The dark side of foreign aid

Our socialist and statist heritage bred our inefficient system.

But foreign aid and remittances were serious enablers.

The struggle against political and economic concentration could finally permit Israelis to overcome this destructive heritage.

Filed under:

fundamentals • reform • limiting government • world affairs

Yes, our socialist, statist heritage bred our distorted, inefficient system. But foreign aid, remittances were enablers. Israel owes the US a great debt of gratitude for all the political and economic aid it has received.

Since the state’s establishment, US aid, economic and military, has amounted to some $105 billion. A goodly sum of money, even if it amounts to less than half of Israel’s current GNP—$235b. At its peak in 1985, aid was $3.8b, representing a hefty 16 percent of Israel’s GDP at the time. It played a significant role in the formation of the Israeli economy’s structure, in a manner that still influences its economic development—and not always for the better.

In 2007 Israel stopped receiving economic aid, receiving only around $3b. a year in military assistance.

Military aid currently represents only 1% of Israel’s GDP, a burden Israel could conceivably carry by itself. It may be important, however, to maintain such aid for other strategic, political and institutional reasons, since it involves Israel more intimately with many important American institutions, not least the US Congress and America’s defense industry.

But there is room for improvement even in the best relationships. As the great development economist Lord Peter Bauer observed decades ago, foreign aid often creates serious problems for the countries receiving it. This is also true for military aid.

MILITARY AID enables recipient governments to free up for other purposes resources they would otherwise have to allocate for defense. However, and this is the major problem with all foreign aid, it is necessarily funneled through governments, and governments naturally operate according to political rather than economic considerations.

Indeed, governments often operate in ways that are detrimental to the economy. They create wasteful public sectors ostensibly designed to enhance the welfare of their citizens, the so-called welfare state. In reality, the plight of the poor often serves merely as an excuse; the real purpose of enlarging the public sector is often the creation of interlocking bureaucracies and tycoons that literally choke economic activity, while enabling politicians to provide supporters with jobs and resources at the expense of economic growth and the general good.

Governments are often the largest employer and purchaser in the economy. The sheer scale of their operations, and their ever-growing thickets of regulation, tend to favor big business. This helps build great concentrations of economic power in the private sector, huge monopolies and cartels. They progressively come to dominate economic activity at the expense of smaller businesses that cannot afford the burdens imposed by government.

Big business tends to exploit its economic clout not only to suppress competition but also to amass political power that helps protect its privileges. The bigger the government, the bigger the burden on small businesses, which are the chief economic engines of innovation and growth.

Lord Bauer’s warning is borne out by what foreign aid did to many African and Muslim countries. The large flow of foreign aid funds through their governments badly aggravated the inherent problems of their authoritarian government rule. It increased an already overbearing concentration of economic activity in the hands of a few institutions and tycoons with strong political ties.

Indeed, in many of these countries, as is clearly the case in Egypt, former government bureaucrats and top military men have become major economic players, with all the abuse of power that this implies. In Egypt, the army is in control of a full third of the economy, not the most efficient or productive way to run a modern economy. The result is the exceedingly high rate of Egyptian unemployment, reaching 30% especially among the young.

The massive impoverishment that follows is a major cause of great political unrest and violence.

THESE ARE the bitter truths of political life. They are too often ignored by observers who disregard economic processes in their analyses of political developments.

In the past such blindness to economic factors was responsible for the failure of so many experts on the Soviet Union to predict its “sudden” collapse.

Today it is responsible for the failure of many to realize how weak the Iranian regime is economically, how dependent it is on its current exports of oil to feed its 60 million citizens and how relatively easily it can be brought to its knees by effectively hurting its oil imports, without even touching its nuclear facilities.

Israel cannot be compared, of course, to destitute African states, certainly not to an economically dysfunctional Egypt. Israel is rightly considered a “startup nation.” It boasts a vigorous, innovative hi-tech sector, and has weathered the post-2008 economic troubles far better than most nations.

