What a Difference a Year Makes

The moment the public suspects that Netanyahu will not cut the 2004 budget as required, or that he will surrender to the dictates of the Electric Corp., the Ports Authority, or the banks, things will start to regress. As a result, all the achievements of the recent period will quickly go up in smoke.

It is now clear that the budget deficit this year will stand at 5-to-6 percent of the gross domestic product (GDP), which translates into the vast sum of between NIS 25 billion and NIS 30 billion. Not only is this deficit too large, but also it is larger than the one last year. The former finance minister, Silvan Shalom, ended 2002, which was a difficult year in terms of the budget, with a 4-percent deficit. An increase in the deficit is a negative indicator of lack of control, growth of debt, a rise in the interest rate, a rush to the dollar, sharp devaluation, price hikes, and the intensification of the recession and of unemployment.

If so, why is this very negative scenario not being played out now? Why is the public continuing to sell dollars, causing a 12-percent revaluation of the shekel in half a year? Why is the public purchasing bonds and bringing about a significant long-term fall in the yield? Why is the public buying stocks and thus causing the value of public companies to rise, despite the new tax that was levied on the bourse this year?

The macro-economic mystery only deepens when we recall what happened in the first half of 2002 - when it became clear that the deficit would reach a level of 5-to-6 percent (the same as now). The public reaction was panic. People moved to the dollar and brought about a rapid devaluation that resulted in a steep rise in prices. People sold bonds indiscriminately, driving up yields to a peak of 12 percent (long-term, non-linked) and 6 percent (long-term, linked). The public, apprehensive that the deficit would lurch out of control and not believing that the government would be able to meet the huge debt repayments, threw the bonds and stock shares it held into the market and bought dollars at any terms and at any price, also sending billions abroad, because in a financial crisis, banks can topple, too, and savings are thus in danger.

The 2002 crisis was halted in a late-night meeting on June 13 between the prime minister, Ariel Sharon, Shalom, and the governor of the Bank of Israel, David Klein. They decided on another cut in the budget and on a sharp increase in the interest rate. The current deficit very much resembles the one a year ago, Finance Minister Benjamin Netanyahu doesn't intend to reduce it - so why is the public's economic behavior the opposite of what it was last year?

There are three main differences between then and now. The first, and most important, is the trust the public has in the country's economic leadership. The public believes that Netanyahu will not allow the economy to spin out of control. True, he will not trim the deficit this year (although he should), but he will trim the 2004 deficit to force it down to 3 percent (as the U.S. administration has been promised), and this will involve an additional cut of NIS 10 billion, which is not going to be easy. Similarly, statements made by Netanyahu about a shift from a centralized to a decentralized economy, about reducing the power of the monopolies (the Israel Electric Corp., Bezeq Telecommunications, the Mekorot water company, the Ports Authority), about the reform in the pension funds, and about a transition from a culture of allowances to a culture of work have earned an impressive vote of confidence from the public, which knows deep down that this is the correct economic road for a country that wants to improve its living standard, be competitive in the global economy, and enhance equality and justice among its citizens.

Another difference between then and now is that at the beginning of 2002, the Bank of Israel's interest rate was too low. It was reduced to 3.8 percent in one fell swoop and generated non-confidence in the markets, since it was inappropriate for the state of the economy. The moment the interest gaps between the shekel and the dollar were reduced and the budgetary danger grew, the public began to rush to the dollar and the crisis was fomented.

The third difference is that the American loan guarantees today serve as a safety net for any trouble that may loom.

Still, the decisive variable is the public's trust and confidence, because what determines economic behavior in the present is not the present state of affairs but the public's expectations about the future: the policy the government will pursue and the overall economic situation. The first scientific description of this behavior was formulated by Prof. Robert Lucas, from the University of Chicago. He termed it the "theory of rational expectations" and received the Nobel Prize in Economics for his work in this field in 1995.

What it boils down to, then, is that all the relative stability that characterizes Israel today, all the signs of growth that are discernible in the economy, depend on the realization of the expectations that Netanyahu has generated about the future. Of course, the future development of the Israeli-Palestinian cease-fire will also play a central role in this regard. However, we should bear in mind that expectations have an unstable character. The moment the public suspects that Netanyahu will not cut the 2004 budget as required, or that he will surrender to the dictates of the Electric Corp., the Ports Authority, or the banks and will not carry out the necessary reforms, things will start to regress. As a result, all the achievements of the recent period will quickly go up in smoke, and the economy will revert instantly to the crisis that wracked it a year ago.