Israeli Economy

Israeli Economy

In August 1997, an international consortium purchased from the government of Israel a controlling, 43-percent stake in the nation's largest financial institution, Bank Hapoalim. The $1.4 billion price tag was considered hefty, even by global standards. Israel's ongoing transition from a socialist to a capitalist economy is thus seen to have arrived at one of its most symbolic landmarks.

Established well before the state itself as the financial arm of the Labor movement, Bank Hapoalim ultimately came to epitomize the state-controlled economy. In line with the socialist belief that the workers should directly control large business entities, the bank was owned by the Histadrut labor federation. The Histadrut used Bank Hapoalim to finance the activity of its sprawling business empire, which included such giants as the Koor conglomerate and the Solel Boneh construction company.

The bank also provided credit to various Labor-linked organizations, without paying sufficient attention to their economic viability. Its managers often failed to adequately evaluate the risks involved in approving various credit lines. They assumed that the government would always cover for them in the event of financial failure.

In 1977 Labor fell from power, and the stage was set for Israel's long overdue economic shift. However, before this change got under way, the situation deteriorated. In 1983, the Tel Aviv Stock Exchange collapsed, bursting a huge financial bubble that had been pumped up for years, by the big banks' manipulation of their own shares.

All this concerted, illegal activity - which allowed the banks, including Bank Hapoalim, to raise funds easily from the public through share offerings - could not be sustained in the long run, and was likely to cause mass bankruptcies of the sort that plagued the US after the Great Crash of 1929. To pre-empt such a calamity, the government bought the public's heavily-devalued bank shares, thus transferring them to the government's hands.

During the next 15 years, a succession of governments agreed that the banks should be privatized, but only in August of 1998 was the largest bank finally sold. Considering that Bank Hapoalim has direct and indirect control of some 770 companies, supplies 35 percent of the Israeli economy's credit pool, and is a major player in Tel-Aviv's financial markets, one must conclude that the bank's privatization reflects a revolution.

A success story

In spite of the shortcomings of the socialist period, a half-century perspective of the Israeli economy discloses a success story.

In 1950, Israel's 1.3 million citizens produced goods and services worth $4 billion at current values, or $3,100 per capita. By 1996, Israel's population had swelled to 5.7 million, and the gross domestic product had climbed to $95 billion, or $16,600 per capita. That makes Israel's economy the 20th most prosperous in the world.

In 1950, Britain's and Sweden's per-capita products were higher than Israel's by factors of 2 and 2.5 respectively; now the three are nearly identical. At that time, Argentina's per capita product was 50 percent higher than Israel's; now Israel's is twice Argentina's.

What allowed the Israeli economy to achieve such progress was its transition to capitalism; what kept it from growing even faster was the slow pace of that transition.

Although the retreat from socialism was gradual, the Israeli economy's 50-year history is highlighted by one major defining moment: the 1985 stabilization plan, which froze civil-service hiring, slashed public-sector salaries, emancipated the Bank of Israel, and abolished a host of government subsidies.

Facets of reform

Since the 1985 stabilization plan, the transition to capitalism has been proceeding along three major fronts: trade liberalization, competition enhancement and financial-market reform.

Trade
Israel's founding fathers believed that consumers and producers must invariably be at odds. Jobs, they thought, could be created only by artificially shielding local products. In reality, with the prices of imported quality goods being boosted by the tariffs which were imposed on them, and with Asian, Latin American and East European products altogether banned, local producers became increasingly inefficient, while consumers became dissatisfied.

The first small step away from that system came in 1962, when the government replaced various administrative import limitations with high duties. The next step was taken in 1975, when Jerusalem and Brussels signed a pact by which Israel and what was then called the Common Market would gradually reduce all mutual duties, until their full abolition in 1989.

