Chronicle of a local crisis foretold - lessons from Israel.

• Author: Kimhi, Omer

Introduction I. The Development of the Israeli Local Crisis A. Socioeconomic Processes B. The Local Political Structure and Lack of State Monitoring II. The Problems with State Monitoring A. The Costs (or Lack Thereof) of a Local Crisis to the State Politician B. The Political Costs of State Intervention III. Lessons from the Israeli crisis A. The Importance of Efficient Credit Markets B. A Procedural Process for State Intervention Conclusion INTRODUCTION

The financial crisis in 2008 stirred a debate about the state's role in the monitoring of the financial markets. The once-dominant neoliberal approach weakened, and various reforms in the state's financial regulation were suggested. Many of the reforms called for more intense state involvement, others called for a more cautious approach. Much less attention, however, was paid to the state's role in monitoring local finances. Although the crisis no doubt affected localities, and despite predictions of massive local defaults, there was little discussion about the state's supervision of local fiscal policies. What difficulties does the state face in monitoring these issues and how can we mitigate these difficulties? This Article aims to explore these issues, in light of the Israeli experience. It demonstrates the pitfalls in the state's monitoring, and suggests partial solutions.

My main argument is that political interests frustrate efficient state monitoring. State politicians do not always internalize the costs of a local crisis, and they may even benefit from local economic weakness. They prefer to maintain the local dependency on the central government's funds, thereby strengthening their own position vis-a-vis the local leadership. An interesting metaphor for the state-local relationship in Israel can be found in the famous fable about the frog and the scorpion. The scorpion asks the frog to carry it across the river. In the middle of the way, the scorpion stings the frog and they both drown. The stunned frog asks the scorpion why it did that, and the scorpion replies, "It is my nature." The same is true with regard to the policies of Israel's central government toward the local sector. Although the local crisis was detrimental to both localities and the central government, the state politicians were largely responsible for it. The nature of Israel's political system incentivized them to shift costs and to underfund the local sector until it was on the verge of financial collapse.

In 2004-2005, localities in Israel underwent a severe fiscal crisis. About three quarters of the local governments suffered from deficits--most of them had deficits of over 30% of their annual budgets. (1) Defaults were prevalent, employees worked for months without compensation, and basic services were not provided. (2) A large portion of the local sector was unable to finance the public goods for which localities were legally responsible. (3) This Article shows that much of the responsibility for this local crisis lies with the state. Since the 1980s, various socioeconomic and political processes joined together and created an environment that facilitated the creation of huge local deficits. The central government shifted more and more responsibilities to the slim shoulders of the local sector, (4) but it failed to finance these additional obligations. (5) On the contrary, the state significantly decreased independent revenues. (6) In addition, although the state had ample authorities to supervise local expenditures, (7) it failed to do so. (8) The state did not force localities to be fiscally disciplined, and it did not sanction localities for violating regulatory duties, even when these violations were readily known and could be corrected cheaply. (9) State politicians preferred to ignore the local plight rather than take actions to correct it. (10)

After examining the state's responsibility for the local crisis, I explore the motives behind the state's behavior. I argue that Israel's political structure incentivized state politicians to neglect the municipal sector and to create a lax supervision system over local finance. Within the Israeli national political system, local issues are not considered an important factor. State politicians are not rewarded for investing resources in distressed localities, and they are not punished for the creation of local deficits. They are better off, therefore, under-financing municipalities, and spending the state's funds on other purposes from which they enjoy political dividends. Underfunding the local sector has an additional benefit: it forces municipalities to beg constantly for assistance, thereby giving state officials the power to decide who will receive additional funding and who will not. Moreover, due to the mayors' power in the national parties, state politicians are reluctant to confront them. Mayors are allowed to overspend and violate state regulations because the minister of interior, who is in charge of the state's monitoring system, needs the mayors' support for his political career. Using Israeli cases, I illustrate the inherent conflict between the interests of the individual politician and the state's monitoring duties.

Drawing on the Israeli experience, I then identify two mechanisms that can decrease the weight of the political interests. One is an efficient municipal credit market, and the other is an established statutory procedure for the state's intervention. The credit market compels the central government to internalize some of the costs of the local crisis and incentivizes state officials to take action. Evidence from the United States shows that states assist local governments to recover from fiscal crises because they are apprehensive of crises' contagion effects on the municipal bond markets. The Israeli experience, on the other hand, suggests that the lack of an efficient credit market aggravates the local plight and holds back local reforms. A statutory procedure for the state's response in the face of local distress can also decrease political pressures. Especially when implemented by an insulated state agency, such a procedure can serve as a commitment device and constrain state politicians in their actions. While these mechanisms cannot guarantee that the state will monitor effectively, evidence shows that they may have positive effects on the local fiscal health.

Although this Article focuses on Israel as a case study, the political dynamics it describes are not unique to a particular country. Similar problems also surface in the United States, where political interests get in the way of efficient state supervision on local finance. Bridgeport's crisis, for example, was partly the result of state-local relations, (11) and the roots of the Orange County bankruptcy were also connected to the state. (12) A study of the difficulties in the state's monitoring can help improve local finances by helping us understand the motives behind the state's local policies, so that we can structure the state's monitoring system accordingly.

1. THE DEVELOPMENT OF THE ISRAELI LOCAL CRISIS

   In 2004-2005, local governments in Israel were in a severe fiscal crisis. (13) The crisis was not experienced by just a few localities with problematic financial practices, but rather it encompassed a significant portion of the municipal sector. In 2004, no fewer than 75% of the local governments (190 out of 255 municipalities) suffered from a budget deficit and had difficulties paying their debts when due. (14) In 2005, the percentage of the localities in deficit declined a bit to 56%, but over 75% of those municipalities (107 municipalities) suffered from a deficit that reached over 30% of their yearly budget. (15)

   Many municipalities in those days did not have enough funds even to pay salaries. In May 2004, 35% of the localities were unable to pay their employees, and many municipalities kept workers without compensation for months. (16) In a private workplace employees might sue their employer for the payment they deserve, but it was pointless to sue Israeli local governments. All potentially sizeable local assets were already repossessed by banks or by other creditors, (17) and there was no way to enforce the judgment. (18) Thousands of employees, therefore, worked in the local government sector for nothing. (19)

   Some municipalities failed to provide even the most basic and essential public services. (20) There were shortages or shutdowns of water and electricity supply because municipalities could not pay electricity and water bills. (21) Garbage was not collected frequently enough and posed health hazards. (22) Infrastructure was not maintained properly, and even school houses were kept in poor physical condition. (23) Although some municipalities did better than others, the local sector in general, and especially Arab localities, (24) did not perform even basic functions.

   The development of such a severe local crisis begs the question, how could Israel, now a member of the OECD, allow the local sector to deteriorate to this level? What caused so many localities to practically go bankrupt? In the following sections, I examine these questions, focusing mainly on the role the state played. I show that the state had a crucial role in the local deterioration and that it neglected its duties to monitor local finance. I do not mean to negate other important causes of the crisis by focusing on the state. The causes are varied, and certainly there were cases of mismanagement and corruption not connected to the state. The scope of the crisis shows, however, that in addition to the specific reasons of each local distress, something was wrong structurally. There were common processes, many of them connected to state policies, that led to the decline of the entire local sector, and it is those processes I wish to explore.

   1. Socioeconomic Processes

      Although the crisis erupted in the new millennium, its roots can be traced back...