Blame strong shekel not Europe for slowdown

Yacov Sheinin

Most of the damage we did to ourselves, through the strong shekel, which cut manufacturing profitability and depressed market activity.

2010-11 were good years for the Israeli economy, with an annual growth rate of 4.7%, but the slowdown hit in early 2012, and growth will be 2.5% this year. This is why the unemployment rate is expected to reach 7.5%, exports have stagnated, the balance of payments deficit will exceed $4 billion, and the budget deficit is expected to reach 3-4% of GDP. I believe that 2013 will be another difficult year, with the same low growth rate and an unemployment rate that is liable to reach 8%.

That is not what Ministry of Finance and Bank of Israel economists thought two years ago. Back then, they predicted 4% GDP growth, and the deficit falling to 1.5% of GDP in 2013. Reality bites. They were wrong and Europe is to blame.

I say that while Europe is partly to blame, most of the damage we did to ourselves, through the strong shekel, which cut manufacturing profitability and depressed market activity. This is a long process, which began in late 2008. We warned about it, but only now is the tip of the iceberg appearing.

Meanwhile, the social protest, which erupted a year ago, is back after easing a bit. Implementation of the Trajtenberg Report will cost a lot of money, which cannot of course be found during a slowdown. There are not even the budget sources to pay for the little that has been implemented so far. If nothing is done, the automatic pilot will be activated, and the projected 2013 budget deficit will reach 4% of GDP.

Government decisions

Under the circumstances, the cabinet approved the decision of Prime Minister Benjamin Netanyahu and Minister of Finance Yuval Steinitz to double the 2013 deficit target to 3% from 1.5%. Governor of the Bank of Israel Prof. Stanley Fischer objected, but he accepts a 2.5% target, in order to keep the downward direction of the deficit target.

In my opinion, freezing the deficit target for the second consecutive year of a slowdown is the right economic decision, and was both important and brave, especially in view of the 7.1% unemployment rate - a very high level for an economy in which a substantial part of its working age population does not participate in the workforce.

It seems that the criticism of Netanyahu is due to a too slow realization by many Israeli and foreign economists that the Israeli economy is headed down the dangerous path of a prolonged slowdown. This is not just due to the crisis in Europe, but also because domestic production has not been very worthwhile for several years.

The inevitable result is the rise in the unemployment rate, stagnant exports, and a large balance of payments deficit of $4 billion a year. That is why, for now, the government should implement an anti-cyclical policy: in other words, when the economy is in a slowdown and tax revenues are not as much as projected, the deficit should be allowed to grow, and taxes should not be raised (except for taxes on very high incomes, which are unlikely to affect activity).

An anti-cyclical policy also means that in times of rapid growth and high tax revenues, the deficit should be allowed to fall and taxes should not be cut. It is the government's job to regulate economic activity: when the public does not consume enough and business does not invest enough, the government is the party that should increase expenditure to encourage economic activity, even though this expenditure will temporarily increase the deficit; when the economy is booming, the public is consuming heavily and investment is flourishing, the government should cut spending to reduce demand and prevent inflation. It is all so simple and logical.

It should also be remembered that, once upon a time, the optimal deficit policy in the Eurozone, as set out in the Maastricht Treaty, was to allow a maximum deficit of 3% of GDP in ordinary times. Israel is one of the few developed countries to meet this target. The deficit in most developed countries was 5-10% of GDP. Moreover, before the 2008 crisis, it was said the reasonable debt-to-GDP ratio was around 60%. That figure rose to a highly respectable and reasonable 75% after 2009.

Growth path

The majority of macro economists agree with the theory of anti-cyclical policies during a slowdown or recession but in the present instance the scale and the threat of the slowdown are still not known and therefore the principle is more important than the substance. The Bank of Israel has agreed to increase the deficit to 2.5% of GDP but not 3%.

In this way, according to the Bank of Israel, we can show the world, and perhaps even ourselves, that our deficit is on a downward trend. In my opinion, the main importance of economic policy is to encourage growth - arguments over the dosage and scale of half a percentage point is superfluous. Moreover, it might even be worth raising the deficit to 3.5% of GDP to stimulate the underground railway infrastructure in the Tel Aviv metropolitan area and the infrastructure and electrification of Israel Railways on main lines so that peripheral regions will move closer more quickly to the center and young couples can live further than 20 minutes travel time from central Tel Aviv where home prices are reasonable (50% of the Tel Aviv metropolitan area). Perhaps that would be more preferable than building apartments to rent that will become slums.

In my belief, in 2013 growth will fall to 2.5% rather than 4%, in other words 1.5% less growth. The classic policies of 2009 allowed a rise of 1.5% in the deficit and that's exactly what Netanyahu has decided.

On average, if we have 4% annual growth and if we keep a 2% of GDP deficit, we will reach a GDP debt ratio of 60% in about 10 years. But for now, in order to get out of this slow growth path that endangers the economy, policies are required that combine aggressive investments with expansive monetary policy. That is to say the interest rate must be lowered now from 2.25% to 1.5%.

It is very reasonable to assume that lowering the interest rate to 1.5% would bring a significant depreciation of the shekel, and that is exactly the policy that is necessary at the moment to encourage manufacturing and investments (in contrast to the interest rate policy that has resulted in a strong shekel over the past five years).

We are not concerned about a rise in inflation following the depreciation. Firstly, the price rises resulting from depreciation are a one-off occurrence, and not ongoing inflation. Secondly, home prices are expected to fall at the same time, which will have an identical influence on the Consumer Price Index (CPI) to the depreciation. So even if there is a depreciation of about 8% in 2013, expect a one-off rise in prices in its wake of less than 1%. On the other hand, a fall in the housing price index of about 3% (after an accumulative rise of more than 20% over the past four years) will bring about a similar one-time fall in prices so that the net effect on the CPI will be minimal.

So it looks as if even meeting a deficit target of 3% will require raising certain taxes but the main effort must be stimulating investment in the economy. Lower8ing the interest rate and direct incentives to increase investments will enable a return to rapid growth. Only rapid growth will allow lowering the national debt from 75% of GDP today to about 60% of GDP in ten years. A policy that slows down growth will inevitably bring a rise in the GDP debt ratio.

Israel must not set out on a path of slowed growth and high unemployment at a time when so many are not even part of the work force. If Haredim (ultra-orthodox) and Arab women (that are still not part of the work force) now want to join the work force, and because there is no employment for these populations, the rate of unemployment could soar to 10-15%.

The problem is not how much debt we pass onto future generations but what net assets (capital inventory minus debt) we pass on. The next generation will always prefer a slightly larger debt but much more assets so that net assets will be larger than a situation of smaller debt and fewer assets. Policies of reducing the deficit during a slowdown might lead to a fall in net assets for the next generation and nobody wants that.

Dr. Yacov Sheinin is the CEO of Economic Models.

Published by Globes [online], Israel business news - www.globes-online.com - on July 3, 2012

© Copyright of Globes Publisher Itonut (1983) Ltd. 2012

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