Taking Stock / Ignoring Keynes

Growth is back. Conservative forecasters like the IMF are talking about 2.5 percent. The optimists are whispering, off the record, that even 4 percent isn't out of the question.

Whatever the figure, the direction is clear: 2004 will be the first year in which Israel's economy will have expanded after three years of retreat.

Even more encouraging, growth is being driven by the business sector. Its product is expected to expand by 5 percent to 7 percent this year, after inching up by 1.8 percent in 2003, and contracting by 2.8 percent in 2002. And what's going to shrink this year? Government spending, of course. Last year public expenditure fell for the first time in 20 years and this year it's supposed to contract by another 0.5 percent. The fat man - Netanyahu's euphemism for the public sector - is still fat, but he's on a diet, and the thin man (the business sector) is already feeling its burden lighten a bit.

Which is a good opportunity to recall all those Keynesian economists, industrialists, and politicians who propounded a year or two ago that to end the recession, the government had to increase its expenditure.

What's that you said?

When Benjamin Netanyahu accepted the job as finance minister at the start of 2003, he was immediately treated to a lecture from the Keynesians, mainly the CEO of a certain bank who saw himself as a master of macroeconomic policy: go forth young finance minister and increase public spending! Pour money into infrastructures, infuse money into the economy, smash the vicious circle, only more and more government stimuli can halt the deterioration.

They were merely repeating the tenets of John Maynard Keynes, the most influential economist in the world, who lived at the start of the last century. He advised president Franklin Roosevelt to help end the Great Depression of the 1930s by substantially increasing government spending.

Roosevelt ignored him, but the massive military expenditure on World War II did the job for them both, extracting the American economy from recession while giving great PR to Keynesian dogma.

The pattern repeated itself a year ago. President George Bush managed to jumpstart the American economy in 2003 and in 2004 by stepping up government spending by tens of billions of dollars, partly to finance the war in Iraq, while expanding the U.S. federal deficit to nearly half a trillion dollars.

Happily for Netanyahu, he was surrounded by people who knew Israel isn't the U.S., and that since Keynes wrote his famous treatise "The Economic Consequences of the Peace," referring to the Versailles treaty, 75 years have passed and the times have changed.

Here isn't there

Keynesian theory is irrelevant to Israel because here, government expenditure and debt relative to GDP are elephantine. Expenditure runs about double that of America's, proportional to GDP, and the proportion of debt runs three times higher.

Not only do increasing the expenditure and deficit threaten Israel's financial stability, but the Israeli government's credibility about fiscal matters is rickety. When the government steps up spending, allowing the deficit to balloon, the result is that investors and consumers do the opposite; they spend less and invest less, knowing there's no such thing as a free lunch. Higher spending and deficit are usually accompanied by rising interest rates, which also strangles economic activity.

Happily, Netanyahu ignored the advise of the Keynesians, and slashed government expenditure in the biggest cut since the great stabilization plan.

Wonder of wonders, Keynesian theory works! Thing is, it works backwards. Government spending has been decreasing for two years straight and the business sector is growing again, investments are resuming, and even consumers have started to step up spending.

You could attribute the trend to the resumption of global economic growth, to the U.S. loan guarantees, to the drop in the regional risk factor. But that would be only part of the story.

The full story is that the drop in government expenditure restored credibility to its economic policy. It improved the mood in the business sector, and freed up resources, too.

The big question now is what to do with this non-Keynesian growth - rush and exploit it to increase spending? Bend to political pleas? Slash taxes even more? Or take the long-term view and use it to adopt lower deficit targets, and to reduce government debt?

The question becomes all the more acute as the treasury officials gird their loins to begin the debate on the 2005 budget. They will have to further cut the budget to reduce the deficit, a difficult task given the optimism the finance minister has been radiating.

When proponents of the free market told Keynes that the market should be left to its own devices, that intervention was bad, he shrugged, "In the long run we are all dead." Quite. Over here, before we curl up and die, we have to worry that not only is nobody thinking for the long run; we also have a finance minister who, in the short run, wants to be prime minister.