Israel's economic turmoil: Gaza war strains budget and national unity

As Israel approaches the one-year mark of its war in Gaza, the nation finds itself grappling with a multifaceted economic crisis that threatens to splinter its political landscape and social fabric. The ongoing conflict has not only taken a devastating human toll but has also plunged the country into financial turmoil, with rising unemployment, contracting GDP, and lowered credit ratings. Prime Minister Benjamin Netanyahu's coalition government now faces the daunting task of navigating these economic challenges while maintaining a delicate balance among its diverse constituents.

The Economic Toll of War

GDP Contraction and Rising Unemployment

The Israeli economy, once a beacon of growth and innovation in the Middle East, has been significantly impacted by the prolonged conflict. Recent data from Israel's Central Bureau of Statistics reveals a stark reality: economic output grew by a mere 2.5% (annualized) in the first half of 2024, a substantial decline from the 4.5% growth observed during the same period in the previous year.

The war's immediate impact was even more severe. In the last quarter of 2023, shortly after the conflict began, Israel's gross domestic product (GDP) contracted by an alarming 20.7% (annualized). This downturn was primarily driven by:

• A 27% decrease in private consumption
• Reduced exports
• Significant cutbacks in business investments

While there was a brief rebound in household spending at the start of 2024, the economic recovery has since slowed.

The labor market has not been spared either. The unemployment rate in Israel, which had been at historically low levels, has seen a concerning uptick. As of July 2024, the unemployment rate stood at 2.80%, up from previous lows. However, this figure may not fully capture the extent of job losses and underemployment resulting from the war.

Credit Rating Downgrades and Financial Market Volatility

The international financial community has taken note of Israel's economic struggles. In a significant blow to the country's financial standing, Fitch Ratings lowered Israel's credit rating from A+ to A, citing the ongoing conflict in Gaza and increased geopolitical uncertainties. This downgrade was not an isolated incident; earlier in the year, both Moody's and S&P had also lowered their ratings for Israel.

These credit rating downgrades have far-reaching implications for Israel's ability to borrow and attract foreign investment. They signal increased risk to potential lenders and investors, potentially leading to higher borrowing costs for the government and Israeli businesses.

The Budgetary Dilemma

Rising Defense Expenditures

The prolonged conflict has necessitated a significant increase in defense spending. The Bank of Israel projects that the costs associated with the war from 2023 to 2025 could reach approximately $55.6 billion. This massive financial burden will likely be financed through a combination of increased borrowing and budget cuts in other areas.

Fitch anticipates that Israel will permanently raise spending by 1% of GDP compared to pre-war levels, which will have unavoidable repercussions on the public deficit. The rating agency's report highlighted that "debt is expected to rise above 70% of GDP in the medium term," indicating a concerning trend for Israel's fiscal health.

The Ultra-Orthodox Subsidy Debate

One of the most contentious issues in the current budget discussions revolves around state subsidies for ultra-Orthodox men. Historically, many ultra-Orthodox men have devoted their time to studying religious texts in seminaries, supported by government subsidies. However, as the economic crisis deepens, there are growing calls to reduce these subsidies and encourage greater workforce participation among this demographic.

This debate is not new. In fact, it harkens back to Netanyahu's own actions as finance minister 21 years ago. During that time, he implemented significant economic reforms, including cuts to ultra-Orthodox subsidies, stating that the crisis required all Israelis to sacrifice and contribute.

West Bank Settlement Policies

Another point of contention in the budget discussions is the treatment of Jewish settlements in the occupied West Bank. These settlements have long been a source of international controversy and internal debate within Israel. The current economic crisis has reignited discussions about the tax benefits and financial support provided to these settlements.

Any attempts to reduce financial support for West Bank settlements are likely to face strong opposition from right-wing members of Netanyahu's coalition, highlighting the complex interplay between economic policy and political ideology.

Political Ramifications

Coalition Instability

The economic challenges and contentious budget debates have put significant strain on Netanyahu's coalition government. The prime minister must navigate the competing interests of various factions within his coalition, including:

• Ultra-Orthodox parties that resist cuts to religious subsidies
• Right-wing parties that strongly support West Bank settlements
• Centrist elements calling for fiscal responsibility and economic reforms

This balancing act has become increasingly difficult as the economic situation deteriorates, leading to speculation about the coalition's long-term stability.

Public Discontent and Social Divisions

The economic downturn has exacerbated existing social divisions within Israeli society. As unemployment rises and living standards decline, there is growing public discontent with the government's handling of the economy and the ongoing war.

The debate over ultra-Orthodox subsidies and workforce participation is particularly divisive, touching on long-standing tensions between secular and religious segments of Israeli society. Similarly, discussions about settlement funding highlight the deep ideological divides regarding Israel's future and its relationship with the Palestinian territories.

Looking Ahead: Challenges and Opportunities

The Resilience of the Tech Sector

Despite the overall economic downturn, Israel's renowned tech sector has shown remarkable resilience. The sector remained relatively unaffected by the conflict, helping to mitigate what could have been an even more substantial economic decline. This resilience underscores the importance of the tech industry to Israel's economic future and may point to a potential path for recovery.

The Need for Economic Reforms

As Israel grapples with its current economic challenges, there are growing calls for comprehensive economic reforms. These may include:

• Measures to increase labor force participation, particularly among ultra-Orthodox men and Arab Israeli women
• Investments in education and workforce development
• Efforts to diversify the economy and reduce reliance on a few key sectors
• Fiscal reforms to address the growing budget deficit and public debt

Geopolitical Considerations

The ongoing conflict with Hamas and tensions with Iran continue to cast a shadow over Israel's economic prospects. Any escalation of these conflicts could lead to further economic disruption and increased military expenditures.

Moreover, the international community's response to the prolonged Gaza war could have significant economic implications for Israel. Potential sanctions or reduced foreign investment could further strain the country's economy.

Israel finds itself at a critical juncture, facing unprecedented economic challenges stemming from the prolonged Gaza war. The country's ability to navigate these turbulent waters will depend on difficult political decisions, economic reforms, and a delicate balancing of diverse societal interests.

As Omer Moav, an economics professor at the University of Warwick, warns, "The human costs of a wider war could be substantial, along with significant economic repercussions." He adds that for Israel, a protracted conflict would lead to "increased expenses and larger deficits".

The coming months will be crucial in determining whether Israel can forge a path towards economic recovery and social cohesion, or whether the current crisis will lead to further political instability and economic decline. The decisions made today will have far-reaching implications for Israel's future, both as a nation and as a key player in the global economy.