The Israeli Economy... Is It Becoming an Obstacle in the Current War?

In recent days, indications have been increasing that the economic situation in Israel is deteriorating, even before accounting for the direct economic and financial costs of the war.

Continued Rise in Prices

On Sunday evening, March 15, the Central Bureau of Statistics published the cost of living index for the month of February, before the outbreak of the war against Iran and Hezbollah. The data indicates that the expectations predicting a decline or stabilization in prices were not accurate.

The cost of living index rose by 0.2% in February compared to January, which exceeds economists' expectations, who estimated an increase of only about 0.1%. As a result, the annual inflation rate has slightly risen to 2% in February, compared to 1.8% in January.

However, this current rise does not yet reflect the effects of the war that began on February 28, as these developments are expected to push the consumer price index in March to further increase, especially in light of the significant rise in global oil prices and rising costs of supply chains and international transportation.

Moreover, the rise in the cost of living index reduces the likelihood of a decrease in the Bank of Israel's base interest rate, even without accounting for the costs and economic and financial impacts of the war. This could slow the pace of consumption and investment, which are key drivers of economic growth.

After the war, it is expected that these problems and economic crises will worsen. This is due to the substantial increase in military expenditures, resulting from the use of large amounts of precise missiles and high-cost interceptive missiles. Additionally, there is the financial burden resulting from the conscription of large numbers of reserve forces, as well as the cost of material damages and destruction in Israeli towns, and the disruption of economic activity, which will lead to losses in GDP and a decline in tax revenues.

All of this is likely to push the government’s fiscal deficit upward and increase public debt. In this sense, the newly approved government budget proposal, which is currently being debated in the Knesset in preparation for its approval, may become an unrealistic budget project that does not keep pace with changes in economic conditions.

Budget Cuts in Anticipation of Crises

To cope with the costs of the current war, the Israeli government has so far approved a general cut in the government budget of 3%. In contrast, it approved an additional budget allocation of about 39 billion shekels to cover war expenses, of which about 28 billion shekels are for the Ministry of Defense, in addition to about one billion shekels to cover civilian expenses. Additionally, an extra fund of nearly 10 billion shekels has been established, to be activated when necessary, equivalent to about 1.85% of GDP. This indicates that the government expects the total cost of the war to exceed the budgets currently allocated for it.

The increase in budgets means that, unless the government takes additional austerity measures and further cuts in the budget, or unless exceptional government revenues are realized, especially from taxes, the government's fiscal deficit by the end of 2026 could exceed 6%, after the target set in the budget proposal was only 3.9%.

Questions About the Government's Ability to Handle the New Economic Situation

In recent days, Israeli media have begun raising increasing questions about the current government's ability to handle the financial and economic costs of the war, and the increasing burden on the government budget for 2026. Several analysts are also questioning the nature of the current fiscal policy and its viability, given its reliance on economic assumptions that some describe as unrealistic.

This debate is growing as the government continues to allocate budgets to coalition partners, especially to the Haredi community and settlements. Many believe that this policy and the budgets do not contribute to achieving economic growth but come at the expense of the budgets of other service and development ministries.

For example, Shlomo Taitelbaum, an economic analyst at "Calcalist" (March 15), wrote, "Since the outbreak of the war, we have been writing about the government's mismanagement of finances. We have often used harsh words like waste, plunder, and lack of responsibility. But now, in the amended budget for 2026, we see that the government is breaking records in irresponsibility... we have even reached a new worrying level of deterioration; this is the first time that no indicators of financial responsibility can be found from the government."

Since the outbreak of the war on Iran, dealing with the government budget has been extraordinary even by this government's standards. The Ministry of Defense first requested a massive addition of about 82 billion shekels, including about 42 billion shekels to fund military operations, and another 40 billion shekels to complete the budget framework. This means that the ministry did not consider the security budget approved about two months ago as final and was waiting for the opportunity to request more funds. Just making such a request is a clear warning sign.

Secondly, the Ministry of Defense has actually received about 39 billion shekels from its demands: 32 billion shekels to fund military operations in addition to 7 billion shekels as a reserve that is likely to be used later.

Thirdly, and most importantly, the significant increase in the budget has not been accompanied by any long-term plan to finance this increase in expenditures. The government has managed to collect only about 1.85 billion shekels through cuts in ministries' budgets and coalition funds, in addition to 900 million shekels due to the cancellation of market reforms for milk. The rest of the financing has come through an increase in the deficit, with the expected deficit rising from 3.6% to 5.1% of GDP.

Fourthly, while the financial deficit is surging, Smotrich has become more generous regarding tax reforms and expanding tax brackets. Despite the deterioration of the financial situation and the scarcity of resources, Smotrich is moving to expand tax brackets, in addition to increasing tax exemptions on online purchases.

This means, according to Taitelbaum, that the Israeli economy stands at a pivotal moment, even though the war somewhat obscures this fact. The decisions made by the government over the last week put Israel on a trajectory of rising public debt. If no clear stance from the government is issued in the weeks following the end of the war regarding its commitment to reducing public debt, it would not be surprising if global markets punish Israel.

The increase in interest payments is unprecedented; in 2023, estimates indicated that Israel would pay about 67 billion shekels in interest in 2027. Now, estimates suggest that these payments will reach about 93.3 billion shekels in 2027, without accounting for the costs of the current war.

Steps Towards Rising Inflation and Increasing Deficit

Alongside the possibility of rising public debt due to the current war, the government is pursuing policies that fuel financial inflation pressures, most notably: the war itself, increasing the fiscal deficit, and reducing taxes. Under these conditions, the Bank of Israel will find it difficult to lower interest rates, despite the strength of the shekel that complicates conditions for exporters, and despite markets and households having long awaited this step.

The war is also expected to lead to a decline in economic growth this year from 5.2% to 4.7%, according to estimates from the Ministry of Finance. However, several economists in Israel believe that this estimate is optimistic and that the slowdown in growth could be greater than that, especially if the war drags on. Journalist Adrian Bilout in "Calcalist" (March 16) reported that these experts estimate that the prolonged continuation of the war could impose additional pressures on the Israeli economy and lead to a greater decline in growth rates.

It is likely, under the current government policies and the financial and economic results of the war, that the governmental fiscal deficit will rise to about 5.5% of GDP. This likelihood increases as the Ministry of Finance has not yet adjusted its tax revenue expectations, as it does not take into account the possibility of a decline in tax collection due to the war, as well as the slowdown in economic growth.

The Economy... From Support to Burden

Israel has bragged about its economy's ability to withstand the shocks and costs of the successive rounds of wars it has waged since October 7, 2023. But it is evident today that the Israeli economy enters the current war under different circumstances. Financial indicators of the government could become a factor limiting Israel's ability to escalate and prolong the war.

The economy has largely exhausted its ability to bear the costs of the war and absorb shocks. Israel has also resorted extensively to borrowing from global markets, driving the fiscal deficit to high levels. Any further increase in the deficit could raise it to over 6% of GDP, and rising public debt to over 70% could create serious difficulties in returning to a stable growth trajectory after the war ends.

In light of this data, a central question emerges in the current war against Iran and Hezbollah: Does the Israeli economy still represent a supportive strength for the war effort, or has it begun to transform into an obstacle to the continuation of the war?