Israel’s Central Bank Chief Teaches a Lesson to a Spend-don’t-tax Netanyahu

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Prime Minister Benjamin Netanyahu and Bank of Israel Governor Karnit Flug.
Prime Minister Benjamin Netanyahu and Bank of Israel Governor Karnit Flug.Credit: Kobi Gideon, GPO

Prime Minister Benjamin Netanyahu doesn’t think much of Bank of Israel Governor Karnit Flug. He appointed her to the job only because his choices weren’t good. Since her appointment, Netanyahu rarely consults with her.

Nor does Netanyahu like Flug’s socioeconomic views, which favor increasing the budget by raising taxes. As we know, Netanyahu espouses the idea of “the fat man and the thin man” – the public sector riding on the back of the private sector. In other words, he believes that both the budget and taxes should be cut as much as possible.

Despite that, Flug managed to catch Netanyahu’s attention at the start of the cabinet session that approved the two-year budget for 2017-18. That was when she warned that the budget proposal was irresponsible because it greatly increased spending (a step supported by Flug) while reducing taxes (a step supported by Netanyahu).

The price of this pincer movement – more spending and less revenue – is a breach of the deficit target, followed by a worrisome forecast by the Bank of Israel of an increase in Israel’s national debt. Flug told the cabinet meeting that according to the Bank of Israel forecast, Israel’s debt-to-GDP ratio, which has been consistently declining since 2003, is expected to rise.

The conservative forecast is that the debt-to-GDP ratio will increase by about two percentage points to 67%. But Flug warned that more dangerous scenarios – like Israel sinking into a recession – could bring the number to 70%.

This statistic made the prime minister fidget in his chair. He asked Flug: Is the Bank of Israel predicting that Israel is at an inflection point regarding the debt-to-GDP ratio?

She said yes. The answer means that after almost 15 years of a constant decline in the debt, Israel is now starting an opposite trend.

Flug’s simple explanation was apparently the first time Netanyahu realized the significance of the hasty decisions made in the cabinet’s all-night sessions on the budget since 2015. The 2017-18 budget is the fourth in a row that the cabinet is approving with a significant increase in spending, almost offhandedly.

And again, the government is refusing to finance the greater spending with greater tax revenue. In the 2017-18 budget things have reached the absurd situation in which spending increased by 12 billion shekels ($3.15 billion) more than originally planned, as taxes were reduced.

Greater interest payments

As a result, the budget deficit for the next two years has been raised to 2.9% from 2.5%. A greater deficit means a greater national debt; it’s as simple as that.

Flug’s simple words made the cliché clear: Money doesn’t grow on trees, even if it’s budget money. When you spend more and earn less, a gap is created, called a deficit.

Because for several years Israel has been consistently increasing its deficit, the moment comes when even relatively good growth figures can’t cope. That’s the inflection point of the national debt switching to an increase from a decline. That’s the point where concerns about Israel’s economic stability start increasing once again, even for a prime minister named Benjamin Netanyahu.

A debt increase is a twofold problem. First, more debt means more interest payments at the expense of money that could be channeled into education, infrastructure or health care.

Second, more debt means Israel’s risk of becoming embroiled in a financial crisis increases. And as we learned from the 2008 global financial crisis, there’s nothing more destructive for a country’s future than a financial crisis.

Some people play down this danger. The 2008 crisis greatly increased the debt of many countries; suddenly a debt-to-GDP ratio of 65% looks excellent in comparison. In addition, the low interest rates worldwide make it very tempting to increase debt, because the annual cost is modest.

Therefore, plenty of qualified economists are preaching a debt increase “because it’s cheap debt, and it’s worthwhile to borrow in order to invest in continued growth and productivity.”

But this preaching suffers from blindness. First, Israel’s debt is small relative to the rest of the world – but not because Israel’s debt is low, but because the world’s debt has soared. Therefore, Israel’s joining the rest of the world in the trend of increasing debt is nothing more than “the sorrow of many is a fool’s consolation.”

Second, the cost of debt today is low, but that will end if there’s a financial crisis. In a world crisis, every additional percentage of debt will turn out to be very expensive and force Israel to carry out painful budget cuts in order to prevent a collapse. This is what happened to us in 2002, only two years after Israel ended 2000 with no deficit at all.

We'll eventually raise taxes

Third, there is no point in accumulating debt when there is no reason for doing so, and Israel’s economy today is strong enough to let it finance itself without debt. It would have been enough if the most recent decision to reduce taxes had not passed and taxes remained unchanged. That would have let the government finance the entire spending increase without increasing the deficit.

Remember that the Finance Ministry forecasts that already in 2019 we will be missing about 12 billion shekels in tax revenue. In other words, chances are that in 2019 we will have to raise taxes, so what’s the point of giving the business sector a runaround by reducing taxes now when we know we’ll have to increase them two years from now? Wouldn’t the business sector prefer a stable corporate tax of 25% to one that declines for two years before increasing?

Fourth, and most important of all, financing the spending increase via a deficit is the easiest decision to make. The current generation celebrates with a generous budget, and the generosity is paid for by our children – who will inherit the debts.

Therefore, increasing the deficit in order to finance growing spending is an unethical decision – the fathers celebrate, the children pay. It doesn’t bode well; the temptation to behave irresponsibly and increase the budget recklessly is great.

The Israeli experience teaches that it’s very easy for us to stumble into this trap. The checks and balances of economic responsibility don’t work properly here.

The proof is that in the current biannual budget we have coarsely trampled all the targets we set for ourselves. Both the spending and deficit targets have been breached without the government even bothering to discuss the transgressions, whether there’s a need for new targets, or what the consequences of the transgressions are.

Flug was the only one in the cabinet room who spoke about the cost of breaching the targets, and had it not been for her clear warning, it’s doubtful whether even the prime minister would have understood where our budgetary irresponsibility might lead us.

Flug, we should recall, doesn’t oppose the spending increases. The lesson she tried to teach the cabinet was a very simple one: You want to celebrate? Fine, just pay for it. Anyone who wants a more generous budget should pay for it with his tax money, not postpone payment until the next generation.

No, money doesn’t grow on trees, so anyone who today is enjoying the fruits of the money should be the one paying for it. That way, the cost of the decision to increase the budget will be transparent and clear, and the budget increase will be rational, responsible and wise. Otherwise, we’ll be walking down a destructive and unethical path.

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