The Heritage Foundation

Backgrounder #881 on Middle East

February 13, 1992

February 13, 1992 | Backgrounder on Middle East

Economic Reform, Not Loan Guarantees: Israel's Only Path toProsperity

(Archived document, may contain errors)

88 1 February 13,1992 ECONOMIC REF'ORM, NOT LOAN GUARANTEES ISRAEL'S ONLY PATH TO PROSPERKY INTRODUCTION Last Friday, Israeli Ambassador to the United States Zalman Shoval met with Secretary of State James Baker to press Israel's request for quick approval of a U.S. guarantee for $10 billion in loans to Israel. Two weeks ago, Shoval is believed to have discussed the matter in a private session with Vice hsident Dan Quayle. Israel claims to need $2 billion a year in loans for each ofthe next five years to help absorb an estimated one million Jewish immigrants expected to arrive from t he former Soviet Union by 19

95. If the Israeli government is unable to pay back these loans, then the American and fmign banks that make them will call upon the U.S. to make good on its guarantees.

On extremely persuasive economic grounds, Is&l would be unwise to take the loan guarantees and become Mer dependent on massive foreign economic assis tance. And it would be unwise for America to grant the guarantees-unless they are tied to fm and measurable commitments by Israel to accelerate dramatically its long-promised but slow-moving reform of its economy by cutting its budget reducing and reforming taxes, privatizing government-owned companies, and deregulating extensively the private sectair.

Wrong Reason. The loan guarantee issue thus should be clear cut. It is not.

Analysis of it has been muddied badly by actions of the Bush Administration.

Baker and George Bush so far balk at the guarantees.The trouble is they do so for a very wrong reason: to force Israel to make concessions in the current round of Mddle East peace talks. The Administration claims that it is using the loan guarantee matter to farce Israel to stop building settlements in 'the occupied ter ritories. What seems more likely is that the threat to deny the guarantees is part of the Bush A dministrations efforts to tilt American policy unpnxedentedly against Israel.

Purely Economic Matter. The Bush-Baker policy thus ties the guarantees to the peace process. This prevents the issue from being considered on its own economic merits. It may well be impossible, in fact, today to untangle Israels re quest for $10 billion in U.S. guarantees from the Arab-Israeli talks. It is wrong far the U.S. to impose political and security conditions on the granting of the guaran tees; it is unwise for Israel to accept such conditions. If the guarantee issue is inex tricably entwined with the pace talks, then Israel should withdraw its request and resubmit it when it cannot be used against Israel in the peace process.

That the loan guarantee is an economic matter in fact, is stressed repeatedly by Israeli and American Jewish community leaders. However, it is Israels economic ills that make a $10 billion loan guarantee unwise for either Israel or America. Such funds only will allow Israel to continue the budget an d economic policies that in the past couple of decades have virtually stagnated what once was an economic miracle. Such policies in the long run, mareover, will make Israel even less economically able to absorb ma immigrants. Rather than addicting Is rael f urther to debt, America should help Israel convert to a free market system 1 2 NO CLEAR CASE FQW LOANS The Israeli government claims that the $10 billion in loans to be guaranteed by the U.S. are needed as part of the estimated $70 billion cost of absorbi n g the ex pected one million immigrants. Israel plans to cover part of this cost with its own funds, part through contributions from Europe, and the rest through borrowing. Is rael claims that over 80 percent of the $10 billion that is to be backed by the U.S will be used for housing, with the rest going for roads, sewers, water systems, and other infrastructure. Some of the funds also are to go to commercial banks to finance business investments.

Israel, however, has not made a convincing case that it needs so much money or that it has any even semi-solid plans for using the money. American policy makers (and Heritage Foundation staffm) Epeatedly have pressed Israel, without success, for mm detail s of when the $10 billion figure has come from. They have asked how the funds exactly will be spent, how many housing units are to be built and where? The answers repeatedly are vague. Observes a Wall Street expert veay familar with the Ismli economy: Its a soft number 1 SeeJamesA.Phillips,Maintaining a B~!auced U.S. policy on Middle Bast Peace, Heritage Foundation ExecutivC Memorundm No. 318, January 13,1992 2 See Foreign Broadcast InformaIion Service Near East and Soiith East Asia (FBIS-NI3) teportp on Se p tember 9 1991 21 September 13,1991 (p. 15 october4,1991 (p. 22 and New Earr Report on October 7,1991 172 2 In fact, accarding to a top Iskli official, no list of specific purchases was com piled to deternine the amount of fareign borrowing required. Rathe r , the Israeli government used some economic formula based on assumptions concerning how much capital may be needed to absorb the immigrants. Perhaps this formula is valid Yet the Israelis have not released it. Were it made public, American policy makers w ould at least be better able to judge the merits of Israel's loan request.

