How Netanyahu Went from Idealism to Pragmatism on Economic Policy

On March 31, 2009, Benjamin Netanyahu asked for and received from Israel’s parliament a vote of confidence in the coalition he had put together following the February 10 general election, thereby becoming his country’s prime minister for the second time. Back then, with the domestic political scene in a flux and the global economy reeling from the worst crisis in 80 years, no one believed that Netanyahu’s coalition — which comprised six parties and held 74 seats in the 120-seat Knesset — would survive more than a couple of years.

After all, no Israeli government since 1988 had lasted the full four-year span of the legally-mandated election cycle. This one seemed particularly fragile, because Netanyahu’s Likud party was not even the largest in the new Knesset, having won only 28 seats to Kadima’s 29. But Netanyahu had outmaneuvered Kadima leader Tsipi Livni in the post-election negotiations, successfully assembled a center-right coalition that included the Labour party and had a seemingly comfortable majority.

Despite the low expectations regarding the government’s longevity, both political pundits and the general public were confident about one key issue. They believed Netanyahu was by far the best-qualified Israeli politician to handle the challenge posed by the global economic crisis. The high regard he enjoyed stemmed from his stellar record as finance minister in the period March 2003 to September 2005 when, also against the background of a deep recession and severe crisis – albeit a more localized one – he unleashed a series of structural reforms that set the Israeli economy on a course of rapid and sustained growth.

Sadly for the pundits, almost everything they had predicted and expected in March 2009 has turned out to be wrong. Thirty-two months after being sworn in, Netanyahu’s coalition is still in office. On October 9, in a prime time broadcast, Netanyahu called for elections to be held early next year after a three-month campaign, which suggests they could be held in January or February 2013. According to a report in Bloomberg Businessweek, he cited opposition from his coalition partners to his austerity budget as the reason. for The consensus regarding Netanyahu’s abilities as an economic maestro has also proven to be mistaken. If anything, it is Netanyahu the politician who has been the star of this government, while Netanyahu the daring reformer has disappeared from sight – and Netanyahu the champion of neo-liberal economic policy has abandoned or actually reversed many of his most prized policies.

Blowin’ in the Wind

A brief review of several key items on Netanyahu’s agenda in 2009 and their subsequent fate shows how far from his intended course he veered over the past three years. The most important of these concern fiscal policy in general and the structure and levels of taxation in particular.

Because his role as Prime Minister removed him from hands-on involvement in economic policy, Netanyahu created the post of Minister for Economic Strategy for himself, to ensure that he had overall control. The key executive position of Finance Minister was awarded to Yuval Steinitz, a close political and ideological ally. Steinitz, a former professor of philosophy, lacked experience in business and economics in either the private or public sectors.

Almost immediately after the government took power, Netanyahu and Steinitz launched an updated and extended version of the tax-reduction program that Netanyahu had legislated in 2004 and that had continued virtually unchanged after he left office in 2005. The thrust of the original program, which was scheduled to run until 2011, was to steadily reduce income taxes on both corporations and individuals. It was now superseded by a new one, which continued the process until 2016. Within this framework, corporate income tax had dropped from 36% in 2003 to 25% in 2010 – and, under the new schedule, was to steadily decline further, eventually reaching 18% in 2016.

The second tax reduction program, passed in July 2009, represented an affirmation of Netanyahu’s belief in the ability of lower direct taxes to spur investment, initiative and growth. This, seemingly, had been proven by Israeli GDP growing at 5% or more from 2004 to 2008, and remaining positive even in the slump year of 2009. However, as Gil Michael Bufman, chief economist for Bank Leumi, one of the country’s two largest banks, notes incisively, the government’s policy “ignored the economic facts of life in Israel, which is a country suffering from a structural fiscal deficit” – a reality that the change in the global economy made painfully apparent. As Bufman explains, “over and above the fragility of state tax revenues whenever the economy weakens, the social and political winds blowing in the wake of the crisis reduced even further the government’s leeway to reduce the budget’s civilian expenditures, which are already low relative to most advanced economies, because of Israel’s high defense burden.” In the post-crisis environment, most developed economies were obliged to raise taxes in order to address burgeoning budget deficits. At home, Bank of Israel Governor Stanley Fischer urged the government to utilize the increase in tax revenues for debt reduction rather than tax cuts.

