Karnit Flug: Israel's macroeconomic situation in recent years
Remarks by Dr Karnit Flug, Governor of the Bank of Israel, at the annual conference of the Israel
Economic Association, Tel Aviv, 6 June 2017.
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Summary
Private consumption has led growth in the economy in recent years, covered for the
slowdown in exports and in investments against the background of moderate global
growth, and supported a significant improvement in labor market data, with an
emphasis on weaker population groups.
Growth based on consumption comes with risks if it is based on factors that are not
sustainable, but the main factor in increased consumption in recent years was
increased income from labor.
The rapid increase in consumer credit in recent years requires closer monitoring by
regulators, increased caution on the part of the public and credit providers, and an
informed examination of repayment capabilities when providing or taking out credit.
Growth that is led by consumption generally leads to lower long-term growth. Low
investment leads to a smaller increase in the stock of capital and in the adoption of
technologies that accompany that investment, and lower exports lead to the
economy being less able to exploit its relative advantages.
The good current state of the economy, thanks partly to the rapid increase in private
consumption, makes it necessary for us today to focus on dealing with the
challenges we face-improving human capital and workers' skills, improving the
business activity environment, and investing in infrastructure. All these will ensure
improved productivity and a better standard of living in the long term.
In recent years, private consumption has become an important component of Israeli economic
growth, and this has various implications. Today I would like to discuss Israel's macroeconomic
situation in recent years, and particularly the significance of the fact that growth is being led by
private consumption, and the long- and short-term implications of this phenomenon.
In recent years, GDP in Israel has grown by higher rates than in most other advanced
economies, but the growth rate of per capita GDP is similar to that of the other advanced
economies. In the past year-and-a-half, growth data have been affected by what economists call
"noise" (mainly volatility in the import of vehicles), but excluding that noise, the growth of GDP
has accelerated, and it currently stands at about 4 percent in annual terms. This is an
impressive rate, particularly if we take into account that world trade, which reflects global
demand for our exports, increased by an average of about 3 percent since the global economic
crisis, compared with an average of 7.56 percent in the years preceding the crisis.
Israel's relatively good economic performance was supported by accommodative fiscal and
monetary policies: low interest rates, the Bank of Israel's foreign exchange purchases, and a
relatively high cyclically adjusted deficit. All these supported activity against the background of
relatively weak global economic activity.
The good performance of the economy is reflected in the very strong labor data. The
unemployment rate is at a low, the employment level is at a high, and it is interesting to note that
these data are also reflected in the improved state of the weaker population groups. For
instance, the improvement in the unemployment and employment data in the past year was
particularly great among population groups with low levels of education. Wages are continuing to
increase, and in the business sector, the rate of increase of real wages accelerated in the past
year to about 3.5 percent. In some industries and professions, there is an apparent significant
lack of workers, which weighs on the ability to continue expanding economic activity. The
combination of increased wages and increased employment is reflected in the relatively sharp
increase in income from labor.
Against the background of these developments, private consumption increased by 4.3 percent in
2015 and 6.3 percent in 2016, and was the main factor contributing to economic growth in recent
years. The rapid increase occurred in all components of private consumption-services
consumption, which constitutes about one-third of private consumption, and goods consumption,
where the increase in vehicle purchases was prominent.
What is motivating private consumption?
A series of studies conducted by the Research Department over the years examined the factors
affecting private consumption in the short and long terms:
- Income from labor and financial income are decisive factors in determining the level of
private consumption in the short and long terms, with elasticities of about 0.3 and about 0.2
respectively.
- The rapid increase in home prices in recent years also contributed to increased private
consumption, through the wealth effect.
- Asset prices, particularly those of financial assets, have the greatest effect on the change
in private consumption in the short term.
- Change in current income does not affect private consumption in the short term, other
than a change in income from transfer payments.
The intensity of the replacement effect of the interest rate is not great.
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How have the variables affecting private consumption developed in recent years?
There has been a real increase of about 6 percent per year on average in income from labor, as
a result of an increase in employment and in wages. There was an increase in home prices and
in the value of financial assets. Outstanding consumer credit (nonhousing credit to households)
increased by 25 percent over the past three years, as interest rates declined. Together with the
lower prices on imported consumer goods, against the background of the appreciation of the
shekel in recent years, which led to a rapid increase in the import of consumer goods, these all
supported the rapid increase in consumption.
Is the growth in private consumption a phenomenon that is unique to the Israeli economy?
Apparently not. Before the global economic crisis, global growth was relatively balanced, in that it
was led not only by private consumption, but also by other uses, chiefly investment. In the years
after the exit from the "pit" of the crisis, since 2012, in most countries growth has been led by
private consumption, while investment has been stagnating. It is worth noting that the first
quarter of 2017 looks to be different. In most economies, including Israel, the figures for the first
quarter are unusual in the sense that investment was again a significant factor in contributing to
growth. However, it is obviously too soon to determine that this quarter indicates a change in
trend or a turnaround.
Of course, there are positive aspects to the fact that private consumption increased relatively
rapidly. Beyond the fact that it has led to an increase in the standard of living in the short term,
the increase in private consumption also covered for the more moderate growth of exports and
investments, which was at least partially a result of exogenous factors. With the help of
macroeconomic policy, the increase in private consumption thus contributed to smoothing the
business cycle. It enabled the economy to continue growing and to lead to a clear improvement
in labor market data as I outlined earlier. However, the fact that growth was led by private
consumption also comes with risks.
