The Magazine

Bibi Does Economics

Can a former prime minister find happiness reforming Israel's economy?

Mar 10, 2003, Vol. 8, No. 25 • By TOM ROSE
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DEMONSTRATING that petty political maneuvers don't necessarily have petty outcomes, last Thursday's decision by Israeli prime minister Ariel Sharon to reshuffle his cabinet may prove to be one of the most important of his career and a huge step toward victory in Israel's 55-year war for legitimacy, permanence, and peace in the Middle East.

At first, Sharon's decision to dump Foreign Minister Benjamin Netanyahu in favor of a lightly regarded Likud party insider named Silvan Shalom sent shock waves through a country seldom fazed by the machinations of its political class. Initially, even Netanyahu's most vocal domestic critics condemned Sharon's maneuver as a trick designed to sideline his longtime party rival at the expense of the national interest.

But a few hours later, something even more shocking happened. Rather than take Sharon's hint to quit the government, Netanyahu took the job Sharon had offered him, finance minister. The Tel Aviv stock market reacted with a nearly 5 percent rise, its single best performance in more than three years. It understood that Israel's most pressing challenge may well be not its fight against Palestinian terror, but its fight to stave off economic collapse.

Thanks in part to continued generous financial support from the United States, successive Israeli governments have been able to maintain the kind of unsustainably extravagant socialist infrastructure that European, Latin American, and East Asian countries have been jettisoning for decades. Today, few countries have larger state sectors, higher marginal tax rates, or more lavish social welfare systems than Israel. Until now, successive Israeli governments have managed to avoid choosing between economic reform and economic collapse by turning to Washington.

In fact, as Sharon was reshuffling his cabinet, his office was putting the final touches on its largest request ever for economic aid. Israel's current request is for $8 billion in U.S. backed loan guarantees and $4 billion in direct cash assistance paid out in $1billion increments over four years. Since the United States already provides roughly $1 billion a year in direct economic assistance, the latest "emergency" request, if granted, would double the level of American economic aid.

It would be a mistake for American policymakers to conclude that Israel no longer needs or deserves American assistance, even though its current request may well merit conditions or modification. The threats Israel faces are real. Maintaining the country's strength and stability in a volatile Middle East still depends on its ability to obtain assistance from the United States. But maybe the time has come for the United States to try helping in a different way: insisting on reforms in return for new economic aid. As long as Israel can count on being bailed out of an economic mess largely of its own making, it will refrain from the changes necessary to propel it to prosperity.

One out of three of Israel's workers is on the public payroll. Another quarter of Israel's workforce is employed by companies either supported or owned by the state. In 2002, government spending accounted for nearly 70 percent of Israel's economic activity. Half of the government's $80billion budget is spent on salaries. Another third is devoted to transfer payments to Israel's protected classes and direct assistance to the poor, leaving less than 10 percent for everything else. On average, Israelis face a full-spectrum tax burden of more than 60 percent. Rather than declining as a share of GDP, Israel's government sector and tax burdens both continue to grow.

Not surprisingly, Israel faces its deepest economic crisis since independence. For one out of five Israelis, government assistance is now the sole source of support. Unemployment is at an all-time high. Half of Israel's children live below the official poverty line. Exports, upon which Israel depends for half of its growth, have declined in real terms despite a 25percent devaluation of the shekel against the dollar. An exploding budget deficit combined with a state-supported banking monopoly dangerously close to insolvency has rendered commercial credit all but nonexistent. Prohibitive interest rates have led to a steep decline in consumer spending and devastated the housing market. New business starts are a thing of the past. In Jerusalem alone, one third of all retail businesses have folded since the renewal of terrorism in September 2000. Israel's response to its economic "perfect storm" has been to make it worse. The independent Central Bank has refused to cut interest rates, while the government has raised taxes and spending and halted privatizations.