Netanyahu and Flug: The Battle Begins

We should support the Bank of Israel governor in her drive to get the government to finally improve the lot of the people.

David Rosenberg
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Two things that Prime Minister Benjamin Netanyanu must rue from his years in office are lobbying for Israel to join the Organization for Economic Cooperation and Development, and naming Karnit Flug to head the Bank of Israel.

Flug has only been in office just a few weeks, but has already become a fiscal thorn in the prime minister's side, with gentle but but pointed warnings about how badly his government is managing its finances. And this is just the beginning: Barring another fiscal miracle like this year's windfall of "trapped" corporate tax payments, the problems are going to grow.

The epicenter of the conflict is differing world views—the low taxing, low spending prime minister versus a governor who sees value in the services and social safety net that government can provide.

Netanyahu presumably knew this, which is why he circled the planet looking for anyone to serve as Bank of Israel governor as long as it wasn't Karnit Flug.
But the OECD? Isn't membership a great achievement, like being getting entrance into the city's hippest dance club?

Us and America

It is, but the OECD has now given us a new standard to meet. Rarely does a week go by when Israel isn't measured up against the leading economies of Europe and North America, only to find itself at the bottom of the rankings. This isn't a just a matter of national self-esteem – the Scandinavians are always the best at everything anyhow, it's hopeless to compete – but it does enable policy makers and the public to see how we have set national priorities and how successful we've been at achieving them.

The latest OECD report on Israel, issued this week, makes quite clear the choices Israel had made over the decade in terms of socio-economic policy.
On purely top-line economic parameters – economic growth, unemployment, inflation and fiscal policy – Israel has been an unmatched success. The ship of Israel sailed through the global financial crisis with almost no tossing, enjoying nearly interrupted GDP growth. Joblessness is at a 30-year low and the government's finances, certainly compared to Europe, are in good shape. The high-tech sector basks in "international admiration."

But when the OECD turns to measures of well-being, Israel comes out looking among the worst of the OECD club.

Israel overdoes it

A fifth of the population is under the poverty line, per capita GDP is on one of the lower rungs the OECD ladder an the country's schools are failing to teach children science, math and reading adequately.

Even civil engagement and trust in government is poor. Life expectancy is high, but the health system is straining.

This tale of two countries – the State of Economic Israel, which is thriving, and the State of Social Israel, which is in crisis – came about in large part because a decade ago Israel adopted what was then called the Washington Consensus. That was a policy advocated by international financial institutions that urged governments to rein in spending and deficit, lower taxes, privatize government companies, deregulate and liberalize business.

The state, said the policy, should focus on developing infrastructure and ensuring basic education. The economic growth that would ensue would generate wealth to lift people out of poverty and ensure a prosperous middle class.

Israel, particularly, Netanyahu, pursued this with gusto.

Mind you, there were good reasons to do so. The Israeli government was a big spender and social welfare policy was out of control, discouraging people from working and obtaining an education. But Israel pursued this policy more than what was good for it.

Today, as OECD figures show, public spending is just 40.2% of GDP, compared with an average of 45.9% for countries belonging to the organization. If you subtract interest costs, government spending as a percentage of GDP is the lowest in the OECD after South Korea.

Contrary to what they think, Israelis don't suffer a particularly high tax burden: Taxes account for 29.5% of GDP versus an average off 33.8% for OECD member countries.

Worse still, the government didn't follow all the principles of the consensus. Deregulation and educational reform have been pursued half-heartedly. Israel's infrastructure, particularly where it affects the country's high-tech prowess, is lagging.

Um, it isn't working

This is where Karnit Flug comes into play. In the gentlemanly way that central bankers do it (or should we say, ladylike), she has been saying the policy isn't working. Economic growth is not enough; the government has to assume more responsibility for the well-being of Israelis.

"The main challenge facing the Israeli economy over the long term is to succeed in creating inclusive growth continuous, sustainable growth whose results will be divided more equally among all parts of the population," she told a business conference last month. She made clear that the big elements that go into this are the standard free market solutions of sustained productivity growth, more competition and a broad industrial base.

But she has also said that more government services are a factor as well.

Flug is tough on deficits, as she should be, so that means more spending as well as more taxing.

'If we choose a large government which will provide public services with high quality and quantity, will invest in infrastructure, and will be actively involved in supporting engines of growth, we will have to bear a higher tax burden," she said when she was formally installed as governor a month ago.

Netanyahu was there. Was he listening?

The two are now bumping heads in a small way over fiscal policy, namely the decision by Netanyahu and Finance Minister Yair Lapid to cancel a scheduled tax hike next year. That is all part and parcel of the Netanyahu philosophy of keeping taxes low and cutting them whenever the opportunity arises.

But while the Bank of Israel issued a statement calling the twin measures "appropriate" because they included equivalent spending cuts, it warned of the battles ahead.

This year's fiscal situation is better than expected and 2014 looks to be strong as well, unless, of course, economic growth tanks, as it might. But Bank of Israel forecast show that things will start to get more difficult from 2015 on. The choice will become a stark one between slashing spending and government services or raising taxes to preserve or improve what there is. We all have an interest in gathering on Flug's side of the battle lines.

Netanyahu knew about Flug's opinions. That's why he combed the world for someone else to head the Bank of Israel. But she's in and the fight is on.Credit:
Newly appointed Bank of Israel Governor Karnit Flug gives a statement to the media outside the Bank of Israel building in Jerusalem October 20, 2013.Credit: Reuters
Prime Minister Benjamin NetanyahuCredit: Emil Salman