An increase in defense spending and an increase in interest rates: this is how the war will affect Israel's economy

At the beginning of the war, we had an open conversation with Prof. Yaron Zelicha, the head of the School of Accounting, Economics and Financial Management at Ono Academic College, about the economics of the war and how it would affect our pocketbook. Over two months later, we're back at it now, to see where we stand.

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What does the economy of the war we are conducting depend on?
"The management of the war itself includes two different components that should be treated separately. The management of the war itself – this component includes a one-time increase in expenses related to the war and a temporary decrease in income resulting from the temporary decrease in economic activity."

What is the financial magnitude of the matter? What effects can it have?
"The scope of the one-time increase in expenses and the temporary decrease in income will reach an order of magnitude of between one hundred and one hundred and fifty billion shekels. The effect of this temporary deficit that will be created is small, because to begin with the government debt is low – about sixty percent of GDP compared to double or more in the United States."

"The low rate of government debt allows us to manage the war, even with the one-time expenses, and the damage to revenues will reach two hundred billion shekels. The Israeli economy will be able to handle the numbers without a major long-term impact."

"The second component is already very problematic and requires treatment, and the sooner – the better. This is the same structural deficit that results from the gap between fixed expenses. Not the same one-time expenses that I described earlier, but fixed expenses for the fixed base of income. We saw that the structural deficit started to get smaller Before the war. From the middle of 2022, the economy is slowing down and the level of income in it is decreasing and the expenditures planned for the 2023 budget, even before the war, are significantly higher than the fixed incomes. That is why even before the war we saw that the deficit was getting closer to 3 percent of the GDP on the order of fifty to sixty billion shekels.

Where did we turn following the fighting and what effects will it have in terms of budget?
"As a result of the war, we are expected to see a permanent increase in defense spending, an increase over many years in the expenses of the rehabilitation department in the Ministry of Defense, in the expenses of the mental health system, and of course in interest payments on the new debt created during the war, those 100, 150 billion shekels, and we are expected to be in an environment with higher interest rates than The zero interest rate that we have been in for many years. All these bring our permanent deficit to the region of 4 to 5 percent of GDP, about 80 to 100 billion shekels.

How long will the deficit affect and what does it mean?
"This is a permanent annual deficit, and it produces several negative consequences on the level of economic activity. First, a permanent deficit, as opposed to a temporary deficit, has a negative impact on consumers' expectations of tax increases, that is, when consumers see such a large deficit, they will expect an increase Taxes. The treasury also wants to raise taxes, so we are expected to harm private consumption."

"Private consumption is fifty percent of the activity in the economy and eighty percent of its growth potential, therefore damage to consumption will slow down economic activity and cause further damage to government revenues, and then instead of the deficit decreasing it will increase. This is exactly the mistake Sylvan Shalom made in 2001 and 2002 when he raised taxes A structural deficit, and the result was that the government's income from taxes continued to decrease. Not only did they not increase, they also decreased."

"What's more, consumer expectations for a further increase in the cost of living also harm private consumption, and it can be seen that there is a significant barrier to growth here. The untreated structural deficit has a negative effect on consumers. Also, the complete lack of action by the Ministry of Finance and the Minister of Finance in the area of the cost of living abandons us to monopolies and exclusive importers and also radiates On this side, on the consumers, and here we are in the face of a snowball that keeps spinning."

What other economic factors does this affect?
"Another thing is that as long as the deficit is so large, and it is not taken care of, it will make it very difficult for the Bank of Israel to reduce the interest rate, so the interest rate is expected to remain high and hit both consumers and mortgage takers and the government itself, which has an interest-bearing debt. Basically, we are in a loop that we are having trouble handling Bo," says Zelicha.

Zelicha has a clear address: "The Minister of Finance refuses to address the structural deficit, refuses to address the cost of living, the war also radiates after all and where are we coming from," he says.

As a former senior official in the Treasury, what do you think about the allegations against the conduct of the Treasury in the resulting crisis? Just yesterday we saw a reservist shouting about the situation.
"Precisely in this aspect of aid to businesses, including self-employed, the Treasury showed generosity, greater than during the Corona period. He proposed a business outline, which is generous and efficient, and yet he could have been much more generous, if he had focused the aid budget on businesses, which are up to Let's say 10 or 20 million shekels, instead of spreading the aid to all the businesses in the world that are 300 and 400 million shekels, he limited the aid to 400 million instead of limiting it to 10 million. With the same money, they could have given more to the small businesses, rather than spending Some of the aid money goes to large businesses, which could manage even without it."

In our previous conversation we talked about the war expenses reaching 50 billion shekels. Where do we stand in relation to this and what should be the expenditure going forward?
"We talked about 50 billion shekels on the expenses side, and even now we are talking about this amount. This estimate remains, but in addition we have to take into account the temporary decrease in revenues. That's another 50 billion shekels."

Are we headed for some tough years financially?
"If we deal with the structural deficit through spending cuts and not through tax increases, because if we raise taxes we won't get far, we will only push consumers to go into the bunker even deeper. We need to motivate consumers to return to the normal level of activity, and this can be done on the one hand through spending cuts Let him convince them that there will be no need for tax increases, and on the other hand, to address the cost of living, which was also true before the war."

How can this be done?
"If they take care of both spending cuts and moves to increase the cost of living, then after the war it will be possible to return to rapid growth and then the long-term consequences of the war will be very small. But if we continue to see a finance minister who does nothing and nothing, neither in this nor in that, he will put us in A recession that will take us a few years to get out of," he concludes.