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2010 Annual Assessment

Two international reports provide a suitable starting point for understanding the Israeli economy at this time: the annual report of the IMF and the report published by the OECD in preparation for Israel’s membership.7

Both reports note that Israel managed to negotiate the crisis quite well, relatively speaking, but that it suffers from structural problems it must deal with in the future. The problems that everyone has been talking about for years are income inequality, which is the highest among OECD members (at a rate similar to that of the United States); deficiencies in infrastructure and education; and the economy’s need to integrate groups that constitute a significant share of Israeli children – Arabs and ultra-Orthodox Jews. Less is said about governmental failures – the inability of the state to carry out tasks for reasons that will be detailed below. The basis of this failure is a lack of long-term thinking but also an inability to maintain systems such as the firefighting service, whose severe problems were exposed during the Carmel fire at the beginning of December, 2010. The inability of the state to carry out national tasks and prepare for emergencies is especially disturbing, considering the strategic threat of conventional missiles covering the entire area of the country. The economic-administrative issue advances, therefore, to the head of Israel’s strategic considerations, while hitherto it concerned only businessmen and professionals.

The growth rate in 2010 totaled 4.5%, with unemployment dropping to 6.6%, and additional jobs spread out over the entire economy. Unemployment is at an historic low. Since 1987, with an unemployment rate of 6.1%, the Israeli economy has always had higher rates of unemployment, except for 2008 when the rate returned once again to 6.1%.

These data point to a feeling of optimism. Employers do not raise the number of their employees if they do not believe that they can sell additional products. Investment in structures and equipment rose by 6.1%, and private consumption rose by 5.9%, a testimony of consumer trust in their own economic prospects. Rising above all of these is the sector that is leading growth in Israel – exports, which rose by 16.5%. However, the future looks less bright, as it is reasonable to assume that this expansion will not continue at the current pace. The CBS estimates that in 2010 exports rose by 6.7% and industrial exports by 11.2%. In contrast, in 2011 exports are predicted to rise by 4.3% and industrial exports by 5.5%. The expected result is a more moderate growth. Still, these data are excellent compared to 2009, which had an infinitesimal growth rate of 0.8% and a peak unemployment rate of 8.0%.8

In order to understand why the Israeli economy did not experience the powerful financial and economic crisis that engulfed the United States and Europe and how the current economic recovery is taking place in Israel – which is contrasted by the lackadaisical growth and high unemployment characterizing the American economy – one can utilize economic and statistical analyses that examined the question: what caused the variations in the magnitude of the crisis?

The inability of the state to prepare for emergencies is especially disturbing considering the strategic threat of conventional missiles covering the entire area of the country

Such data concerning differences were provided in the tables above, which show that Canada suffered less from the crisis, although it is the United States’ neighbor and largest trading partner. These analyses show that the increase in private credit explains the magnitude of the crisis. 9 And indeed, in Israel, private consumer credit did not expand. Analyses of the events point to the role of the banking system: where the damage to the banking system was smaller, so was the crisis. Therefore the basis for understanding the situation in Israel is the strength of the financial system: in Israel, banks did not go bankrupt and did not even experience difficulties requiring Bank of Israel intervention. There was no outbreak of inflation or rush to foreign currency, nor was there a significant drop in credit available to companies and households. Another explanation is that Israel’s main export market – the high-tech sector – recovered quickly from the crisis, and therefore the country did not suffer a problem in demand for its primary export component. Is the absence of a financial crisis a result of good fortune or good thinking? Apparently, a little bit of both. Several mistakes were made, but they were overcome with good fortune.

