Israel’s Economy Likely Cannot Afford an Extended War with Iran

I use the word relatively because Iran has hit Tel Aviv with missiles too. Israeli stocks have been up the last couple of trading days, reflecting the success of their air campaign and Iran’s publicly demonstrated willingness to negotiate, but what if Israel doesn’t want to negotiate? Trump wanted to make a deal and Israel attacked Iran just before his diplomats were to meet with Iranian negotiators for another round of talks. The symbolism of that strike is difficult to ignore, and it would not be inaccurate to say that it looks like a rebuke of Trump’s diplomatic strategy. Israel is forcing a military conflict now, and they are threatening to take it all the way to regime change.

Which was not in its government budget this year. Nor was its escalation in its genocide of Gaza beginning in March. “As a result, the government will be left with the unpleasant options of raising taxes, cutting civilian spending and/or increasing the deficit” wrote Haaretz. Israel has widened its deficits to pay for their genocide in Gaza, but this is exactly what S&P is warning about, as its current deficits are sitting around a nervy number of five percent of GDP. Deficits don’t matter until they do, and the Republican Party is learning how in a world where the United States spends more on interest expense than we do on defense, credit agencies will downgrade the mightiest economy in the world for further widening the deficit. Israel is dealing with a similar dynamic around their military spending for their wars of choice. At a certain point, the math just doesn’t add up, and that’s when economies can go haywire, as the bond market has been warning us about this entire year.

As many have noted since the genocide began, Israel is heavily dependent on US support, as Israeli Finance Ministry data shows that in 2023, US investments in Israel totaled $24 billion, followed by France at $3.7 billion, India at $1.2 billion, then the UK at $1.1 billion. If foreign investors are fearful of investing in a warzone, they will pull back, and Israel has a fairly high share of foreign direct investment relative to their GDP. Add in the domestic pressure in the US to divest from Israeli investments that could further accelerate if they are successful in dragging us into their unpopular war, and it’s fair to ask how many investors who leave will ever return. Another area where Israel will see investors and consumers pull back is in tourism, which represents a little over five percent of its total GDP. These are the two main concerns in any prolonged war, as no one wants to invest in or travel to a country who is being bombed.

The other problem Israel faces is that its economic might is concentrated in an industry whose workers are highly mobile: tech. If the war lasts long enough, you’ll eventually see people fleeing a warzone and working from a different location where their tax receipts will not help pay for Israel’s wars. Israel is in a position of military strength right now, but Iran knows that the longer this goes on, the weaker their hand at home gets alongside its inevitable economic contraction undercutting support for Netanyahu’s regime.

Israel is one of the most expensive OECD countries, in large part because as the OECD writes, “Israel’s distance from key trading partners and tense relations with some neighbouring countries limit trade opportunities and reduce integration in supply chains. Trade barriers, driven by difficult border procedures, complex regulatory standards and tariffs on agricultural products have also raised the price of imports.” Israelis have protested this rising cost of living in several famed instances dating back to at least the 2014 “Milky protest,” and war will only exacerbate this problem as further trade routes get cut off.

While the Israeli economy has proven resilient to the shocks its crimes against Gaza create and its economic recovery from 2023 is accelerating, 2023 demonstrated that its economy is still extremely fragile to war with an opponent who Israel can overwhelm. Prior to this war against a much more formidable fighting force in Iran, S&P had the country’s financial outlook pegged as “negative,” and it is due entirely to the fact that the “geopolitical and security risks Israel faces remain very high” (also because Trump’s tariffs “will impinge on Israel’s economy both directly and indirectly”). Given Tel Aviv’s vital importance to Israel’s economy as a disproportionately large contributor to its GDP, the longer Iran bombs the famed “start-up city” that is also a tourism hub, the less economic growth it can contribute to a strong but fragile economy heavily dependent on foreign investment.

This war is a disaster for Iran’s economy too, which in a way could heighten the ultimate economic risk in this situation, with “the world’s most important oil transit chokepoint” their best card to play in this fight. Shutting the Strait of Hormuz down would obliterate Iran’s economy, but if economic disaster is certain and the threats to its regime are existential, then shutting down a straight where 20 percent of the world’s oil consumption flows through could make sense as a bargaining chip to put on the negotiating table. This is the economic shock the whole world fears, and should Israel push Iran to the brink of what amounts to an economic murder-suicide, then Israel would be dramatically harmed by foreign investors pulling back from all investment entirely as oil prices spike and push inflation up (with Trump’s tariffs elevating it even more). The future of Israel seems to be a choice between a dynamic tech hub or an oligarchic unaffordable kleptocracy, and unfortunately for Israel’s economy, it’s ultimately up to Benjamin Netanyahu to decide.