Consequently, export growth is hobbled and cannot drive overall economic growth”.
Avi Temkin, senior economic commentator at Globes, Israel’s leading business daily, adds another layer of dissatisfaction over the country’s economic performance: “The rate of growth has to be related to the rapid growth of Israel’s population – which increased by 2% in 2015, up from 1.8%-1.9% in previous years. These are much faster rates than in the US, let alone those of Europe, so that when measured on a per capita basis, Israeli GDP growth is actually very low – in 2015, it was negligible”.
Thus, what seems at first blush to be a good performance is widely considered not good enough. The question then becomes what should be done to improve matters – but the answers are complicated by the implicit assumption that solutions are readily available. That assumption is undermined by the reality that the Israeli economy is small and very open to international trade and investment, so that its fate is by no means solely in its own hands.
Short-term versus long-term
The policy implications of this situation were a central theme in an important policy address entitled “Economic Policy Challenges for the Short and Long Term”, delivered by Bank of Israel Governor Karnit Flug at conference on December 30. In this programmatic paper, Ms Flug defined the role of monetary and exchange rate policy – which the central bank is charged with formulating and executing – as “focused on smoothing the short-term impact of economic volatility on inflation and on growth and employment”, while fiscal and structural policy “is focused on achieving inclusive growth which … increases in the standard of living of the entire population over the long term”.
Ms Flug went on to discuss the problems which the central bank has been grappling with for the last two years and expects to continue doing so in the next two. First, inflation as measured by the Consumer Price Index has been negative for the last two years, while the central bank’s mandate is to achieve a target range of inflation of between 1-3% per annum. This situation “stems in great measure from the fall in the prices of commodities and energy, and from price reductions initiated by the government. These factors reduced the CPI by 1.7% in the last year; net of these factors, the CPI rose by 0.8%”, the Governor noted.
In other words, negative inflation – Ms Flug was careful to avoid the dreaded ‘deflation’ word – is largely imported. The same is true of the other problem plaguing monetary policy, namely the rise in the value of the shekel – also the result of the zero-rate interest policies pursued by major central banks.
“Against this background”, the Governor explained, “the Bank of Israel has deployed the full range of policy tools: an expansionary monetary policy, together with a declaration of the Monetary Committee that it expects policy to remain expansionary for a long time; intervention in the forex market to prevent a further sharp revaluation; and a series of stabilizing measures to address the dangers developing in the housing market” – this last a reference to the rapid rise in house prices and in mortgage lending in recent years..
However, and in sharp contrast to the short-term nature and mainly foreign origin of the challenges facing monetary policy, said Ms Flug, “the long-term structural problems facing the economy are not amenable to monetary policy tools. They need new, revised fiscal and structural policies…”.
In her remarks, the Governor homed in on “two central challenges facing the government: raising the rate of productivity growth …and closing (social) gaps and reducing the scale of poverty”. She went on to identify three key policy directions needed to successfully meet these challenges: pressing ahead with the implementation of policies aimed at integrating marginal population groups in the workforce; raising the level of human capital in the workforce, via both the education system and technological training; and removing barriers to growth, to which end she listed a slew of needed policy measures.
It is a measure of the extent to which Flug personally and, under her leadership, the Bank of Israel as an institution, have distanced themselves from the economic strategy and policy priorities of Prime Minister Benjamin Netanyahu, that her policy prescription is largely endorsed by outside critics of the government. Zvi Eckstein, who was himself Deputy Governor at the Bank of Israel from 2006 to 2011, during Stanley Fisher’s tenure as Governor, has authored numerous policy papers presenting proposals for measures, especially with respect to the pressing problem of improving productivity in the domestic economy.
As an outsider, he can – and is – today be much more openly critical of the government’s inaction than can senior officials in the central bank. “The current government is focused on measures to get prices down”, he says, implying that this is a misplaced priority, at least from an economic perspective. Whilst not overtly accusing Finance Minister Moshe Kahlon of populism, Eckstein tartly notes that “the Finance Minister is engaged in keeping the promises he made to his voters regarding prices in general and house prices in particular”. Even if these efforts are successful, they will do nothing to resolve the long-term structural problems that Eckstein and Flug have each highlighted and sought to address.
Avi Temkin, the media analyst, agrees about the problem of low productivity but is not prepared to accept the exoneration from blame that Flug has given monetary and exchange policy – and hence implicitly to herself and her colleagues. Temkin points to another aspect of Israel’s macro-economic success story that puts the spotlight back on monetary and exchange rate policy.
“As a result of the current account surpluses that Israel is running, we are consistently accumulating overseas assets, which now exceed $100 billion on a net basis. This simply means that excess savings generated by the Israeli economy are being channeled overseas.
“What we should be doing”, says Temkin, in a sharp departure from accepted economic thinking both in Israel and generally, “is to use the savings for domestic investment. That would reduce current account surplus and take some of the upward pressure off the exchange rate, while addressing the long-term problems of low productivity and the need to generate faster and sustainable growth”.
Temkin shares Eckstein’s disappointment with Moshe Kahlon’s policies and priorities as finance minister. He also highlights Netanyahu’s absence from the area of economic policy-making, in both the current and previous governments. Although Netanyahu has been premier since 2009, in the coalitions he formed after the 2013 and 2015 elections he was obliged to give the stewardship of the Treasury to the head of a rival political party – whereas in the 2009-2013 government, the Treasury was in Likud hands and Netanyahu was directly and closely involved in formulating economic strategy and directing policy.
It therefore seems that so long as the economy is able to continue growing at a reasonable – although unexceptional – rate, its longer-term and underlying problems will simmer gently on the back-burner. Only a dramatic change in either the economic or the domestic political situation is likely to disturb this convenient, but ultimately undesirable, state of affairs.