The Israeli Economy on the Eve of the October War: A Macro-Economic Review

On the eve of the October 7th war, the Israeli economy was characterized by rapid growth at the end of 2022, relatively restrained inflation, and confidence in global markets. Researchers at the Taub Center, Professor Benjamin Bental and Dr. Labib Shami, point out several fundamental issues afflicting the Israeli economy, particularly low labor productivity and the high cost of living. Their review addresses these topics and some of the impacts of the controversy surrounding the current government’s proposed judicial reform.

GDP per capita

Over the past decade, the gap in GDP per capita between Israel and the median OECD countries significantly narrowed. According to the pre-war forecasts of the International Monetary Fund, thanks to the rapid growth of the economy, especially following the end of the COVID-19 crisis, this gap was expected to continue narrowing into the current decade. This trend is attributed to Israel’s GDP per capita growth rate, which has been higher than the median growth rate among OECD countries, and it was expected to remain high in the coming years.

The growth rate of different GDP components after the COVID-19 crisis — private and public consumption, investment, exports, and imports — generally returned to their long-term trends. However, the growth rate of private consumption remained slightly below the long-term average. Consequently, GDP per capita in the second quarter of 2023 was about 2% higher than the long-term trend. In contrast, per capita consumption decreased by about 10% compared to its hypothetical value. Thus, the share of private consumption in GDP dropped by about 2 percentage points: from 53% of GDP in 2019 to less than 51% in the first three quarters of 2023.

Government revenues and expenditures

Until the end of 2022, the government had more revenue than expenditures. In the second and third quarters of 2023, a deficit began to accumulate, which was expected to reach 1.5% of GDP by the end of the year. With the outbreak of the war, the picture has changed completely.

The large revenue surplus at the beginning of 2022 reflected the high growth that characterized the economy in the final quarter of 2021. The large surplus accumulated in January 2022 was balanced by the deficit in December of the same year, regardless of this, the year ended with a surplus. The government, which took office at the end of 2022, also had low expenditures relative to revenues at the start of its term. This situation changed in the second and third quarters of 2023, during which a deficit accumulated to 0.3% of GDP for the first three quarters of the year. As mentioned, the deficit was expected to reach 1.5% of GDP by the end of the year.

The distribution of government expenditures between defense and civilian expenses remained stable until the crisis of October 7th. Despite the change in government and priorities, civilian expenditures in the first three quarters of 2023 remained similar to those of the previous year.

Labor productivity

The gap in labor productivity between Israel and the median OECD countries, which was 30% at the beginning of the previous decade, narrowed to 20% by its end. One reason for this is the acceleration in the growth of output per work hour, which began in the middle of the previous decade — likely related to the increase in the amount of capital available to Israeli workers. In the years following the COVID-19 crisis, the gap narrowed even further and is now about 10%.

The research indicates that labor productivity per hour in the information and communication sector is nearly double the average in the business sector, and the growth rate of productivity per hour in this sector is the highest within the business sector.

The high-tech sector

The year 2022 and the first three quarters of 2023 brought significant challenges to Israel’s high-tech industry. During 2020‒2021, there was a dramatic increase in investments in the sector. Specifically, compared to 2019, investments in the last quarter of 2021 were roughly four times larger. However, these investments have been steadily declining since then, and by the first three quarters of 2023, they had nearly returned to their 2019 levels.

Inflation and the cost of living

Overall, from the beginning of 2019 until mid-2023, inflation in Israel was significantly lower than that of the OECD countries. An examination of annual inflation highlights the greater range of price changes in tradable goods. From the beginning of 2019 until mid-2021, the prices of tradable goods generally declined, directly contributing to the reduction in Israel’s inflation rate. In the following period, the prices of tradable goods tended to rise faster than non-tradable goods, but this trend changed towards the end of 2022.

Regarding the cost of living, typically, countries with a low GDP per capita are characterized by a low cost of living, and vice versa. However, although Israel is not the wealthiest country in the OECD, in 2022, prices were 31% higher than the level that would match the country’s GDP per capita. This result seems to be largely attributable to the unusually high weight of housing in Israel’s consumer price index, which is linked to the ongoing housing shortage.