In late June 2002, Israel’s bond market started to collapse. Government bonds lost 7% of their value within a month, and Israel’s 10-year government Shahar bonds were trading at a high yield to maturity of 12.5% − a sign that investors believed the government was increasingly fiscally unstable.
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That was the highest return ever for shekel-denominated government bonds, and capital market animals had no doubt as to what it meant: Israeli investors were voting with their feet against their government. They thought the government was on its way to bankruptcy, and sent its bonds into junk bond territory.
In retrospect, the few investors who dared buy bonds at that time made the deal of their lives. At that critical point, when Israel was on the way to losing the markets’ faith and sliding into financial collapse, the government came to its senses and got the economy under control. The plan worked and Israel’s bonds recovered. Nowadays, those same bonds are trading at reasonable returns of 3.6%.
What steps did the government take at the time? It mainly showed that it was serious about addressing serious problems − the massive government deficit and economic collapse. It started slicing aggressively in order to balance its budget − child stipends, income guarantees, unemployment pay, stipends for the elderly and grants to poorer municipalities.
All these budgetary items − which help the poor, of all people − got hacked. The government sliced more than NIS 6 billion from the National Insurance budget in 2002 and 2003, and along with the cut in assistance to poorer locales, the result was a sharp increase in the poverty rate.
There’s no question that the 2003 budget was one of the cruelest, most regressive budgets in Israel’s history. It was also one of the country’s most important, since it achieved two critical goals: First off, it stabilized Israel’s financial situation and pushed off a financial crisis, and second, it sowed the seeds for improving how the country functions via structural changes such as increasing competition, removing barriers to business and pension reforms, among others.
In retrospect we know how to judge that budget − it launched Israel into five years of growth, which let us get through the global financial crisis of 2008 with minimal damages. Poverty rates and inequality increased significantly due to that budget, but the workforce participation rate of poorer people also increased. The latter process led to shrinking social gaps over the past few years.
The lesson of the 2003 budget is that it’s worth accepting tough cutbacks if they offer hope for the future. Cutbacks that stabilize Israel financially, alongside structural changes that help address problems stymieing the country’s growth, are what make an economic plan daring and important.
Can this be said about the 2013-2014 budget? Yes and no. The budget definitely contains cutbacks, although not to the same degree as the 2003 budget. The cutbacks are harsh but critical, since they will push Israel away from crisis. The real concern is that if Israel doesn’t get its deficit under control in 2014, the June 2002 scenario could reoccur.
That said, some of the cutbacks are indeed disappointing. Finance Minister Yair Lapid’s surprising decision not to cancel the VAT exemption on fruits and vegetables, or to cut back even slightly the exemptions on continuing education funds (kranot hishtalmut), cost the public as a whole higher VAT, higher income tax and higher real estate purchase taxes. This is another instance of the majority paying for a strong minority, namely the Histadrut Labor Federation.
As for structural changes that herald hope for the future, the budget has a few of these. At least one section resembles the 2003 budget in terms of its content and force: The section that deals harshly with the ultra-Orthodox, in the hope that this will force more members of this community to join the workforce. This is a tough section, but it also contains hope: Without a core curriculum in their schools and without a significant portion of the community working, the ultra-Orthodox are currently on a path to destruction. Israel has to change this, and there’s no way of doing so without forcing the Haredim to study core subjects and work (while giving them all the assistance it can on the way). If the 2013 budget does indeed succeed in changing ultra-Orthodox society, then we’ve launched a revolution in Israel’s future growth.
Several other structural changes also give hope: The recommendations to increase competition in several fields and to cut back bureaucracy. We also need to remember that continuing to increase the budgets for transportation, education and employment also boosts growth. No, that’s not a mistake − the new budget actually allocates more for these items.
That said, the 2013 budget does not offer hope for one of the toughest tripping blocks − government inefficiency. Not only does it not include reforms for public sector labor relations, the ports or the power utilities, it raises serious concerns about potential future reforms. Histadrut chairman Ofer Eini completely manipulated Lapid in their negotiations on public sector salary cuts. Eini’s contribution to the cuts was miserly − a 1% public sector pay cut. Everything closer to Eini − pensions, continuing education fund tax exemptions − were left untouched. This doesn’t bode well for Lapid’s ability to get Eini to agree to make concessions when it comes to public sector reforms.
But we should note that at least two strong pressure groups took hits − members of the Mossad and the Shin Bet security service, some of whose pensions will be cut; and the upper decile, which took a major hit to its pension savings. On the other hand, the haves in the public sector, including port workers and Israel Electric Corporation employees, managed to scare Lapid into leaving them alone. Addressing these latter groups will be Lapid’s real test.