From 1950s rationing to modern high-tech boom: Israel’s economic success story

From a war-torn nation struggling for survival and lacking natural resources, the biblical land of milk and honey has become a technological powerhouse which has seen economic growth for 15 consecutive years.

“We can stop and look back with satisfaction” at the “amazing achievements made by the Israeli economy in the 70 years of the State’s existence,” Bank of Israel Governor Karnit Flug said at a press conference in Jerusalem in March.

Israelis’ standard of living has risen from 30 percent of Americans’ standard of living at the time of the state’s founding to 60% today.

Israel’s economy has experienced a yearly average growth of 3.3% since 2000, higher than in many OECD countries, partly driven by a strong population growth. Its labor market is close to full employment and the unemployment level is the lowest it has been in decades.

Israeli tech firms raised record funds in 2017 and the year saw $23 billion worth of company exits, defined as merger and acquisition deals and initial public offerings of shares. The nation has some 94 companies listed on the Nasdaq exchange.

The country’s population surged from 806,000 at the founding of the nation to 8.84 million today, and the state has absorbed some 3.2 million immigrants over the years. Life expectancy for Jewish men jumped to almost 81 years from 65 in 1949, and for women to just over 84, compared with just below 68 in 1949. The nation is ranked the 11th-happiest country in the world, and, to top it all, it has also found natural gas reserves off its shores, which will help lead the tiny country to energy independence. (See related story for economic data.)

If you look at the “big picture, at the perspective of 70 years,” the Israeli economy by and large “clearly did very well,” said Omer Moav, professor of economics at the University of Warwick in Coventry, UK, and at the IDC Herzliya, in a phone interview.

The country has gone from a “chronic balance of payments,” huge debt, and runaway inflation to “a balance of payments surplus, a surplus of assets over liabilities, and inflation that we would like to be a little higher,” Flug said.

And all of this has taken place while absorbing and resettling huge waves of immigrants and fighting off hostile neighbors.

How did this come to pass?

Israel’s economic success is due to a number of factors that have merged to bring the nation to its current state.

A lack of natural resources pushed its dwellers to find alternative ways to cope, leading to the development of drip irrigation and water desalination plants — technologies that are now sold globally.

The wars the country has fought have led the nation’s military to develop cutting edge technologies that have also permeated the civilian sphere, creating the basis of Israel’s thriving tech scene.

The country has also managed to absorb huge waves of immigration, and this population surge has contributed to a mix of cultures and languages — from Russian to Arabic and Ethiopian and English — that have remained distinct as much as they have melded, creating friction at times but also a fertile ground for innovation.

The impact of the immigration was such that “there had to be rationing of resources in the early 50s, like oil and food,” said Prof. Eytan Sheshinski, an emeritus lecturer in economics at the Hebrew University of Jerusalem in a phone interview.

This rationing continued well into the 60s, with the government deeply involved in the economy. From 1950 through 1955, Israel’s economy grew by about 13% each year, and just under 10% in the subsequent years into the 1960s, according to “Start-Up Nation,” a book by Dan Senor and Saul Singer that documents the story of Israel’s “economic miracle.”

The government provided jobs and set up infrastructure projects using money from overseas, mainly from Jews abroad but also from German reparations given as compensation for Nazi crimes. “These were critical to the economy” and helped build roads, ports and trains, Sheshinski said.

Then, in the 70s, inflation started. The 1973 Yom Kippur war forced the country to recruit most of the labor force to the military effort for up to six months, bringing business activity to a halt. Government policies that artificially propped up salaries led to ballooning debt, and tax rates were raised.

Hyperinflation hit in the early 80s and in 1984 it reached 445%. This “disrupted the function of the economy — and there was a large deficit in the balance of payments,” Sheshinski said. In 1985 a stabilization plan led by finance minister Shimon Peres together with US secretary of state George Shultz and IMF economist Stanley Fischer, was set up to reduce public debt, curb government spending, and start a spurt of privatization of government-owned companies.

The program “froze prices and wages and stopped inflation,” Sheshinski said. “The privatization created a competitive industry and continued well into 1990s.” At the same time the government undertook a program of liberalizing the economy, opening the Israeli markets to imports and lifting curbs on the currency.

“Israel became part of the global economy,” Sheshinski said. Because of the small size of the economy, the industry focused on foreign markets, boosting Israel’s exports. In the 1990s the government also had the foresight to set up a program called Yozma, which helped create a local venture fund industry that invested in burgeoning Israeli technologies.

Then, the boom of the internet broke down geographic barriers and Israeli entrepreneurship mushroomed.

“The internet very much suited the Israeli character and many young people entered the field,” said Yossi Vardi, an Israeli entrepreneur and investor who backed Mirabilis, the founders of ICQ, the first instant messaging program for the web. It was sold to America Online in 1998 for some $300 million.

“Israel is a small country with no local market, and the barrier to entry for the internet was very low; some managed, others failed, but it inspired people,” Vardi said in a phone interview.

A wave of immigration in the 90s brought with it more than 900,000 new immigrants, many of them engineers, professors and scientists from the former Soviet Union who fed Israel’s nascent tech scene with much needed professional skills.

