Israel the Fish

For months David Brodet listened, learned and delved, as he chaired the panel looking into the defense budget.

The profile of the Israeli army that Brodet sketched is little surprise: wasteful, ungainly, living blithely in a bubble detached from the stark economy realities, ignoring the economic price of its moves. As Brodet wrote - obtuse.

But now the plot takes a twist. After having analyzed the director-general, in an interview with TheMarker last week, Brodet declared that it was time for strategic change in Israel's economic policy. Public spending should be increased, because "our problem is not at the macroeconomic level any more, but at the level of public services".

Is that so. We think the Brodet commission's report on the defense budget is one of the greatest macroeconomic misses in years.

And the beat staggers on

Ostensibly, the Brodet report has all the elements. It pins down many of the biggest problems in the military system and suggests reforms in budget management, including formulation of long-term plans.

But the actual probability that any change will arise in Israeli general budget management because of the report, in resource allocation and priorities, is vanishingly small.

Note the report's discussion of the retirement age in the army. Ordinary Israeli men retire at 67 (women at 64). Career soldiers, whether they're paratroopers or tailors, retire at 46. Brodet et al urge that the retirement age be raised to 57.

Why 57? Why not 67? Didn't Brodet himself write that the army's pension terms are completely detached not only from the rest of Israel, but from its public sector too?

Since over the decades the army trained the entire public sector to see that the rules for taxpayers are one thing, and the rules for itself are something else completely - Brodet and his colleagues never did set their sights particularly high, and the new, low standards for efficiency that they set will be slashed and eroded over the years.

Brodet, formerly a director-general at the Finance Ministry, is joined by another ex-director-general, Aharon Fogel, who also believes that public spending should be hiked, to improve service to the public.

Brodet is right in that budgetary restraint is not a proper target in and of itself for the government. It is a means, not an end, a means to enable the quality of service to improve.

The question is the quality of service can be improved. By increasing budgets? Or through management and resource reallocation?

Brodet evidently assumes that the gigantic slabs of flab in the public sector, and the bad management, cannot be removed or repaired. So his answer is to increase spending. He bases his proposal on Israel's strong macroeconomic condition in the last couple of years, and seems to believe that it will continue ad infinitum.

But it won't. Israel's brisk economic growth in the last couple of years does not attest to any fundamental change in the structure of its economy. It is not based on strong pillars: it is mainly the result of the global economic boom.

Why Israeli stocks are soaring

Many economic pundits try to ascribe the boom in Israeli share prices, on the government's wise economic policy combined with achievements of leading businessmen. Yes yes yes, but look at the following figures. They show the performance of 36 leading stock markets in the last year:

Shenzhen (China) - 149%
Ljubljana (Slovenia) - 95%
Mexico - 80%
Manila (Philippines) - 73%
Sao Paolo (Brazil) - 66%
Jakarta (Indonesia) - 62%
Singapore - 51%
Warsaw (Poland) - 50%
Johannesburg (South Africa) - 49%
Frankfurt - 48%
Prague - 45%
Mumbai (India) - 44%
Budapest - 44%
Lisbon - 41%
Moscow - 40%
Oslo - 40%
Helsinki- 39%
Madrid - 38%
Athens - 38%
Stockholm - 38%
Seoul - 38%
Istanbul- 37%
Copenhagen - 35%
Zurich - 34%
Tel Aviv - 34%
Hong Kong - 33%
Brussels- 33%
Dublin - 32%
Taiwan - 30%
Amsterdam - 30%
Paris - 29%

Ladies and gentlemen, stock markets the world wide soared. (Thai stocks gained a mere 12% but then it went through a military coup.)

What will happen when the worldwide boom slows or ends? What will happen to Israeli tax collection?

We've seen the stocks. If we check how Israel's economy compares, we have trouble adopting Brodet's assertion that Israel's macroeconomic troubles are over.

If anything, we may find they have worsened. As the global economy booms like never before, the gap between Israel and the benchmark countries widens.

 Problems in the pond

Merrill Lynch analyst Haim Israel dished up an interesting viewpoint last week. While the Bank of Israel and Finance Ministry celebrate Israel being invited to discuss joining the OECD, Haim reminded them that joining that organization could trigger a tsunami-sized outflow of foreign money from Israeli stocks.

Why? Because right now Israel is classified among the emerging markets, which are markets that are evolving into developed ones. Much of the foreign money streaming into Israeli stocks originates with global investment funds allocating a proportion of their money to stocks in emerging markets. They also allocate a proportion of their money to stocks in developed markets.

Each country gets a proportion of the portfolio based on its weight in an index of emerging markets or developed markets.  (The most influential index of emerging markets is Morgan Stanley's.)

Anyway, Israel has higher weight in the emerging markets category than it can expect to have in the developed-nations category, says Haim Israel. As an emerging market it would get a greater proportion of these funds' money than as a developed nation.

Colloquially, Israel is a big fish in a small pond. When the pond turns into an ocean, it looks very small indeed.

Naturally, the problem is more complex. Even in the pond, Israel is not the biggest fish. The standard of living here is higher than in most other ponds, but Israel's GDP is growing much more slowly than that of the top fish.

One could argue about the reasons that reduced Israel to its sluggish economic performance in the last decade, and how to remedy the situation. But one thing is for sure. Israel is nowhere near solving its macroeconomic problems, and any attempt to abandon the methodical effort to reduce public spending could cost us dearly when the global trend changes direction.