However, a closer examination of the Israeli economy reveals some very deep problems. Despite arguably the best human capital in the world—tiny Israel has more start-ups than all of Europe—and despite over $300 billion invested from foreign sources, the Israeli economy pays most of its skilled workers a pitiful $2,200 a month. This when prices of most consumer goods and services in Israel are higher than in the US.

Millions of Israeli workers are struggling to make ends meet. Economic concentration that curbs competition and efficiency is a major reason for this predicament.

An April 2010 Bank of Israel study has confirmed that excessive concentration in the Israeli economy poses a danger to its stability and viability. It noted that “some 20 business-groups, nearly all of family nature and structured in a pronounced pyramid form, continue to control a large proportion of public firms [some 25% of publicly listed firms] and about half of market share.” These same groups also receive most of the credit given by banks to the business sector and 60% of the non-bank credit. They show, the bank’s report warned, “higher levels of financial leverage – and therefore also of risk,” than stand-alone companies.

Our two major banks and these pyramid-style conglomerates have become “too big to fail.” The possibility of their failure, which was tested in the past and may be tested again soon, is so threatening to the total economy that they gain immunity for their anti-competitive practices.

BUT WHAT does all this have to do with foreign aid and with the economic interaction between the US and Israel? What has sown the seeds of our extraordinary concentration of economic and political power is no doubt Israel’s socialist past. But even after the demise of socialism in the late Seventies, concentration still increased as a statist ideology and practice continued to dominate economic life in Israel, and extensive government intervention was justified not on socialist grounds but on nationalist ones.

The initial dominance of the government, namely of politics, over the economy was maintained after the creation of the state by the government consuming over 80% of GNP and 90% of all savings. Most assets, including banks, were held by government or by its political base, the Histadrut Labor Federation. Foreign remittances and aid played a significant role in making this possible.

Government still plays a major role in the economy even now when its share in the GNP has shrunk to close to 50% (or perhaps a little over) and even after most of the assets that belonged to government and the Histadrut were sold, in a phony privatization process to cronies, to some dozen families who bought these assets for very little with loans taken from their allies in the bureaucracy, the managers of the nationalized banks.

True, government no longer controls 90% of all credit, but credit is still heavily misallocated to big business in Israel. It is a major factor in the dysfunction of the Israeli economy and in its domination by inefficient and rapacious conglomerates, banks and insurance companies that are mostly managed by former high government bureaucrats with very questionable business skills and ethics (witness the low rate of return on capital of these businesses and the exceedingly high rate of non-performing banks loans. Also consider the very low return Israeli pension funds receive on their immense, and as it turns out very risky, investments in these conglomerates. As for ethics, witness their managers’ rapacious behavior, the inflated salaries and bonuses they allocate themselves for their poor business performance while exacting high monopoly rents from the poorest strata in Israel).

The misallocation of credit to big business is also a chief reason why the Negev and the Galilee, Israel’s so-called periphery (a mere 160 kilometers from the center) is suffering from a prolonged and severe credit crunch. The small and medium companies that are based there cannot take off and develop.

The conglomerates also erect a thicket of entry barriers that keep their would-be competitors out. They are aided by protective tariffs and by government permitting them to control even the shelf space in supermarkets.

Lack of competition, combined with so-called “progressive” labor laws, has resulted in low efficiency that translates to low per-capita productivity (about half that of the US). It also translates into dismally low wages for Israeli workers, and causes inadequate performance of our economy and increased social problems and tensions.

So yes, it was our socialist and statist heritage that bred our distorted, inefficient system. But foreign aid and remittances were serious enablers.

The struggle against political and economic concentration could finally permit Israelis to overcome this destructive heritage. If they are to successfully meet the many serious challenges facing them, Israelis must build a more efficient and equitable economic system.

For this they can find inspiration in the strong American free market tradition, a tradition that America, too, is struggling to preserve.

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