Analysis

How Did Israel Reach a NIS 40 Billion Budget Deficit?

The blame for the deficit is being placed everywhere - from professional incompetence by treasury officials to an inability to implement structural reforms in areas like the defense budget.

On the eve of Shavuot, the government passed the controversial 2013-2014 budget that includes some harsh budgetary measures, disappointing many in the public after the countless electoral pledges to reduce the cost of living.

The storm surrounding the budget this past week was so severe that Knesset members Miki Rosenthal (Labor), Issawi Freij (Meretz), and Knesset State Control Committee Chairman MK Amnon Cohen (Shas) clamored for the establishment of an investigatory committee to look into the oversights that led to it. In response, the State Comptroller's Office announced that it would examine different aspects relating to the budget.

However, the State Comptroller must take the broad view with its investigation to understand how the economic skies over Israel turned gray so fast. It's hard to recall  a sharper economic change than the one the economy suffered since the beginning of 2010. Just three years ago, the Israeli economy was in a state of euphoria almost identical to the we've-never-had-it-better atmosphere following the 1967 Six Day War. Economists in Israel and abroad didn't hesitate to crown Israel as the economy to come out of the 2008 global economic crisis in the best shape.

However, just three years later, we have fast been hurled into the feeling that the economy is on the cusp of a serious recession necessitating emergency budgetary measures.

Does this power trip-turned-disaster mirror that which took place in the late 1960s so much that an investigatory commission like the Agranat Commission after the 1973 Yom Kippur War is needed? Is there a need this time as well for an investigatory committee to examine if our economic leaders behaved in an unbalanced fashion? Or maybe it is just Israeli manic depression that causes us to swing between hollow economic pride and baseless feelings of crisis?

A large part of the blame rests with bureaucrats in the Finance Ministry, according to a former senior Finance Ministry official. Everything that occurred in the past four years is strange, he said. The [treasury's] Budget Department gave the feeling that the time has come to dole out the funds and the government accepted what the bureaucrats were telling it. If the proceedings will be investigated, nothing interesting will be found at the political level; it will only be found among the bureaucrats.

The official continued: 2012 ended with a much larger deficit than it was supposed to. It wasn't a frightening year like 2008, when the American investment bank Lehman Brothers collapsed. The bureaucrats were simply interested in pleasing the government instead of implementing drastic steps.

In March 2009, the Netanyahu government was sworn in and Yuval Steinitz took his place as the head of the Finance Ministry. Steinitz replaced his predecessor, Finance Minister Ronnie Bar-On, who was criticized for listening to a conservative and worried Bank of Israel Governor Stanley Fischer.

Two months later, in May 2009, the Finance Ministry was hit by its first crisis. Budget director Ram Belinkov resigned, announcing that my responsibility for the state budget and the economy forces me to resign. In his resignation letter, Belinkov criticized the package deal the treasury had negotiated with the Histadrut labor federation and the large sums of money promised to employers as part of that deal. Belinkov's replacement was Udi Nissan, who was a key contributor to the growing deficit over the following years when he instituted a new fiscal rule that allowed the government to increase its budget as long as the national debt was getting smaller. The new budget rule allowed an NIS 1 billion increase in government expenditure in the 2011-2012 budget.

Belinkov's resignation foreshadowed the storms that would hit the treasury's Budget Department in the following four years. The department suffered from infighting, partly due to the economic figures that came in as a result of the crisis. The biggest confrontation took place between budget director Gal Hershkovitz and his deputy Eyal Epstein.

At the end of the 2010, the Israeli economy set out on a new experiment: the government budget became biennial to promote longer-term planning. The trouble was that the new budget was implemented during a period of euphoria in the Israeli economy that didn't reflect the oncoming future. In 2009 and 2010 the treasury was accused by opposition of being intentionally deceptive because the budget deficit in these years was between 4 percent and 5 percent of GDP, instead of the 5.5 percent to 6 percent that was forecasted.