On the face of it, moreover, it seems strange that foreign borrowing is required for housing. After all, the new.immigrants will provide plenty of labor, while building materials ar e readily available in Israel. Imports requiring foreign curren cy BF~ not needed for this.

Disturbing Quaion& To be sure, Israel would welcome an extra $10 billion in hard currency. What country would not? But without substantial economic reforms, the hu ge new loans will be squandered by wasteful government spending habits and economic policies that discourage job creation and hinder economic growth. While Israel's budget is not available in English for study by American policy makers being asked to appr o ve loan guarantees, what facts are hown raise disturbing questions about Israel's need for fareign assistance. Last August, for example, the Israeli government announced it would hire 15,000 new government employees. Another 880 government jobs are being created for archaeologists.

This means, apparently, that the Israeli government pfen to spend money on make-work jobs rather than on housing for immigrants acknowledged last month Speaking about his country's budget, Israeli Finance Minister Yitzhak Moda'i Every year it is more and more wild. This year the Knesset parliament] will pencil in money that simply isn't there. The Fiance Minister will then have to go dour-to-door, to try to raise the money from the U.S. and from diaspora Jewry. Then you will say , and rightly so, that the government is inconsistent in its economic policy. 3 Recent history teaches that extending loan guarantees simply will allow Israel to delay economic =form. In the 19809, the International Monetary Fund and World Bank loaned bill i ons of dollars to debt-ridden Argentina, Brazil, Mexico and other developing countries. This was wasted on money-losing state industries and bloated government payrolls. Only when no more large handouts were avail able were reformers in these countries ab l e to push through the free market policies that have begun fueling prosperity and raising living standards 3 hw Anarchic Distorts Israe4.s Budget Finuncial Times, January 2,1992, p. 3 3 PHANTOM ECONOMIC' REFORMS Despite some very halting steps toward priv a tization, [the government] still controls the impart of many staples. It sanctions dozens of monopolies Government denies free or easy access to the market and ties the hands of producers with onerous labor laws. It imposes on labor and employers punitive taxes that de troy their competitiveness and nip in the bud new enterprises. t If housing is needed for immigrants, meanwhile, the Israeli government seems hardly the best agent to provide it. Last year, to accommodate the first wave of im migrants, the g o vernment built housing far from where the jobs were. Most im migrants refused to move into the new buildings, preferring to crowd into urban housing, often with several families in each apartment. They wanted to be close to work. That this project was a f ailure is conceded privately by Israeli officials who admit further that the projects that will be financed or encouraged by the new money will be planned and executed by the same bureaucrats responsible for the earlier failures.

Though Israeli officials b oast that their country never has missed a debt payment the only way it pays its cmnt debts to the U.S. is from the $1.2 billion of Economic Support Fund money received annually from the U.S U.S. military aid to Israel, depending on how it is calculated, i s another $1.8 billion to $2.8 bil lion annually Using fareign aid to pay off loans does not impress economists Poor Credit Risk. Without major economic reform, Israel is a poor credit risk 1 who, when determining a country's credit-worthiness, typically l ook not at a 4 Daniel Doron Israel's Economic CWnge: How the U.S. Can Help Heritage Lecture No. 350, Sepkmber 5 See Jim McGee US. credit Analysts Fault Israel on Economic Reforms Washingron Post, October 3,1991 20,1991, p. 3 p. Al 4 countrys past debt-pay ment Tecord but at its-future potential for servicing its debt.

