Israel’s survival, peace, depend on economic prosperity

Republican Jewish Coalition
26 May ’05
Washington, DC

“Most of you have visited Israel,” ICSEP president Daniel Doron began his address to the Republican Jewish Coalition in Washington on May 25th.

“You saw a vibrant, seemingly well-to-do country.

“You ate at posh restaurants full of prosperous Israelis, visited their impressive villas and saw their expensive cars.

“And yet, Israel, chock-full of human talent and energy, a world-class high-tech leader, seems in perpetual economic trouble.

“If the country is to survive it must reform its economic system, and do it soon.”

Read the entire speech.

Most of you have visited Israel. You saw a vibrant, seemingly well-to-do country. You ate at posh restaurants full of prosperous Israelis, visited their impressive villas and saw their expensive cars.

And yet, Israel, chock-full of human talent and energy, a world-class high-tech leader, seems in perpetual economic trouble. Hundreds of thousands are unemployed, with the unemployment rate reaching over 10%. Over a million workers receive supplemental government income because with their measly $1200 salary, they can’t make ends meet. Israelis pay a third to a half over international prices on everything they consume because of “rents” exacted by the Israeli monopolies, which totally dominate the economy.

About half the government’s $70 billion budget is devoted to transfer payments and social expenditures. Yet Israel’s educational, health and welfare systems are constantly on the brink of bankruptcy, as are its profligate universities. As you know too well, Israeli institutions and individuals are constantly clamoring for help from their Diaspora brethren. This need not be so, since Israel has the human capital and the capital resources to become one of the wealthiest countries in the world. Only Israel’s highly-concentrated, non-competitive and inefficient economic system prevents it from becoming highly prosperous.

If Israel is to survive it must reform it economic system, and do it soon. Economic reform that can lead to prosperity is not merely about a better standard of living for Israel’s citizens. It is, I repeat, about its survival. Israel will not be able to keep its young at home on the measly salaries and limited career opportunities its laggard economy offers. Nor will Israel be able to pay its defense bills, which will keep growing even if peace breaks up tomorrow, unless its GNP grows dramatically. So again, economic growth is a matter of survival for Israel.

Until two years ago, when Finance Minister Benjamin Netanyahu launched his courageous reforms, Israel was on the verge of an Argentina-like collapse. After a six-year spell of deep recession, the government could not pay its bills. Businesses were going bankrupt, threatening the entire banking system with insolvency. Because of an extremely low rate of per capita productivity growth over the last decade, Israel lost over $100 billion in potential Gross National Product. This is a loss equivalent to fifty years of US military aid! Just imagine the trouble AIPAC goes to in order to increase US government allocations to Israel by several hundred millions of dollars, and think of all the billions wasted simply because the Israeli economy does not perform even close to its potential.

The reasons for the great difficulties facing Israel, economically and socially are 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 that inhibit growth. Except for its high-tech entrepreneurs, the Israeli rich have traditionally amassed their fortunes by exploiting monopoly privileges and political contacts. The system corrupts both politics and economics.

The cure to these problems is also simple. Transform the Israeli economy into a modern competitive market economy and its productivity will skyrocket (look at how Israeli entrepreneurs excel everywhere outside Israel!).

Easier said than done, of course, but it is doable. In fact, the transformation of Israel’s economy has already started to occur. Under Netanyahu’s leadership, excessive public spending has been repeatedly slashed, not yet enough, perhaps, but considering the political obstacles, a miracle nevertheless. 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.

This is the general picture. Let me now focus in greater detail on the crucial reform now taking place in Israel’s financial markets.

One of the major reasons for Israel’s economic malaise is its monopolistic, dysfunctional banking system. It is far more powerful and concentrated than the Japanese banking system and it has damaged the Israeli economy far more than that country’s.

Israeli banks are run by a cabal of retired high Bank of Israel (which is supposed to regulate the banks) or Ministry of Finance officials with little business experience, but with great contacts with the regulators and the political establishment. When the banks are privately owned these high powered bureaucrats are employed by a small group of oligarchs with strong political ties. The banks therefore wield enormous political clout and are accountable to no one. They can get away with murder despite the fact that the bankers’ follies and ineptitudes twice almost caused the meltdown of the Israeli economy.

