Economy under fire: Israel’s fiscal future hinges on war’s endgame

Since the early hours of Friday morning, senior economic officials in Israel’s government and at the Bank of Israel have communicated three essential messages regarding the nation’s economy amid escalating conflict:

1. The Israeli leadership had anticipated potential attacks and had prepared frameworks to ensure operational continuity and compensation for affected citizens.

2. They are also ready to address more severe and prolonged scenarios that may arise from the current conflict.

3. It remains too soon to determine the full economic repercussions of this attack, as these effects heavily rely on the evolving security situation, with all their models presently being speculative.

These statements, while foundational, lack the depth and transparency that the public seeks in understanding the numerous dilemmas and uncertainties linked to Israel’s economic outlook. However, the Bank of Israel has attempted to convey a more informed perspective by convening the “Financial Stability Committee,” the first public disclosure of such a meeting, indicating a recognition that the Israeli populace is poised to engage with complex economic assessments.

Despite the premature stage of evaluating the conflict’s economic fallout, a couple of conclusions can be drawn with relative certainty:

1. The markets continue to exhibit considerable confidence in Israel’s military capabilities.

2. Both the 2025 and likely the 2026 budgets will undergo significant adjustments as a result of the ongoing conflicts.

Focusing on the first point brings a sense of reassurance amid uncertainty. Following a previous volatile episode, the Israeli Securities Authority made the critical choice to reopen the stock exchange shortly after the initial attacks on October 8, 2023. Initially, the exchange experienced moderate declines, yet it promptly rebounded to show gains. Furthermore, Israel’s risk premium surged from 96 basis points before the conflict to 110 by the following Friday, and subsequently exceeded 120 by Sunday. While elevated, this level is still considerably below the 150-point peak witnessed in October 2024, amid escalated tensions with Iran.

The military demonstration of strength through Israel’s opening strike on Iran, coupled with robust defenses against retaliation, sent a message of military and technological superiority. This, together with the nation’s capability to maintain economic continuity under duress, has somewhat assuaged market nerves.

International credit rating agencies such as S&P, Fitch, and Moody’s have refrained from hastily downgrading Israel’s credit rating or issuing investor warnings. This restraint is noteworthy since all three entities had previously indicated that an escalation with Iran might prompt such actions. Their measured approach seems to be a reflection of the reality that, although the human cost on the home front remains significant, essential civilian infrastructure has so far remained intact, and the long-term ramifications of this conflict are still under evaluation.

However, Israel’s military dominance over Iran does not render it immune to economic repercussions. The previous conflict with a less formidable opponent, Hamas, showcased the potential for profound human and economic costs. Consequently, in analyzing the current situation, the reality emerges that war, while impacting the human experience, comes with substantial economic burdens.

The immediate aftermath of conflict includes a steep increase in government spending, with significant allocations toward military supplies and reparations for damages. This reality necessitates a revision and potential expansion of the 2025 budget. If the conflict continues, tax revenues may also dwindle, aggravating fiscal deficits. Should civilian life face persistent restrictions, GDP growth, initially projected at 3.5% for 2025, is likely to decline.

In this context, Israeli economic policymakers might find themselves once again confronting a familiar dilemma reminiscent of the COVID-19 era—balancing the needs of defense and public health against the necessity of reopening the labor market. Economists tend to sidestep such conflicts, but if restrictions persist and the economy remains below full capacity, the fiscal damage could be severe. Alternative models allowing for high levels of security while maintaining economic activity are available but would require strong advocacy from economic leaders to come to fruition.

Despite the grim scenario, unwarranted hope lingers among Israeli policymakers that this conflict could significantly alter the regional power dynamics, potentially decreasing long-term defense expenditures, lowering risk premiums, and attracting foreign investment.

Yet, this optimistic framework is only one potential scenario. The aftermath of military control in Gaza serves as a cautionary tale; a military victory did not yield reduced defense spending but instead led to mounting expenses tied to sustaining military governance.

In essence, the conflict with Iran may not produce a “peace dividend.” Instead, one could foresee further budgetary constraints.

Ultimately, the economic future of Israel remains entrustingly interlinked with the conflict’s progression. How and when the war concludes will not only define Israel’s economic trajectory and fiscal policies for years ahead but also shape the everyday lives of its citizens. As these developments unfold, the emphasis will remain on the delicate balance between military preparedness and economic sustainability—a topic that demands continuous and measured dialogue among all stakeholders involved.

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