Here Israel scares very low. Standard and Poors Corporation, for example, cur rently gives Israel a BBB- credit rating for long-term government bonds not back ed by the U.S. This is Standard a nd Poors lowest rating for investment grade bonds is the reluctance of banks to lend Israel money without a U.S. guarantee. These banks axe saying something to which Israel should listen. Some Israeli officials deny this and insist that their problem is n ot obtaining bank loans. The problem they say, is the high interest rates for the loans. According to these officials, inter national banks will reduce interest rates if the U.S. guarantees the loan.

If lower inmst rates thus a~ the main reason for Israel seeking the loan guarantee, there is an easier solution than the guarantee-if Israel, of course makes the convincing case for new massive loans. Washington could consider giving an annual grant to Israel for the difference between the higher commercial ra t e that Israel would pay without the guarantee and the lower rate that Israel could have obtained with a guarantee. The advantage of this is that America would not be a guarantor of or co-partner with the Israeli economy. If Israel then defaulted on its lo an, it would be a matter between Israel and the banks.

What would be avoided would be the enonnous political damage to Israels reputation in America were Israel to default on guaranteed loans. This kind of default surely would trigger a parade of American and foreign banks coming to the U.S. Treasury to collect the billions owed to them by Israel. Owing money directly to foreign banks, without the shield of a U.S. guarantee, mareover, could impose enough discipline on Israeli leaders to prompt economic ref orm Message from Banks..The;best indicator of Israels ability to repay, of course NO FREE GUARANTEES The American taxpayer should be wary of granting guarantees of any kind.

Proponents of such guarantees typically glibly assm skeptics that they cost noth i ng. At one time, perhaps, this may have seemed plausible. But in the past decade Americans to their horror have learned that loan guarantees come back to bite6 In 1990 alone, defaults by middle class American college graduates on loans under written by th e U.S. government cost theTreasury $2.5 billion. Guaranteed ac counts in Savings and Loans will cost the taxpayers hundreds of billions of dol lars. And countries that long had had perfect credit histories, in the past decade walked away from their debts, leaving Western banks and countries holding the bag 6 See Ronald Utt, Ph.D The Six Mion Dollar Debt Iceberg: A Review of the Governments Risk Exposure.

Heritage Backgrouder No. 774, June 28,1990.

America thus painfully has learnedthat "guarantees" are not cost-free or risk free. If Israel needs money to meet real humanitarian needs, let it ask for an out right humanitarian grant. America seldom has refused such genuine requests.

Guaranteeing loans likely will create future debt problems.

That Israel desp erately needs economic reform is recognized by many Israelis who propose bold plans to follow the path of Argentina, Mexico, and other developing countries that have begun growing rapidly after adopting free market policies. And the Israeli government in r ecent years also has recognized the need for economic reform, unveiling one reform after another. Yet Israeli officials admit that while some propss has been made, the reforms have remained mainly words. Last October's overview of the Israeli economy by t h e Bank of Israel and the Ministries of Finance and of Economics and Planning, states Although the government has acted in the right direction, it has not yet succeeded in carrying out all the reforms on which it has Mded...p articdarly as regards the priv a tization of government corporations. A more =solute implementation of these reforms might have facilitated faster sustainable growth and more employment. 7 Israel will have little incentive to abandon its failed economic policies if the U.S. continues to b ail it out CONCLUSION The weight of the economic evidence argues strongly that Washington should refuse Israel's request for loan guarantees. To refuse in the current geopolitical climate, however, in the midst of the peace talks, would appear to punish I srael unfairly. Yet, to accede to the request, in its cmnt form, also would be unfair to Israel and to American taxpayers.

Thus what now would be best far Israel and America would be for Israel to withdraw its request for loan guarantees. Far one thing, withdrawing the request would remove pressure from Israel to compromise its negotiating positions in its talks with the Arab s and would deny Bush and Baker a lever to press Israel on the settlements in the occupied territories. Israel should not allow its critics to hold it hostage over the loans.

