Productivity and long term growth

Economic Survey of Israel 2009: Economic developments and policy challenges


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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Israel published on 20 January 2010.

The  Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.


A small open economy with a dramatic history

Israel’s economic development has certain parallels with that of some OECD countries, in particular its earlier move towards market-oriented policies that aided an expansion of high-value adding export sectors. A sea change in macroeconomic policy and a shift towards market-oriented structural reforms was prompted by chronic hyperinflation and unsustainable public-debt levels in the mid-1980s. Anti-inflationary measures were particularly successful, allowing the introduction of inflation targeting in the early 1990s, which brought price increases down to low, single-digit levels by the end of the decade. The early 1990s also saw the emergence of a world-class, export-based high-tech sector specialising in computer hardware and software, medical technologies and pharmaceuticals. Thus, the economy rode high on the bubble but also slumped following its collapse, with a recession in the early 2000s.

But Israel’s unusual history and geopolitical situation means the economy is atypical in many respects. Significant financial and human resources are absorbed by a large defence force and civilian security services; military aid contributes to a large net balance of inward transfers in the current account; and trade and investment flows are substantial with the wider world, but relatively limited with neighbouring economies. Furthermore, society is complicated, with many policy agendas rooted in ethnicity and religion. And the population has been profoundly shaped by immigration, most notably in recent history by a massive influx from the former Soviet Union in the early 1990s. Immigration flows have subsided since then, but population growth remains well above that in most OECD countries due to high birth rates in the Arab- Israeli and Ultra-orthodox Jewish (Haredi) communities.

A high average long-run growth rate but substantial room for catch-up

In light of the substantial and frequent past shocks to the economy, growth from mid-2003 to mid-2008 was uniquely stable, with almost constant annual real GDP growth at a little over 5%. And, despite past fits and starts and the current downturn, growth has averaged nearly 4% since the mid-1990s, a fast pace compared with most OECD countries. That said, per capita performance has been less impressive, and substantial gaps in living standards with those of top-flight countries remain. GDP per capita on a purchasing-power-parity basis is currently about 80% of the OECD average but, for instance, only 60% of that in the United States. The key challenge here is the need to increase productivity growth over the longer term through both improving the business environment and raising educational outcomes.

Recovery from the downturn is underway

The current downturn is the result of one of the few purely external shocks in Israel’s recent history. Conservative lending by banks and relatively light exposure to foreign toxic assets saved the authorities from bailouts, takeovers or emergency surgery to financial-market regulation. Nevertheless, credit flows did contract severely, and the market for corporate bonds dried up completely at one point. This damped domestic demand at the same time as external demand was hit by the wider global recession. Real GDP growth was negative in the final quarter of 2008 and the first quarter of 2009 before turning positive again in the spring. For the full year it is expected to be near zero. For 2010 and 2011, according to OECD projections, growth may be about 2¼ and 3¼ per cent, respectively.

Monetary responses to the recession and recovery have been vigorous…

Following the deepening of global financial problems in September 2008, the Bank of Israel cut its policy rate aggressively. As with many OECD central banks, more unconventional steps were also taken to ease liquidity, including quantitative easing through the purchase of government bonds and technical adjustments to the management of liquidity. The Bank has also responded boldly as the downturn has receded. In August 2009 it raised its policy rate from 0.5 to 0.75% (and did so again in November), a still expansionary stance. No OECD central bank had yet raised rates at that stage in the cycle. In recent months, inflation has been ramped up by one-off factors. However, there are no signs of significant upcoming inflationary pressure; yield differentials between indexed and non-indexed bonds indicate that expectations of inflation one year ahead are well within the Bank’s target band of 1 to 3%. December-to-December inflation on OECD projections is expected to be 4.3% in 2009 and 2% in 2010 and 2011.