In the eighties, the infamous bank share manipulation cost the Israeli taxpayers at least $10 billion directly, and scores of billions of dollars more in lost economic growth. But urgent reforms, proposed two decades ago by a prestigious judicial commission following the banks’ share collapse, were never implemented. The powerful bank lobby managed to stop them all.

As a result, the banks continue with their near total control of Israeli financial markets. Out of 1.4 trillion shekels in savings, the banks manage an astonishing 1.2 trillion, with over 800 billion through their provident and mutual funds. With interest earned on bank savings declared tax exempt, 80% of all savings went to them.

The banks paid savers below market interest rates (their financial spread is over 5%!), causing an annual transfer of wealth in the hundreds of billions of shekels from productive Israeli savers to the dozen or so families that control them.
What’s more, the bankers squander the public’s hard-earned savings by making bad loans at favorable conditions to a very small group of business associates. 70% of all bank loans went to 1% of borrowers, mostly bankers’ partners or cronies. Loans were invested in very speculative, highly leveraged deals in real estate and entertainment, at the peak of a stock market bubble. Most of these loans went sour. The banks now admit to 61.4 billion shekels in questionable debts (their own capital is only 47 billion!). Despite great losses on these loans, the banks still managed to make huge profits by extorting exorbitant commissions and usurious rates from households and small businesses.

The banks failed lending policy deprived the Israeli economy of productive investment, especially in medium-sized and small businesses. Discriminatory credit allocation has had grave national consequences. A credit crunch they created forced 70,000 of these businesses to close. The Negev and the Galilee, where mostly small or medium businesses operate, were starved for credit and stagnated.

The banks were able to maintain their stranglehold because the two major parties, Labor and Likud, owed them large sums. Knesset members were warned not to cross the banks if they wanted loans for their primaries and political campaigns. 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 to break up the banks’ monopoly position and introduce competition and new players into financial markets.

The banks put together a ten million-dollar war chest and waged a campaign of disinformation and enormous political pressure to fend off the reform. But to no avail. Netanyahu, with strong support from a significant segment of Israel’s economic media, and from independent pro-market think tanks, and over 60 Knesset members (organized, surprisingly, by 2 Shas members), stood firm. A Finance Ministry task force, headed by its Director General Yossi Bachar, faithfully translated the reform proposals into operational legislation. After considerable political push and shove, Prime Minister Ariel Sharon was convinced by some of his knowledgeable aides that the government had no choice but to go ahead with the reform because the alternative was not just a return to economic stagnation but a return to the risk of an Argentina-like financial collapse. Sharon’s support turned out to be crucial.

If despite the present political instability the reform will go through and the Israeli economy will finally perform to its potential, the year 2005 will be remembered as an historical turning point not only for Israel’s economy, but for its social and military strength as well.

Israel’s economic situation has far-reaching consequences not only internally but also internationally, especially vis-a-vis its relations with the Palestinians. If you will bear with me, I will try to explain why all peace efforts, like the past Oslo agreements or the present road map, which ignore the underlying realities of economic life, have little chance of success. Arrangements that only reflect political constraints often fail to address the real needs of people, and they fail to create the necessary peaceful background that can alone give peace substance.

If you doubt the preeminence of economics, consider please the fact that it wasn’t peace processing or political work that ended centuries of conflict and carnage in Europe, that helped reconcile two seemingly irreconcilable enemies, France and Germany. It was the total defeat, first, of the aggressor, Germany, which permitted the subsequent launching of an economic process – the establishment of a steel and coal community that initiated the reconciliation. Economic growth depends on cooperation and it makes former differences seem irrelevant, or at least less important.

The latest mission impossible embraced by those who would instantly resolve the Middle East conflict (forgetting, apparently, that it took centuries to reach peace in a far more civilized Europe) is the effort to “democratize” the Palestinian Authority, an organization that has thrived on repression, violence and aggressive irredentism. Meanwhile, a far more promising route to peace – the path of economic cooperation and development – is being neglected. It’s as if the Palestinians are doomed to be subjected to an endless repetition of the failing formula that has prevailed in the last ten years – the provision of billions of dollars of foreign aid to the huge bureaucracies of a criminal and terrorist Authority that has squandered or stolen much of it, while promoting the lawlessness and corruption that suppressed private initiatives. It seems so absurd that policy mavens would insist on repeating this failed formula when a better alternative has proven itself before Oslo, in a period when the slow growth of a Palestinian middle class with a real stake in peace was gradually mitigating the conflict and making it manageable and ripe for a solution.

