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Israel"s Economic Challenge: How the U.S. Can Help

By Daniel Doron Especially now when everyone's attention is riveted to the divisive issue of whether the United States should grant loan guarantees to the Israeli government, and if it does should it ex- ploit its leverage to extract economic or political concessions from Israel, it may be useful to step back and consider these questions in a historical perspectiv e . A proper understanding of the Is- raeli predicament-of how a nation so rich in human capital came to have such a lame economy -and of the steps that must-be-taken to-help -it-overcome -its difficulties may also have a sig- nificance transcending the par t icular case of Israel. "Of all the lands there are for dismal scenery," Mark Twain wrote in 1867 in The Innocents Abroad, "I think Palestine must be the prince. The hills are barren ... dull .... The valleys are un- sightly deserts fringed with a feeble v e getation... (peopled by] swarms of beggars and peddlers [struck with] ghastly sores and malformations.... Palestine sits in sackcloth and ashes.... Only the music of angels ... could charm its shrubs and flowers to life again ...... It took, indeed, relig i ous visionaries and, later-when the enlightenment secularized Europe's Jewish intelligentsia- utopian socialists to revive this "hopeless, dreary, heartbroken land." No Homo Economicus moved by rational expectations would have submitted himself to tunger, dis- ease, pillage, and murder in lawless Ottoman Palestine in order to resuscitate its "waste of limitless desolation." Thus I wrote in 1988, thoughtlessly repeating the prevailing myth that socialism played an es- sential role in the resettlement of wha t was then desolate Ottoman Palestine. The truth was that from the modem Jewish resettlement, Palestine in the mid- 1 800s, it was entrepreneurs, later aided by private charities, who established the first agricultural colonies and towns. They took enormou s risks because they were moved by a deep religious faith that this was the way to redeem Israel from its atrodous exile. Socialist Myth. After the turn of the century and until 1914, the Jewish population in Pales- tine doubled from 35,000 to 70,000. Duri n g that fourteen year period, private entrepreneurs established or extended in a most hostile environment three thriving towns, ten colonies, rudimentary industry and commerce, and an impressive educational and cultural network. It was during this same per i od that about 3,000 young, secular, penniless, socialist pioneers also ar- rived, five hundred of ithem to establish three collective settlements that were maintained by public support.Yet Zionist mythology credited the young socialist pioneers of the Sec o nd Aliyah with founding modem Israel. It obliterated all memory of the true founders, so much so that even though my great-grandfather was among the first settlers, and our family cherished the memory of his remarkable achievements, 1, too, thoughtlessly a ccepted the myth about Israel's socialist origin. This little episode is, worth relating because the story of how socialism came to dominate the Zionist enterprise-reshaping its history, as well as eventually transforming the nature of the Jewish communit y inPalestine-contains a moral far transcending Israel's particular predica- ment. An Eastern European ethos has conditioned the development of modem Israel ever since

Damel Doron is Directce of the Tel Aviv-based Israel Center for Social and Economic Progress. He spoke at The Heritage Foundation on September 20,1991. ISSN 0272-1155. 01991 by The Heritage Foundation.

