Lapid’s Free Lunch Is No Bargain

There's a high price to pay for exceeding the 8.5 billion shekel ceiling of the 2015 budget deficit.

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Finance Minister Yair Lapid as the treasury presented its 2015 draft budget, September 28, 2014.Credit: Emil Salman

No one talks about it, but the government’s 2015 budget deficit is set to exceed the 8.5 billion shekel ceiling, because that is what Finance Minister Yair Lapid wants.

Here is a mathematical puzzle: Government regulations limit the growth in spending for 2015 to 8.5 billion shekels ($2.3 billion) more than the 2014 budget. The draft budget includes a 2.5 billion shekel increase in defense spending, with another 6 billion shekels added to ministry budgets, particularly health, education and social services — but Lapid and Prime Minister Benjamin Netanyahu agreed a week ago that the defense budget alone would grow by about 6 billion shekels.

They also agreed that this additional defense spending would not be paid for by cutting the budgets of other ministries. So how can all this come in under the 8.5 billion shekel limit?

The answer is simple: It can’t.

The reality is that the 2015 spending ceiling has been exceeded by about 3.5 billion shekels, which is the difference between the planned increase in defense spending (2.5 billion shekels) and the true increase (6 billion shekels at least — and Defense Minister Moshe Ya’alon is demanding much more).

The original deficit ceiling for 2015 was 2.5% of Israel’s gross domestic product. As a result of the economic slowdown and the effects of Operation Protective Edge in Gaza this summer, there was general agreement that it was possible to raise this a bit, to 3%. That, at least, was what the economists of the Bank of Israel and the economists in the Finance Ministry thought.

It was only the non-economist who occupies the finance minister’s seat who decided that the right move would be to raise that ceiling to 3.4%.

The only reason no one is talking about it this way is that the treasury plans on pulling one of its well-known accounting tricks out of its hat, treating the excess spending as a one-time occurrence paid for with funds that exist in a black box somewhere outside the realm of the budget deficit.

The last time the treasury used the black-box trick was in 2006, after the Second Lebanon War. Then, too, the government exceeded the deficit ceiling because of the increase in defense spending, which was designated as a one-time, exceptional event.

In 2006 it worked out all right, because both the Israeli and international financial markets were enjoying high levels of growth. We were able to fund the black box without paying the price of an increased deficit. But today world markets are treading water, the Israeli economy is in the midst of a slowdown, and in any case, the black box is nothing more than a marketing trick.

The black box is a way to fool ourselves (and, we hope, the international ratings agencies), to hide from ourselves the fact that we have increased the deficit. It will be tough to foil the ratings agencies, since they are not as dumb as we tend to think, but what with the wonderful marketing skills of our finance minister, this trick might just work on the Israeli public. Israel is fooling itself.

One popular economist

Here’s another puzzle, this time a logic puzzle. John Maynard Keynes, the greatest economist of the 20th century and the father of modern economics, led a fiscal revolution during the Great Depression. He taught the U.S. government, and ultimately the rest of the world, that the worldwide depression justified greatly increasing government spending, even at the price of creating large deficits, with the goal of stimulating the fading economy.

Since then, Keynes has become the most popular economist among politicians all over the world. Thus the present political leadership in Israel, starting with the Finance Ministry and cabinet ministers from Lapid’s Yesh Atid party, have become unduly fond of quoting Keynes. After all, Keynes said it was okay to create deficits when there was an economic slowdown, didn’t he?

Without being an economist, here is a puzzle anyone can solve: Does it seem logical to you that a saying such as, “It’s okay to create deficits, continuing spending money freely,” was what turned Keynes into the greatest economist of all time?

You don’t need to be an economist to understand that this is far too facile a stance and couldn’t possibly be what Keynes said. In fact, Keynes approved wider budget deficits only in the extreme cases of an non-functioning economy. In a very severe recession, when there was no choice but to revive it by using government spending, ignoring the price to be paid for it in the form of accumulating deficits was the only solution.

Keynes did not mean — and never said — that budget deficits are the most efficient medicine for dealing with economies in normal situations. It never would have occurred to him to say such a foolish thing.

Just as no sane doctor would recommend that a basically healthy, cancer-free person should undergo chemotherapy, no sane economist would recommend creating large deficits in a basically healthy economy. And the Israeli economy is a basically healthy one. It has suffered only a mild slowdown, with a growth forecast of 2.8% for 2015 — quite good compared with most developed countries.

The problem is that people without any economic education, who don’t understand what Keynes said at all, are quoting him incorrectly. This problem becomes a serious failure when those lacking any education in economics are also the ones making the decisions.

A steep price

Here is the third and last puzzle, a cultural one: Why is it so hard for the average Israeli to understand there are no free lunches?

The answer: The non-economist who heads the Finance Ministry is convinced that a deficit of 3.4% is legitimate for a growing economy. As a polished politician, he knows he will not pay any political price at all for exceeding the deficit ceiling. Instead, the average Israeli seems to be thankful for this socially conscious finance minister who personally blocked any tax increases or spending cuts.

Average Israelis, in other words, do not think there is much of a price for raising the deficit too high. Average Israelis are convinced this can be done without paying any price at all; they believe in free lunches.

But that’s the problem: There is no such thing.

There is a steep price, maybe even an unbearably steep one, for blocking both tax increases and spending cuts. In the best case, both will lead to an increase in Israel’s risk premium — in other words, to higher spending on interest costs on the national debt.

Remember that Israel still devotes more than 13% of the budget to paying interest on its debt, making it one of the largest items in the budget. Since the country is viewed around the world as a risky place, the rate of interest Israel pays is one of the highest in the world, but the responsible fiscal behavior the government has demonstrated over the past decade has saved us considerable interest costs. Spending was able to grow by about 10 billion shekels a year because of that responsible fiscal policy.

Wrongheaded idea

It is wrongheaded to think it is acceptable to increase the deficit as a way of avoiding cutting spending or raising taxes, to think that in doing so we are supporting economic growth. It may be okay to run up debts to fund investment, but only in reasonable amounts. Otherwise, every small business could take out millions of shekels in loans on the grounds that the money is being invested.

Moreover, the money in this case is not even being used for investment at all, but for defense and tax breaks for first-time home buyers, so there is not even any hope the money will be returned in the form of future economic growth.

In the worst case, increasing the deficit could bring Israel to the brink of a financial crisis, as almost happened in 2002 during the second intifada. It is worth remembering the price we paid for that near-crisis, which forced cutbacks of billions of shekels in government spending, including child allowances, schools, higher education and local authorities. The government deepened the poverty of its citizens, sent its academic institutions downhill and almost destroyed the poorer municipalities — it did just about anything to stabilize its fiscal situation.

That was a terrifying cut into living flesh, and that is the price we may very well have to pay if we continue to think there is such a thing as a free lunch.

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