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Israel at a Crossroads

Economic reform is in Sharon's hands.

12:00 AM, Oct 7, 2004 • By DANIEL DORON
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ISRAELIS RECENTLY OBSERVED the 31st anniversary of the 1973 Yom Kippur war. This anniversary is made much of, because Israel's near defeat revealed some basic flaws in its system of governance. The debates about these flaws are still going on, gradually transforming Israeli society in profound and painful ways.

In that war, Ariel Sharon, then a division commander, played a critical role. Many believe he saved Israel from ruin.

In 1973 Israel was simultaneously attacked by overwhelming Soviet-trained and equipped Egyptian and Syrian forces. Its tank corps and air force, the two pillars of its military superiority, were virtually neutralized. If not for the personal bravery of Israel's middle rank and file, who literally stopped the enemy with their bodies, the surprise could have turned into a rout. Most of Israel's top political and military leaders were so confused and depressed by the war's initial setbacks they were virtually paralyzed.

Not the cool-headed Sharon. In a daring and risky move, he had his tattered, relatively small force cross the Suez Canal. They outflanked much larger Egyptian forces, and eventually forced them to sue for a ceasefire.

Sharon is faced now with a similarly consequential peacetime decision. He has to decide whether to throw his weight behind a bold economic reform plan elaborated by his finance minister, Benjamin Netanyahu, or let it languish. It is a reform--especially of financial markets--that far transcends its concrete objectives. It might mark Israel's crossing of a Rubicon, from a centralized, government-dominated, and monopoly-ridden dysfunctional economy to an efficient, competitive market system that allows Israelis to fulfill their enormous potential.

It is certainly not as dramatic a decision as that taken during a crucial battle. Still, it is a decision that will affect Israelis' future no less than a victory in war. For Israel, economic growth is not merely about a better standard of living, but about survival. Israel cannot hope to keep its young at home for long on the measly $1,200 a month salary most Israelis earn (while prices for most consumer goods and services are higher than in the United States); nor will Israel be able to foot its spiraling defense costs (and a strong army will always be required) if its economy keeps lagging.

There are many reasons why the Israeli economy under-performs so badly. Neither Israel's manpower resources, nor its land, nor its capital, is deployed in an economically sound manner. The failure of Israel's financial intermediation sector to generate productive investments is, however, most glaring of all.

Israeli banks are even more concentrated and monopolistic than their notorious Japanese counterparts. They too have tentacles reaching into every sector of the economy, and symbiotic relationships with government bureaucracies (many top bank managers are former high government officials) and with the interlocking monopolies that dominate Israel's economy. This gives the banks tremendous political clout, which they enhance by giving loans to political parties and members of the Knesset and by deploying an army of lobbyists.

The banks have become the linchpin of a culture of cronyism perpetuating Israel's Socialist and statist heritage. Through government-granted tax privileges, the banks have come to control over 80 percent of Israeli savings. They lend 70 percent of their loans to 1 percent of borrowers, who are their partners and cronies. These non-recourse subsidized loans, not covered by adequate collateral, were spent on highly speculative and leveraged investments in entertainment ventures (cable TV and such) and shopping malls, most of which flopped. The banks now admit that they carry $13.6 billion in "problematic" loans (their capital base is only $10 billion). This has forced them to curtail their lending, creating a dangerous credit crunch that nearly plunged Israel into an Argentine-like crisis a year and a half ago.

The banks make up their heavy losses on loans by gouging Israeli households and small businesses. They charge hundreds of commissions and exact usurious rates on the overdrafts of struggling families. The spread between the exorbitant rates charged on household loans and the interest paid on savings (some 5 percentage points) is a major source of profit for the bank monopoly. Low interest on savings also results in a huge wealth transfer from productive Israelis to the 16 or so families and entities that control the banks and most assets in Israel. As for small businesses, in the last two years alone, 75,000 of them folded up, many for lack of credit. Many thousands more never took off because getting a start-up loan from a bank was mission impossible.

