BACKGROUND PAPER ON THE GOVERNMENT-S MACRO-ECONOMIC DECISIONS - 22-Mar-95

BACKGROUND PAPER ON THE GOVERNMENT'S MACRO-ECONOMIC DECISIONS OF MARCH 19, 1995

(COMMUNICATED BY GPO ECONOMICS DESK)

On Sunday, 19 March 1995, Finance Minister Avraham Shohat and Bank of Israel Governor Jacob Frenkel announced a number of macro-economic steps intended to facilitate continued economic and industrial growth and to ensure that the Government reach its goal of reducing inflation.

The Finance Minister proposed that the Government reduce taxes by NIS 1.2 billion and in order to finance this, reduce Government spending by an equivalent NIS 1.2 billion. The Cabinet, in its Sunday meeting, approved these proposals, which must now be approved by the Knesset Finance Committee and ultimately the Knesset. Governor Frenkel announced that the Bank of Israel would reduce interest rates to commercial banks by 1.5%, thereby bringing down the interest rate to 14.8% from 16.3%.

According to Shohat, the cuts in the tax base from income taxes is scheduled to occur on 1 September 1995, with the final form of the cuts to be decided by the Knesset.

The NIS 1.2 billion cut in the Government's budget is scheduled to begin on 1 April 1995 with a reduction of NIS 900 million in the 1995 budget, because the budget cuts are beginning four months into the year, with the remainder being deducted from the 1996 budget. These cuts will take place in a number of areas, according to Shohat, including reducing the Government work force by 2%, Government purchasing spending by 2%, local defense spending by 0.25%, education spending by 0.5%, crisis aid to the kibbutzim and the defense industries, the budget for home mortgages, and the Government's development budget by 2%.

Shohat said the Ministry was taking these steps in order to guarantee a growth rate of approximately 5% for 1995. He noted that the decision is not a one-time attempt to trim the budget, but will remain in place to ensure that government expenditures remain lower in the future.

Bank of Israel Governor Frenkel announced the reduction in interest rates following signs that inflation is slowing down enough to allow the decrease, even though, he said, seasonal factors were also responsible for the past months' lower inflation rates. Frenkel said that the Bank had weighed the decision to reduce interest rates and sought to strike a balance between the need to continue stable growth and hold inflation down. The Government's goal for 1995 is an inflation rate of between 8-11%, and Frenkel said that the cut in interest rates would allow the Government to reach its aim.

There was a consensus in the Israeli press that the decision to cut the budget was linked to the decision to reduce interest rates and thus constituted a victory for Bank of Israel Governor Frenkel. There had been repeated calls during the past few weeks by various industrial and trade organizations as well as from the Finance Ministry to reduce interest rates, but Frenkel reiterated his position to the Finance Ministry that he would not reduce rates until the ministry reduced Government spending, according to an article by David Lipkin in Ma'ariv (20.3.95). Lipkin noted that, "He forced the Prime Minister, Yitzhak Rabin, and on the Finance Minister, Avraham Shohat, to implement the cuts as a condition for any real step in reducing interest rates. Frenkel's ultimatum forced Rabin and Shohat to push forward implementation of a budget cut, which was planned for the second half of the year." Lipkin further noted that Frenkel was not forced to compromise his position. "He held a number of meetings with the Prime Minister at which he madde cleara that the Finance Minister had during the past year increased the budget by extraordinarily large amounts, which had contributed to an increase in inflation...Frenkel sent a clear message to Yitzhak Rabin and to Avraham Shohat to not expect from him a reduction in the interest rates of 2-3 percent, without a real cut in the national budget."

Gabi Kessler, writing in Ma'ariv (20.3.95) found that Frenkel's "steadfastness paid off." "The Bank of Israel's Governor, Professor Jacob Frenkel, taught Finance Minister Avraham Shohat, how to properly manage the economy... When the pressure to lower the interest rates increased, Frenkel decided to draft the Government, that until then had looked on from the side at the Governor as he alone fought inflation. He put before Shohat and Rabin an ultimatum do you want a real drop in the interest rates? Then make a reciprocal cut in the budget. Shohat demanded the Governor immediately reduce interest rates without connecting them to supporting steps from the Government, however Frenkel was stubborn and won the entire pot."

Sever Plotzker, writing in Yediot Ahronot (20.3.95), focused on the decisions' effect on the average citizen concluding that while the Government and the Banks' steps are politically motivated, in effect, economic electioneering, they are still economically correct. "Are these economic electioneering steps?" he asks. "Yes, but appropriate and correct economic steps. Practically speaking, there is no critique of the package that the Government approved yesterday. The components are fine. It is good to reduce the Government's budget, and especially the number of Government workers." Plotzker added that Frenkel was able to draft a high member of the Government to his side: the Prime Minister. "After the business with the tax on the bourse, Rabin said to Shohat, take your hands out of the citizen's pocket. And Shohat began to act. The hand which went to the citizen's pocket to collect more taxes, was taken out as if it had been bitten by a snake, " wrote Plotzker.

Nehemia Strassler writing in Ha'aretz (20.3.95), found that both Shohat and Frenkel worked behind the scenes to convince Rabin of the need for the reductions, "yet Shohat did not believe that Rabin would go along with the process, and thus said to his ministry's senior officials that from a political viewpoint, "he [Rabin] cannot pass along the reductions... Yet Rabin surprised him ... and during the Cabinet meeting gave an economic speech that could have been written for him by Milton Friedman," noted Strassler.