Yitzhak Klein

As the new Minister of Finance Yair Lapid just began to design his policy, the Bank of Israel handed in its annual report for 2012, a report that holds an important lesson. Quietly, without fanfare, and without an explicit admission, The Bank of Israel rescinded everything said in the past few years regarding macro-economic policy – by the Bank as well as others.

Some background: the Israeli economy contracted between the years 2000 – 2003. In 2003, then-Finance Minister Benjamin Netanyahu carried out a policy of sharp cuts to the budget. The result was unequivocal: an almost immediate return to rapid growth. For the next five years, the Ministry of Finance maintained a policy that limited the rate of increasing the State budget (funded by citizens’ money) to half the growth rate of the economy. The result was a reduction of state expenses relative to GDP, paving the way for annual tax cuts. This policy maintained Israel’s economic growth and facilitated a steady expansion of employment. When the global financial crisis erupted and other Western countries entered a deep and prolonged recession, the Israeli economy hiccupped slightly for one year and then charged ahead.

Change of Direction

Such was the situation until two years ago. In 2011, the wise men of the economy decided that what had worked for eight years was no longer good enough. Even before the social protests broke out that summer, claims that Israel wasn’t spending enough on social services had already been raised. Such was also the conclusion of the Trachtenberg Committee, which noted with concern that public spending in Israel had fallen below the OECD average (apparently we’re only allowed to pull the average up, not down). Following the report, I had a conversation with a colleague from the Bank of Israel’s research department: “The entire world is in a crisis of excess spending that proved disastrous for their economies,” I noted. “We’re the only ones who escaped unscathed, we’re the only ones who are stable and continue to grow. Is now really the time to expand public spending and raise taxes?” My interlocuter’s face broke into a compassionate smile. “Read the Bank of Israel’s latest report [for 2011],” he recommended.

Like my friend, many were enamored by the Bank of Israel’s new economic policy. Even Prime Minister Netanyahu, who led the 2003 policy that returned the economy to growth became Mr. I-have-plenty. Following the Trachtenberg recommendations, his government adopted a new and expensive benefits program for the middle class.

Then 2012 hit. The European economic crisis deepened, growth in Israel dropped by 45%(!) compared to 2010, and tax revenue forecasts missed their target by 18 billion shekels. Despite an emergency mid-year tax hike, the state budget deficit doubled to nearly 40 billion shekels, with more to come in the current year. Israel, unfortunately, is on a fast track to becoming a European country.

Back to the Old Policy

The Bank of Israel took note. Its new 2012 report gravely discusses the need to reduce public spending. That’s all very well and good, but the time for such thinking was two years ago, before the government confirmed far reaching benefits for the middle class. Here is a gem from the current report (chapter 1, page 19):
“In light of the slowdown in growth, it appears that the desired solution lies in a multi-year plan to reduce the deficit, which would include a detailed and legislated set of measures to achieve the target, similar to the plans adopted in 1985 and 2003”.

So there you have it – an explicit recommendation to return to Netanyahu’s 2003 policy.

Still, there is obviously no way to discuss a return to a budget-cuts policy without addressing the subject it immediately raises – taking care of the poor.

“Fischer to Lapid:”, a headline in one of the daily newspapers blasted, “We Must also Care for the Poor”. How do we do that? The newspaper wrote only those words, but the Bank’s latest annual report dedicated an entire chapter to answering the question.

The cut to welfare benefits carried out by Netanyahu in 2003 incentivized tens of thousands to enter the workforce, especially in sectors with low employment rates, such as Arab women and ultra-Orthodox men. This cut was an essential part of the broad reduction in the state budget, which restored the economy’s growth and ensured that jobs would be created to absorb all the new workers.

The Bank of Israel’s 2010 report noted that from 2003 to 2008, the inequality index made a U-turn: while social disparities did indeed widen dramatically following the 2003 benefit cuts, this held true only in the immediate term. Gradually, till 2008 the income lost by the poor population (whose benefits had been cut) was replaced by income from work. The Bank projected that if the upward trend in employment continued, the poverty problem would resolve itself, since the strongest weapon against poverty is work.

Contrary to the 2011 report, the current report learned the lesson and seeks to return to a policy of reduced budgets and incentivizing work. As is well known, low education levels and the lack of experience among populations not previously accustomed to the world of labor means lower wages that don’t always lift the family above the official poverty line. The Bank proposes three solutions for this. The first is raising the minimum wage, which can make the entry to the workforce more worthwhile (free-market economists object to this measure on other grounds). The second is a “negative income tax,” through which the government rewards grants to those who go out to work for low wages. Unlike traditional benefits and income supplements, this grant is paid to those who work rather than to those who sit idle, thus increasing the incentive to work. It also costs much less than a regular welfare policy. The Bank notes that the negative income tax program was expanded to cover all low earners in 2011, but it’s too early to assess its impact. The third way to increase new workers’ income is to provide them with vocational training.

It appears then, that “taking care of the poor” requires three policy directions:
Government reward for work and an absence of reward for unemployment;
Vocational training for workers with low earning capacity;
Restrained budgetary policy, which encourages long-term growth and thereby creates jobs for new workers.

The common denominator of these three proposals is the insight that the solution to poverty lies in an economic environment and government policy that encourage work, not in an enervating policy of charity.

(Picture Credit: Ori Farkash)