In the first half of 2010, the recovery in the Israeli economy continued, impressive growth rates were recorded, the surplus in the economy's currency balance growing, and the unemployment rate returned to the low level that existed in the beginning of 2008, then Finance Ministry director general Haim Shani wrote in an appendix to the budget published in October 2010.

The failure began with the biennial budget, says Prof. Avi Ben-Bassat, former Finance Ministry director general. In 2003 they examined the topic of a biennial budget and [I and Prof. Momi Dahan] explained why it was bad. The key problem is the lack of certainty regarding economic activity. You cannot know how much to levy in taxes and how much money you can spend. From the international perspective, we saw that Canada was the only country to try this in the past and canceled it when it was burned. But here such a budget was announced in 2010, when the economy was in excellent condition.

We live in a world of uncertainty, and with a biennial budget you give up flexibility and the ability to correct course if there are problems," Ben-Bassat continued.

"What happened afterward is that growth slowed down, the world financial crisis reached us. This is one of the reasons for the deficit. In addition, they expanded government expenditure without raising taxes and the biennial budget prevented retailoring [the budget] to the situation. The slowdown in economic growth had already begun in the second quarter of 2011. With an annual budget, they would already have prepared a different budget in the middle of 2011.

An annual budget compiles all the decisions made by the government during the year. Budgetary discussions are where these decisions are put into a framework, said Yarom Ariav, who served as director general of the Finance Ministry from 2007 to 2009. But with a biennial budget this compiling [of government decisions] doesn't take place at year's end.

In the meantime, other crises have been unfolding in the treasury. In May 2011, Nissan resigned. In September of that same year, Shani also resigned following confrontations between him and Steinitz. Both of them didn't stay on to deal with the key economic factor of recent years – the social justice protests, which placed the treasury and the government in a bind and that led to an uncontrolled increase in spending.

It's impossible to tell treasury officials 'be nice' and afterwards when asked why budget cuts weren't implemented ask why weren't they? said a source who was a senior treasury official during the period in question. Maybe they don't remember, but there were waves of strikes that made it unpleasant for us to walk outside. During the doctors' strike they told me, don't go to a hospital, and I'm not usually recognized in public. After that came the strike of the temporary contract workers and that of the prosecutors. There was an atmosphere whereby every bargaining group gets what it wants.

The result was that red lines were crossed," the source continued. "During the doctors' strike nobody got up and said, 'Doctors, we love you, you do holy work, but the size of the pie is limited.' Afterward the nurses' strike began, three weeks before the elections. At the same time, the opposition leader came out and attacked us. What do you expect? That three weeks before the elections the prime minister would say 'Now I will show the nurses what's what?'"

"People forget today, but we gave NIS 300,000 to every doctor who moved to [Israel's geographic] periphery. The result was that the agreement with the doctors cost NIS 1 billion annually. The agreement with the social workers costs another couple hundred million shekels," he added.

In the past six months, the finance minister already presented an objection to every budget decision that was passed including legislation on discounts in municipal tax which turned him into the enemy of the disabled, which included a crazy decision to pay billions in compensation to those relocated from Kfar Shalem. This includes a bill presented by Daniel Ben Simon according to which every building erected must have a guard post equipped with an air conditioner costing NIS 50-100 million. But still, how much of a bad guy in these matters can you be? In the past six months, when the wave of populism became impossible, we thought of compiling all the proposals handed to us in a month and we reached a sum of several billion shekels. In a month.

Government liabilities ballooned due to agreements reached following the strikes, the recommendations made by the Trajtenberg Committee became future liabilities that weren't felt immediately and allowed the treasury to prevent the budget from exceeding its boundaries. It's easy to blame the social justice protest, but the job of the responsible authorities – that wasn't done – was to ensure calculations were made to determine where the money would come from. While rushing to fill the demands of all the various sectors, no prioritization was defined and no thought was given to where the funding would come from.

Looking back, the treasury did identify the problem with the deficit. The growing deficit was regularly tracked and there were those who warned about its growth, but still not enough was done to change the picture.

The forecasts were inaccurate, says Ariav. When planning a deficit for two years you must be conservative and use a large error margin. There was an error in judgment in the margin of error that was chosen. There was a problem at the diagnostic stage, as well as at the correction stage.