… and other policy responses generally appropriate

In addition, the government took several measures to assist the corporate bond market, and businesses and households more generally. Though individually helpful, these did not constitute a substantial fiscal boost to the economy. In the Israeli context this was sensible. Falling tax revenues have acted as a significant automatic stabiliser and have strained fiscal balances uncomfortably as it is. As elsewhere, the global financial crisis has prompted debate on the regulation and oversight of the financial sector. Even though the current system has not shown itself to be obviously problematic, one useful change would be for the supervisory duties directly carried out from within the Ministry of Finance to be transferred to a more independent body; such direct ministerial supervision is unusual.

Commitment to reducing the debt-to-GDP ratio needs to accommodate the costs of achieving structural reform…

Trade-offs in fiscal policy between vital debt reduction, strong spending pressures and promised tax cuts have been heightened by the recent recession. Despite at times draconian past efforts at fiscal consolidation, the ratio of public debt to GDP has remained too high. The upswing to mid-2008 helped bring the ratio down to 78%. However, revenue losses incurred during the downturn are pushing it back up despite impressive efforts made to contain the deficit in the exceptional 2009-10 two-year budget. Central-government deficits are projected to turn out at around 5.5 and 5% of GDP for 2009 and 2010, respectively, and the debt-to-GDP ratio may reach 82% by the end of 2010. Substantial reduction in the debt ratio will require much lower deficits. Achieving this in 2011 may prove difficult because several temporary tax increases are scheduled to end. Sustainable reductions in the deficit and debt need to be the central focus of fiscal policy.

This is especially the case because the longer-term outlook for the public finances is mixed. Fiscal pressures due to population aging are expected to be relatively mild by OECD benchmarks, due to favourable demographics and fairly light commitments to pensions, health care and long-term care from the public purse. However, defence spending is several percentage points of GDP higher than most OECD countries. And civilian spending as a share of GDP has already been whittled down to a relatively low level. Thus, much of the low-hanging fruit for cutbacks through efficiency gains or cuts in services and transfers has probably been picked, though there remains some room to cut back on bureaucracy in some areas. Indeed, the analysis of education and welfare policies in this Survey illustrates that progress in structural reform will most likely require an initial fiscal investment.

Tackling the high rates of poverty has to remain a priority

Despite the need for a tough fiscal regime, Israel’s deep socio-economic cleavages must be given due priority. Just over 20% of households are below the relative poverty line compared with an OECD average of 11%. Poverty is concentrated among the 20% of the population who are Arab-Israelis whose poverty rate is around 50% and the (estimated) 8% who are Ultra-orthodox Jews whose poverty rate is around 60%. Both groups typically live and work in communities that are separate from the mainstream population and that are some distance from the core of economic activity. Both share the same immediate causes of poverty – low employment rates and large families – but the socio-economic backdrop differs enormously. Arab-Israeli poverty is fuelled by poor education feeding through to low-paid jobs for men and by cultural norms limiting learning and work for women. In addition, the OECD’s parallel review of Israel’s labour-market and social policies documents econometric evidence comparing wages and employment rates that points to discrimination against Arab-Israelis. In contrast, low material living standards among the highly insular Ultra-orthodox community stem more from choice than circumstance. The community puts a great emphasis on learning for men, but largely of a religious nature. Indeed the majority of adult men devote their lives to full-time religious study, with substantial implications for living standards. As for women, a large percentage (over 95%) participate in final examinations in secular subjects although often using a different system of coursework and tests from that that used in mainstream education.

Unrealised educational potential and low employment rates represent not only hardship for those immediately concerned, but also untapped resources for the economy as a whole. Issues relating to these communities are core to many of the problems in education and labour-force participation discussed in Chapters 3 and 4 of this Survey. Work on solutions cannot wait. Rapid population growth means Arab-Israelis and Ultra-orthodox now account for over 45% of children currently starting primary school.

How to obtain this publication

The complete edition of the Economic Survey of Israel is available from:

Additional information

For further information please contact the Israel Desk at the OECD Economics Department at

The OECD Secretariat's report was prepared by Philip Hemmings and Charlotte Moeser under the supervision of Peter Jarrett. Research assistance was provided by Françoise Correia.




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