The Novice, the Tribal Elder and the Deficit Target

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Finance Minister Yair Lapid, still wet behind the ears, was taught a stinging lesson this week by a great tribal elder - Bank of Israel Governor Stanley Fischer.

Lapid came to a meeting with Fischer on Sunday, hoping to enlist his support in raising the deficit target for 2014 (and in its wake, for 2013 as well).

If Lapid thought he'd charm Fischer into helping him, he was wrong. Fischer, let us recall, thought from the outset that the deficit target set for 2014, 2.7%, was already too high, so he had no intention of supporting an additional increase, certainly not two months before he completes his tenure. What experienced central banker would risk allowing such a thing just before he retires, knowing he won't be around to fix the resultant damage?

So Fischer said no.

More precisely, Fischer said the deficit target is within the authority of the finance minister, not the governor of the Bank of Israel, but he does not believe the deficit should be more than 3%.

Lapid may be a fledgling finance minister but he's been around long enough to know one doesn't disagree with the tribal elder. Certainly not after said elder berated the previous finance minister and prime minister when they decided, six months ago, to increase the deficit target for 2014.

Still, it’s not fun to be a new, young finance minister and get a public earful from the governor of the Bank of Israel right off the bat.

At this point, Lapid has made the sensible decision to adopt Fischer’s recommendation – that is, he has had to fold publicly (as reported in the media) and widen the deficit target to a range of 3.25% to 3.5%.  Adding insult to injury, to stay within the deficit target of 3%, he will have to raise taxes.

Where will the new taxes come from? The list of possibilities is long but most of it is problematic and brings with it the dangers of too sharp a tax increase in too short a time.

Even within the Finance Ministry there are differences of opinion as to what the new taxes should be; there are also those who say the damage caused by new taxes is greater than the benefit of decreasing the deficit. This suggests that there are those at the Treasurywho believe it would have been possible to concede a bit on the deficit target.

To put it more bluntly – even at the Finance Ministry some people think Lapid was right and it was Fischer who erred in the meeting between them.

These same voices at the Finance Ministry, incidentally, also aren't sure the disagreement on the deficit target was decided once and for all at that meeting. They think that when the politicians have to deal with the consequences of lowering the deficit to 3% -- i.e. that problematic list of tax hikes – it isn’t at all certain that Fischer’s voice, in the twilight of his time in office, is the one that will prevail.

These are isolated voices, of course. The majority at the Treasury believes it's necessary to rein in the deficit and that the damage to growth as a result of the interest payments on the debt would be just as dangerous as that caused by increasing taxes.

“Three percent is a symbolic limit," says a top Treasury official, hinting at a danger to financial stability after three consecutive years in which Israel has deviated from its budget deficit target, even though it's not in the midst of an economic crisis. "We mustn’t cross that line because psychologically it could be perceived as bad by the markets.”

This disagreement, apparently, has influenced the novice finance minister and his frequent changes of mind. At the moment, the tribal elder has decided for him but it's uncertain if this will be enough for Lapid to clear the hurdles of the government and the Knesset. That is where his real test of fire will be.

Former Bank of Israel Governor Stanley Fischer, now vice chairman of U.S. Federal Reserve.Credit: Daniel Bar-On

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