To Presentation (Hebrew)

The Governor of the Bank of Israel spoke today at the Globes Israel Business Conference. Following are the main points of her address:
The discussion of the cost of living has had a prominent place in Israel’s socioeconomic agenda recently. Part of the discussion focuses on specific, or even incidental, anecdotes. The latest example is of course the “international comparison”, in quotes, of the price of a Milky pudding. However, enticing as it may be, the Milky by itself cannot carry the public discourse on the cost of living in Israel. Dealing with the cost of living requires an examination of the main processes occurring in the economy, and which impact on Israelis’ cost of living over time.
Public protest is an important, sometimes necessary, tool, in bringing about a process of examination and change. However, the examination process that leads to a real change needs to be deep, serious, and pertinent, and cannot rely on pointing out symptoms or formulating a catchy password. This is especially true these days, when the political discourse is expected to be extreme, and sometimes shallow, and that is precisely why it is important to deal with the issues at hand by relying on facts and sophisticated analysis. Such analysis is not limited to economics, but economic analysis plays an important role in identifying the failures and resolving them.
What do we really mean when we talk about “an increase in the cost of living”? How does the discussion of the cost of living fit in with the broader question of Israeli citizens’ standard of living? Essentially, we want to examine the relative change between the development of the price of the basket of products that we consume and the change in household net income, which it uses to purchase that same basket of products. In the public conversation on this issue, three main questions arise, which we need to examine: Has the price of a consumption basket for a typical family in Israel increased markedly in recent years? Is it really more expensive in Israel relative to other advanced economies? And finally, what about income—which is the means we use to purchase the typical consumption basket—what has happened to it over time?
In the past 11 years, beginning with 2003, the inflation target set by the government has been 1–3 percent per year. Accumulated inflation since then, that is, the increased price of the basket of products consumed by a typical household, has totaled 23 percent, a rate which seems a bit troubling. However, a simple calculation indicates that the average increase in prices is 1.8 percent per year—very close to the midpoint of the inflation target range. Thus, over time, monetary policy succeeded to fulfill its main objective—to maintain price stability in the economy. Long-term inflation expectations, which are near to the midpoint of the inflation target range, indicate that the public believes that policy will continue to succeed in doing so the future as well.
The increase in the Consumer Price Index (CPI) is, of course, a type of average—it’s the average rate of change in prices of the hundreds of products included in the goods and services basket of the “average consumer”. They didn’t all increase at the same rate. We naturally tend to focus on prices of products that we see every few days in the supermarket. And yes, food prices, for example, increased by 39 percent, much more than the general index, as did the price of home maintenance, which increased by 42 percent. The housing component also increased at a relatively large rate of about 40 percent. In contrast, there are components in the index that increased at a rate below that of the general index, or even declined, and the public discourse tends to deal very little with them: prices of clothing and footwear, for example, declined by 26 percent during the period, primarily as a result of globalization and of the opening of the economy to imports—an important process, which of course impacts on employment as well. Prices of home furnishings and equipment declined during that period by about 15 percent. What was discussed quite a bit in the public discourse was the price of communications services—accounting for about 4 percent of household expenditure—which declined by about 19 percent since the beginning of the reform in mobile communications.
It is important to note that the trends described, of moderate increases in prices of the consumption basket, occurred for all population groups: the consumption basket of the bottom quintile increased in price more or less by the same rate as for the upper quintile.
For good reasons, though this is not the place to get into them, home prices are not included in the CPI. (This is in contrast to the cost of housing services—calculated via the cost of rentals—which is included.) After a prolonged decline in their real prices, homes have become more expensive (nominal) by 95 percent since the middle of 2007 (that is, about 75 percent more than the increase in the CPI), and became a real burden for the households that wanted to purchase a home during those years. Recently published research by the Bank of Israel Research Department’s Sigal Ribon and Yoav Friedman found that the decline in the interest rate on mortgages significantly cut the mortgage repayment burden, in particular with the extended term to final repayment, the increased down payment, and the increase in average household income (we’ll get back to that later), the burden of the monthly mortgage payment did not increase in a comparison of the periods 2004–06 and 2009–11.
