Israel’s Prosperity, Peace Depend on Economic Reform

Gilder/Forbes Telecosm 2009 Conference
10 Nov ’09
Tarrytown House Estate, Tarrytown, New York

Tiny Israel, barely the size of New Jersey, is the object of too much attention; mostly the wrong kind of attention.

This why George Gilder’s book “The Israel Test” and this conference, dealing with solid concrete achievements and not with politics and its speculations, is so very different and so very important. A conference conceived by two luminaries of hi-tech and entrepreneurship brought into focus another kind of Israel, an Israel that does not often appear on the evening news because it cannot be reduced to sound-bites, an Israel that devotes much of its energy and talent to peaceful occupation, to the advancement of knowledge and of human welfare—all while it has to struggle, daily, for its very survival.

For focusing your conference on these insights, Steve Forbes, and for your book and this conference, George Gilder, Israel—and may I add all peace seeking people around the world—owe you a deep debt of gratitude. So too to the distinguished participants of this conference. Even seasoned Israelis, perhaps even the authors of the riveting book Start-Up Nation, have discovered so many new aspects of Israeli hi-tech and their possible applications, some revolutionary, on our economies and our societies.

There are other ways in which little Israel can serve as a laboratory, or as a test case of significant social and economic developments. Tonight I want to speak to you briefly on some of them, especially on the impact of economics on peace.

Since the recent crisis we have heard many –- disappointingly even from former defenders of the market economy—voice advice, indeed demands that we no longer place our confidence in it because the crisis revealed that the market economy was deeply flawed; that the invisible hand cannot be relied upon any longer to promote economic transactions and we must therefore resort more and more for the correction of its putative faults on the all-too-visible hand of regulation, namely of government.

The powerful lessons we have learned in Israel run in the opposite direction. They teach that government control and regulation aggravate rather than solve problems. They also point out that globalization, namely enhanced global trade, also under attack, has been highly beneficial precisely for developing nations. But above all we have learned in Israel that free and prosperous markets provide the most powerful incentive for peace, not just paper peace signed by politicians but a real peace between people who recognize the profits that peace can bring about, when it is based on the mutual interests of people and on mutual cooperation and the benefits it engenders.

Let us start with the power of market-oriented reforms to change the direction of an economy and the society it supports. In February 2003 Israel was facing an Argentina-like collapse: bankrupt banks, closing enterprises and hundreds of thousands of workers –- about 10% of the workforce—unemployed. About half the government’s $70 billion budget was devoted to transfer payments and social expenditures. About a third to debt service. Despite constantly growing expenditure on education, health and welfare, all these systems were in trouble.

This was not ordained from above. As you know by now Israel has the human capital and the capital resources to become one of the wealthiest countries in the world. Only its highly concentrated, non-competitive and inefficient economic system, left by a long legacy of Socialism-cum-statism, prevented it from becoming highly prosperous.

It needs to be stressed that economic reform, leading to prosperity, is not merely about a better standard of living for Israeli citizens. It is about survival. To make it in a very hostile world Israel must have a strong economic base. Israel was not able to keep its young at home on the poor salaries and limited career opportunities its laggard economy offered. Unless it can make its GNP grow dramatically Israel will also not be able to pay its defense bills, which will keep growing even if peace breaks out tomorrow. So let me reiterate, economic growth is a matter of survival for Israel.

When Finance Minister Benjamin Netanyahu averted this Argentina-like collapse, Israel was in the throes of a decade-long deep recession. The government, the greatest purchaser in the Israeli economy and the greatest employer (every third person is employed by the public sector), could not pay its bills or meet its payroll. 70,000 businesses went bankrupt, threatening the entire banking system, which was shaky to begin with, with insolvency.

The reasons for the great difficulties facing Israel, economically and socially, were painfully simple. During sixty years of collectivism and statism, Israel, like the countries of Eastern Europe, developed a counter-productive economic system, replete with costly and wasteful monopolies and cartels, hamstrung by huge bureaucracies, and bedeviled by all manners of vested interests, all inhibiting growth.

The cure to these problems was also simple. Transform the Israeli economy into a modern competitive market economy and its productivity will skyrocket.

Easier said than done, of course, but it was done, at least in part. Under Netanyahu’s leadership as finance minister, excessive public spending has been repeatedly slashed—not enough, perhaps, but considering the political obstacles, a miracle nonetheless. Netanyahu has also privatized the ports, slashed exorbitant social benefits, encouraged welfare recipients to go back to work, reduced taxes and started to curtail the bureaucracy.