Middle-Class Revolt

Netanyahu chose to ignore both the new global zeitgeist and Fischer’s warnings. His boldness seemed to be rewarded by a return to growth rates of more than 5% per annum in 2010 and early 2011. But then his strategy was up-ended by an entirely unexpected, indeed unprecedented development: The Israeli middle-class rose in revolt. Starting in early 2011, widespread protests began against large hikes in petrol tax. Soon, the unrest — possibly spurred by the Arab Spring then sweeping through the Middle East — spread to encompass products from cottage cheese to apartments. In the summer, hundreds of thousands of people participated in demonstrations, set up tent camps in Israeli city centers and held impromptu meetings on economic theory and the very practical issues of pricing and income inequality.

Underlying the rage – which has largely faded from view over the last year, but still simmers beneath the surface and is likely to play an important role in the upcoming election – is something broader than any of the specific gripes the protesters raised. The Israeli public, especially the younger generation, was rejecting the entire neo-liberal economic doctrine on which Israeli economic policy had been based since the early 1990s – and of which Netanyahu had been the most prominent and enthusiastic proponent.

Netanyahu’s response to the social protest movement was typical: He established a committee to consider the issues and recommend solutions. However, in contrast to a slew of such committees appointed to consider issues on the public agenda, the Trajtenberg Committee – headed by Manuel Trajtenberg, a respected economist who had Netanyahu’s trust – was not a ploy to bury the problems, but to come to grips with them. The committee worked virtually non-stop to meet its seemingly-impossible six-week deadline and presented a long list of policy proposals, all of which were accepted by the government and many of which have been implemented. Many, but not all: Avi Temkin, a columnist for the Israeli business paper Globes and head of Globes Research, highlights the fact that “one of the committee’s critical recommendations, that the resources needed to finance additional social expenditure be transferred from the defense budget, proved impossible to realize.”

First among Trajtenberg’s proposals was the need to jettison the tax-reduction program and cancel the cuts scheduled from 2012 through 2016. Specifically, the committee proposed rolling back the cut in corporate income tax implemented in 2012 (i.e., raise the rate back from 24% to 25%) and increasing tax rates on high-income earners. Also proposed were tax breaks for middle-class families, such as making kindergarten free for three- and four-year olds.

Fiscal Time Bomb

These changes were implemented in a law passed on December 5, 2011, turning Netanyahu’s fiscal policy on its head. The move from tax cuts to tax hikes has continued this year under pressure from a growing budget deficit. It is almost certain to continue after the election, irrespective of who wins. The budget deficit — driven by a cyclical fall in revenues as the economy slows and by a steep rise in both defense and civilian expenditures — is now a “fiscal time bomb” in the view of Temkin. He says unless the next government is willing and able to adopt measures currently considered politically impossible such as cutting the defense budget and taking on strong unions, “it will be unable to close the gap or even narrow it.”

But the protest movement’s agenda was not limited to fiscal issues. Indeed, the sea-change in public opinion that drove the social protest movement helps explain why other elements of Netanyahu’s economic program withered on the vine. Most remarkable, perhaps, is the absence of privatization sales of state-owned corporations in recent years – after Netanyahu led a blitz of privatization as finance minister from 2003 to 2005. Yet in the same way that public perceptions have swung from seeing cuts in direct taxation as “pro-growth” to viewing the parallel cuts in social services (and hikes in many indirect taxes, fees and duties) as “eviscerating the middle-class,” so too has privatization metamorphosed in the public eye from a positive phenomenon to a form of crony capitalism designed to enrich “tycoons” and rich Israelis.

Netanyahu’s willingness to bend to the new winds blowing in 2011 has been interpreted by some experts as the victory of the politician in him looking for re-election, over the ideologue striving to remake the Israeli economy in the neo-liberal image. Others, like Globes’ Temkin, suggest that “Netanyahu left the economic battlefield in 2011 to focus his energy and time on foreign and security affairs – first and foremost the effort to prod the international community to take action against Iran.” In other words, Netanyahu – like other prime ministers before him – felt obliged to sacrifice his economic policy agenda to address what he perceived to be urgent and even existential threats facing Israel.

