Is Israel Really in Such Bad Economic Shape?

The Bank of Israel seems to have panicked when it ordered a second interest rate cut in two months. Bad luck, the war is over.

David Rosenberg
David Rosenberg
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A portrait of Yair Lapid on a propaganda poster, twisting in the wind.
A portrait of Yair Lapid on a propaganda poster, twisting in the wind.Credit: Olivier Fitoussi
David Rosenberg
David Rosenberg

The timing couldn't have been less fortuitous.

The decision by Governor Karnit Flug and the Monetary Committee on Monday to lower the bank's base lending rate to a record low 0.25% came a week after the Central Bureau of Statistics reported a sharp slowdown in economic growth in the second quarter. It was also a day before a cease-fire ended the Gaza war.

That day, things looked bleak. But there won't be the slightest sign of doom and gloom when the Bank of Israel releases in another 10 days or so the minutes of the meeting that led to the fateful decision. If you've ever had the pleasure of reading them, you already know they contain all the drama of a cup of lukewarm coffee, followed month after month by the comforting words, "The Bank of Israel will continue to monitor developments in the Israeli and global economies and in financial markets." Whatever controversy there may have been comes in the vote of the committee members, in the rare instances where decision isn't unanimous.

But those of us on the outside can't help but think that the mood that Monday afternoon was gloomy, if not panicky.

Operation Protective Edge was about to enter its eighth week. Everyone was talking about a war of attrition that would sap an already weakening economy. Add in the latest, depressing statistics on growth, the slowing European economy and the Ukraine crisis hanging over the eurozone, and the very real concerns that Israel's economic policy-making leadership is in disarray and

The result is we now have a lower rate of interest than Stanley Fischer ever felt was necessary even during the darkest days of 2008 and 2009, when it looked like the global financial system would collapse and bring down the world economy with it. Not only are interest rates at record lows, but the bank apparently views the current situation as so dire that it reduced them two months in a row and in effect fired the last bullet it had left to shoot down a recession monster that it apparently feels is stalking Israel.

Are we really in such bad shape?

Disheartening numbers, you'd think

Let's first look at the second-quarter data. Taken at face value, the numbers are disheartening. Gross domestic product rose at a 1.7% annual rate in the second quarter, even before the fighting in Gaza began, dropping from a 2.8% pace in the first quarter. Exports, a critical part of the economy, plunged at close to an 18% annual rate.

Investment was down at a 4.5% rate, and not just in residential construction, which has ground to a halt as builders await Finance Minister Yair Lapid's zero-value-added tax plan to win Knesset approval. Investment in machinery and equipment, which is as good an indicator of business sentiment as any, was down sharply for the second quarter in a row.

On a per capita basis, the economy shrunk in the second quarter, since population growth is typically higher than 1.7%.

But even at face value the figures aren't really troubling. First of all, they are preliminary and stand a good chance of being revised upward, in particular that dreary export number, which economist Ofer Klein of Harel Insurance & Finance notes doesn't square with the monthly data the stats bureau itself has been publishing. Consumer and government spending both rose, and business sector GDP was the highest in four quarters.

In any case, even a cursory examination shows that the on a quarter-by-quarter basis, the numbers fluctuate considerably. Take a few sequential quarters in 2012 and 2013: GDP rose at a 3.4% rate in the final quarter of 2012, tumbled to a 1.6% rate in the first quarter of 2013 and then jumped to a 5.3% rate in the second.

In other words, we're a small economy and one quarter of economic data doesn't make for a trend, much less a recession. In any case, the weakening of the shekel in the last few weeks promises to help improve exports going forward, as well as the government's strong finances, which make it easier to pay for the war.

Tweets are no criteria to assess war

Now let's look at the war itself. It's dangerous to assess the impact of a conflict from the perspective of newspaper headlines, tweets and day-to-day experience. The sounds of sirens, the images of people running to shelter and of empty shopping malls, and the endless tails of woe (and pleas for government compensation) by business owners and others left the impression that the economy had collapsed under a hail of Hamas rockets.

But let those boring old numbers speak and they will give you a fairer picture of what really happened.

What they show is that the tourism industry was hit hard, with arrivals and overnight stays in hotels down by double digit percentage points from a year ago. Retails sales were down by just 8% nationwide.

Self-reported damage to agriculture may have been about 250 million shekels and to industry 1.3 billion, both manageable numbers and probably exaggerated.

Except for tourism, which lost its peak season in what was shaping up to be a record year, a lot of those losses will be earned back as shoppers return to stores and factories make up for lost production with overtime. And what about the war of attrition? Ah, yes that was last week. Now we have a cease-fire and this one looks like it will hold.

There's no sign yet that we're facing a recession, even after taking into account the damage inflicted by Operation Protective Edge. We look like we are on our way to a slowdown, but hardly the kind of thing that would justify two back-to-back rate cuts by the Bank of Israel. No matter, now that interest rates are close to zero, that leaves the task of minimizing the impact of the slowdown in the hands of Mr. Lapid.

Bad news: Minister learned ropes

The good news is that Lapid listened to treasury mandarins last year when he was a neophyte finance minister and imposed tax hikes and spending cuts. That gave us a budget deficit small enough this year that Protective Edge's costs won't leave a pile of fiscal wreckage. It also gives the government a certain amount of credibility with the financial markets when it widens the budget deficit next year as it will almost certainly do. Increasing deficit spending is what governments are supposed to do when the economy is slack.

The bad news is that Lapid is no longer a neophyte finance minister who listens to his advisers but a cynical politician who listens to nobody. His insistence of going ahead with the zero-VAT program in face of the wall-to-wall opposition of economists is certainly the example par excellence of the new Lapid.

Another unfortunate example is his unwillingness to see the budget as anything more than a Facebook posting, something with which to score points with the public and show them he is indeed there to help the struggling middle class, the long-term impact of it be damned.

As the Bank of Israel is now advocating, widening the budget deficit would help shore up economic growth. But widening it to the extent the Finance Minister is advocating to avoid raising taxes and cutting spending is needless and irresponsible.

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