As Israel Turns 71, Here Are Some Reasons Behind Its Economic Success
By: Sarvesh Mathi
Tags: Startup, Israel, Culture, History, Economics

The State of Israel was established on May 14, 1948. Today, the country turns 71. As far as nations go, Israel is still a teenager. But the country’s economic parameters do not reflect that of one. In all measures, Israel is among the most world’s most developed nations.

GDP per capita (current US$). Data from the World Bank.

Israel’s GDP per capita at the end of 2017 was $40,270, which is higher than the EU average of $33,836. It is also more than all of its immediate Arab neighbours put together. It has a low and stable inflation rate of 1.4 percent and an unemployment rate of 4 percent. Israel is ranked 22 out of 189 countries in the Human Development Index — a metric that captures a country’s performance in three dimensions: life expectancy, education and gross national income per capita. The start-up scene in Israel is unparalleled. It has the highest number of start-ups per capita in the world and the per-capita venture capital investment in 2008 was “2.5 times greater than in the United States, more than 30 times greater than in Europe, 80 times greater than in China, and 350 times greater than in India.”¹

At 71 years of age, isolated from its neighbours and constantly embroiled in border tensions, these statistics are astonishing.

Much of the research done on this subject has provided us with conventional reasons to explain Israel’s success. These reasons include the role of state intervention in the early years, the benefit of foreign aid and the effects of the 1985 Stabilization Plan. But some questions remain unanswered. For example, how did Israel meet the sudden increase in labour demand after the Six Day War and how have cultural factors acted in tandem with government policies to give Israel a unique advantage over other countries with similar policies. This article answers these questions and provides a more comprehensive explanation for the economic success of Israel.

Israel’s economy is best studied in three phases: 1948–1965, 1967–1973 and 1985 — now.

The groundwork for the first phase was laid by the Yishuv, the Jewish community in Palestine before the State of Israel was established. The land was not richly endowed with natural resources and the agricultural economy was abandoned by the Arab population under the Ottoman rule. Despite this, the first two waves of Jewish immigrants in 1882 (known as First Aliyah) and 1904 (Second Aliyah) sought to revive it.² These attempts to settle would have failed, if not for Baron Edmond Rothschild, a member of a rich European banking family, who financed settlements of the First Aliya, and then once again, of the Second Aliya.³

When the state of Israel declared independence in 1948, the economy was guided by the Yishuv’s socialist ideology. The two pillars of socialism in the Yishuv period was Histadrut, the trade union that organised all economic activities of Jewish workers and kibbutzim, the collective agriculture societies that contributed the lions share to the economy in the first phase.⁴ This is different from state intervention that one would normally associate socialism with. There was direct state intervention as well, which began after independence, but it was more of a necessity for the primitive economy, rather than an ideological stance. Large-scale infrastructure projects required massive funding and could not be carried out by private industries.

Soon after the Declaration of Independence, the new state was left shattered from the 1948 Arab-Israeli War. Many of the enterprises were destroyed and the country was isolated from its neighbours. There was large-scale immigration and the population almost doubled in less than five years. When the government needed to raise money to rebuild the economy it turned towards the Jewish communities abroad for help and received around $750 million in aid from the US and Europe from 1949–1965.⁵ This aid was of significant help in building the newly established state. However, this alone does not explain the 10 percent annual growth rate that Israel enjoyed in this period. The most unlikely stimulus for the growth of Israel was the reparations paid by West Germany to compensate Jewish victims of Nazi crimes. These paid for most of the capital goods that the newly established state needed. In the research published by the Royal Institute of International Affairs titled German Reparations to Israel: The 1952 Treaty and Its Effects, the importance of these reparations is well documented. The reparations accounted for 30 percent of Israel’s budget in currency and 10 percent of her import budget for ten years, and “these percentages, in fact, give only an inadequate idea of the economic benefits.” The author of this article calls the nearly $800 million worth of free capital input “a vital transfusion of blood.”⁶ Despite providing a comprehensive account of the reparations, the research does not go into how the capital was efficiently paired with human capital to result in such rapid development. This missing explanation is provided by the authors of Start-up Nation and will be looked at a later section of this article. With the input of capital from these reparations and the foreign aid, along with the influx of immigrants for labour, Israel was able to build its nascent economy and grow rapidly in the first phase until 1966.