The continued growth in exports established the Shekel’s strength and made it easier to conduct a policy aimed at preserving stable prices

Paradoxically, and fortunately for Israel, the global crisis of 2002 hit Israel harder than the rest of the world. The crisis, a result of first the bursting of the high-tech bubble amplified later by the economic aftershocks from 9/11, was accompanied by the Second Intifada and therefore greatly damaged Israeli exports. It was preceded by a financial crisis in which the banks suffered losses, and faith in the system dropped. At the same time inflation began once again, due, among other things, to a one-time reduction in the interest rate, which caused a large devaluation of the Shekel and low public confidence in price stability. At the height of the crisis, the rate of exchange reached 5 NIS per dollar, and there was fear of a significant devaluation. The government could not borrow from the local market, as interest rates on government bonds had peaked. This crisis was averted by rapid action on the part of the Bank of Israel and the government, in the form of a raise in the interest rate and budget cuts. These actions restored confidence in the financial system.

The lessons from this crisis were that the Bank of Israel should be allowed to control the interest rate without interference, that the Ministry of Finance must have control of the deficit, and that it is necessary to reduce the ratio of debt to GDP, since the fear of government bankruptcy decreases when its debt is reduced. Another conclusion was that bank supervision must be tightened to ensure that they hold a larger share of equity capital in relation to the credit that they provide in order to be able to withstand future crises. All of these items were implemented and thus strengthened the foundations of the economy, which allowed it to withstand the economic earthquake that is the current crisis. The continued growth in exports established the Shekel’s strength and made it easier to conduct a policy aimed at preserving stable prices.
On the other hand, in the United States, again paradoxically, the problem was that the 2002 crisis was less severe and was quickly ameliorated by aggressively lowering the interest rate, a measure taken by then Federal Reserve Chairman, Alan Greenspan. The temporary success of this policy concealed the need to deal with the structural economic problems. Meanwhile, the savings problem was exacerbated when the Bush administration turned the budgetary surplus inherited from Clinton administration into a record deficit due to tax cuts and large expenditures on the wars in Iraq and Afghanistan.

The 2008-2009 corporate bonds market crisis

The routine reports regarding the Israeli economy and its resilience in the face of the crisis do not represent the complete financial picture. There was a severe problem in the capital market, although not in the banking system. Beginning from 2004, Israel experienced a financial reform outside the banking system which was tied to the propensity for deregulation but which almost resulted in a local financial crisis. The issue was credit provided by institutional bodies to business corporations, in the form of corporate bonds. A series of reforms conducted in the capital market and in long-term savings (the Bachar Reform was just one of them) brought forth a situation in which the institutional bodies – provident funds, pension funds, and insurance companies – searched for investment avenues for their clients. The banks were not interested in these monies, and the institutional bodies, for their part, were not overly interested in investing in the banks. The result was that Israeli corporations, both large and small, issued their own bonds – corporate bonds – which were snapped up like hotcakes without sufficient consideration of risk. Bonds issued by corporations owned by tycoons who invested in foreign real estate were traded with low interest, close to the rate of the banks and the cell-phone companies, despite their significantly higher risk. And indeed, when the crisis arrived, the risk became reality. The interest rate on real estate company-issued bonds, such as those of Africa-Israel, rose by several dozen percentage points, and finally there was a series of bankruptcies, most of which concluded in creditor arrangements.10

The Ministry of Finance supplied a limited safety net that helped to calm the corporations’ bonds market

The corporate bonds crisis brought about a complete halt in bond issues during the months of the crisis at the end of 2008 and the beginning of 2009, and there was concern that this market would collapse. The account holders in the provident funds, who lost dozens of percentage points off their investments, began to increase their withdrawal rate. Fortunately, the panic did not spread to most of the Israeli public, which understood that it would be preferable not to sell at the height of the crisis. In addition, the Ministry of Finance supplied a safety net – quite limited in scope, to be sure – but apparently it helped calm the market.11

The corporate bond market is, therefore, an example of luck overcoming a lack of solid thinking on the part of the economic policy makers. It is noteworthy that other reforms planned by the Ministry of Finance were not implemented – reforms that were supposed to bring to Israel American-type institutions and arrangements, the very foundation of the current crisis. One such reform was the creation of mortgage-backed securities (MBS), the same financial products at the root of the recent world crisis. It thus appears that the Israeli bureaucracy actually contributed, in this case, to the stability of the economy.