Why Israel’s economy is resilient in spite of the war

War is taking a toll on Israel’s economy.

Israel’s war in Gaza and more limited conflict with Hezbollah on its northern border with Lebanon is taking a toll on the Israeli economy.

In the final quarter of 2023, Israel’s gross domestic product (GDP) – a measure of a country’s economic health – shrank by almost 20%. Consumption dropped by 27% and investment by 70%.

It’s important to note that these are annualised figures relative to the same period a year ago. The 5.2% drop in GDP from the third quarter was substantial, but it is likely to be a temporary setback unless the war with Hezbollah intensifies.

The outbreak of war disrupted around 18% of Israel’s workforce. In October, 250,000 civilians fled or were evacuated from border communities. Meanwhile, around 4% of the workforce – some 300,000 people – were called up as reservists as Israel mobilised for its military offensive.

Over the next few years, the war will cost Israel an estimated 255 billion shekels (£56.6 billion) due to reduced economic activity and increased expenses. But the projected rise in national debt from 60% to 67% of GDP by 2025 is manageable, as is the plan to raise annual military spending from 4% of GDP to 6% or 7% by the end of the decade.

Israel entered the war with a relatively low national debt and foreign currency reserves equivalent to about 40% of annual GDP. Its population is young and still growing, and data reveals that Israel has surpassed current military spending levels before. Between 1967 and 1972, military spending averaged 20.3% of GDP, rising to 28.7% from 1973 to 1975 before stabilising at 20.8% between 1976 and 1985.

The years following the Yom Kippur war in 1973 and through the first Lebanon war (1982–85) are often referred to as “lost years” for Israel’s economy. Per-capita GDP growth averaged 4.8% in the 12 years before this period; over the following 12 years it dropped to just 0.8%. Inflation gradually rose, peaking at 445% during 1984.

So the question is not if Israel can weather the current storm, but whether the burden of higher military spending will be offset by budget cuts elsewhere to ensure economic growth resumes and public debt returns to a sustainable trajectory.

So far, Benjamin Netanyahu, Israel’s prime minister, and other members of his coalition have resisted advice from economists to change the government’s spending priorities. They have done so for fear of upsetting the small but influential constituencies whose votes keep them in power.

Political opportunism

Netanyahu has demonstrated a good grasp of market economics. As finance minister between 2003 and 2005, Netanyahu implemented sweeping reforms that lowered tax rates, privatised state companies and raised the state pension age. He also used his tenure to curtail the country’s bloated benefits system and introduce requirements for job training.

Yet since the start of Netanyahu’s second term as prime minister in 2009 (the first was 1996–99), many of these reforms have been scaled back or eliminated, particularly the cuts to the benefits system. This benefits system disproportionately advantages the ultra-Orthodox Haredi community, whose parties form part of Netanyahu’s governing coalition.

Netanyahu was once again elected as prime minister in November 2022. Though a proponent of a limited role for the state, his new government included a record 34 different ministries. This was to satisfy the appetite for patronage and ministerial salaries among the different coalition partners as well as factions within his own Likud party.

To secure the continued support of ultra-Orthodox parties he also promised unprecedented levels of funding for religious schools and seminaries. In seminaries, grown men spend their lives studying religious texts at the public’s expense and are exempt from military service. Despite the need to fund the war and for more young men in uniform, Netanyahu and Bezalel Smotrich, the finance minister, have resisted nearly all suggestions that these budget items be reduced.

Here we have a case study where political opportunism easily defeats ideology. We know what Netanyahu believes and what he understands about good economic policy, and we can isolate these from what he is willing to do to remain in office.

Will he choose to defray some of the costs the war will impose on the budget by eliminating wasteful spending on useless ministries? Or will he introduce policies that grow the economy by incentivising higher labour-force participation among the ultra-Orthodox community? The plan for the moment is to borrow more.

Strong civil society

We may also overestimate the role politicians and governments play in ensuring a country’s success. Since its founding in 1948, Israel’s electoral system of proportional representation has yielded weak, unstable coalitions.

Historically, the Likud party has strongly supported the independence of the country’s judiciary. But after the last election, Netanyahu’s government introduced new legislation that, among other things, would have given the Knesset (parliament) the power to override Supreme Court decisions with a simple majority vote.

Had these changes been implemented they would have further magnified the worst properties of the country’s dysfunctional (unwritten) constitution. People do not invest money in countries where court decisions can be overturned by politicians and property rights are not secure.

Yet, despite the weaknesses of its government institutions, Israel has absorbed millions of poor refugees from every corner of the Earth, has fought back when attacked and has defeated far larger neighbours over its 75-year history. It has done so all while transforming itself from an impoverished backwater to a first-world economy and a centre of high-tech innovation.

In the first nine months of 2023, hundreds of thousands of Israelis demonstrated in the streets to defend the rule of law and the independence of the country’s judiciary. Many of those same people rushed to join their reserve units on October 7 to defend the country’s borders. Others, acting without any government direction, organised relief for the survivors and displaced while ministers dithered or disappeared from view.

Countries with strong civil societies and highly engaged populations survive and even prosper not because of their political leaders, but despite them.

Michael Ben-Gad does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.