the very inc eption of Zionism about 130 years ago, as I shall later explain. Therefore, the trials and tribulations of the Israeli economy, as it struggles to make the transition from a statist to a market economy, can shed significant light on the challenges and difficulties that Eastern European countr i es may encounter and can guide friends wishing to help. I have advisedly chosen to dwell on what might seem as a tangential issue: the secondary role outside influences can play in an economic systems s evolution. Many here may be involved in facilitating the transition in Eastern Europe. Israel's case demonstrates that the role of outside in- fluences can sometimes be quite critical in shaping developments and alas, despite the best of intentions, not always in the most salutary manner. For sometimes help misapplied cannot only be counterproductive, but positively harmful and regressive. Well-Intentioned Filiends. To return, then, Zionism certainly has a predisposition to contract socialism fever. Historical circumstances, especially the long entrenched au t ocratic abusive regimes that were legitimized by orthodox Christianity, made all of Eastern Europe, particularly the Jews, vulnerable to revolutionary fervor and utopian temptations. However, this disposition could not have successfully taken over Zionism if not for the well-intentioned intervention of friends, most from the West, many from America, who participated in events in Palestine without much foresight or care. When in 1920, under the British Mandate, Palestine's"doors opened, tens of thousands of dis- placed European Jews clamored to emigrate. A totally unprepared Zionist organization stopped them, ostensibly for economic reasons, but really because its purpose was to shape the develop- ment of Palestine's Jewish community in a certain direction. E astern European Zionist leaders such as Chaim Weizman accepted the anti-Semitic calumny that Jewish society was at least partially responsible for its misery because Jews were not a productive, land-tilling people, but parasitic capitalists. They therefor e wanted to create a new Jewish person and society, based on "honests, labor, and not the traditional middle class society of entrepreneurs. Conversely, Judge L)uis Brandeis and his followers in American Zionism were convinced that only the encouragement o f private enterprise could provide a sound economic basis, and that a collectivist system would pose a danger to democratic society. But they remained a minority. The Utopian collectivist ideology prevailed; Brandeis resigned from the Zionist Organization o f America, and Weizman and his supporters were able to channel all Zionism's resources into the collectivist sector, thus turning it from a tiny mipority to the dominant economic and political force in Zionism. Inhibiting Entrepreneurship. The Zionist set t lement department and its considerable resour- ces were devoted to the promotion of a socialist-dominated society, while great handicaps were devised to inhibit the growth of middle class entrepreneurship. This occurred despite repeated failures of the co l lectivist sector, which survived only through constant infusions of public money. Public moneywas raised, ironically, mostly from middle class American Jews who sin- cerely wanted to help,but could not really bother to learn the issues facing Zionism or t o act carefully to prevent their help from tilting the balance in favor of socialism. As it has had elsewhere, socialism has had a devastating effect on Israel. In the thirty years preceding the State's establishments and in the forty years following it, I s rael created, with the benefit of huge capital inflow (over $70 billion since the State's creation), with back-breaking work and with sometimes superhuman sacrifice, a laggard economy incapable of offering the Is- raeli worker more than. a measly $ 1,000 monthly average salary. Instead of permitting the Jewish people to invest their considerable talents and resources in creating an urbanized, highly-in- dustrialized center with advanced service industries and a sophisticated financial industry

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capable of absorbing millions of highly-educated Jews, Zionism established, before inde- pendence, only a small com miunity based on a weak, agrarian economy. After independence, it spawned a centrally-dominated and collectivist economy, which made Israel econom i cally de- pendent on foreign help. Zionism's inhibitions on urbanization and industrialization, which could have assured a high standard of living to all die inhabitants of the land, had serious repercussions. The backward col- lectivist economy, withits e ssentially discriminating political manipulation, sharply increased social and ethnic divisions. Incessant struggles over the division of the pie corrupted politics and degenerated economics. It also gravely damaged productivity by the wholesale misalloca t ion of resources and by channelling so much energy into the seeking of privileges. The economy's politicization also aggravated the Arab-Israeli