Land of silicon and money

The OECD’s invitation to Israel is a “seal of approval” but the country still needs more reforms.

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Following 15 years of negotiations, Israel, whose per capita gross domestic product approaches $30,000 (approaching that of Germany), was invited last week to join the OECD’s club of democratic, market-economy countries. After receiving what Prime Minister Benjamin Netanyahu termed “a seal of approval,” Israel is now poised for another quantum leap in its development.

The OECD invitation will make Israel even more attractive for investors and help accelerate the country’s already remarkable growth rates, which in the pre-crisis years was about 5% per annum. Israel withstood the global financial meltdown much better than most industrialized economies, avoiding a recession and the sort of exploding budget deficits we now see in Europe and the U.S.

“This is an important further step in the acceptance of Israel as the advanced economy it is, and of its integration into the global economy,” Stanley Fischer, the governor of the Bank of Israel, told me.

It has been a long haul. Possessing some of the best human capital in the world, Israel was hamstrung from its inception by its Socialist heritage (remember the universally admired kibbutzim, now practically defunct?). Since its founding in 1948, when seven Arab armies attacked the tiny nation of 650,000 at the time, it had to cope not only with several wars and relentless terrorist attacks, with blockades and boycotts, but also with a statist system rife with bureaucracies and monopolies that impaired competition and efficiency. They left the talented Israeli worker half as productive as his American counterpart, and poorly compensated.

Everything used to be nationalized in Israel: land, water, electricity, the banks (in practice), most large industries and businesses, education, and health care. Israelis learned to their chagrin what Americans are now about to find out—that it is sometimes simpler to win wars than to repair the ravages of powerful bureaucracies, especially in education and health care.

In 1984, runaway inflation of an annual 400% and a near financial-market collapse forced Israel to start reforming its anti-productive system. But it was only after the tax cuts, deregulation, and privatization that Benjamin Netanyahu pushed through—first as Israeli prime minister in the late 1990s, and particularly later as finance minister in 2003—that the Israeli economy took off. As George Gilder documented in his riveting book “The Israel Test,” it was then that the country evolved into a “leader of technological progress and scientific advance.” Israeli high tech, Mr. Gilder noted, is the source of some of the most profitable American developments. When you open a computer and read “Intel Inside” it might as well say “Israel Inside.” The most significant innovations of the Intel chip are Israel-made.

Despite its stunning technological prowess that has launched 2,500 startups in a nation of only 7.5 million, Israel was, and still is, inhibited by an anti-productive economic system. Its economy is dominated by about 20 families, who have been able to take advantage of a politicized privatization process and gain control of many of the major assets that once belonged to the government and trade unions. A recent Bank of Israel report noted that these pyramid-style conglomerates control more than half the market assets in Israel. This great concentration of economic and political power, according to the bank, is not only a great impediment to competition and efficiency but may actually expose Israel to extreme risk. A collapse of one of these groups (which was only narrowly avoided recently) might have devastating domino effects on Israeli markets.

The good news is that both the Israeli government and the Bank of Israel say they are prepared to take strong measures to rectify this dangerous situation. These will involve tightening some regulatory practices to make it more difficult for minority owners to gain control of a chain of firms through a highly leveraged pyramid structure. It will also require the abolition of some tax privileges that these pyramid groups enjoy, as well as moves to increase transparency and competition.

The oligarchs will naturally resist with all their considerable might, including help from academic and media “consultants” and from the monopolistic trade union federation. But reformers are determined to continue improving Israel’s economy by further reducing government debt (already cut to 80% of GDP from over a 100% earlier this millennium), cutting taxes, and increasing competition in financial markets.

Joining the OECD will no doubt assist Israel’s development. But it may also put additional burdens on its economy, which is already reeling under the heavy load of welfare costs and transfer payments that consume a third of its $70 billion budget. The powerful Israeli welfare lobby has already announced that it will use the OECD’s comparative statistics to push for increased welfare expenditures.

But generous welfare systems have not worked well for the OECD’s richer members, and have proven devastating for some of its poorer nations, as is evident in Greece. Should OECD “benchmarks” push Israel to increase its high welfare expenditures even more, it will impede the country’s efforts to reduce the already extensive government interference in its economy. We can only hope that Israel’s extraordinary vitality and creativity will again prevail, even in face of such new challenges.

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