Israel Economics

[DewDiligence]

[Economic] Miracle in the Holy Land

http://online.wsj.com/article/SB119707331817717861.html

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By MATTHEW KAMINSKI
December 8, 2007
Jerusalem

'Here is the past," says Benjamin Netanyahu. "That's the future." The Likud leader, at his Knesset office, is talking about Jerusalem and Tel Aviv -- less than an hour's drive apart but on different planets. If regional turmoil and political intrigue hang heavy over this ancient capital, the party town along the Mediterranean brims with entrepreneurial energy. And of late, Tel Aviv's youthful, capitalist spirit is rubbing off on the rest of Israel.

Little noticed amid the grim Middle East headlines, a Jewish state founded by European socialists and long hobbled by stagnant growth and inflation is turning into a mature market economy. This ongoing transformation is no less dramatic than Eastern Europe's since 1989.

In the past half-generation, an economy dominated by the state and monopolies began to join the outside world. But it was a dose of shock therapy, Israeli-style, in 2003 that jolted the country out of its deep sleep. That year, when Mr. Netanyahu took over the finance ministry, a deep recession and debt burden put Israel, in his words, "on the verge of an Argentina-like collapse." Subsequent cuts in welfare benefits, the removal of remaining currency and capital controls, and liberalization of the banking sector didn't make Mr. Netanyahu many friends. But today even his detractors, hardly an elite club in Israel, credit him for the recovery.

The third consecutive year of strong growth, up to 5.5% in 2007, is driven by exports of software, pharmaceuticals, consulting and other services. The 2,500 or so hi-tech start-ups located in and around Tel Aviv and Haifa give the coast the feel of Silicon Valley, only with a Gaza Strip down the road. Israelis are now investing heavily abroad. Only the U.S. and Canada have more technology companies listed on American exchanges than Israel.

Signaling that these changes are supposed to be permanent, the government in 2005 tapped a new central bank chief whom Israeli politicians couldn't easily push around. Stanley Fischer made his name at MIT and later as No. 2 at the IMF. Born in today's Zambia, he first came to Israel at 17 to work on a kibbutz. Upon his return two years ago, he found that socialist traditions today coexist with a modernizing economy -- even at the Bank of Israel. His staff went on strike last month, a reminder of organized labor's sway in the country.

But he sees the trend lines going in the other direction. "As the economy develops, the power relations will change," Mr. Fischer says, pointing out that unions went along with Mr. Netanyahu's budget cuts, labor reforms and the slow shift to private pension schemes. Taxes are falling, though with the top individual rate at 44% they are still high.

"The government has been squeezed very hard in the last four to five years," he adds, with spending down from 52% of GDP, on par with Scandinavian countries, in 2003. "Hopefully we'll finish this year at 45% or below."

In a 1997 speech in Hong Kong, Mr. Fischer called for the IMF to push countries to gradually remove restrictions on capital flows. His experience in Israel has shown that liberalization is more important than he thought. "This economy is totally changed -- but totally changed -- from 15 years ago when it had capital controls," he says. "I knew the technical issues of getting rid of capital controls. What I didn't realize is that it also forces people to change their approach."

In a protected economy, business focuses on local markets and exports. "The full opening of the capital account in the context of globalization made everyone realize they had to compete in the world," he says. "Israeli businessmen are of a different quality than 15 years ago."

Israel hasn't had reason to regret it. Inflation is around 2%, down from 400% in the 1980s. The country is unaffected by the subprime shake-out. With the shekel stable, Mr. Fischer doesn't have a weakening currency on his hands as does his most famous graduate student from his MIT days, Fed chief Ben Bernanke. "Whatever exchange rate system you have, there will be days when you wished you had another one," Mr. Fischer says with a smile. But, "so far, so good."

The Netanyahu reforms shook up the structure of the economy without changing the country's political culture. Spending pressures are re-emerging. The state owns too much land -- "only 93%," deadpans Mr. Netanyahu, now in opposition. Israel needs a far more serious dose of liberalization to become another Ireland, a small, low-tax, investment-driven boom economy. "Trying to explain market economics to our politicians is like trying to explain sex to a eunuch," says Daniel Doron, who runs the Center for Social and Economic Progress in Tel Aviv.

Israel can't afford a return to expensive welfare policies. It already spends north of 8% of GDP on defense. This won't soon change. The economy is handicapped by the lowest labor participation rate of any developed country. One in four ultra-Orthodox working-age Jewish men, and about as few Israeli Arab women, hold down jobs. That leaves only 37% of Israelis in the work force, compared with around 45% in a typical Western country. As a result income per worker is on par with Europe, notes economist Omer Moav, but per capita significantly lower.

With the right policies, Mr. Netanyahu says, Israel could grow at an Irish-like 8% for a decade. But its experience already shows that strong human capital and an opening market are the best resources any country could ask for -- a good lesson for the oil-rich Middle East. And while far from finished, the mini-revolution of recent years ties Israel into the world, and vice-versa. That's good news for its future prosperity and security.
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