Israel's military ramp-up threatens another 'lost decade'

It was an intelligence failure most of all: Across the security establishment, there had been the conviction that the enemy next door was deterred. Yes, it'd been observed carrying out military exercises, but it wouldn't dare attack. Then, as hostile fighters poured into Israel, where soldiers were on home leave for a Jewish holiday, death and destruction mounted rapidly. Israel had to lean on the US for equipment and ammunition. It was a lesson, leaders said, that the country needed to vastly increase military preparedness and spending.

That may sound like Israel today as it fights an unforgiving war against Hamas in Gaza. But it's in fact an account of the 1973 Yom Kippur War, when Syrian tanks rumbled across the Golan Heights unimpeded. After 18 days of extremely bloody conflict, Israel spent years recalibrating the balance between defense and development.

What happened then is being viewed by economists as a cautionary tale. The insistence that Israel should never again be caught flat-footed led to a huge ramp-up in defense spending, which averaged almost 29% of gross domestic product in 1973-1975. The side effects were devastating. The government deficit grew to 150% of GDP, fueling 500% annual inflation. The period, known in economic circles as "the lost decade," ended in the 1980s when the country enlisted outside specialists to help draft tough reforms that slashed state spending, stabilized the shekel and attracted foreign investment.

Israel is a very different country today, but the parallels are haunting. The war in Gaza is the most expensive in the country's history: The central bank has estimated the total cost of the conflict will run to 250 billion shekels ($67.4 billion) through 2025. The fourth quarter of 2023 saw a 21.7% annualized drop in economic output.

Defense spending before the war was at an all-time low of 4.5% of GDP. It's set to double this year to 9%, according to Manuel Trajtenberg, a professor emeritus in the economics department of Tel Aviv University. (By comparison, the ratio is 3.4% for the US and 1.5% for Germany, according to data compiled by the Stockholm International Peace Research Institute.) "The decisive test will be the government's ability to lower the defense-spending-to-GDP ratio back to reasonable levels within several years," he says. "Otherwise, we may slide back into another lost decade."

Some scholars say the Israel of 1973—isolated, poor and with a state-led economy—was so much worse off that the comparison is specious. In the past 15 years, Israel's per capita GDP has risen above that of Britain, France and Japan. The number of multinational companies with operations in the country has grown to more than 400, from fewer than 150. David Brodet, a former director general of the finance ministry, says Israel entered the current conflict with a large stock of foreign currency reserves and low national debt, with a debt to GDP ratio of around 62%, now expected to rise to 67%.

Nevertheless, some experts warn the country's growth streak—a more than two-decade-long run, interrupted only by the pandemic—is in jeopardy. Perhaps the biggest risk is a reversal in investment flows into the all-important technology sector if international giants pull up stakes and startups decamp to other locales in search of workers. "We can't even begin to measure how many people have decided not to invest in Israel in the short term, let alone on a permanent basis," says Dan Ben-David, a macroeconomist who runs the Shoresh Institute, a policy research center in Tel Aviv.

"Unlike almost every other war in our history, this isn't going to be a short episode from which we can quickly bounce back," says Gad Yair, a sociologist at Jerusalem's Hebrew University. "This is going to stretch out for at least two to three years as we figure out how to defend our borders." Besides Hamas, considered a terrorist organization by the US and European Union, Israel faces security threats from Iran-backed militias including Hezbollah in Lebanon and Yemen's Houthis.

Reichman University's Zvi Eckstein says preserving Israel's success as a technology exporter depends on continued investment in the country's high-quality workforce. Yet it's precisely areas such as education and health, where Israel already underinvests compared with developed economies, along with transportation and welfare, that will be targeted for spending cuts in the coming years, as policymakers look to free up funds for military upgrades.

Karnit Flug, a former Bank of Israel governor who's now at the Israel Democracy Institute, says that since public trust in the central government is so low, education and welfare budgets should be transferred to municipalities which should be given greater power for service delivery.

The government has made some modest cuts to spending so far and introduced new taxes, but it's mostly relying on bond sales to cover a widening budget gap—a formula economists call unsustainable.

The budget pressures caused by the war are accentuating the divisions within Israeli society, where the top two deciles of the population contribute 60% of all revenue from direct taxes. Those earners are also the core of the military reserve force. When Hamas attacked and some 300,000 reservists rushed into uniform, the tech industry suddenly found itself short of labor, while businesses in and around the Tel Aviv area lost some of their best customers.

Prime Minister Benjamin Netanyahu is under increasing pressure to cut back some of the billions of shekels in spending he's committed to the ultra-Orthodox and right-wing parties in his coalition government. A letter to the government signed by scores of economists warns of a "spiral of collapse" in which Israel's better-educated, high-earning citizen choose to emigrate rather than shoulder the burden of supporting the ultra-Orthodox and their large families. It calls for an end to public support for schools that don't train students for the modern labor market and doing away with the military draft exemption for the ultra-Orthodox.

Most believe it would take an election to force through such changes. (None is planned at present.) But while many believe the wily Netanyahu has used up his nine political lives, there's no guarantee that whoever eventually succeeds him as prime minister will be able to govern without the support of right-wing parties. Says Brodet, the former finance ministry official, "If the next government is also dominated by extremists and the ultra-Orthodox, we could be facing not one lost decade but several."