conflict. Concentrating the Zionist effort on agriculture inhibited economic growth and naturally intensified t he confronta- tion with the Arabs, who were mostly rural. It focused the struggle on land and water, which are limited resources that are difficult to sham. And slow economic growth and sluggish demand for labor also sparked a struggle over employment in M andatory Palestine. Economic Discrimination. Later, in independent Israel, when much of the economy belonged to national or public entities, with economic benefits a political coin, the Arab popula- tion, lacking political clout, was subject to the econom i c discrimination inherent in excessive politicization, much in the same way and for the same reasons that the Sephardim were dis- criminated against. To this day, lack of opportunity and economic discrimination strain the fealty of Israeli Arabs. By the t i me of the creation of the State, socialism was, of course, well entrenched, but its repeated economic failures forced Labor governments slowly and painfully to reduce their total control of the economy, though not nearly speedily enough. In the late 1970s , growing discon- tent with the malfunctioning of the Israeli economy was a major factor in Labor's loss. A reformist party siphoned off enough Labor votes to gain sixteen Knesset seats, thus enabling Likud to become the majority party and form a governmen t for the first time. Ostensibly pro-private enterprise, Likud made a hasty, ill prepared and tentative attempt to reform the economy. It was so ill conceived and executed that it caused skyrocketing inflation. Also, soon enough the allure of power and the strength of populist elements in the party led it to greatly increase the goverment's involvement in the economy. It had far more involvement than labor, by exploiting increased foreign aid to greatly extend social benefits, the welfare system, and huge s u bsidies to industry and the consumer. Even today, when economic aid mostly covers the repayment of debtand is therefore merely a bookkeeping exercise, it still enables the govern- ment to delay vital structural change. Tangle of Regulations. Under Likud, t hen, government intervention in the economy reached new heights. Ile government owns over 200 corporations in all economic spheres. Despite some very halting steps toward privatization, it still controls the import of many staples. It sanctions dozens of m onopolies. The goverment has recently moved to lift many import regulations, but in too many cases, it has simply switched from bureaucratic restrictions to high duties to protect inefficient Israeli industries from pompetition. One can scarcely engage in any profession or auk without a government permit or compliance with a tangle of regulations, an especially serious impediment to the Russians wishing to enter the economy. Government denies free or easy entry to the market and ties the hands of producers with onerous labor laws. It -imposes on labor and employers punitive taxes that destroy their competi- tiveness and nip in. the bud new enterprises. As a result, Israel has a very small proportion of small businesses, which in turn curtails competitivenes s and efficiency. Israel has over two

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dozen different major taxes and dozens of special levies (imposed, for example, on stud rams, camel markers, and febmials). As much as 55 percent of gross national product is taken in taxes, although about 25 perc ent is returned in subsidies and transfer payments. Discredited Statism. Yet despite the fact that Israel has perhaps earned its bad annual report cards, there are tremendous changes afoot there. In the past few years, statist ideology has been almost tot a lly discredited in Israel. Ironically, even when the government attempts to intervene in a massive way, as in a. recent plan to promote employment by granting generous subsidies to industry, it does so putatively to "assist the workings of the market" and to "encourage enterprise." But such excuses do not usually wash, and most of the press and many in the policy community are quick to -expose the absurdity of such government assistance. This is light years away from what prevailed even as recently as six o r seven years ago, when government proposals were often criticized, but only on the grounds of their ineffective execution, while their necessity or raison detre was seldom questioned. As a result, a number of major economic initiatives the government pla n ned, that would have cost Israel billions of dollars, have been squashed. Even though it seems that the political establishment is reluctant to accelerate change, it ap- parently understands where the wind blows. In September, we witnessed an astounding p h enomenon: a Labor party that still finds it difficult to separate itself from its red flag and May Day oelebration, launched a massive ad campaign attacking the Likud government for not being friendly enough to free enterprise. A new Labor election platfo r m calls for privatization and reduced government interference in the economy. The