Those risks mainly have to do with the question of whether such growth is sustainable, or
whether it comes with a risk of a sharp turnaround. The answer to that question has to do with
the sources upon which the economic growth rests. As long as growth relies to a greater extent
on increased consumer credit, a sharp increase in the future debt servicing burden may put the
ability to continue consuming in the future at risk. As long as the increase relies more on an
increase in asset prices-the "wealth effect"-and as long as this turns out to be temporary, the
turnaround in prices may lead to a turnaround in private consumption as well, and therefore in
activity. A study conducted by Arnon Barak of the Bank of Israel Research Department, which
was published this week, shows that in recent years, the main factor leading the increase in
private consumption (according to a long-term comparison estimated in the study) is the
increase in income from labor. The increase in financial asset prices and in home prices made
less of a contribution than income from labor. Household debt figures show that despite the
increase in outstanding mortgages and consumer debt, the debt to GDP ratio and the debt to
disposable income ratio increased only moderately. At the macro level, therefore, the risk is
moderate. However, the rapid increase of consumer credit in recent years requires closer
monitoring on the part of regulators, extra caution on the part of the public and credit providers,
and an informed examination of repayment capabilities when providing or taking out credit.
The interim conclusion, therefore, is that given the relatively weak state of the global economy,
the growth of private consumption contributed to maintaining a strong growth rate and a robust
labor market. The fact that most of the increase in consumption relies on an increase in income
from labor makes it more stable, but we must be particularly attentive to the part of the increase
that is supported by increased credit and asset prices.
So if the economy is growing solidly, the labor market is strong, and the engine of growth is
private consumption, is there something that needs to concern us?
The question is whether growth that relies mainly on private consumption in a small and open
economy can persist and be strong enough to reduce the gap in the standard of living relative to
the other advanced economies. In this context, it is important to remember a number of facts in
relation to the two main uses that have been weak in recent years:
Investment in the primary industries contributes not only to activity in the short term, but also to
future production capacity, and investment in machinery and equipment means adopting the
technologies inherent in that equipment, meaning that investment contributes to future growth by
increasing production capacity and through its contribution to an increase in productivity.
Exports make it possible for a small and open economy to exploit its relative advantages and the
economy of scale. Export industries in general, and also in Israel, are therefore characterized by
relatively high productivity.
How have investments and exports developed in recent years?
Investment as a share of GDP in Israel is low by international comparison, despite the fact that
national savings is not low, as we showed in the Bank of Israel Annual Report for 2016.
Therefore, not only are we not close the gap in capital per worker relative to other economies, the
gap is even growing. By the way, the investments that increased in 2016 were mainly in
residential construction and in the electronic components industry, but not in the other industries,
such that the increase in investments made a relatively small contribution to a broad increase in
production capacity. A factor that is complementary to private sector investment is government
investment in infrastructure. Despite some increase in the past two years, the level of this
investment remains lower than it was at the beginning of the decade. As a result, the stock of
capital in the economy is lower than the average in the other advanced economies.
Exports as a share of GDP also declined in recent years, affected by the weakness in world
trade and the strengthening of the shekel. This fact is not harbinger of good news in terms of the
dynamics of productivity. In this context, we can examine what happened to labor productivity in
Israel over time. Despite its low level at the point of departure in 1995, its pace of growth was
lower than what could have been expected given the fact that in general, the increase in
productivity is greater in economies that begin from a lower point, if only because of their ability to
adopt technologies that exist in countries at the technological forefront. The fact that the
productivity gap has not been closed is particularly disappointing given that growth in productivity
in the other advanced economies has also been relatively low in recent years.
Other than the composition of growth and the insufficient level of infrastructure, I have discussed
other reasons for the low level of productivity at various opportunities. The main reasons are
unsuitable human capital, as shown by the PIAAC tests examining the cognitive skills of the adult
population in Israel-such as problem solving skills in a digital environment-the problem of
excessive and inefficient bureaucracy, and the fact that the economy is not sufficiently open to
international competition in various aspects, such as the attitude toward competitive supply from
abroad or relatively high non-tariff barriers.
The question of the implications of growth led by consumption over the long term has been
discussed by various international entities in recent years, and the main conclusions from their
studies are similar to the analysis we have conducted. Such growth tends to be weaker, and it
also generally leads to lower future growth. The reason for this is that the export industries,
which tend to be an engine of innovation and productivity, are not contributing their part in pushing
productivity forward, and the low level of investment contributes less to increased production
capacity and to increased productivity derived from the adoption of technologies inherent in new
capital.
The strategy that will support more balanced growth, which for its part will contribute to stronger
and more prolonged growth, must therefore include the following components:
- Improved human capital and workers' skills-Providing content and abilities that will
enable successful integration in the labor market for all parts of the population, including broad
technological education at various levels;
- Improved business activity environment and removal of barriers that hinder
competition from abroad
- Investment in infrastructure-Such investment will make a particularly large
contribution in Israel in view of the low level of infrastructure, particularly that of public transit.
The good state of the economy, in part thanks to the rapid increase in private consumption,
actually requires us now to focus on dealing with the challenges so that we can ensure continued
improvement in the standard of living in the long term.