A Macroeconomic View and the Short-
and Long-Term Implications of Growth Based on Private Consumption
Private consumption has led growth in the economy in
recent years, covered for the slowdown in exports and in investments against
the background of moderate global growth, and supported a significant
improvement in labor market data, with an emphasis on weaker population groups.
Growth based on consumption comes with risks if it is
based on factors that are not sustainable, but the main factor in increased
consumption in recent years was increased income from labor.
The rapid increase in consumer credit in recent years
requires closer monitoring by regulators, increased caution on the part of the
public and credit providers, and an informed examination of repayment
capabilities when providing or taking out credit.
Growth that is led by consumption generally leads to
lower long-term growth. Low investment
leads to a smaller increase in the stock of capital and in the adoption of
technologies that accompany that investment, and lower exports lead to the
economy being less able to exploit its relative advantages.
The good current state of the economy, thanks partly
to the rapid increase in private consumption, makes it necessary for us today
to focus on dealing with the challenges we face—improving human capital and
workers’ skills, improving the business activity environment, and investing in
infrastructure. All these will ensure
improved productivity and a better standard of living in the long term.
In recent years, private consumption has
become an important component of Israeli economic growth, and this has various
implications. Today I would like to
discuss Israel’s macroeconomic situation in recent years, and particularly the
significance of the fact that growth is being led by private consumption, and
the long- and short-term implications of this phenomenon.
In recent years, GDP in Israel has grown by
higher rates than in most other advanced economies, but the growth rate of per
capita GDP is similar to that of the other advanced economies. In the past year-and-a-half, growth data have
been affected by what economists call “noise” (mainly volatility in the import
of vehicles), but excluding that noise, the growth of GDP has accelerated, and
it currently stands at about 4 percent in annual terms. This is an impressive rate, particularly if
we take into account that world trade, which reflects global demand for our
exports, increased by an average of about 3 percent since the global economic
crisis, compared with an average of 7.56 percent in the years preceding the
Israel’s relatively good economic
performance was supported by accommodative fiscal and monetary policies: low
interest rates, the Bank of Israel’s foreign exchange purchases, and a
relatively high cyclically adjusted deficit.
All these supported activity against the background of relatively weak
global economic activity.
The good performance of the economy is
reflected in the very strong labor data.
The unemployment rate is at a low, the employment level is at a high,
and it is interesting to note that these data are also reflected in the
improved state of the weaker population groups.
For instance, the improvement in the unemployment and employment data in
the past year was particularly great among population groups with low levels of
education. Wages are continuing to
increase, and in the business sector, the rate of increase of real wages
accelerated in the past year to about 3.5 percent. In some industries and professions, there is
an apparent significant lack of workers, which weighs on the ability to
continue expanding economic activity.
The combination of increased wages and increased employment is reflected
in the relatively sharp increase in income from labor.
Against the background of these
developments, private consumption increased by 4.3 percent in 2015 and 6.3
percent in 2016, and was the main factor contributing to economic growth in
recent years. The rapid increase
occurred in all components of private consumption—services consumption, which
constitutes about one-third of private consumption, and goods consumption,
where the increase in vehicle purchases was prominent.
What is motivating private consumption?
A series of studies conducted by the
Research Department over the years examined the factors affecting private
consumption in the short and long terms:
Income from labor and
financial income are decisive factors in determining the level of private
consumption in the short and long terms, with elasticities of about 0.3 and
about 0.2 respectively.
The rapid increase in home
prices in recent years also contributed to increased private consumption,
through the wealth effect.
Asset prices, particularly
those of financial assets, have the greatest effect on the change in private
consumption in the short term.
Change in current income
does not affect private consumption in the short term, other than a change in
income from transfer payments.
The intensity of the
replacement effect of the interest rate is not great.
How have the variables affecting private
consumption developed in recent years?
There has been a real increase of about 6
percent per year on average in income from labor, as a result of an increase in
employment and in wages. There was an
increase in home prices and in the value of financial assets. Outstanding consumer credit (nonhousing
credit to households) increased by 25 percent over the past three years, as
interest rates declined. Together with
the lower prices on imported consumer goods, against the background of the
appreciation of the shekel in recent years, which led to a rapid increase in
the import of consumer goods, these all supported the rapid increase in
Is the growth in private consumption a phenomenon
that is unique to the Israeli economy?
Apparently not. Before the global economic crisis, global
growth was relatively balanced, in that it was led not only by private
consumption, but also by other uses, chiefly investment. In the years after the exit from the “pit” of
the crisis, since 2012, in most countries growth has been led by private
consumption, while investment has been stagnating. It is worth noting that the first quarter of
2017 looks to be different. In most economies, including Israel, the figures
for the first quarter are unusual in the sense that investment was again a
significant factor in contributing to growth.
However, it is obviously too soon to determine that this quarter
indicates a change in trend or a turnaround.
Of course, there are positive aspects to the
fact that private consumption increased relatively rapidly. Beyond the fact that it has led to an
increase in the standard of living in the short term, the increase in private
consumption also covered for the more moderate growth of exports and
investments, which was at least partially a result of exogenous factors. With the help of macroeconomic policy, the
increase in private consumption thus contributed to smoothing the business
cycle. It enabled the economy to
continue growing and to lead to a clear improvement in labor market data as I
outlined earlier. However, the fact that
growth was led by private consumption also comes with risks.