refutation of statist ideology has also brought about other changes in policy. While only a few major reforms have been successfully completed so far, those familiar with po l itical under- if i profound future changes. currents can discern sign icant beginnings for Them were two developments within the Israeli economic and political system that caused many of these changesand that are worth commenting upon because they may con t ain sig- nificant lessons about how the internal dynamics of a statist economy eventually mandates transition to a market economy. If we were to analyze; Israeli politics strictly by the hypotheses of social choice theory, there could be very little prosp e ct for economic reform. Since Israeli politicians are in almost total con- trol of the economy, only revolutionary change could force them to forego their enormous power. Yet it seems that the extensive use of economic favors to buy political influence fi n ally makes the political exploitation of the economy self-defeating. Vested Interests. One can observe an interesting favor-seeking process on the national scene, even, most significantly, within political parties. Having offered so many government favors to their followers, Israeli political parties have in effect, been transformed into unstable coalitions of vested interests vying for government favor. Since even the Israeli government does not pos- sess unlimited resources, party lords cannot ultimately satisfy the needs of all their constituencies, whose expectations keep rising much faster than favors can be granted. Moreover, even if UL attempt was made to satisfy them all equally, it would not prevent a des- tabilizing struggle from developing, for e a ch group would consider itself more deserving and would demand more favors, not least as a token of its larger political clout. Thus, for every satis- fied customer that a leader acquires by dispensing political favors, he creates a number of dissatisfied clients, and several political enemies. Parties then resemble families torn by conflict and intrigues as a result of a sudden inheritance that must be shared. With no objective economic criteria to indicate how such a windfall can be divided and no produc tive effort to be rewarded,

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personal and political ambition become the predominant factors and rivalries and jealousies abound. Finally, they destablize and break apart the family or the party. It seems then that while the setting of a constitutional limit on the economic power invested in government and in political parties may be necessary, what will make such a limit acceptable and even desirable to politicians is the realization that the dispensing of political favor is even- tually counterproduc t ive. Politicians must recognize that rather than securing their hold on power, in the long run it undermines it. They also must realize'that since a nation's strength depends on its economic viability, its political system cannot long survive massive gove r nment control of the economy, as we have witnessed in Eastern Europe and even in Sweden. A second process that holds great promise for spontaneous grass roots and market-generated reform can be witnessed in Israel in the way market forces eroded the polit i cal establishment's economic base while einpowering previously disenfranchised citizens. Decades of political manipulation and misallocation of resources have finally taken their toll on industrial enterprises owned by government, the Labor Party and the b anks, as well as the Labor-affiliated sick fund, pension funds, and agricultural cooperatives. Moreover, the same relentless forces that are final- ly weakening Israel's statist economy are also beginning to reward, albeit, haphazardly, Sephardic Jews who lacked access to the system and therefore had to make it independently, mostly in the informal economy.. Healthy Attitude. A survey of income disparities in Israel between Ashkenazim (Jews of European background) and Sephardim (Jews from Arab countries) d i scovered that despite ex- tremely high taxes and transfer payments, income gaps kept growing among these groups in the public sector. But among independent wage earners, Sephardim moved up faster and overtook the Ashkenazim. Ashkenazim, mostly well establ i shed officials, discovered to their chagrin that while education and contacts gave them access to coveted jobs, they remained highly taxed. The more recently arrived Sephardim, lacking such connections, moved into trades and small busi- nesses where they s atisfied rapidly expanding demands and participated in the underground economy. Never having been infected by the ethos of socialism, they were generously rewarded for their healthier attitude toward en=prise. Many Sephardim rose in the Israeli political h ierarchy through the direct elections of mayors, making them more responsive to public needs and accountable to their constituencies than Mem- bers of Knesset who are put on the slate by the executive committee. However, what might really force the hand o f the system and