Cost of a tragically botched war

Any serious commission of inquiry ought to examine Netanyahu's tenure at Finance, and Fischer's at the Bank of Israel.

August 15, 2006 21:36
4 minute read.
Cost of a tragically botched war

idf tank lebanon298 88ap. (photo credit: AP [File])

The unacceptable results of war in Lebanon have engendered a chorus of demands for the appointment of a commission of inquiry. Regrettably, any investigation is likely to ignore the economic aspects of Israel's defeat. That would be unfortunate. Economic decisions made prior to the war contributed greatly to the IDF's poor battlefield performance, and economic decisions made during the war will greatly exacerbate the war's long-term social and economic damage. I would argue that any comprehensive inquiry into what went wrong should include economic decision-making - with a focus on two key events: Binyamin Netanyahu's repeated demands for cuts in defense spending; and Stanley Fischer's decision to raise interest rates to 5.5% in July. What was wrong with these decisions? In a nutshell, everything. THE FINANCE Ministry and the Bank of Israel both relentlessly pressed for sharp reductions in defense spending. Underpinning their view was the idea that the IDF is an inefficient, wasteful organization. Interestingly, neither the ministry nor the bank have any personnel genuinely qualified to judge whether the IDF is indeed inefficient, nor have they ever studied the matter in any systematic way. Up until Netanyahu took over, Finance never succeeded in making any real dent in the Defense Ministry's empire. The lobbying was just too good. Netanyahu changed all that. He succeeded in engineering a series of sharp reductions in defense spending between 2003 and 2005. Most important, many of these cuts were implemented halfway through the relevant fiscal years. This greatly increased the damage done to Israel's readiness. It is one thing to shave NIS 1 billion off a NIS 33-billion budget given six months of advance warning. It is quite another to shave a billion off the budget six months into the current fiscal year, when most of that money has already been allocated or spent. Faced with the need to slash spending fast, the IDF did the only thing possible - it cut training and readiness expenditures. As a result, most reservists did not train or even don a uniform in the past three years. Meanwhile, the "regulars" replaced the reservists on operational assignments, leaving them with no time to train either. The IDF tried to put a brave face on all this, circulating stories that the conscripted personnel were actually sharpening their skills by participating more intensively in operational tasks, but do paratroops really improve their light infantry skills by manning roadblocks? My hunch is that any serious inquiry would show that Netanyahu's actions contributed to the poor tactical outcomes that dogged the IDF throughout the war. WHAT ABOUT Fischer? Outside Israel, he is widely regarded as less than competent. Reading the minutes of the July 24 meeting of the Monetary Policy Committee, one gets the impression that he has learned little from past mistakes. Now Israel is already beginning to show signs of a slowdown - its third in a decade. Unemployment, for example, has not declined in four months and is stuck at a staggering 9% level. Under such circumstances, any responsible central banker would push for lower interest rates, but Fischer actually raised rates again in July. Two reasons were offered for the rate hike. The first was that the war in the North was likely to cause a temporary contraction in supply that would be only partially offset by a contraction in demand. Supposedly, this could engender near-term inflationary pressure, and hence a rate increase was called for. This argument is without merit. For such a situation to be inflationary, there has to be a aggregate shortfall in supply. Yet, as I mentioned above, unemployment is at 9%. That suggests that the loss in output from factories in the North could easily be offset by ramping-up idle productive assets in the rest of the country. Second, even if Israel was at full output already, and such an asymmetric reduction in supply and demand really was about to take place, monetary policy could not be used to address the problem. IT TAKES between 12 and 18 months for an interest rate change to really have an impact on demand. Yet it is hard to believe that production in northern Israel will not have returned to normal within a few months. Hence, the Bank of Israel instituted a policy that will reduce demand over a year from now because it believes that demand will exceed supply for the next few months. Of course, Fischer offered a second justification for raising interest rates. He feared the war would lead foreign investors to avoid the shekel, contributing to a devaluation that would engender inflation. Hence a rate increase that would make the shekel a more attractive currency to hold was called for. This is an odd argument. There is no direct relationship between interest rates and the strength of the currency. In a country facing an unsustainable balance of payments (or foreign debt problem), higher interest rates - and the resultant reduction in demand for imports - can indeed strengthen a currency. Heavily indebted Turkey, for example, is currently maintaining high interest rates in order to deal with large foreign debts that have weakened the lira. In Israel, a large international net creditor with a relatively weak banking system and low return on capital, such a rate increase could actually backfire and lead to a weakening of the currency. Of all people, Fischer should know this. After all, he engineered repeated rate increase throughout Asia during the 1997 financial crisis, and the result was the collapse of currency after currency. Bottom line? Fischer's move to raise interest rates will engender higher unemployment and lower growth. And his decision should count as part of the cost of this tragically botched war. Finally, let's recall who brought Fischer to Israel to run the bank: Binyamin Netanyahu. The writer, an economist, is Chief Investment Officer for Forum FIE.

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