Netanyahu greatest achievement was the breakup of the bank duopoly that misallocated credit in Israel and was responsible for its laggard development. Like in Japan, Israeli banks were able to maintain their stranglehold because of their enormous political clout. So the banks were confident that they could continue fending off any reform, even when Finance Minister Benjamin Netanyahu –- the first high-level Israeli politician to really understand economics –- embarked on a courageous reform path, determined to break up the banks’ monopoly and introduce competition and new players into financial markets.

The banks put together a big fight. But Netanyahu, with strong support from several of Israel’s top economic commentators, and from independent pro-market think tanks and over 60 Knesset members, stood firm and the Knesset finally ratified the reform.

The reform was a great success. The bankers, who first claimed that it would be impossible for them to sell their provident funds in less than six years, sold most of them for high prices within a few months, and new competitive players have entered the Israeli economy. Making financial intermediation in Israel more competitive and efficient was bound to have great consequences, as productive investment creates new opportunities and releases the enormous energies of Israeli entrepreneurs who were barred by the banks from participation. The reform turned twenty years of recessions and laggard development into five years of spectacular (5% annual) growth and is credited with enabling Israel to weather the recent crisis better than most expected. The purchase by Warren Buffet of an Israeli non-hi-tech firm, that nevertheless has exceedingly high profits margins, is one notable example of the great potential of the Israeli economy, and of the great benefits it will offer to investors once the full repercussion of its financial reform, and other reforms, are realized.

Another lesson Israel teaches is that globalization is a great boon for developing countries. You have heard about the great achievements of Israel’s hi-tech sector, but these would not have happened if globalization did not encourage investors to reach further afield, beyond their national economies, and to invest in start-ups in countries whose prospects were not so promising at the time.

So yes, globalization is the unsung hero behind the great achievements of Israeli hi-tech since Israeli banks had no interest at the time in investing in venture capital, and Israeli capital markets generally were not developed enough to sustain such risky investments.

And now to economics and peace, the last item of our talk. Because Israel’s economic situation has far-reaching consequences not only internally but also internationally, especially in its relations with the Palestinians, I will try in the few remaining moments to explain why all peace efforts, like the Oslo agreements or the Roadmap and what succeeded it, which ignore the underlying realities of economic life and seek a cold formal political peace based on the separation of people and the hiding behind walls, have far less chances for success than a peace rooted in the rule of law and in the creation of a prosperous economy for Palestinians as well as Israelis, in full cooperation between them. Arrangements that only reflect political considerations often fail to address the real needs of people or dissipate their animosity, and they usually fail to create the necessary peaceful basis and the public support that can alone make peace deeply rooted and lasting.

Remember, that it wasn’t peace processing or agreements alone that ended centuries of conflict and carnage in Europe and reconciled two seemingly irreconcilable enemies, France and Germany. It was the total defeat, first, of the aggressor, Germany, which permitted the creation in Germany of the rule of law and the subsequent initiation of a cooperative economic process –- the establishment of a steel and coal community that jump-started a true reconciliation. Economic growth calls for cooperation. It makes former differences seem irrelevant, or at least less important.

The latest mission of the undaunted “peace processors” was to “democratize” the Palestinian Authority, an organization that has thrived on repression, violence and aggressive irredentism. Now that this failed they will try an even more difficult mission impossible: to have the Hamas, a terrorist organization whose very raison d’etre is waging an uncompromising war against Israel, change its spots and transform itself from a tiger into a pussycat.

Meanwhile, a far more promising route to peace –- the path of economic cooperation and development –- has been systematically neglected. It’s as if the only form of economic life possible for Palestinians is the one that has been imposed on them by the so called international community, namely the Brussels bureaucrats –- the provision of billions of dollars of foreign aid to the huge bureaucracies of a criminal and terrorist Authority. Predictably most of these billions met the fate of the UN Oil for Food program. They were either squandered or stolen, promoting the lawlessness and corruption that suppressed private initiatives.

Before the 1993 Oslo agreement was signed between a deluded Israeli leadership and Arafat’s terrorist PLO, a most promising though non-political process of economic collaboration led to a gradual reconciliation between Arabs and Jews. From Israel’s 1967 conquest of the disputed territories to the 1987 Intifada, Israel followed a laissez faire policy. It maintained open bridges with Jordan and did not interfere in Palestinian Arabs’ internal affairs. Israel’s maintenance of a modicum of law and order in the disputed territories of the West Bank and Gaza facilitated the development of trade and rapid economic growth. Crowds of Israelis ate and shopped on weekends in Arab towns and markets. Hundreds of thousands of Palestinian workers, freed from backbreaking drudgery on primitive Arab farms by Israeli-introduced modern farming techniques, moved from a bare subsistence existence in the backward Palestinian economy to far more lucrative jobs in the growing Israeli economy.