promote change is the massive wave of new immigrants from the Soviet Union. The challenge of housing and providing jobs for tens of thousands of new immigrants can simply not be met by Israel's sluggish economic sys- tem. As a matter of fa c t, already the government has had to forego its intervention in the initial absorption process and allow for direct absorption by handing each immigrant family a subven- tion with which to purchase housing, food, clothing, and education. As a result, Isra e l was able to absorb the first wave of almost 300,000 immigrants without initially having to add to the exist- ing housing stock. Suddenly, tens of thousands of empty apartments, which were owned as inflation-proof investinents, were put on the rental mar k et, and provided the necessary housing. In the area of employment, too, markets have operated much more gingerly than statistics reveal. Official figures show an I I percent unemployment rate in Israel. Yet it is difficult to secure the services Of IL mai d for even $10 an hour (the average monthly salary in Israel is $1,000), and there aremany thousands of illegal foreign workers from Poland, Portugal, Ghana, Turkey, Romania, and the Philippines (besides the scores of thousands of Arab workers from the Wes t Bank, Gaza and even southern Lebanon) who find employment in Israel. This apparent paradox of jobs goingbegging while there is apparently such a high rate of unemployment is due

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not only to the disincentives provided by high unemployment compensation on the one hand, and significant taxes imposed on low income brackets on the other, but also because much employment is in the i6irmal sector. Altogether, the existence of a vigorous informal sector, while saving Israel from being torn apart by disruptive social tensions and economic hardships, has also reduced the pressures for reform, especially of the tax system. People often wonder why Israelis, who are among the highest taxed peo p le in the world, have not declared a tax revolt. The reason seems to be that they have "privatized7their revolt, sometimes by individual tax evasion, but more often by sec- torial arrangements whereby although the taxable portion of the salary is small, t h e worker rec'eives various perks, on which often only the employer pays taxes.- Ile unfortunate result is that while take home pay is very low, the cost of labor to the employer is very high. Once hidden excess capacities in the job and housing markets ar e exhausted, however, the need to create additional jobs and additional housing for the immigrants will come up against the rigidities inherent in Israel's statist economy. The greatest hope for rapid employment expansion is small businesses. Their proport i on in Is- rael is much smaller than that prevalent in Western economies, because the Israeli economy is rife with government-sanctioned monopolies, with government bias in favor of large enterprises, with onerous entry limitations (one, for example, canno t establish a pharmacy within a radius of 500 meters from an existing one), and heavy taxation at low brackets preventing capital ac- cumulation. If Israel is rapidly to expand employment, massive deregulation and lower taxation must be instituted. In hous i ng, too, government interference is the major hindrance to rapid expansion. We have calculated that the average three-room apartment in Israel that now costs $100,000 contains at least $65,000 in government-imposed costs: inflated land prices (the govenim e nt owns 93 per- cent of the land), capi4l consuming lengthy planning and regulatory procedures, high taxes on building materials and labor, government-sanctioned monopolies in steel, iron, cement and in contracting services. A Blueprint for RefDrm. So wha t can be done besides complaining and issuing bad report cards? In February 199D, my organization, the Israel Center for Social and Economic Progress, held an international conference with the participation of over 2,000 people (including Israel's Presiden t , ministers, Kiesset members and other pillars of the establishment, and foreign dig- nitaries, such as Milton Friedman, Justice Antonin Scalia, Trevor DeCleane, Stuart Eizenstat, and others). With their help we were able to produce a blueprint for reform . * The government budget and taxes must be cut drastically. We put together a detailed plan that pointed out chapter and verse how to cut 10 percent of the budget simply by eliminating duplication and waste. # Tax systems and capital markets must be refor m ed and hidden capital legitimized so a thriving underground economy can be integrated into the formal one, and thus increasing productivity. # Government companies, including those in the defense industry, must be sold, but not through a lengthy piecemeal process that encourages powerful interests to acquire them at preferential terms. They must be incorporated into two or more competing mutual funds whose shares should be offered to the public. * Government must release vast tracts of land and sell them t o the highest bidder.

