The Achilles Heel in Israel’s Economy

Joseph Dana

For many economies around the world, 2018 has been anything but smooth sailing. While the American economy is still strong, spurred by tax cuts and a rush to buy before president Donald Trump’s campaign of global tariffs begins to bite, emerging markets are struggling. From Turkey to South Africa, key economies have watched their foreign reserves dry up, inflation soar and currencies weaken. Israel, despite its small size and economic position at the nexus of East and West, has fared better through these rough waters. But that could be changing and a recent shakeup at the country’s central bank reveals the fault lines.

This month, Israeli prime minister Benjamin Netanyahu decided not to renew the tenure of Karnit Flug, the central bank governor, which will end in November. According to the Israeli media, Netanyahu and his finance minister, Moshe Kahlon, have grown tired of Flug’s public comments regarding the finance ministry’s handling of Israel’s endemic housing crisis and other cost-of-living challenges. Where Netanyahu and Kahlon favor tax cuts, Flug regularly pushed for infrastructure investment and, perhaps more critically, a focus on human capital.

Flug will be replaced by Amir Yaron, a professor at the University of Pennsylvania’s Wharton School of Business with an impressive list of qualifications for his work on macroeconomics in the US, but little experience in Israel’s aggressive economic climate. The appointment is subject to vetting by a government committee but is expected to pass without issue.

Yaron was born and raised in Israel but has spent his entire professional life in the US, which raises questions about his practical knowledge of the Israeli economy. Given that Netanyahu removed an outspoken governor in Flug, one assumes Yaron will quietly toe the prime minister’s line. Otherwise, he wouldn’t have been chosen for this key position as the country enters an election year. Beyond cost-of-living pressures on average Israelis, the question on the minds of many economists is whether the country can withstand another global recession. The answer is mixed.

Under Stanley Fischer, the World Bank economist and former vice chairman of the US federal reserve who moved to Israel to lead the central bank in 2005, Tel Aviv was mostly spared the carnage of the 2008 global financial crisis. Buoyed by a robust technology sector, an expansive military industry, a budget surplus and low deficits, the economy has grown over the past decade. The problem now for Israel is how the growth is trickling through the economy. Latest GDP figures put growth at 3.7 percent this year and 3.6 percent for 2019, with inflation hovering around 1.2 percent. One of Yaron’s first tasks will be how to handle rising asset inflation, specifically in the housing market, and wage stagnation.

His decision will be compounded by several factors. The housing market, for example, is shrinking. Tax revenue is slowly declining and the deficit is starting to grow. According to the financial daily, Globes, Israel recently recorded one of the steepest declines in the share of GDP received by salaried employees because of stagnating wages. Kahlon’s plan to increase housing supply and bring home prices under control doesn’t appear to be working as figures released by the Central Bureau of Statistics in August show new home purchases fell 22 percent in the first half of 2018. New home construction is also near record lows as a consequence.

While the central bank has focused on keeping consumer inflation low, asset inflation in corporate bonds and housing prices is rising. How the next central bank governor handles this challenge will be a defining characteristic of his tenure. While the social-justice protests that swept the country in 2011 might be a distant memory, the concerns central to the nationwide movement are still pressing and could flare up at any time. Those protests began in tents in the center of Tel Aviv as young people took to the streets to complain about the lack of affordable housing. For the majority of young Israelis, the prospect of buying a house remains as remote as flying to the Moon.

Netanyahu’s decision to shake up the central bank ahead of key elections highlights the sensitivity of cost-of-living issues among the electorate. Many of Flug’s comments on the economy and human capital were correct and need to be addressed. Take the country’s technology sector. Recent reports have drawn attention to a massive brain drain. For anyone who is a technology pioneer or operating a successful start-up, the chances are that they are looking for a way to move to Silicon Valley or Berlin.

It might be beyond the purview of the central bank governor to solve this problem, but it is clear that Israel’s traditional economic pillars are slowly eroding because quality of life in the country is diminishing and life itself has become exceptionally expensive. Tel Aviv, for example, ranks as one of the world’s top ten most expensive cities (ahead of the likes of Sydney, according to surveys). Yet, according to the Mercer Quality of Living survey, it doesn’t even break into the top 50 cities for quality of life.

These are the types of issues that quickly get overshadowed by political concerns in Israel. But if the next central bank governor doesn’t heed the warnings of his predecessor, Israel’s economy could be in for a major hit in the advent of a global recession. Security politics will not change that reality.

Joseph Dana, based between South Africa and the Middle East, is editor-in-chief of emerge85, a lab that explores change in emerging markets and its global impact.