The fact is, most forget, that before Oslo a process of economic-driven gradual conciliation between Israelis and Arabs was successfully progressing. It was a genuine “peace process”, because it greatly benefited both sides, and it was very successful despite being unacknowledged by politicians, by the media and by professional peace pundits, because it had no formal political expression or sanction. I’m referring to the process that took place from the 1967 Six Day War until the 1987 first intifada, and that continued to a degree even after it.

During these two decades, political paralysis, which most experts believe is dangerous and untenable, actually enabled Israel to maintain a modicum of law and order in Palestinian areas. As long as there was a rule of law the Palestinian economy flourished. Palestinian GDP more than quadrupled, the standard of living rose dramatically. Infant mortality fell, seven new colleges and universities were established (where none had existed under Jordanian rule) and the welfare of the people, especially of women and children, improved so much that the population grew by leaps and bounds.

While the Palestinian Arabs were far from thrilled by Israeli occupation – nobody likes to be an underdog – they overall accepted it because it enabled them to prosper in an unprecedented way. Two peoples who had been separated from 1948 by physical and emotional barriers, by intense hatred, managed to develop mutually beneficial interactions, as every weekend thousands of Israelis would flood Arab towns to evade Israeli blue laws, to shop and dine. The relative advantage the Palestinians enjoyed in labor-intensive trades – agriculture, construction, textiles and footwear – boosted the Palestinian economy while enabling Israelis to increase the purchasing power of their highly taxed salaries. Arab agriculture, once primitive and unproductive, was revolutionized by Israel’s example. It brought Arab farmer’s great prosperity. It also resulted in a manpower surplus that was channeled to relatively well-paid employment in Israel.

That this process enjoyed wide acquiescence by the Arab population is evident from the fact that every year hundreds of thousands of Palestinians found work in Israel. They enjoyed total freedom of movement. Had they been so inclined, they could have wreaked havoc in Israel. Yet in over twenty years, terror incidents were few and far between, and were mostly perpetrated by PLO hirelings.

The Palestinian economic revolution also had far-reaching social consequences. Enhanced wealth hastened social mobility. It loosened the oppressive grip of clan and family. Arab women were principal 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 also had a revolutionary impact on Arab society, not all of it positive. Rapid, radical changes did not sit well with the Arab elites and with Moslem traditionalists who saw their way of life threatened and their privileges eroded. It made them determined to remove the threat that Israel represented.

In the mid-eighties, a deep crisis and runaway inflation hit the Israeli economy, hitting the Arabs who were at the bottom rungs of employment hardest. There were also economic difficulties in the Gulf region, where many Palestinians found lucrative employment. These difficulties brought Palestinian prosperity under Israeli rule to a halt. To make matters worse, Israeli bureaucracy, which makes life unbearable for Israelis, also increasingly strengthened by then its stranglehold over Arab life, levying very high taxes and 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. Arafat later exploited the wave of economic misery to mount 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 quite remarkable. Along the 1948 Green 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.

Israel’s messianic pace camp could never adjust to an imperfect and informal quiet peace. It kept clamoring for a perfect, total, “Peace Now”, especially after the 1987 First Intifada. Prime Minister Yitzhak Rabin – worried by the reaction of Tel-Avivians to Saddam’s nightly scud attacks, which he wrongly interpreted as lack of stamina – acquiesced with Oslo. A misguided Israeli government, led by the machinations of Yossi Beilin and his utopian mentor Shimon Peres, 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 extremist terrorist organizations in a way that Israel constitutionally could not do. The rest is history. Oslo put an end to the very encouraging, if informal peace process that preceded it.

The moment that Arafat and his minions took over, they first destroyed the local economic and political leadership in order to make room for 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 and to undermine economic wellbeing, to impoverish their population and then channel its frustration and anger against Israel.