The outcome was dramatic. The GDP of the Palestinians more than quadrupled. Education levels rose, and some seven universities were established where none existed before under Jordanian rule. So did health levels, especially of women and children. The population grew rapidly.

There were remarkably few terrorist attacks during this period. The few that happened were mostly perpetrated by PLO hirelings and did not express popular support. Not that the Arabs were enamored of Israeli occupation. No one likes an occupation. But they found the occupation a lesser evil to Arab rule, realizing the enormous benefits it brought to them. (This was even truer after Oslo when Palestinians learned first-hand what PLO rule meant, so when it was rumored that Arab sections of Jerusalem were to be ceded to the Authority real estate prices plummeted.)

The economic revolution of the Palestinians also had far-reaching social consequences. Enhanced wealth translated into social mobility. It loosened the oppressive grip of clan and family. Arab women were great beneficiaries. They received better health care and education and began entering the work force.

Contact with a rambunctious Israeli democracy and with a fairly permissive modern society has also had an impact that was not all positive, or welcomed. Rapid, radical changes did not sit well with the Moslem tradition-bound Arab elites, who saw their privileged positions eroded and their way of life threatened. They became convinced that to survive they ought to get rid of Israel and its influence, direct or indirect.

In the mid-eighties a deep crisis in the Israeli economy and economic difficulties in the Gulf region, where many Palestinians found lucrative employment, brought Palestinian prosperity to a halt. Concurrently Israeli bureaucracy, which habitually makes life miserable for Israelis, also increasingly strengthened its stranglehold over Arab life, levying high taxes while imposing complex administrative strictures on Arab businesses, designed mostly to protect Israeli monopolies.

When in 1987 an Israeli truck accidentally hit some children in Gaza, the Palestinian areas were already a tinderbox waiting to explode. Thus started the first Intifada; it was later exploited by Arafat to launch a political and military revolt against Israel.

The response of Palestinian merchants to the first Intifada, which prevented Israelis from shopping in Arab cities, was remarkable. Along the 1948 Armistice Line, hundreds of them spontaneously created mobile markets for Israelis now afraid to visit their towns, but unwilling to kick their Saturday shopping habit.

But Israel’s messianic peace camp could not adjust to this imperfect peace. It kept clamoring for a total “Peace Now”, especially after the 1987 First Intifada. Prime Minister Itzhak Rabin, worried by the reaction of Tel-Avivians to Saddam’s nightly scud attacks, which he wrongly interpreted as lack of stamina, acquiesced to Oslo. A misguided Israeli government made its Faustian pact with the devil. It invited the PLO, a terrorist organization dedicated to the destruction of Israel, to become its partner in a putative peace process. Foolishly, Israel expected the PLO to do its dirty work, to fight the extremist terrorist organizations in a way that Israel, hamstrung by a very liberal supreme court, could not fight.

The moment that Arafat and his minions took over the disputed territories, they first destroyed the local economic and political leadership and replaced it with their own henchmen from Tunisia. They established a rule of terror, eliminating all opposition, systematically undermining the power of the merchant class by imposing upon them “partnerships” with PLO operatives and extorting all manner of payments, confiscating property and goods. Arafat’s “Authority” was never interested in establishing any kind of civil or legal order. It preferred to foment terror and mayhem so as to undermine economic activity, impoverish their population and then channel their frustration and anger against Israel. Oslo put an end to a very encouraging if informal peace process that preceded it.

Arafat’s men also destroyed the spontaneous markets that had sprung up by sending assassins and bombers to scare Israelis away. They devoted special efforts to destroy the really remarkable peaceful coexistence between Arabs and Jews in Jerusalem.

East Jerusalem Arabs are very fervent Moslems and nationalists. Jerusalem and its grand mosques became the focus of intense nationalist feelings for them. Yet, because thriving tourism and commerce made most East Jerusalem Arabs very prosperous, 99% of them opted for Israeli rather than Palestinian papers when they were asked to choose between them after Oslo. They chose so because while intensely disliking Israeli occupation, they were even less enamored of Palestinian misrule, terrorism and economic extortion and misery.