The squandering of 20 years' worth of savings by the banks and the subsequent credit crunch is probably the main reason for the lack of growth in Israeli per capita productivity in the last decade (a better indicator of growth than GNP, which also reflects non-productive and even anti-productive activities of the government and of Israel's many interlocking monopolies). Recently, the trend has been downward.

But this is only one of the disasters that a distorted banking system has inflicted on Israel. Since the 1980s, when the bankers were caught massively manipulating their own shares--and had to be bailed out by the government (costing the economy $7 billion in direct, and many more billions in collateral, damage)--Israeli bankers have engaged in adventurous practices that brought them to the brink of bankruptcy at least twice more. Each time, their adventurism and irresponsibility cost the Israeli taxpayer billions.

Their failure to generate productive investment may also account for Israel's massive unemployment--with all its attendant social ills, including the mushrooming of the government deficit caused by skyrocketing transfer payments, which now make up over a third of the $60 billion plus budget. Self-inflicted economic hardships that come on top of a very difficult security environment are a major cause of the despondency plaguing so many Israelis.

Over 20 years ago, the famous Beijsky commission recommended breaking up the banks' monopoly by forcing them to sell their holdings in provident and mutual funds that now amount to 21 percent of all savings. These holdings cause severe conflicts of interest, since the banks habitually sell the funds they control shares in companies they float (the banks also act as underwriters) at exorbitant prices. (This may be one reason the bank-owned funds have an average yield of 4.5 percent, far below that of privately-held funds.)

Essentially the same steps have apparently been recommended by the Bachar treasury task force appointed recently by Finance Minister Netanyahu. Yet for over two decades the bankers managed to frustrate reform by using their political clout to preserve their stranglehold over the Israeli economy. They are now mounting a huge effort, costing millions, to nix the current treasury recommendations.

Netanyahu is virtually alone among Israeli leaders in understanding economics. He also realizes the enormous damage, counted in the many billions of dollars annually, that monopolies generally, and the bank duopoly in particular, inflict on the Israeli economy. Netanyahu is the first politician to tackle Israel's powerful monopolies, chief among them the Histadrut, the Labor Federation that mainly serves the interests of the public monopoly unions in the electricity, water, transportation, and energy industries and the banking unions. All these sectors suffer from featherbedding, nepotism, corruption, low productivity, and salaries three to four times the national average. The Histadrut never hesitates to call a general strike to protect the interests of privileged monopoly union workers, even when it comes at the expense of all other workers.

Netanyahu's struggle with the Histadrut is just beginning, yet he simultaneously took on the powerful bank monopoly. True, the solution his task force recommends is not the classical liberal prescription: trust market forces to establish competition and break up undue market domination. That is because, in Israel, the concentration of economic power in the hands of extremely few entities, and the enormous political power this grants them, is such that government intervention is required to correct a political "market failure" (created, of course by government). Government must break the banks' domination of financial markets before competition can do its work.

The reform program must be presented to the cabinet for approval before being made public. Sharon has not yet presented it, though it was scheduled for presentation a few weeks ago. Undoubtedly, Sharon will eventually support the reform. He must know that the Israeli government has committed itself to this and other reforms, as well as to budgetary restraints, as a condition for receiving U.S. loan guarantees. The question is when and how.

Sharon has known in the past how to handle complex situations by keeping his eye on the target. It will be tragic if at this crucial stage he lets extraneous considerations defeat a reform plan that may turn out to be the greatest achievement of his government. For if this reform were to bring about the liberation of Israelis from their disabling economic system from a system that has enslaved and impoverished a talented and energetic people and kept it from realizing its enormous potential--it will indeed become his crowning achievement.

Daniel Doron is president of the Israel Center for Social and Economic Progress, a private think tank in Jerusalem.

Correction appended 10/7/04: Article originally said that Israelis recently celebrated the 21st anniversary of the Yom Kippur war. The war took place in 1973, the recent anniversary was the 31st.