“Our ability to absorb immigrants and integrate them is something not many other countries have done,” said Yaniv Pagot, an economist and head of strategy for the Ayalon Group, an Israeli institutional investor. “This is an achievement that has huge economic implications and also long term social impact.”

It was a combination of venture capital money, the internet, an influx of engineers and scientists, hardheadedness and determination, and years of thinking out of the box to finding solutions to pressing needs that has led to Israel’s thriving tech industry.

The main achievement of Israel’s economy is that “we have gone from being a very poor weak and small country, 70 years ago, to an innovation powerhouse, globally known as a center for startups and innovation,” said Saul Singer, the co-author of “Start-Up Nation.”

Not only does Israel have “the highest density of startups of any country in the world,” he said, “Israel’s startup ecosystem continues to grow and attract more investment and large companies from all over the world, who are buying up Israeli technologies and are setting up research and development centers locally.”

At the end of 2017 there were 365 active foreign R&D centers operating in Israel, including giants like Google Inc., Facebook, Intel Corp., and Apple. Intel’s massive $15.3 billion acquisition of Mobileye, a Jerusalem-based developer of advanced vision and driver assistance systems, in March 2016 is testament to the mark Israeli technologies have made globally.

If, however, Israel’s tech scene is the most evident sign of its success, there are other major factors that have contributed to the flourishing of its economy. Israel has set up solid regulatory and financial institutions like the Bank of Israel, commercial banks, the Israel Securities Authority, and the Finance Ministry that are “first class and at global standards,” said Ayalon’s Pagot. These systems have been tested in crisis situations and have proved themselves.

A plethora of talented people with world-class skills set up and lead an “economic system that works,” he said.

In addition, Pagot said, and possibly most importantly, for the past 20 years or so, Israel has also implemented a policy of fiscal restraint that has kept budgets in check.

“Perhaps one of Israel’s greatest economic achievements is having attained a credibility for fiscal discipline,” said Pagot. “Today this is something we take for granted, but it should not be. The Israeli governments have been managing a responsible fiscal policy – staying within the budget and lowering government deficit, without breaking out of the set framework.”

While in the early 2000s Israel’s ratio of debt to GDP was around 110%-115%, today it is around 55%, he said.

“This lower debt-to-GDP ratio is the basis for lower financing costs to the country and to companies and is the basis of investor confidence in the Israeli economy,” Pagot said. “This is not something the public really realizes, and it is not a sexy subject. It is like talking about the chip or processor within the computer. Users see the computer, but not the chip. But it is the chip that allows the computer to work. So, people tend to talk about the easily noticed achievements, like the technology boom, but this lower debt-to-GDP ratio is the heart of the economy.”

Big challenges lurk ahead

Still, while Israel celebrates its economic achievements, it faces urgent challenges that need to be addressed to ensure the nation’s continued prosperity.

GDP per capita, although it has risen, is still 24% lower than the average in other advanced economies, and while it grew more rapidly than the average in those countries from 2008 to 2013, in recent years growth rates have tracked those of other economies, according to Bank of Israel data.

Worker productivity is low compared to other developed countries, and the gap has not closed over the years, according to the Bank of Israel. The main reasons for this are over-regulation and a bureaucracy that hinders businesses: Israel came in at 54th out of 100 overall in the 2018 World Bank Ranking for ease of doing business, and its infrastructure does not match the needs of the growing economy and the local industry. For example, inadequate public transportation creates a barrier to expanding the labor market by making it harder for people to travel to their jobs.

And perhaps most importantly, the technical skills of the bulk of the citizenry — notably those 15 and older — are poor, hampering their ability to function in the digital environment. Ironically, in the Startup Nation, most people still don’t know how to handle online banking or use the internet well.

Some population groups lag far behind the average in numeracy, literacy, and problem-solving — namely, ultra-Orthodox Jews and Arab Israelis. This is reflected in high wage inequality.

“When you look at the skills, which is the ability to read and write the ability to do basic math, to handle tech, Israel is actually on average way behind the typically developed country,” the economist Moav said. In addition, he added, after the sweeping reforms of the mid-80s and 90s in Israel, not many grand economic gestures have been made by subsequent governments. “By and large there isn’t much happening in recent years.”

The Israeli economy has huge potential, he explained, but the government is not doing enough to cut regulation and fight the “extremely powerful” labor unions, and is “failing consistently in taking care of Israeli transportation issues.”

The greatest woes ahead, however, could come from the fact that Israel’s high-tech engine is losing steam due to a lack of skilled workers.

“The big shortage in terms of expanding the startup ecosystem is human capital,” said Singer. “That is the only thing stopping us from growing substantially and it is the only threat to the system.  To increase our human capital we must include groups that have been underrepresented in high tech: women, Arabs, and the Haredim.”

The ultra-Orthodox and Arab populations, among the poorest in Israel today, are expected to constitute half of the population by 2059, according to the OECD.

“We need to improve our educational system  — we can and we need to reinvent education for the 21sth century — and if Israel does this it will greatly increase our human capital. And I mean not just urging people to study math and science. It is deeper than that. We need to reinvent education for the current age. Our education system, like every other in the world, is stuck in the industrial age, not designed for our world today.”