All That Glitters / The Myth of Israel’s Iron Budgetary Discipline

Our experiment with two-year state budgets could come to an ignominious end as government spending rages unchecked. Comparisons with Athens, anyone?

The endless reports and commentaries on Greece’s epic economic meltdown all lead to one conclusion: that it was caused by a complete and utter lack of budgetary management.

The trade unions representing the public sector forced the politicians to hire more and more people, further inflating an already bloated workforce and adding to the burden of paying out wages, pensions and benefits. Big business forced the politicians to protect local industries and services, which became fossilized in the absence of competition. And everyone squeezed the politicians for tax benefits, obtained legally or by turning a blind eye.

Greek riot - Bloomberg - 22022012

The stories from Greece would be funny if they did not end in soaring unemployment and poverty and the country’s collapse.

How bad is it? Well, one big Greek hospital has dozens of gardeners on the payroll − and nothing to garden. Civilian pilots retire before they turn 50, and the private sector has shed half a million jobs since the crisis began, in 2008. Unemployment exceeds 20% but not a single public-sector employee has lost their job.

You need a special permit to operate a truck in Greece, but the government hasn’t issued any since 1970. The economy has tripled in size during that period, sending the prices of overland transport into the stratosphere: It’s cheaper to move an office, by truck, from Belgium to Greece than it is to move it within Athens.

On the same subject, a truck that takes goods from Athens to Thessaloniki is prohibited from taking a return load. And while we’re on protectionism, consider this: Until recently cruise ships were banned from docking at Greek ports unless a majority of the crew was Greek, a practice that cost the Greek tourism industry significant lost revenue.

Does reading this make you queasy? You’ll pay through the nose for a nausea remedy at a Greek drugstore, thanks to a government regulation that guarantees pharmacists a 35% profit on all drugs they sell. In addition to helping to jack up the cost of living, the provision also created an incentive for doctors to prescribe as many drugs as possible. As a result, Greeks use more drugs than any other European country.

Do you want to buy a vacation home on a Greek island resort? You can’t, unless you’re prepared to lease it out. Would you rather build a home instead? Fine, but only if it’s next to a big hotel.

The deficit dance

But nothing like this ever happened in Israel, you say, and it never will, right? Prime Minister Benjamin Netanyahu, Finance Minister Yuval Steinitz and Bank of Israel Governor Stanley Fischer keep telling us that we have superb budgetary discipline, a veritable light unto the nations and source of national pride.

In fact, budgetary discipline is the Netanyahu government’s most important accomplishment. Netanyahu’s repertoire does not include peace, or peace talks; last summer’s social protests were a public report card on his performance on social issues. And the promised major structural reforms have not been made, except on marginal issues such as royalties on natural gas.

What do we have, then? Fiscal discipline. Or do we?

The historical data do not lie. Israel had kept its budget deficit at reasonable levels compared to major Western nations such as France and the United States. But it has been mushrooming for months. The deficit is not supposed to exceed 2% of gross domestic product this year, but the Finance Ministry itself projects a deficit of 3.4%.

How did this happen? A Bank of Israel report issued last week indicates that the Defense Ministry asked for, and received, more money. Labor strikes resulted in public-sector wage hikes. The minimum wage was raised. Then there were the recommendations of the cost-of-living committee headed by adviser Manuel Trajtenberg. Combined, these additional allocations dug a hole in the state budget of more than NIS 6 billion. In its report the central bank urged the government to cut spending or at least to note, after serious consideration, where cuts could be made if needed.

Yet interestingly, and worryingly, despite the evidence the Finance Ministry won’t admit its budget ceiling is being breached. Nor has the Bank of Israel called its bluff.

Why? According to the central bank, in order not to discredit Israeli economic policy. Or in other words, in order not to ruin the precious myth of Israel’s budgetary discipline carefully cultivated over years.

Israeli bonds, not exactly safe haven

Netanyahu, Fischer and Steinitz know what they’re doing. They are well aware that Israel’s economic image is crucial, locally and internationally. They know bond investors could hit swiftly and hard, depressing Israeli bond prices and driving up yields, if they decide Israel’s deficit is growing quickly. We aren’t the United States or Germany, whose bonds people buy for safe shelter, pretty much ignoring the returns. One can understand why Netanyahu and Fischer prefer to deliver a message of budgetary responsibility.

Even if the facts are accurate a central banker would never say something like, “Truth be told, the economy isn’t in great shape. There’s this one bank where your money might not be safe.” Nor would a prime minister be caught dead saying, “Budget shmudget, the only thing I care about is keeping my coalition from falling apart. I do anything that would annoy those lunatics in the party center or the Haredim and I can’t do a thing about the big unions. I can’t even touch the interests of this tycoon guy because he owns a big newspaper. I certainly can’t in an election year.”

They can’t say that: They have to deliver reassuring messages of stability, calm and safety. But the reality is otherwise. In reality, the government of Israel began the fiscal year 2012 knowingly breaking a number of laws it enacted itself, which were approved in the Knesset. ‏(The national budget is enacted through law each year; under Netanyahu the budget law has spanned two years, but law it is and the deficit stated in the budget is therefore also law.‏) It is therefore law that the government deficit may not exceed 2% of GDP in 2012. There are other laws requiring the government to make adjustments the second its deficit starts to deviate from the path of righteousness.

What adjustments? The government could cut its budget. Or raise taxes to increase its income, restoring the deficit to the right path. But the government hasn’t done either of those things. Another option is for the ministries to “underperform their budgets,” which is red-tape-speak for “spend less than budgeted this year”. But that is difficult to achieve. The sums involved are simply too great.

But this behavior has implications. First, developments show the downside of planning budgets for two years rather than one: Circumstances change. None of this would have happened had the 2012 budget been planned at the end of 2011, which is the normal timeline of events. It could well be that for all its advantages the two-year budget experiment, which had been Steinitz’s darling, is over.

Second, running a budget in violation of the law and with no ceiling or other constraints is a slippery, dangerous slope. A general election is likely this year − an awkward time to enforce budgetary discipline. Also, tax revenues are likely to fall short of forecasts because of the global economic troubles and the ensuing decline in exports.

Now we’re starting to smell a whiff of Greece. The base level and angle of the trend are very different. But Greece’s latest odyssey started with an unchecked upward spiral of the deficit as the government spent and spent and spent ‏(expenditure‏), while tax collection remained weak ‏(income‏). And they can spin like dervishes but Israel’s economic leaders won’t be able to hide the truth over time.

From this point, two scenarios come to mind. The first is that the government slashes its spending or raises taxes, or both, getting the deficit back on track. The other is that the bond market will start to sense that the Israeli government’s iron budget discipline is rusting and investors will dump Israeli bonds, sending their prices spiraling down and their yields spiraling up.