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* A pending law toencourage rental housing must be finally enacted. This will help make the building industry more efficient and competitive. # Once competitiveness and efficiency have been accelerated, municipalities can privatiz e their services, and so save a large portion of their outlays. This will enable them to reduce local taxes, which are a heavy burden, especially on small businesses. * Above all, the Israeli economy must be massively deregulated to become truly competiti v e. A blue ribbon committee should be established to review all government regulation of economic activity. Those that are not proven cost effective or that impede economic grow& should be abolished withina reasonable -period of time. Now that our seven ye a rs of work have conspired with circumstances to convince most Israeli decision makers and public opinion molders that economic reform is a top priority, and that only a market economy can assure Israel's viability and security, the hard work has only begu n on how to get fimn here to there. As experts in Eastern Europe point out, it is not enough to con- vince people that reform is necessary; it is not even enough for them to want it desperately. They still have to develop concrete strategies, adapted to an economy's particular circumstances, to its unique institutional setting and its social relationship, if they wish to see reform not only enun- ciated but actually carried out. You have to identify the groups that would cooperate on economic reform and try to win over those resisting it in order to both generate support and eliminate or modify opposition. This re- quires more than annual rhetorical exhortations telling the government to shape up and do certain things or to refi-ain from doing others. It tak e s a much more arduous effort to persuade decision makers that reform is in their best interest in the long run, to teach them the ABC's and the syntax of proper economics so that they can all write a better economic scenario in their own spheres of action . Holding out a foreign model for reforniers and expecting them to follow it on faith will just not do the trick. The setting up of foreign models to be emulated may prove to be counterproductive unless done with the utmost sensitivity and discretion. The p articular ethos of different countries, their unique aspirations, institutional dynamics, and even their peculiar semantics may be so different, that those opposing reform could easily seize on such differences in order to discredit the notion of reform. J udicious Criticism. To those who exhort Israel to follow the example of Hong Kong or South Korea, many Ismelis would retort that since these are not democratic countries, they can resist the pressure to close great discrepancies in wealth. Also since, at l east until recently, large parts of their populations were not well educated, they could not serve as models to a country like Israel wishing to integrate a great mass of very educated immigrants who thought that if the price for democracy and greater equ a lity must be greater government involvement in the economy, so be it. It should also be remembered that strident, often simplistic, even slanted, foreign criticism of Israel, and attempts by outsiders to twist the arm of its government, even if well motiv a ted, may alienate many Israelis.For they already feel that they are exposed to far too much foreign scrutiny and double-standard criticism. This criticism may play into the hands of those who resist reform by enabling them to recruit patriotic feelings. S o , to be effective, fbreign critics must act very judiciously and sensitively and not indulge in generalities and in intemperate rhetoric. They must remember what a daunting task basic economic reform is even in countries which enjoy relatively free market economies and not ex- pect that by acting as visiting firemen they can institute reforms in foreign economies overnight.

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This is not to say that foreign friends should keep away and not lend a helping hand. To the contrary, they have a vital role to fulfill in encouraging local advocates of reform. Since official U.S. representatives tend to confine their contacts and attention to official circles and the estab- lishment that is associated with them in statist economies, the population gains the imp r ession that U.S. sympathy and prestige are behind the policies they follow. It is therefore vital that voluntary U.S. organizations find a way to convey to the people in these countries what the U.S. really stands for in terms of the values and policies a s sociated with the market economy, by establishing their own ties with their counterparts in these countries. Where such counterparts are lacking, as in many autocratic regimes in Latin America, the Arab countries, and the Far East, they might want to emul a te the example set by the Open Society Fund which successfully sowed the seeds of a civil society in many East European countries when they were still communist. Local reformers should be helped by permitting them easier access to the experience accumu- l a ted by reformers elsewhere, and the means should be provided to help transmit such knowledge in their native language and in terms assimilable by their own culture. Often it is most difficult for such reformers to raise funds for their activities in their own countries since the source of most wealth is in the government's hands and with those who benefit from government intervention and would therefore oppose reform. Rethinking Foreign Aid. Above all, the time has come for proponents of economic reform to give some very serious and urgent thought to how to neutralize some of the very destructive con- sequences of government-to-government foreign aid that in the past often resulted in creating in the beneficiary countries an overbearing and injurious public sector. Can government aid be used as a leverage to encourage the private sector of developing countries, and if so, how? It is clear that most countries wishing to make the transition from a statist to a market economy am facing formidable problems. They urgently need help. But, as the saying goes, it is better to teach them how to fish than to provide them with fish. Educating people to function in a market economy is a long, arduous process, but there are no short cuts. It is the reformer's task not to hit their opponents over their heads, but to educate them patiently, convince them that through individual freedom and free markets their yearning for a better life can be realized sooner, more peacefully, and even more justly.

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