When a country falls head over heels into debt, unemployment and economic lethargy, what is the best way to pull itself out - with fiscal austerity and by cutbacks, or the opposite, by increased spending? This has been the economic question of the year.
Under ordinary circumstances, decision-makers respond to economic recessions or slowdowns by reducing interest rates and increasing spending to stimulate activity. This approach has worked fairly well in the past. Alternatively, they deal with excessive debt and budget deficits by reducing expenses, decreasing debts, restructuring and starting over. This approach is thought to enhance credibility and encourage investment, thus restoring economic growth. It, too, has been quite effective in the past, notably in Israel's economic stabilization program of 1985.
But in the current crisis, there are problems with either approach. Many countries, including European nations and the United States, fell into recessions partly because they had excessive debt and ballooning budget deficits. How can these spending problems be solved with more spending?
Yet on the other hand, Eurostat, which collects data about European countries for the European Commission, reported last weekend that in the current environment, the more a country reduces its budget, the more its economy slows down.
It seems decision-makers have had their main tools for dealing with recession taken away, and it is unclear what others they have available. They cannot reduce interest rates, because they are already close to zero. Nor can they increase government spending because budget deficits are huge and need to be reduced.
There is no clear formula, and each country has to decide for itself. Europe chose to demand that Greece and other countries cut their budgets in return for help repaying their debts. Several economists have described this policy as "madness" or "suicide." Nobel laureate and New York Times columnist Paul Krugman is the most prominent of these critics. His argument, although it sounds a bit bizarre, is that a country whose government is in debt must pour more money into the economy to avoid sinking into full-blown depression.
Eurostat's data appeared to back up Krugman's thesis. To what extent do budget cuts contribute to economic slowdown? Several people have done the math, including Martin Wolf, the Financial Times' senior economic commentator. He examined three years of data from the International Monetary Fund and found that for each percentage point by which a government reduced its budget, economic growth decreased between 1.25% and 1.5%. For example, when Greece cut its budget by 8%, its GDP shrank by 12%.
Israeli exceptionalism?
The opposing idea, that budget cuts fight against economic slowdowns by promoting economic credibility and growth, does not appear grounded in reality, at least not in Europe. Rather, Wolf shows that small budget cuts lead to slowdowns and large budget cuts lead to recessions.
Where does this leave Israel? Sooner or later, Prime Minister Benjamin Netanyahu and Finance Minister Yuval Steinitz will have to enact budget cuts and tax increases to shrink Israel's budget deficit to a legally and economically viable size.
On the surface, this looks like a recipe for disaster. Judging by Europe's experience over the past several years, the government's efforts to balance the budget could cause an economic slowdown. But Israel is not a European country, and unlike most European countries its interest rates are well above zero and so can be lowered. It is possible, then, that interest rates, the relative budgetary discipline of the past several years, and the credibility of the Bank of Israel and its governor, Stanley Fischer, will allow Israeli decision-makers to avoid a European-style slump.
One thing is certain: With elections here only months away, the battle over budgetary policy will soon resume. The government and opposition will present their competing versions of what's happening in Europe and the United States. The opposition, with an eye toward the leaders of the social protests, will call for an increase in the budget and budget deficit, arguing that spending cuts in Europe have failed to put the continent back on its feet.
The government will tell voters that fiscal discipline will save the economy from Europe's fate and that Israel must protect its credibility so it can raise funds in the international markets.
There is no reason to expect changes in policy before the elections. Neither Netanyahu nor Fischer has been converted to Paul Krugman's creed. They will both continue preaching discipline - even if they do not always practice it - and protect Israel's attractiveness to foreign investors before all else. When when the debate over the budget does begin, though, it could make for an interesting summer.
