The year 2023 was a difficult one for the Israeli economy. During the first nine months of the year, controversy surrounding the judicial reform created economic uncertainty, worsened further with the outbreak of the war. Taub Center researchers, Prof. Benjamin Bental and Dr. Labib Shami, review the Israeli economy prior to the war, which was characterized by rapid growth at the end of 2022, relatively low inflation and confidence in global markets, alongside low labor productivity and a high cost of living. They also describe a number of fundamental problems from which the Israeli economy suffers, and the effects of the judicial reform.
Thanks to the economy’s rapid growth, particularly following the COVID-19 pandemic, the gap between Israel and the OECD median in GDP per capita continued to narrow
According to IMF forecasts made prior to the war, this gap was meant to continue narrowing in the current decade. The continuing reduction of the gap is attributed to the fact that the rate of growth in GDP per capita in Israel has been higher than the median rate of growth in the OECD countries and was expected to remain so in coming years.
The rates of growth in the components of GDP following the pandemic, namely private and public consumption, investment, exports and imports, returned to their long-term levels. The rate of growth in private consumption remained somewhat lower than its long-term average. Overall, GDP per capita during the second quarter of 2023 was about 2% higher than its long-term trend. In contrast, consumption per capita is about 10% under its hypothetical level. Consequently, the share of private consumption within GDP fell by about 2 percentage points, from 53% of GDP in 2019 to less than 51% during the first three quarters of 2023.
Until the end of 2022, government revenues exceeded expenditures. In the second and third quarters of 2023, a deficit began to accumulate, which, according to estimates, would have reached 1.5% of GDP by the end of the year if not for the war
The year 2022 began with a large surplus of revenue, which reflected the high level of growth that characterized the economy in the last quarter of 2021. The surplus that accumulated in January 2022 was offset by the deficit in December of that year; nonetheless, the year finished with a surplus. The expenditures of the new government, which came to power at the end of 2022, were also low relative to revenues at the beginning of its term. This situation was reversed in the second and third quarters of 2023, as the deficit accumulated to 0.3% of GDP in the first three quarters of the year, and it was expected that the deficit would reach 1.5% of GDP by the end of the year.
The division between the government’s defense and non-defense expenditure was relatively stable until the events of October 7th. Non-defense expenditure in 2023 was also similar to its level in the previous year, despite the change in government and in priorities.
The gap in labor productivity between Israel and the OECD countries narrowed during the past decade, although there remains a gap of 10%
The gap in labor productivity between Israel and the median of the OECD countries, which was 30% at the beginning of the previous decade, narrowed to 20% by the end of the decade. One of the reasons for the decline in the gap is the growth in output per work hour that began in the middle of the previous decade and apparently resulted from growth in the quantity of capital available to Israeli workers. In the years since the pandemic, the gap narrowed even further and it is currently about 10%.
The findings of the study show that output per work hour in the information and communication industry is almost double the average in the business sector, and that the rate of growth in output per work hour in that industry is the highest in the business sector.
Dr. Labib Shami, one of the study’s authors, comments: “Despite the narrowing of the gap, output per work hour in Israel remains significantly lower than in other countries with a similar economic structure. One of the reasons is Israel’s lag in the development of public infrastructure. Therefore, it is important that the government invest in infrastructure as a growth engine, particularly in view of the current crisis.”
Israel’s lackluster performance on the index of greenhouse gas emissions relative to GDP are to a large extent due to Israel’s relative weakness in GDP per capita
The state of the environment is receiving increasing attention worldwide, and a major source of concern is greenhouse gas emissions, which contribute greatly to global warming and climate change. From a macroeconomic perspective, reducing greenhouse gas emissions means reducing emissions per unit of output. The researchers point to an ongoing improvement on this index in Israel and the fact that its performance is similar to the OECD average. Nonetheless, Israel is significantly below the median, and is ranked even lower relative to the leading European countries in environmental protection policy and action.
Israel’s lackluster performance on this index is explained to a large extent by its relative weakness in GDP per capita, according to which Israel is located between the average of the 38 countries and the median. At the current level of emissions, if Israeli labor productivity was similar to that of other high-income countries, then its performance with respect to emissions per unit of output would also be similar.