So is everything rosy? Definitely not everything. What we have shown so far, is that in the past decade there has not been an extraordinary change in the average price level. Are prices in Israel too high to start with—maybe higher than other countries?
A comparison of prices vis-à-vis other countries is not simply a comparison of the price in shekels of a specific product in a European supermarket. Economic literature teaches that the wealthier and more developed a country is, the higher the prices there are, in particular the prices of services and other nontradable products. In a country with a higher per capita GDP, we would expect higher wages, and therefore, for example, the price of a haircut will be higher than in a country with a lower salary. Another difficulty derives from the fact that the comparison is of a product in different currencies. The exchange rate set by the foreign currency market each day does not necessarily reflect the relative purchasing power of consumers in two countries (and additionally, it is given to considerable volatility, as well have seen in recent months), so for international comparisons it is generally accepted to use an exchange rate adjusted for purchasing power.
An analysis conducted at the Bank of Israel (based on an analysis of the entire basket of products, and compared with all OECD countries, and not based on an incidental comparison of a single item in a single city) indicates that in 2013, personal consumption prices were 12 percent higher in international comparison than what would have been expected in line with per capita income using the exchange rate adjusted for purchasing power—not an extraordinary gap.
An examination conducted several years ago at the product group level indicated that food prices, in particular prices of milk and soft drinks, where higher than what was derived from the level of per capita income. Prices in restaurants and hotels in Israel are also relatively high. It’s known that automobile prices are relatively high in Israel, because tax rates on them are high. At the same time, prices of clothing and footwear in Israel are not high relative to the world.
Various differences between prices of various products in various countries will, of course, always exist. In the case of large gaps, we need to try to find explanations, and to ask ourselves if they can be dealt with, and what the cost of that would be. For example, reforms that would increase competition and efficiency in production and marketing segments are of course required, and the reform in the cellular communications market is an example of a well-known and successful reform. In recent years, there have been important reforms to increase competition in various areas—such as banking, parallel imports, and civil aviation. The reduction of customs duties increases the choice for the consumer and forces domestic producers to increase efficiency (the tax on automobiles is not a good example), but there is a budget cost—the taxes that are cut will need to be replaced with other taxes, and that is of course a different discussion already.
There are also objective reasons for the high cost of living in Israel—high defense expenditures, for example, require the government to charge taxes, which increase the price of products, or reduce net income, and it can also be assumed that being a small economy, geographically isolated from its trade partners, prevents us from enjoying economies of scale in production and trade.
So this is essentially the picture on the price side—prices increased at a reasonable rate, with a sharp increase in certain components and a more moderate increase, and even decline, in others. What has happened during this time to wages and income?
Since 2003, gross salary per employee job has increased at a moderate rate of 0.7 percent. This is the rate of change in real wages: that is, beyond the increase in the CPI. Obviously, the ability of a company to increase wages and to remain profitable over time is contingent on a process of increasing productivity.
But this is not the entire story. Household disposable income is made up primarily of the wage of the household’s wage earners, minus taxes, and plus transfer payments received from the government. Disposable income increased, on average, over the past decade, precisely as per capita GDP did, and at a rate greater than wage increases, and the increase was similar for all income quintiles.
What explains the gap between the very moderate increase in real wages and the greater increase in disposable income? First, the period that we are talking about was marked by a process of reducing direct taxes, which contributed to an increase in net income primarily for high-wage earners, whose salary is above the tax threshold. Second, this period was marked by an increase in the labor force participation rate, and thus an increase in the number of employed people per household, which mainly had an impact on lower-wage earners. This process derived from, among other things, a cut in allowances, which increased the need to boost income from work. Over the course of the period, there was a sharp increase in the share of households with two wage-earners, so that the total income from work increased markedly.
But here too, the picture is not completely rosy—it’s complicated.