Comprehension that we had a frightful deficit came late," Ariav continued. "This is problem you must address when it is still small. Once the problem grows the only feasible move you have is to try and insure that it doesn't explode during your term. From a political perspective, it was convenient to cave in to the demands.

In the summer of 2012, the Israeli economy was also reminded of the high price of the stagnation in the peace talks with the Palestinians. The IDF's Operation Pillar of Defense in Gaza cost close to NIS 2 billion, further exacerbating the budgetary deficit.

In July 2012, when the treasury noted the shortfall in tax revenue, officials requested that a new budget made to account for the lower-than-forecasted income from tax. The updated budget was presented but not approved. The treasury increased the tax rate, with most of the measures coming into effect in 2013. Still, by the end of 2012 the prime minister knew that he couldn't pass a new budget, and in light of the need for significant budget cuts and the drop in tax revenue he announced that he set a date for early elections.

When 2013 came, Israel found itself without a new budget. The pre-election atmosphere dictated that the government would continue with the same biannual budget that was formulated under completely different circumstances. Government ministries continued to receive their monthly budget based on a simple formula: a 1/12 of the previous year's annual budget. If that wasn't enough, some of the ministries exceeded their budget and applied to the Accountant General's Exceptions Committee for additional funds.

It would be easy to describe the situation created as a perfect storm, where all the possible factors worked together to plunge the government budget into its current deficit. But the writing was on the wall.

The trouble with the future is that it has a strange trait of actually coming in the end, said a former senior treasury official, referring to financial obligations accumulated by the outgoing government. And this future came during the term of Finance Minister Yair Lapid.

In the treasury this week no one knew what all the fuss was about. Israel misses its deficit target almost every year, said a source who recently worked at the treasury. Last year we had a better outcome with the deficit and they didn't say anything to us.

In recent months, the international ratings agencies contacted the treasury's Budget Department to discuss the long series of stories published in Israeli media regarding an out of control deficit. A source in the treasury termed this coverage, a lack of fairness that is likely to result in harm to the country. He added Part of it stems from political considerations and part of it from ignorance.

Nevertheless, as a senior former treasury official said: There never was the continual overshooting of forecasts like that we have seen in the past two years. If an investigatory committee is established it will need to read through the protocols and speak with figures outside the ministry. If the State Comptroller will examine how things spun out of control, it will be amusing.

This continual overshooting of forecasts has consequences. Since the beginning of May, the ratings firm S&P has lowered Israel's local currency rating. This past week, the OECD published a report that crowned Israel as the Western country with the highest poverty rate. In light of these figures, when the next social justice protests beaks out it won't be as difficult to locate where it stems from. This time, it won't appear from a euphoric atmosphere like that which preceded the last protest.

Officials at the treasury stressed that the government expenditure increased and that the Israeli public had no reason to complain but that the public's disappointment stems from its starting position and especially the high expectations Lapid raised.

The entire issue is the reference point, says Ariav. Even though the budget has grown relative to previous years, the moment that you create budgetary obligations you are eventually forced to recalibrate things – and not where you would if you were thinking about spurring growth and closing [socio-economic] gaps.

In the defense budget, for example," Ariav continued. "They postponed dealing with the problem instead of addressing it. The plan is that the budget will be cut now but that it will resume growth starting in 2015. This will lead to a situation whereby after this date there will need to be extreme budgetary cuts. They didn't implement structural changes. We could of told the defense establishment that there is a cut in the budget and that it these budgets would not be returned. Right now, the army is giving the government a loan and it seems that the rate it is charging is very high. Also concerning the ports and the Electric Company – more determined messures could have been done, for example one could have defined that a reform would be defined within 60 days. But the finance minister decided to pick his battles."

Israeli history demonstrates that it is impossible to implement economic revolutions during periods of prosperity, and rather only times of crisis can drive substantial reforms. From this perspective, it appears that we had to reach the current crisis in order to implement reforms that will eventually allow the treasury to raise the money that is missing for spending that the public demands.

Oren Nachshon