In 1966 the rapid growth came to a halt, partly due to the new policies implemented by the government. In order to control the rising inflation and widening trade deficits, the government tightened credit and reduced the budget. Unfortunately, these policy changes came at a time when major infrastructure projects were still being carried out, leading to a sudden decline in construction and a less than 2 percent growth rate for two years.⁷ The brief recession ended after the Six-Day War when the acquisition of new territories presented opportunities for new development projects. Furthermore, the decision by France to stop supplying arms led to the emergence of Israel’s own defence industry, creating growth in the electronics and metal sectors.⁸ Yossi Vardi, one of Israel’s foremost entrepreneur puts it best, “The two real fathers of Israeli hi-tech are the Arab boycott and Charles de Gaulle because they forced on us the need to go and develop an industry.”⁹ But, there’s still an element missing here. Whilst new development opportunities emerged in the captured territories, the nation was able to take advantage of this opportunity and grow at 12 percent per year because of an increase in labour supply as well. Immigration was low during this period, so where did labour come from? The answer to this is outlined by economists Ali Kadri and Malcolm MacMillen in their study The Political Economy of Israel’s Demand for Palestinian Labour.

According to their study, the labour demand required to carry out the new construction projects was fulfilled by the Palestinians from the occupied territories of West Bank and Gaza Strip. This labour was not only cheaper than Jewish labour but could also be used as a mechanism to influence the wage rates and employment in the occupied territories. The study remarks that “Jewish labour from the Eastern bloc cannot cope with the hardships of the work carried out by Palestinian labour” and because of Israel’s small labour market the occupied territories have become a “pool of surplus labour.”¹⁰ However, this study does not explain how the labour requirements were fulfilled in instances when Israel barred Palestinian labour in the interest of national security. Israel periodically stopped Palestinian labour from entering Israel during heightened tensions and this would have been a hindrance to any major projects that were carried out during the time. Perhaps, new settlers and Asian labourers were the other sources that continued to help meet the labour requirements.¹¹ Fueled by new opportunities and the supply of cheap labour, Israel’s economy rebounded from the brief recession. This second phase of economic growth, however, lasted merely six years, coming to a halt after the Yom Kippur War in 1973.

After the war began a decade-long period of slow growth and high inflation. The war expenses and the rising energy costs were a catalyst, but the policy of the government to index wages allowed deficits to grow out of control. The government was forced to rely on printing money to cover spending that drove the inflation rate to as high as 450 percent in 1984 and reduced the growth rate to a mere 3 percent.¹² People joked that it was cheaper to take a taxi than a bus because the fare would be cheaper by the end of the ride when the currency would be worthless.¹³ The most pressing concerns required massive reforms in government and public thinking. The interventionist model was beginning to fail. The heavy government influence in the markets was proving to be inefficient in the era after massive infrastructure projects. Finally, in July 1985, the government introduced the Economic Stabilization Plan that led the way to reform the market structure and encouraged private industries. The government slashed the budget deficit, devalued the currency, deregulated financial markets and foreign trade, and most importantly, privatized most of the state-owned companies.¹⁴ This marked the end of a state-led economy in Israel that lasted for over three decades and ushered in the era of a free market.

The new policy changes, along with an influx of skilled and educated Soviet immigrants, led Israel back to the path of rapid expansion for the decade since 1985. The new environment unleashed the entrepreneurial spirit of the country and led to the emergence of one of the world’s most advanced technology industry. Israel’s new economy was able to absorb the shocks of the economic recessions that occurred in 1997, 2001 and 2008 and emerge stronger than most other developed economies.¹⁵ Most economists attribute the current status of Israel’s economy to the implementation of the 1985 plan. Barry Rubin, the author of Israel: An Introduction, does a thorough job comparing the state of the leading industries before and after 1985. The leading industries in Israel, high technology, chemicals and pharmaceuticals, defence, textiles, and energy have all benefitted from the stabilization plan and the subsequent policies that encouraged entrepreneurship. Each of these industries has seen a growth in the number of companies and an increase in exports.¹⁶

