WHEN FORMER prime minister Benjamin Netanyahu took on the thankless job of finance minister last March, Israel was facing a grave economic crisis. In the sixth year of a deep recession, the country had seen its tax receipts plummet while welfare transfer payments kept growing, amounting to more than a third of the government's $70 billion budget. The budget deficit had reached a perilous 5 percent of GNP. It was feared that the government might not be able to meet the payroll of a bloated public sector that employs every third worker in Israel, or keep paying generous benefits to the more than 10 percent of the workforce that is unemployed. To guard against inflation, the Bank of Israel kept interest rates so high (9.1 percent in real terms at their peak) that the economy was choking. There were murmurs Israel might slide into an Argentinian-style crisis or a deflation like Japan's.

The economic hard times have greatly aggravated social and political tensions. Many hardworking and intelligent Israeli workers earn less than $1,200 a month, barely making ends meet. Near poverty even in the professional classes and extreme wealth among a few well-connected economic and political operators have created one of the worst income gaps in the world. Israel's fractious politics are made even worse by the intense competition among interest groups vying for government favor. In short, a lot is riding on the success or failure of the finance minister.

The wildest optimists would not have predicted that Netanyahu could reverse this downward economic trend, and in fairly short order. Yet the economy is growing again. Netanyahu has managed to make substantial cuts in two consecutive budgets and reduce the bloated public workforce and salaries (though not enough). He has even managed to reduce unemployment benefits that discouraged lower paid Israelis from working.

Netanyahu also launched a modest tax reform, bringing the top marginal rate below 50 percent of income. And he courageously took over the Histadrut-controlled pension funds that were going bankrupt as a result of the labor federation's mismanagement. But the Histadrut, cynically posing as the protector of workers' pensions (that the union itself has squandered), launched a well-financed campaign of massive demonstrations, strike threats, and a PR drive vilifying Netanyahu as the benefactor of the rich (because he cut taxes). The strikes, only some of which materialized, almost broke an already teetering Israeli economy.

Netanyahu's showdown with labor is an epic struggle. He wants to privatize the hugely wasteful public-sector monopolies, but that means taking on Israel's most powerful unions. Workers in the seaports and airports and in the electrical and water works--all government-owned monopolies--earn five times the average Israeli salary and have cushy work arrangements. Jaguar-driving union bosses enjoy fantastic perks for no-show jobs. They threatened to bring the economy to a halt to protect these privileges, counting on support from other public-sector workers, government employees, teachers, etc.

Their leader in this is the politically ambitious boss of the Histadrut, Amir Peretz, a member of the Knesset who heads his own political party. Together with the Labor opposition, Peretz's unions have done everything in their considerable power to thwart Netanyahu's reform plans. But Netanyahu garnered great public sympathy that made the strikers back down. He still faces the threat of general strikes that may halt the progress of his reforms.

Netanyahu has shown great political skill in putting his economic rescue plan through a skeptical and divided government and a fragmented Knesset. Only Prime Minister Ariel Sharon has given him strong backing in his fight with the Histadrut. His fellow government ministers had other political axes to grind, and altogether they would not mind very much to see Netanyahu fail. His trump card was, no doubt, the $9 billion in American loan guarantees this summer that allowed the government of Israel to tap international markets for desperately needed funds, as they have nearly depleted local credit markets. The U.S. government astutely made the loan guarantees conditional on the enactment of basic economic reforms, tipping the political scales in favor of Netanyahu's bold moves.

Despite these manifest achievements, it is not a safe bet that Netanyahu will be able to break the monopolies that have dominated Israel's economy for decades. Some argue that Netanyahu should first have tackled the private monopolies that add about 30 percent to the prices paid by Israeli consumers. This would have been of great benefit to lower paid workers and would have helped him to counter the union charges that he is catering to the rich.