Reforming Real Estate

While both interpretations are at least partly true, neither explains an earlier and more resounding failure — that of Netanyahu’s declared intention to reform the real-estate and construction sectors. This putative reform encompassed all the main themes in Netanyahu’s economic philosophy, from privatization of state-owned land (93% of the total) via deregulation of the layers of bureaucracy that make planning and construction difficult and costly, to spurring competition and efficiency in the construction sector. Launched with great fanfare in 2009, these reforms ran into massive opposition on many fronts. Conservationists decried the potential encroachment on urban and rural open spaces; the extreme right and extreme left found common cause in denouncing the sale of land to private and potentially hostile entities; and a range of vested interests lobbied hard to protect their turf, literally. Within a year, Netanyahu had to accept defeat, with only a minor restructuring of the Israel Lands Authority to show for his efforts.

The failure of real-estate reforms has fed into another concern of the general public, namely the high and rising cost of buying or renting apartments. This issue emerged in 2009-2010, after the Bank of Israel cut interest rates to record lows. Unwilling to accept rock-bottom yields, investors backed away from equities and poured funds into the real-estate market, which had been in a long-term downtrend from 1997 to 2007. The prolonged slump had caused building starts to fall far below the level needed to meet underlying demand stemming from demographic growth. As a result of sharply increased demand and insufficient supply, home prices inevitably rose rapidly.

The government responded with a series of measures designed to boost home building. Real estate construction expanded steadily until mid-2011. Then it began falling and has continued to recede ever since. Consequently, the price declines that occurred in 2011 have been reversed. Housing is a major issue for large swathes of the general public and hence a political hot potato. But why is it proving so difficult to correct the shortfall in supply?

According to Bufman, “all the factors constraining supply are controlled, directly or indirectly, by the government and its agencies.” These include financing for contractors – where the regulator-imposed ceiling for lending to the construction sector has been reached by the two largest banks and is about to be reached for the others; release of greater quantities of (state-owned) land, and at reasonable prices rather than with a view to maximizing government income on each deal; and the lack of qualified personnel in key areas of the construction industry, which requires the government to issue more permits for foreign workers or to allow more Palestinian workers to enter Israel daily and find jobs there.

Bufman is convinced that breaking the supply-side logjam in real estate would also spur growth throughout the domestic economy, generate extra state revenues and at least partially compensate for the slowdown in exports that stems from global weakness. Conversely, failing to bring the construction sector into balance will exacerbate both economic problems and social tensions.

Policy Successes

The failures of the Netanyahu government noted above do not represent the full picture; there have been numerous examples of policy successes and achievements. The most obvious of these is the continued relatively high growth rate and, especially, the ongoing expansion of the labor force. This is perhaps the most critical difference between Israel on the one hand and the U.S. and EU on the other, in recent years. Specific areas such as education, transportation and health care services have been targeted with varying degrees of success.

Foreign analysts agree that many, if not most, Western countries would be delighted to have the economic situation that Israel faces. Precisely for that reason, the discontent over social and economic policies, especially among the youth, is the more remarkable, and the tendency to blame Netanyahu for everything, even things that are entirely out of his control, is the more significant. His response has been to adjust his policy stance, in some cases quite radically. This display of pragmatism, to judge by the opinion polls, seems to have paid off for Netanyahu’s own and his party’s standing. Now, as he campaigns for a third term as prime minister – a feat achieved only by the country’s founder, David Ben-Gurion – Netanyahu will have to persuade voters that he not only hears their complaints and understands their problems, but that he can also take steps to improve their situation without impairing the country’s security in an ever-more volatile region.

Web links

Bloomberg Businessweek: Netanyahu Calls for Early Israeli Elections, Citing Budget

Haaretz: S&P Leaves Israel’s Credit Rating at A+

The Jerusalem Post: Israel’s Housing Market Poised for Hard Landing

The New York Times: Protests Force Israel to Confront Wealth Gap

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