Israel’s high volatility in the risk premium and uncertainty in the financial markets
During the final months of 2022, the risk premium on Israeli five-year bonds stood at 0.4 percentage points. As a result of the policies of the new government, it rose to about 0.65 percentage points during the first third of 2023 and settled at a level of about 0.55 percentage points during the course of the year. The events of October 7th raised Israel’s risk dramatically, and its risk premium rose to 1.4 percentage points; however, toward the end of November the market calmed down somewhat and the risk premium fell to 1.1 percentage points.
Another indication of the increasing uncertainty in the market is the significant increase in the shekel’s exchange rate against foreign currencies. Research has found an impressive regularity in the association between the shekel’s exchange rate against the dollar and the S&P 500 index. In general, an increase in the S&P 500 index is associated with an appreciation of the shekel and vice versa. At the beginning of January 2023, following the government’s announcement of the planned judicial reform, the connection was severed and the shekel exchange rate was decoupled from fluctuations in the S&P 500. Following October 7th, the shekel’s rate of depreciation accelerated even further, however, the reduced concern about an immediate conflagration on the northern border, the intervention of the Bank of Israel, an increase in share prices in the US, and the weakening of the dollar in global markets, the exchange rate returned to its pre-war level.
The excess depreciation can cautiously be attributed to the uncertainty caused by the political divisions in the country. Prior to the war, the excess depreciation reached about 50 agorot or about 15% in the shekel exchange rate that would have prevailed had the association with the S&P 500 remained. The events of October 7th raised the level of the exchange rate to more than 4 shekels to the dollar, and thereby raised the excess depreciation to about 20%. As mentioned, toward the end of November 2023, the shekel exchange rate against the dollar returned to its pre-war level. Corresponding to the rise in the S&P 500 during that month, the excess depreciation also returned to its pre-war level of about 15%.
Investment in the high tech sector plummeted after reaching record highs at the end of 2021; young companies were particularly affected
In 2022 and the first three quarters of 2023 there were significant challenges to the Israeli high tech sector. In 2020–2021, there was a dramatic increase in investment in high tech, and, in particular, investment in the last quarter of 2021 was four times that in 2019. However, since then, investment has consistently declined, and during the first three quarters of 2023 it returned to near its 2019 level.
The high level of investment in recent years provided the high tech companies with the resources to keep operating for a while and the weakening of the shekel also provided support. Even though external investment in young companies — and in particular those in the initial stage of funding — grew substantially, the decline in their number may portend a major decline in the number of exits in a few years. The preservation of the high tech sector is essential for economic recovery.
In recent years, inflation in Israel has been significantly lower than the OECD average, however, the cost of living in Israel remains high. It is likely that the continuing crisis in the housing market contributes significantly to this
Inflation in Israel was, in general, significantly lower than in the OECD countries from the beginning of 2019 until mid-2023. An examination of annual inflation shows particularly large fluctuations in the prices of tradable goods. From the beginning of 2019 until mid-2021, the prices of tradable goods declined in general, which directly contributed to reducing inflation in Israel. In the subsequent period, the prices of tradable goods tended to rise more rapidly than those of non-tradable goods, although this trend reversed toward the end of 2022.
With respect to the cost of living, countries with low GDP per capita are also characterized by a low cost of living, and vice versa. Despite the fact that Israel is not the richest country in the OECD, prices in Israel were 31% higher than those predicted by its GDP per capita. It seems that this can largely be attributed to the exceptionally large weight of housing services in Israel’s basket of consumption goods, which is related to the persistent housing shortage.
Prof. Benjamin Bental sums up: “Despite the political shock resulting from the new government’s proposed judicial reform, the Israeli economy was in a healthy position prior to the events of October 7th. This strength, which was the result of the fiscal responsibility exhibited by Israeli governments during the past two decades, is what provides Israel with the economic resilience to carry out a difficult and protracted war. In view of the many challenges waiting for us in the future, it is essential that the government preserve the economy’s resilience and continue to maintain fiscal responsibility.”
The Taub Center for Social Policy Studies in Israel is an independent, non-partisan socioeconomic research institute. The Center provides decision makers and the public with research and findings on some of the most critical issues facing Israel in the areas of education, health, welfare, labor markets and economic policy in order to impact the decision-making process in Israel and to advance the well-being of all Israelis.
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