Netanyahu's greatest challenge remains the overly concentrated and dysfunctional Israeli financial markets, which are reminiscent of Japan's in the way they misallocate capital and hinder growth. Israeli banks, led by the Ha'poalim and Le'umi duopoly, control over 80 percent of all savings and also issue stock that is bought and sold by funds owned by the banks in a stock exchange they control. It is a situation rife with conflict of interest--70 percent of credit has been allocated to one percent of borrowers--and arguably the chief cause of a decade of nongrowth in Israel.

Commenting on a new Finance Ministry initiative to distribute options to Israelis for the purchase of privatized bank shares, Guy Rolnik, Israel's sharpest financial writer, remarked that "very few crucial economic changes are easy. The structural reforms Israel needs generally hit at very powerful interest groups. It is [therefore] easier to lavish shares on the people than to slash the deficit to 4 percent of GDP . . . [or] grapple with the bank barons over their domination of the [economic] system, or to wrest the mutual funds from their grasp."

Netanyahu will be measured, Rolnik concludes, "by real economic parameters . . . of unemployment, which is not budging . . . and by the real pace of economic growth," which at 1.5 percent is still anemic.

In fairness, though, given the strong resistance by vested interests, an immediate attack on the monopolies may have been too much to hope for. But Netanyahu is smart enough to know that he will eventually have to take on the powerful banks and break up the private monopolies if he is to have any hope of seeing healthy growth rates on his watch. What's more, he understands that without such growth, his hope of again becoming prime minister will diminish.

THE NEXT FEW MONTHS will reveal whether Netanyahu has the power to push a comprehensive economic reform plan that finally undoes the damaging legacy of decades of Israeli socialism. To succeed in such an ambitious undertaking, he will need public support.

Many Israelis realize that economic reform and growth are not merely a matter of an improved standard of living. They are a matter of survival. Israel will not be able to keep its young at home and attract vital immigration unless its economy is vibrant. Nor will a laggard economy be able to finance Israel's rapidly rising security costs.

For this reason alone, Netanyahu deserves the backing of the U.S. government. But there are deeper reasons for Washington to support such a reform effort. Hope for peace with the Palestinians will diminish considerably unless a thriving Israeli economy can help the Palestinians rebuild their ruined economy and establish a civil society capable of living in peace. Few people noticed, but until the 1996 Oslo agreement there was an informal but very real "peace process" going on between Israelis and Palestinians, and it was rooted in economic development.

Given the choice between progress under Israeli occupation and being ruled by the terrorists and criminals known as "The Palestinian Authority," the verdict of most Palestinians was always in favor of a peaceful economic coexistence. Between the 1967 Six Day War and Oslo, Israel employed annually hundreds of thousands of Palestinians who had total freedom to move everywhere in Israel. In all these years there were only a handful of terrorist acts, mostly by Arafat's hirelings. Clearly, a silent majority of Palestinians were ready to live peacefully with Israel despite the occupation. It was only after Oslo, and the incessant brainwashing and incitement by the PLO Tunisian gang, that the mood among the Palestinians turned murderous.

But even after Oslo, when residents of East Jerusalem, mostly zealous Muslims and fervent nationalists, were given the choice between Israeli papers and PA citizenship, 99 percent chose Israeli papers--not because they became Zionists or learned to love Israeli occupation, but because they rationally chose the lesser evil. They realized that under Israeli occupation, however infuriating, they benefited from the rule of law, freedom of movement, and economic opportunities that more than quintupled their standard of living.

Trying to put the political horse before the economic cart, and years of political meddling by well-meaning and not-so-well-meaning parties have only aggravated the conflict. Perhaps it is time to return to the pre-Oslo model of a quiet but real peace process between ordinary people, a process based on real interests served by economic relationships rather than on radicalizing political fantasies. Helping Israel put its economic house in order could be just the peace plan Washington is looking for. It is surely worth a try.

Daniel Doron is president of the Israel Center for Social and Economic Progress, an independent pro-market policy think tank.

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