The Palestinian Authority rule of terror suppressed economic activity and resulted in massive unemployment, reaching in some areas 60% (up from nearly full employment before Oslo). It bred despair—a fertile ground for the incessant drumbeat by Palestinian Authority organs of vile, anti-Israeli and anti-Semitic propaganda in schools, in mosques and in the electronic and print media. It engendered such bitterness and hatred towards Israel that it is really a wonder that only dozens rather than hundreds of Palestinians were ready to become martyrs and suicide bombers in the cause of jihad. Just consider what five years of intensive pre-WWII Gobbles propaganda did to a civilized German population after it was ravished by hyper-inflation, and you will understand the hatred those eleven years of far more intensive PLO anti-Israel propaganda and economic misery inflamed.

Not that Israel was completely without fault. The notorious Israeli bureaucracy made a dependent Arab population miserable with it arbitrary and oppressive strictures. Because of pressure from Europe, the US and its own leftist “peace camp”, Israel was reluctant to fight terrorism the only way terrorism can be successfully fought –- by totally eliminating its leadership and logistic infrastructure. Instead, Israel tried to fight terrorism incrementally, by ineffective half-measures. Worse, by resorting to ineffective defensive measures, such as imposing unnecessarily strict closures, erecting roadblocks and such, Israel in effect punished many innocent Arabs, helping the terrorists gain wider support.

Despite all the misery and hatred that the putative political peace process has inflamed, and even despite the recent Hamas victory, all is not hopeless. The situation might still be reversed. There is a possibility of restoring better relations between the two people based on economic cooperation. But for this to happen, we must first do away with the grand illusions propagated by politicians and others that this conflict can be resolved mostly through political action and only by securing the cooperation of the PLO and its criminal leadership.

The victory of Hamas offers the opportunity to try and neutralize politics as much as possible for a while, and to establish in Palestinian areas the rule of law, that facilitates economic development. The rule of Hamas may provide an opportunity to funnel monies away from a Hamas-dominated PA and redirect them to private initiatives. For example, where housing is needed, especially to alleviate the miserable conditions of the refugees, cheap loans should be offered to families to build their own homes, rather than channeling money for housing through the corrupt Authority. Tenders for infrastructure projects should be opened to private contractors through an open process of competitive bidding.

True, the Palestinian economy may not be ready soon for hi-tech development. Yet it has a lot of other potential. It has a relatively educated and capable work force that could develop very rapidly, provided the proper circumstances and incentives are in place. Even now, it could become a center for outsourcing, manufacture and services for the Gulf States and other less developed Arab countries. And yes, the current reforms in Israel that will make the Israeli economy less restrictive and monopolistic will open up markets for competitive Palestinian enterprises as well. Since for the foreseeable future trading and cooperating with Israel is the Palestinians’ best economic option, such developments should be encouraged.

I do not mean to imply that economics can solve all problems. But it can certainly mitigate conflicts and it can create the conditions for the emergence of a middle class with a real stake in peace. At present, the so-called Arab street is prey to radicalism and violence because a UN-established welfare regime has rewarded pregnant and nursing mothers, and thus increased the birth rate and helped create a population that is mostly very young, unemployable and shiftless. Rapid economic development can change this destructive demographic trend, and have a positive effect not only on Arab society but on its volatile politics as well. Only an economically prosperous Israel can help bring real economic progress to the Palestinians. But for Israel to become so it must fight strong vested interests and a leftist, welfare state ideology supported by most of the media and its elites.

The economic reforms now being planned or implemented present Israel and its friends with a truly historic choice. It can determine whether Israel will finally become a modern economy that gives full scope to the enormous talents and energies of its citizens, to allow them to live proudly from their own efforts, or whether it will remain a backward welfare state, a charity ward. The second alternative is not really an alternative at all because it could lead to Israel’s decline. The other alternative has already proven, even when limited by circumstances, what great things can be accomplished in Israel. This conference was an eloquent expression to this hopeful vision, a vision that promises a far better, more peaceful life for Israelis and Palestinians alike and for the Middle Eastern region as well.

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ICSEP has circulated the following letter together with a PowerPoint presentation: “A Competitive Capital Market – A Growth Engine for the Israeli Economy”.

Dear friends,

Enclosed is a draft document on the reform of financial markets in Israel. We hope it explains why such a reform is so vital for Israel’s viability, and why Israel needs a strong economy to meet the extraordinary threats and challenges facing it.

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