Arafat’s men also systematically 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 that was taking place in Jerusalem between Arabs and Jews.

East Jerusalem Arabs are the most fervently Moslem and nationalist among Palestinians, since Jerusalem is the focus of intense feelings for Arabs and Jews alike. Yet, because of the thriving tourism and commerce that made these 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 Authority misrule, terrorism and economic extortion and misery. Palestinians were so skeptical, that recently, when discussions were held about ceding certain neighborhoods in Jerusalem to Palestinian rule, real estate prices there plummeted.

For the rest of the Palestinians, massive unemployment, reaching in some sectors 60% (this from nearly full employment before Oslo), 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 (partially funded by European, and yes, American money!). This propaganda has engendered such bitterness and hatred towards Israel that it is really surprising 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 what hatred was inflamed by eleven years of far more intensive PLO anti-Israel propaganda.

Not that Israel was completely blameless. The notorious Israeli bureaucracy made a totally dependent Arab population miserable with it arbitrary and oppressive behavior. Because of pressure from Europe, the U.S. and its own “peace camp”, Israel failed to fight terrorism the only way terrorism can be successfully fought – by totally eliminating its leadership and logistic infrastructure. Instead, the Israelis tried to fight terrorism by half-measures, ineffectively. Worse, by using ineffectual defensive measures, such as imposing unnecessary closures, erecting roadblocks and such, Israel punished many innocent Arab bystanders, helping the terrorists gain wider support.

Yet despite all the unnecessary misery and hatred that the false political peace process has engendered, the situation is still not hopeless. In fact, now that Arafat, the master terrorist is out of the way, now that the Arab population has suffered so much from his Al Aksa war, there is indeed 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 other professional “peace processors” that this conflict can be resolved mostly through political arrangements, and only be securing the cooperation of the PLO and its criminal leadership, the soft-spoken Abu Mazen who is actually no less a radical than Arafat.

The more promising direction is to try to neutralize politics as much as possible for a while, and to establish in Palestinian areas the rule of law, so that economic development can play its truly constructive role again. Where possible, private initiatives should be supported, rather than pouring massive sums of money to the P.A., ostensibly for economic development. Where housing, for example, is needed, especially to alleviate the miserable conditions of the refugees, cheap loans should be offered directly 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 high 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, the Palestinians could establish 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, this is a very encouraging development.

I do not mean to imply that rapid economic development 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 system 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, propagated in the universities (with massive US contributions!) and supported by most of the media and large part of the Israeli elites.

To succeed in this mission we must follow two principal courses of action:

First, we must counteract the propaganda that passes for teaching in our universities. I know it’s hard to believe, but our institutions of “higher learning” are even more radical than yours when it comes to preaching the anti-capitalist gospel of The New Left.

We must teach our graduates, our future leaders, the merits of a free economy or we will be doomed to remain saddled with a third world economy.

This is what we at ICSEP – the free market think tank that I have founded and directed with the continued and invaluable support of friends like Dick Fox, ICSEP’s board chairman – have been doing for two decades. Some say we have been so successful that the alarmed Left has mounted a counter-revolutionary action plan to neutralize our influence. We have so far trained over 1000 students and there are hundreds more on our waiting lists. Recently 800 of them came to hear Bibi Netanyahu speak on economic reform at a university that was very hostile toward him and the market economy, and they gave him a standing ovation. Still, we must redouble our efforts and we must devote far more resources to these students than we presently command.

Second, we need to cajole decision makers to initiate desperately-needed reforms. This too we have been trying to do for the last two decades, but only with moderate success. Mostly, we have been busy with damage control, preventing the government from taking very costly, sometimes potentially catastrophic steps. Luckily, Finance Minister Benjamin Netanyahu is determined to implement far-reaching reforms, and luckily he enjoys the full support from the Bush administration, which wisely tied US loan guarantees to Israel undertaking significant reforms. Still, Bibi will have to overcome enormous resistance from powerful quarters, and he needs the help from civil, non-political groups like ours.

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, since it would lead to Israel’s steady decline.

The choice is clear, my friends. With your help Israel can make the right one.

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