Time for True Reform. For another thing, withdrawing the loan guarantee re quest would give Israel the time to develop a tru reform plan which would reduce or even eliminate the need for assistance. Finance Minister Moda'i, in fact, has implied that he recognizes the value of a push from America. Last 8 7 Bank of Israel, Ministry of F i nance and Ministry of Economics and Planning National Budget for 1992-1994 8 See Stanley Fischer and Herbert Skin Overhaul the Irsraeli Economy New YorkTims, October 12,1991 October, 1991, p. 3 p. A29 6 December l2, he-toldhe Jerusalem -Kol-Israel radio: T here-may -be economic linkages, but I welcome these because, if the guarantees 8~e accompanied by con ditions for refoms in the Israeli economy, I also believe that reforms are needed We will make the reforms with0 t them being conditional. That is why su ch con ditions will not bother me at all.

One Condition. When the time comes that the issue of U.S. loan guarantees to Israel can be decided on its economic merits, the U.S. should give it sympathetic consideration. The U.S. should impose only one conditio n: that Israel make the economic reforms needed to enable Israel to pay back the loans. If Israel refuses to make such reforms, no amount of foreign loans or guarantees will help Israel for long b Edward L. Hudgins, Ph.D.

Director, Center for Internationa l Economic Growth and The Walker Senior Policy Analyst in Economics Joel C. Rosenberg Assistant to the Director of Research contributed to this study 9 Jerusalem Ko1 Israel Radio in Hebrew, translated in IBIS-NE, Decembez 13,1991, p. 4445 7 For Further -I nformation Bank of Israel, Israeli Minisay of Finance, Israeli Ministry of Economics and Planning, Na tional Budget for 1992-1994, October 1991.

Note: This publication in English is a government analysis of recent Israeli economic performance, current policy and future trends. The actual 1992 budget for the State of Israel is not available-in English.

Michael Bruno, One Million Immigrants: An Absorption Program, Bank of Israel, April 1991.

Michael Bruno, Israels Crisis and Economic Reform: A Historical Pe rspective, Working George Bush, Address to the Knesset, The Reagan Administration and Israel (Toby Der Paper No. 3075, National Bureau of Economic Research, Inc., August 1989 showitz, editor American Israel Public Affairs Committee Paper on U.S.-Israel Re lations Number 13,1987.

Patrick Qawson and Howard Rosen, The Economic Consequences of Peace for Israel, the Palestinians and Jordan, The Washington Institute Policy Papers Number 25, The Washington Institute for Near East Policy, 1991 No. 350, September 20,199 1.

Daniel Doron, Israels Economic Challenge: How the U.S. Can Help, The Heritage Lectures Edwin J. Feulner, Dont Blame Israel, Heritage News Forum, March 28,1991.

Yaacov Fisher and Pinchas Landau, Israels Current Economic Situation, Forecasts for 1991 92 and Trends in Economic Policy, Israel Center for Social and Economic Progress, Sep tember 1991.

Richard T. Mchack, Prospects for Prosperity and Peace in Israel, Speech to the New Economics, New Politics confemce sponsmd by the Israel Center for Social and Economic Progress, November 22,1991.

Richard T. Mchack, The Challenge of the Immigration and Obstacles to Growth in the Is raeli Economy, Speech to the American Israel Economic Carporation, June 26,1991.

Leora (Rubin) Meridor, The Role of the Public Sector in the Israeli Economy 1960-1986 Facts, Causes and Implications, Program for the Study of the Israeli Economy, Mas sachusetts Institute of Technology, February 1988.

Larry Q. Nowels and Clyde Mark, Israels Request for U.S. Loan Guarantees, CRS Brief (up date Congressional Research Service, January 3,1992.

James A. Phillips, Maintaining a Balanced U.S. Policy on Middle East Peace, Heritage Foun dation Executive Memorandum No. 318, January 13,1992.

Alvin Rabushka and Steve H. Hanke, Toward Growth: A Blueprint for Economic Rebirth in Is rael, Institute for Advanced Strategic and Political Studies, December, 1988.

Joel Rosenberg, Land of Promise: Restoring Israels Econom ic Miracle, Policy Review, Fall 1991 8 Joel Rosenberg, Israel Needs Americanhssure to Adopt .Economic Reforms Moment Em Sohar, Israels Dilemma: Why Israel is Falling Apart and How to Put it Back Together Herbert Stein, Israels Economy: Observations of An Advisor, The American Enterprise December 1991 Shaplsky Publishers, 1989.

May/June 1990 9