Is it time for austerity?

Many were taken by surprise by the economic decisions taken by the Netanyahu government to cut most ministry budgets by 5% across the board and raise VAT by 1% last week.  We kept hearing until then how well we were doing – so why the sudden need for austerity measures?  With unemployment at historic lows, and the social protests from last summer taking a violent turn recently with a rash of self-immolations, is this the time for the Treasury to impose new taxes and reduce government spending?

Prime Minister Benjamin Netanyahu attended the weekly cabinet meeting on July 30. (photo credit: Uri Lenz/Flash90)


Finance Minister Yuval Steinitz and other government representatives are all over the media stressing the need for responsible government, and the spectres of Spain and Greece are invoked liberally.  Clearly we don’t want to get there, right?

The questions informed citizens need to ask are whether this comparison makes any sense, what real threats to the Israeli economy does the crisis in Europe create and what policy response makes the most sense.

Let’s start with Europe.  Conventional wisdom will have you believe that the European story is one of unsustainable public debt created by overly generous benefits in the European periphery, and that therefore the solution is to drastically cut back on government spending.  Indeed, this is the “cure” the EU has been imposing on its member states.

Unfortunately, the facts don’t match this story, except in the case of Greece.  Spain, for example, was running a surplus in the years leading up to the crisis.  Indeed, again excluding Greece, none of the EU countries had a debt problem that caused the crisis.  That is not to say they do not have debt and deficit problems – it is just that the causality runs the other way.  A financial crisis, combined with a monetary union that was poorly thought out, has caused a sovereign debt crisis.

Basically what has happened is that, as in the US housing crash in 2008, the European periphery experienced a housing bubble that crashed the financial system.  The ensuing recession caused increased unemployment, reducing government revenues and increasing automatic outlays for the social safety net, driving up debt.  So far, the story is all too familiar.  The twist in Europe is that the creation of the Euro (phased in between 15 and 10 years ago) removed the key levers for addressing these types of problems from the European member states.  Generally the way back from debt problems involves a depreciation of the currency (to gain back competitiveness) and the ability to “print” money so that debt obligations can be met.  When these get out of control they can create runaway inflation, but they are important tools in the arsenal of a central bank facing a crisis.  European member countries no longer have that option.  Monetary union for Europe worked well while everything was good, but its weaknesses have been exposed by the crisis it now faces.  Even in Greece, where public debt was part of the cause of the crisis, the common currency makes the standard methods of intervention impossible to implement.

At this point, as it seems likely that the crisis in Europe will lead to a severe recession, whether or not the central bank manages to save the monetary union. (By the way, despite the fact that in retrospect creating the Euro was a bad idea, undoing it now is not a pleasant option to comtemplate, although I would not rule it out).  This recession will of course have global consequences, and Israel will not be immune.  Exports will drop, foreign investment may be impacted, and we can expect unemployment to rise and even if we avoid a full-on recession, economic growth will at least slow.

The government, therefore, is being quite reasonable in preparing for this scenario.  However, we need to remember that public debt problems are a result of crises and not their cause.  Furthermore, they are not insurmountable as long as a country borrows in its own currency, as Israel does.  Given that, is the government’s decision to focus on the deficit a smart move at this time?

The answer depends on what the correct response is to recession.  There are two schools of thought here.  One, which seems to have enthralled much of the political class in the EU and elsewhere, is that recessions need to be fought with government cutbacks – so that the private sector can be free to emerge and grow.  Unfortunately, this theory, while still popular, fails the test of evidence.  The countries (Ireland, UK, the Baltic States, etc. etc.) that have followed this path have not prospered.    It also flies in the face of the basic insight of macro-economics – the paradox of thrift.  If everyone  cut back at once, no one succeeds in saving more because total spending in an economy equals total income.  When both the public and private sector cut back spending, everyone’s income drops so the spending cuts are not successful in cutting back debt.

The other approach is the Keynesian and neo-Keynesian model which was the main lesson of the Great Depression (that we seem to have forgotten).  When aggregate demand falls, and monetary policy runs out of steam because interest rates cannot drop any further, governments need to step in to spend more, even if it means larger deficits in the short run, to get the economy going again.  This was the theory behind the US fiscal stimulus started in 2008, which had a big part in stopping the economic free-fall and whose greatest failure was that it was too small to do the job fully.

The Bank of Israel, under Stanley Fischer’s steady hand, still has a bit more rope on the monetary policy side.  Unemployment here is still quite low, although there are some warning signs in the pipe.    Therefore, even from the Keynesian perspective it is not time for a fiscal stimulus.  If the government is taking some mild austerity measures so that the budget deficit will not grow before we go into the crisis, allowing more room to maneuver once it hits, it may be a smart move.  There is a lot to be said about how the specific cuts and tax increases are implemented, but the overall goal could be right.

On the other hand, if the government believes that austerity will be the right response to the crisis, and that this is just the first down payment, then we are going down a path that has been failing consistently everywhere else it has been tried.  Given the history of the people involved and the rhetoric they are employing, I fear that is where we are headed.

(Note: The basic outlines of this analysis should be familiar to readers of Paul Krugman of the NYTimes, as well as other economists.  I hope my application to the situation in Israel is helpful.)

About the Author
Shawn Ruby is a recent refugee from Israeli hi-tech, launching a new career in Rabbinics and education. He is a veteran immigrant to Israel from Canada, via the US. He is married with 3 children. Older blog posts at