While Barry Rubin, like many other researchers, highlights the role the government played in helping establish new start-ups by providing venture capital, the authors of the bestselling book Start-Up Nation, Dan Senor and Saul Singer, provide a different perspective by focusing on the culture and the nature of the people of Israel. Their perspective runs like a thread connecting all the elements that have led to Israel’s economic success, but most importantly, explains the start-up success that this young nation enjoys. The authors summarize that Israel’s success is “a story not just of talent but of tenacity, of insatiable questioning of authority, of determined informality, combined with a unique attitude toward failure, teamwork, mission, risk, and cross-disciplinary creativity.” Senor and Singer describe the entrepreneurial drive of the people, their commitment to an idea and their persistence as the Israeli chutzpah — “gall, brazen nerve, effrontery, incredible ‘guts,’ presumption plus arrogance.” This chutzpah is seen in the everyday life of an Israeli and is a key ingredient to the start-up success, as well as the economic success in the earlier years. Bitzu’ist is another Hebrew word that the authors use to describe the people of Israel. It loosely translates to pragmatic. Bitzu’ists are seen as “crusty, resourceful, impatient, sardonic, effective, not much in need of thought but not much in need of sleep either.” Another intangible feature that drives the people is davka. Davka can be roughly translated to mean “despite” with a “rub their nose in it” twist.¹⁷ This attribute drove the people of Israel to work in factories that were in areas frequently bombed by enemies.

A key ingredient is the role of the military in the lives of the people. Most of the founders of successful start-ups have come from the military. The time spent in the military provides the youth with maturity and experience like none other and the elite units of the military have served as incubators for many of the tech start-ups. Immigration played a major part in Israel’s success as well. Gidi Grinstein, the President of Reut Institute, explains that immigrants are risk takers and are not averse to starting over and as a result “a nation of immigrants is a nation of entrepreneurs.”¹⁸ The government policy to assimilate these immigrants further enabled these people to thrive and contribute to the economy.

The features highlighted by Senor and Singer have shown the cultural and personal attributes that have contributed to Israel’s economic success. Although their book has many stories of how these factors have come to play an important role, these features are mostly intangible and can only be measured by proxy of economic parameters. So, it is difficult to establish a causal relationship between concepts such as chutzpah, bitzu’ism and davka and economic success. But having said that, these features make Israel unique compared to nations with similar economic policies but less economic success.

While this article has focused on research that highlights the economic success of Israel, there are opposing views that have arguments of merit. Perhaps the most supporting evidence for these arguments is the annual growth rate that has been between a low 2 to 4 percent since 2015. Shir Hever, the author of The Political Economy of Israel’s Occupation, says that the macro level indicators published by the Central Bank of Israel hide the widening income inequality that is among the worst in the developed world. Hever also finds Israel’s GDP to be a misleading figure that is only high during wars and crisis when it increases as a result of spending in war industries.¹⁹ This brings into question the sustainability of Israel’s economic success. One factor that researchers across the board agree on is the deteriorating quality of Israel’s education system, which once provided quality human capital, propelling the high-tech industry of Israel. Hever highlights the widening gap between Israel and the other OECD countries and Dan Ben-David, a leading economist in Israel, supports this with statistical evidence from math and science test scores.²⁰ An article published by Wharton Business School also talks about the duality of Israel’s economy. It argues that while high-tech export is flourishing, the domestic economy is not, and this could lead to the downfall of Israel’s economy in the long-term.

Withstanding criticism, Israel’s economic progress will remain a case study for years to come. Born only over 71 years ago, Israel has embraced both socialism and capitalism and overcome significant hurdles to stand as one of the world’s most developed economies today. The key factors leading to this success include the foreign aid and reparations received in the early years, the availability of Palestinian labour when needed most, the landmark policy shift in 1985, the immigrants, the role of mandatory military training, and the cultural factors deeply embedded in the Israeli way of life. These elements, identified by different people at different times, all come together in explaining Israel’s past economic success.