Alongside the increase in income from work, due to the increase in the number of wage earners, there was also an increase in expenditures related to heading out to work, led by the cost of childcare. Thus, the increase in disposable income is intertwined with expenditures that are necessary in order to achieve the income, and which are not reflected in the calculation of disposable income. Yet at the same time, the half-full part of the glass is that the Trajtenberg Committee’s recommendations to expand mandatory free education to younger ages were adopted and implemented, and there is another quarter-glass full, which is the expansion of daycare centers and the subsidies for them, but here there is quite a distance still to go.

What else is not rosy?
  • We have seen that the problem of the cost of living does not lie in price increases over time, or in large gaps in the level of prices compared with advanced economies. The path to an increase in our standard of living and purchasing power passes through an increase in productivity. In order for us to have the purchasing power of consumers in wealthy countries, we need to earn like them. For that, we need our labor productivity to be similar to the labor productivity in those countries. Wages in Israel are increasing too slowly, because productivity is increasing too slowly, and we are not succeeding in closing the productivity gap between Israel and other OECD countries. Until we produce with the same efficiency as advanced economies, we will not be able to allow ourselves to consume at the same level. Productivity that has increased at a rapid pace, which supports a rapid increase in the level of wages, will allow an increase in the standard of living and a decline in the cost of living.
  • Inequality is still very high. In recent years there has been a marked increase in the labor force participation rate. However, without an increase in productivity, too many employees’ wages remain low and there are large gaps in wages and income.


  • At the same time, the share of civilian expenditure in GDP—that is, the expenditure on public services such as health, education, welfare payments, etc.—declined markedly. This development imposes a heavier expenditure burden on households that are financing a larger share of expenditure on civilian services, at the same time as support and allowances are being reduced. This process reached its peak two years ago, and since then there has been a slight increase in the share of the government’s civilian expenditure in GDP.


So what is the solution?


No, there is no magic solution, and there are no free lunches. Some of the changes required can be made relatively easily, and some are complex, painful, and entail dealing with interest groups. Some of them also require an investment of resources that all of us will need to finance, for our wellbeing and our children’s. The most straightforward way to increasing the standard of living is to deal with the factors in the low productivity:


ü  Structural reforms, which will increase competition, enhance productivity, and will help the Israeli worker to produce the maximum he or she can. There are several such reforms in various stages of planning and implementation, and we mustn’t let them get bogged down in the bureaucracy.
ü  Investment in infrastructure, which will increase capital stock and will also help to increase labor productivity.
ü  Investment in human capital, including effective professional training that is in tune with the times and in line with the changing needs of the modern labor force.
ü  Reduction of bureaucracy and improvement of the business environment.
As far as dealing immediately with the income level of low-wage working households, a measured and gradual increase in the minimum wage, which takes into account increased productivity, can even, under certain circumstances, positively impact on productivity. At this time, and in order to focus an increase in minimum wage on low-wage earners, we should work in parallel to correct the distortions in the definition of wage used to calculate the eligibility for income support under the Minimum Wage Law. In addition, the earned income tax credit (negative income tax) should be expanded, as it is the most efficient tool to reduce poverty, by increasing the incentive to work.
In addition, we should act to increase competition in industries that suffer from low levels of competition, and to continue to lower the barriers to import in order to increase competition and reduce prices on imported products. In this regard, we should hope that the conclusions of the Committee for Increasing Competition and Reducing Import Barriers, whose recommendations were approved by the Ministerial Committee on the Cost of Living, will in fact be implemented.
And what is not the solution?


We cannot solve the problem of the cost of living through artificial means, such as widespread supervision of prices. We have recently seen several initiatives to expand supervision over prices. Such supervision is only appropriate and correct in circumstances in which there is a monopoly, or some other defined and identified market failure, and when the supervision is of standard products. In any other situation, price supervision is a recipe for bureaucracy, and causes companies to allocate resources to searching for various ways to side-step the supervision.


In conclusion: The cost of living is a complicated and multidimensional concept. Both diagnosing the problem of the cost of living and the ways of dealing with it require a range of policy tools—there are no shortcuts, no “snap your fingers and it’s done”.
One final note:


Naturally, the question arises these days about the economy’s dealing with the political instability, and the ramifications of the in-between period until a new government is set up. It is important to say: although the economy itself is in some slowdown, which originates in the global slowdown, our economy nonetheless is stable, and experience indicates that the economy is resilient to shocks in general, and to political shocks in particular. The operating rules for intermediate periods, such as the 1/12 budget, have been operated successfully in previous such periods as well. With that, there is no doubt that the major challenges that the economy faces, some of which I spoke about today, will require reforms and decisions that only a stable government, which lasts for a while, will be able to carry out consistently and determinedly.