Those risks mainly have to do with the
question of whether such growth is sustainable, or whether it comes with a risk
of a sharp turnaround. The answer to
that question has to do with the sources upon which the economic growth
rests. As long as growth relies to a
greater extent on increased consumer credit, a sharp increase in the future
debt servicing burden may put the ability to continue consuming in the future
at risk. As long as the increase relies
more on an increase in asset prices—the “wealth effect”—and as long as this
turns out to be temporary, the turnaround in prices may lead to a turnaround in
private consumption as well, and therefore in activity. A study conducted by Arnon Barak of the Bank
of Israel Research Department, which was published this week, shows that in
recent years, the main factor leading the increase in private consumption
(according to a long-term comparison estimated in the study) is the increase in
income from labor. The increase in
financial asset prices and in home prices made less of a contribution than income
from labor. Household debt figures show
that despite the increase in outstanding mortgages and consumer debt, the debt
to GDP ratio and the debt to disposable income ratio increased only
moderately. At the macro level,
therefore, the risk is moderate.
However, the rapid increase of consumer credit in recent years requires
closer monitoring on the part of regulators, extra caution on the part of the
public and credit providers, and an informed examination of repayment
capabilities when providing or taking out credit.
The interim conclusion, therefore, is that
given the relatively weak state of the global economy, the growth of private
consumption contributed to maintaining a strong growth rate and a robust labor
market. The fact that most of the
increase in consumption relies on an increase in income from labor makes it
more stable, but we must be particularly attentive to the part of the increase
that is supported by increased credit and asset prices.
So if the economy is growing solidly, the
labor market is strong, and the engine of growth is private consumption, is
there something that needs to concern us?
The question is whether growth that relies
mainly on private consumption in a small and open economy can persist and be
strong enough to reduce the gap in the standard of living relative to the other
advanced economies. In this context, it
is important to remember a number of facts in relation to the two main uses
that have been weak in recent years:
Investment in the primary industries
contributes not only to activity in the short term, but also to future
production capacity, and investment in machinery and equipment means adopting
the technologies inherent in that equipment, meaning that investment
contributes to future growth by increasing production capacity and through its
contribution to an increase in productivity.
Exports make it possible for a small and
open economy to exploit its relative advantages and the economy of scale. Export industries in general, and also in
Israel, are therefore characterized by relatively high productivity.
How have investments and exports developed
in recent years?
Investment as a share of GDP in Israel is
low by international comparison, despite the fact that national savings is not
low, as we showed in the Bank of Israel Annual Report for 2016. Therefore, not only are we not close the gap
in capital per worker relative to other economies, the gap is even
growing. By the way, the investments
that increased in 2016 were mainly in residential construction and in the
electronic components industry, but not in the other industries, such that the
increase in investments made a relatively small contribution to a broad
increase in production capacity. A
factor that is complementary to private sector investment is government
investment in infrastructure. Despite
some increase in the past two years, the level of this investment remains lower
than it was at the beginning of the decade.
As a result, the stock of capital in the economy is lower than the
average in the other advanced economies.
Exports as a share of GDP also declined in
recent years, affected by the weakness in world trade and the strengthening of
the shekel. This fact is not harbinger
of good news in terms of the dynamics of productivity. In this context, we can examine what happened
to labor productivity in Israel over time.
Despite its low level at the point of departure in 1995, its pace of
growth was lower than what could have been expected given the fact that in
general, the increase in productivity is greater in economies that begin from a
lower point, if only because of their ability to adopt technologies that exist
in countries at the technological forefront.
The fact that the productivity gap has not been closed is particularly disappointing
given that growth in productivity in the other advanced economies has also been
relatively low in recent years.
Other than the composition of growth and the
insufficient level of infrastructure, I have discussed other reasons for the
low level of productivity at various opportunities. The main reasons are unsuitable human
capital, as shown by the PIAAC tests examining the cognitive skills of the
adult population in Israel—such as problem solving skills in a digital
environment—the problem of excessive and inefficient bureaucracy, and the fact
that the economy is not sufficiently open to international competition in
various aspects, such as the attitude toward competitive supply from abroad or
relatively high non-tariff barriers.
The question of the implications of growth
led by consumption over the long term has been discussed by various
international entities in recent years, and the main conclusions from their
studies are similar to the analysis we have conducted. Such growth tends to be weaker, and it also
generally leads to lower future growth.
The reason for this is that the export industries, which tend to be an
engine of innovation and productivity, are not contributing their part in
pushing productivity forward, and the low level of investment contributes less
to increased production capacity and to increased productivity derived from the
adoption of technologies inherent in new capital.
The strategy that will support more balanced
growth, which for its part will contribute to stronger and more prolonged
growth, must therefore include the following components:
ü Improved human capital and workers’ skills—Providing
content and abilities that will enable successful integration in the labor
market for all parts of the population, including broad technological education
at various levels;
ü Improved business activity environment and removal
of barriers that hinder competition from abroad
ü Investment in infrastructure—Such
investment will make a particularly large contribution in Israel in view of the
low level of infrastructure, particularly that of public transit.
The good state of the economy, in part
thanks to the rapid increase in private consumption, actually requires us now
to focus on dealing with the challenges so that we can ensure continued
improvement in the standard of living in the long term.