Israel's growth is not as good as it seems

Shai Babad and Moshe Kahlon  / Photo: Lior Mizrachi

Prof. Omer Moav argues that it's per capita growth that counts, and the 1.3% average annual rise in Moshe Kahlon's tenure as finance minister is below the OECD average.

Ministry of Finance director general Shai Babad wrote last week in "Globes" that the Israeli economy was in excellent condition. He asserted that the focus on the deficit was unreasonable, and that the deficit was not a real problem, because the ratio of government debt to GDP was declining, and Israel's credit rating had not been downgraded.

Babad stated in his column, and several media interviews, that he was a civil service officeholder. The public perceives such an official as a professional, in contrast to politicians who are justly perceived as being willing to distort the figures in order to support their views. Babad's job is indeed a senior civil service official, but he acts like a politician in the way that he practices public relations for the Israeli economy, and especially for his patron, Minister of Finance Moshe Kahlon, while misleading the public.

When it serves his purposes, Babad cites the differences between Israel and the other OECD countries. For example, he mentioned the exceptional defense burden in Israel. He ignores one important difference, however - Israel's exceptional population growth rate.

Israel's population is growing by nearly 2% a year, a far greater rate than the average in OECD countries, most of which have low birth rates.

Babad compares Israel's economic growth to that of the OECD countries, and claims that Israel is a standout in growth. In the graph he displays, growth is indeed far greater than the OECD average. The reason why growth is important, however, is that GDP is linked to the standard of living and public welfare. A country that produces more can invest more in the future and consume more in the present: both private and public consumption. It is obvious, however, that welfare depends on per capita GDP, not on GDP per se. Babad does not believe that India is a wealthy country because it produces more than Israel. India is a poor country because its people are poor - per capita GDP in India is low.

Babad ignores this simple fact, which is obvious to everyone who works in the Ministry of Finance, and certainly to the highest-placed civil service officers in it. He compared growth in total GDP in Israel to the average growth in GDP countries, not growth in per capita GDP.

This is simply deception. The concept of economic growth refers to growth in per capita GDP. When per capital GDP growth is compared, the picture is very different - Israel is no longer ahead of the rest.

Israeli per capita growth lower than OECD under Kahlon

The Israeli economy came very well through the 2008 crisis, and grew faster than in the other OECD countries. During Kahlon's period as minister of finance, however, things changed. Per capita GDP growth averaged 1.3% a year in the past five years, less than the 1.6% OECD average during this period. The boasts of Babad, Kahlon, and Prime Minister Benjamin Netanyahu are therefore unjustified.

The government deficit (the difference between government revenues and government spending) increases the debt, and the debt is a burden on the future. Every shekel of deficit increases the debt by one shekel (a shekel that bears interest). It is convenient, however, to camouflage this fact by looking at the ratio of debt to GDP. The population growth rate, which Babad ignores, also plays a key role here. The faster the population growth rate, the faster the growth in total GDP, so it is easier to reduce the ratio of debt to GDP. All that a reduction in the debt-GDP ratio means is that the denominator (GDP) grew faster than the numerator (the debt).

A deficit is like a pyramid: consumption today comes at the expense of future generations. Israel is able to put a greater burden on the coming generations - our children, grandchildren, and great-grandchildren - simply because we have many descendants (in comparison with other OECD countries). Babad flatters himself and his patron by saying that the debt-GDP ratio did not increase in comparison with the developed countries, while ignoring the special circumstances of the Israeli economy.

Even worse, he also ignores the need that population growth creates for investment. A growing population makes it possible to run a large deficit, but a growing population requires massive government investment in infrastructure merely to keep up. In order to maintain electricity, water, sewage, and road infrastructure; public transportation; public buildings; and residential construction at the same per capita level, the stock of infrastructure and buildings must be increased by 2% a year. But we do not want merely to keep up.

In comparison with the developed countries, Israel lags far behind in infrastructure. Were the government, led by the minister of finance and the prime minister, taking advantage of their ability to increase the deficit in order to finance the infrastructure needed for the growing population, I would not dissent. The deficit burden can be imposed on the future generation if is aimed at the future generation's welfare, but this is not the case.

The deficit was created by spending money on pleasing pressure groups

Kahlon increased spending and the deficit in order to finance current consumption - he distributed gifts to various population groups, obviously at the expense of the public in the future, and at the expense of investment in infrastructure. Needless to say, there is a difference between debt for the purpose of financing important investments and debt for the purpose of financing current spending, but Babad ignores this difference.

One of Babad's astonishing contentions is based on a quote by US President John F. Kennedy, who said, "The time to repair the roof is when the sun is shining." Babad adds, "The economic figures show that as of now, the sun is shining in Israel." Babad is right that the Israeli economy is in a state of full employment (meaning that there is no recession), but he ignores the conclusion that this is the time "to repair the roof" - to prepare for hard times.

Together with economic growth, modern economies feature business cycles - transitions from growth to recession. A responsible economic policy tries to moderate the fluctuations in economic growth, and especially to reduce the damage to income when the economy is in a poor state. A responsible policy therefore features a conservative approach during periods of growth: avoidance of an increase in spending beyond the multi-year plan, and reduction of the deficit and debt in preparation for the hard times ahead. Had the large deficit created by Kahlon been the result of a recession, I would not dissent. Tax revenues fall during a recession, and it is not desirable to cut spending, because it can worsen the recession. Furthermore, a deficit resulting from a recession is a temporary deficit, not a structural one. Kahlon's policy, however, introduced a structural deficit into the Israeli economy, and did not repair the roof, even though the sun was shining.

Babad proudly cites the "numerator" that the government took on itself. The numerator requires the government to provide a budget resource for any future spending commitment. This is a very important rule that can eliminate excessive commitments to future budget spending without creating a current deficit. What Babad does not mention, however, is that to a large extent, the government is simply ignoring the restrictions it imposed on itself. Babad himself has admitted this, for example when policemen were given an enormous pay increase to compensate for "absence of job security," without any budget resource to pay for it.

To sum up, the Israeli economy is not in a recession. A responsible minister of finance would have reduced the deficit, and would certainly not have increased it in order to distribute various and sundry gifts and make irresponsible commitments to future spending. The Israeli government, however, led by Kahlon and Netanyahu, prefers short-term demagogy at the expense of the future. Babad, the political civil service officeholder, is misleading the Israeli public in an attempt to defend their policy.

The author is a professor of economics at the Interdisciplinary Center Herzliya and the University of Warwick in the UK.

Shai Babad and Moshe Kahlon  / Photo: Lior Mizrachi
Shai Babad and Moshe Kahlon / Photo: Lior Mizrachi
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