Unfortunately, progress on this front was halted and even reversed in the early 1980s, as Israel's trade deficit and foreign debt grew sharply, and the government expanded its system of administrative defenses for locally-produced goods. In all, during the first half of the eighties there was a 60-percent increase in the number of goods, the import of which involved special licensing, Hebrew labeling and special standard approval.

Fortunately, those bad times ended, when Israel and the US signed a free-trade agreement in 1985. That pact committed Israel to fully abolish all non-tariff barriers on American-produced goods by 1995.

Israel's unique combination of free-trade pacts with the US and the EU allowed those regions' generally expensive products to dominate Israel's imports. To treat that distorted situation, an import-exposure plan was introduced in 1991, in order to expand the scope of Israel's liberalized trade to new horizons, beyond North America and Western Europe.

By 1998 - exactly half a century after the establishment of the state - import duties will have been reduced to an average level of 8-12 percent, approximately in line with the developed world's norms.

Competition
Since its omni-presence in the economy's early years, the government has gradually made a remarkable retreat from the marketplace. Back in the 1950s and 1960s, the legendary finance minister Pinhas Sapir would decide - using his famous "little black notebook" - which plants would be built, where, by whom, and with what kind of state aid.

In recent years, that way of doing things has been all but eradicated. Direct state aid has been sharply reduced, the new approach being to allow the markets to control resource allocation. The state aid that still exists is distributed by a much more regulated and professional process.

In the same period, most state subsidies were abolished, with the exception of public transportation and agriculture. More recently, some of the state-owned utilities have been exposed to competition, most notably Bezeq. The veteran telecom monopoly has been partly sold on the stock market, and now competes with private companies in the cellular-phone and overseas-calls markets. Similar reforms are planned for the Electric Corporation, the ports, the fuel industry and public transportation.

Financial markets
Until 1985, Tel-Aviv's financial markets were all but nationalized. Acting through the big banks, the government would use them to raise capital. Some of those funds ended up in the national budget, other money went to the business sector and some ended up pampering assorted sectorial, and even personal, interests. In contrast, private companies needed government approval for even the most modest bond offering. All that changed after 1985. The decisive defeat of hyper-inflation enabled the government to control the budget. The chronic deficits vanished, and the business sector, finally redeemed from three-digit inflation, could return to rational, long-term planning.

Today's financial markets, though by no means enjoying full freedom, are no longer state dominated. State bonds are used to finance only the budget deficit. The government no longer extends credit for exports or investments, nor does it decide which company will be allowed to issue bonds.

Foreign Currency

The government and the Bank of Israel have recently removed supervision on foreign currency by lifting restrictions on foreign currency trading. From now on, all transactions in foreign currency will be permitted except for those specifically forbidden. Citizens will only be required to report activities such as opening bank accounts abroad, buying apartments or investing overseas. Israelis may invest and trade anywhere abroad and in so doing the Israeli shekel will become fully convertible.

The control of international credit transfers has also been eased, though insufficiently, and this year more restrictions are being lifted. However, the pension funds are still compelled to invest most of the public's long-term savings in state bonds. That, indeed, is now the most glaring distortion in the operation of Israel's financial markets.

The Socialist Index

In today's world, where taxation is progressive, no economy is fully free from government intervention. In this context, one may pose the question of where to locate a country in the broad spectrum whose two extreme ends are pure socialism and pure capitalism. That position can be judged by the extent to which the public sector milks the national product, which in turn can be gauged by the size of the budgets of local and national governments.

In the 1960s, the Israeli public sector gobbled a mere 35 percent of the national product. However, after the 1967 and 1973 wars and the dramatic increase which they generated in defense spending and welfare costs, that figure shot up by the early 1980s to 72 percent.

In the wake of the 1985 austerity plan, that trend has been clearly reversed. Today, public sector spending stands at 55 percent of the national product, still well above the 35 percent level of the US and Japan, and the 42 percent average which prevails across the industrialized world.

While the Israeli economy has come a long way in its historic retreat from socialism, it has yet to fully meet Western standards of low public spending.