Living on Borrowed Time?

Israel’s macro economic performance in recent years has been enviable: above-average growth, below-average unemployment, a trade surplus, moderate inflation, and a shrinking public sector debt as a fraction of output. As Professor Eran Yashiv, Chair of the Taub Center’s Economic Policy Program shows in the new State of the Nation Report 2010, Israel weathered the 2007 to 2009 financial crisis better than most developed economies, with a downturn that was both smaller and shorter than that of the US and most of Western Europe.

While the current economic picture compares favorably to what other Western countries are experiencing, there is also reason for concern. In contrast to the current economic indicators, Yashiv shows that indicators foreshadowing future economic performance paint a more worrisome picture. Israel’s economic future requires investment in physicalcapital such as equipment, buildings, and public infrastructures, and it requires cultivating human capital including general work skills and habits as well as a high degree of training and specialization in the lines of work demanded by a highly specialized 21^st century global economy. Though both kinds of investment are critical for its future, Israel has been lagging.

Private savings provide the main source for investment spending, but in recent years savings have declined from 24 percent of GDP to about 18 percent. Not surprisingly, investment is declining; as shown in the first figure.  Though levels of gross domestic investment in Israel have tended to fluctuate between 20 and 30 percent, they fell to an all-time low of just over 15 percent in 2010 – which is lower than the 20-24 percent of output that is common in comparably well-developed countries.

Alongside the shortfall of private investment, Israel is also experiencing a shortfall of public investment. The capital stock of the government sector has been growing recently at just over one percent, below that of any OECD country, where the average is over three percent.

Finally, Israel lags in investment in human capital. Large numbers of Israelis, particularly Israeli men, do not participate at all in the work force. The second figure shows that even after a 1.2 percent increase in labor force participation among prime working age Israeli men, and a 2.6 percent decrease in the comparable figure for men in the OECD, Israel’s employment rate is still five percentage points below the OECD average.

Among those who are in the work force, a very large number are in low-skilled, low-paying dead-end jobs. Yashiv refers to a “dual job market:” one sector of the labor force has job security, which also translates into on-the-job training and skill development; another sector has low skills, low pay, low levels of employment stability, and, concomitantly, a low degree of skill development alongside their already low level of skills. Five to six percent of Israeli employees are employed by manpower companies (outsourcing or temporary agencies) where even if the worker happens to work for the same nominal employer for a long period of time, he or she is, in fact, changing jobs all the time as locations and tasks are changed by the contractor.

Yashiv suggests a linkage between the lags in physical and human capital investments. The lack of skilled labor leads to a perpetuation of outdated production technologies that favor low-skilled, low-paid workers over more modern, capital intensive approaches that require more investment and more skilled workers with higher productivity. In other words, the labor force deficiencies reinforce those of the production sector and vice versa.  This economic problem is creating an acute social problem of economic stratification between two Israels: one that is benefiting from modernization and globalization, and one that is being left behind.

So, while competent management of monetary and fiscal policy has been keeping the Israeli economy in relatively good macro economic shape, compared to other OECD countries, Israel faces some major long run problems in the labor market and with regards to physical capital. These problems reduce the potential for economic growth and for standards of living that characterize developed economies, a process that may leave Israel farther and farther behind. In addition, these problems tend to aggravate inequality, which in turn reduces social welfare, engenders friction, and further perpetuates the long-term problems of the economy. The current system of government in Israel does not generate optimism for the possibility of adopting policy steps that will effectively deal with the dysfunctional aspects of Israel’s labor market.