Nicknamed the ‘Start-Up Nation’, Israel in the 21st century is home to a plethora of high tech enterprises and within the Middle East is the most developed nation. How did a country that was at one stage the most socialist economy outside of the Soviet Bloc become a modern and dynamic economy? Simply put, free market economics and courage to reform a broken system.
Roman historian Livy ascribes the failure of the Roman Republic to the environment where “we can bear neither our diseases nor their remedies.” A reluctance to live with the problem or risk a solution similarly existed with the Israel economy in 1973. The rising price of oil had produced an inflation rate that exceeded 30%. Growth had slowed to a halt which when coupled with a seemingly exponentially growing unemployment rate, resulted in large scale emigration of the skilled population. Years of high government intervention, wage controls, extensive state ownership of production, foreign exchange controls, and public sector spending that totalled 80% of the economy had resulted in an economic catastrophe.
Despite the apparent failure of the economy, the fear of a political backlash mixed with the dangerous potion of complacency stunted any serious attempt at reform. Up until 1977 Israel was led by the Labor party, with Likud’s first victory in 1977 representing an opportunity for reform. Not wasting any time, Likud employed the counsel of free market economist Milton Freidman who proposed large market economy reforms. Unfortunately, this advice was largely ignored and the 1980s represented the culmination of a ruinous economy. In 1983 the largest four banks in Israel were nationalised after their stocks collapsed; by 1984 the inflation rate had reached 450% and was estimated to increase to 1000% in 1985. No longer could the soothing elixir of gradualism or continuous short term stop gap solutions soothe the deep wounds that years of big government had inflicted upon the economy.
With trepidation and courage driven in part from necessity, Prime Minister Shimon Peres implemented a Stabilisation Plan in 1985 that introduced large reform. The plan paid homage to the ideas of Freidman; Government expenditure was gradually cut falling from 57% of GDP in 1988 to 47% in 2000. Importantly Israel established a Free Trade Agreement with the United States in 1985 which tripled bilateral trade by 1996. Following these reforms GDP increased from US $11,000 in 1990 by over 50% to US $17,000 in 2000. In 1987 the inflation rate was under 20% and foreign investment in 2000 accounted for US $8 billion and 7% of GDP.
Despite these positive steps, Israel’s productivity rate in the 1990s had only increased by 0.6% compared to the global average of 3%. Simultaneously the Movement for Quality Government in Israel began to log hundreds of corruption cases from the public sector. The global slowdown in 2000 generated a sense of urgency that facilitated an environment conducive to greater economic reform. By 2003 unemployment was higher than 10%, the budget deficit was at $579 million and was growing rapidly. The reforms of 1985 were positive but were not enough to solve the inherent issues of inefficiency and corruption that plague big government economies.
In 2003 Finance Minister Benjamin Netanyahu announced a Four Pillar plan The first pillar of the plan was shrinking public sector spending; in 2003 the public sector made up 55% of Israel’s GDP and Netanyahu announced it was to be reduced to 30%. Welfare spending from 2003 fell steadily each year as excessive benefits were phased out. The second pillar involved privatisation and tax reform. The largest public holdings were privatised including: the national airline El Al, the ports, as well as the banks. The tax code which had last been revised in 1975 was reformed to cut tax levels sharply to the same level as the European Union. The third pillar was breaking up monopolies and cartels within the Israeli economy, that are estimated to have costed a cumulative $100 billion in GDP since 1948. Incentives for small and medium businesses were introduced that combined with new trade agreements with Poland, Hungary, Mexico, and Canada improved growth. The final aspect of the plan was a major restructure of the capital market. Previously 1% of the population had received 70% of bank loans, restricting the viability of entrepreneurship and economic growth.
What were the results of the 1985 Stabilisation Plan and the 2003 Four Pillar Likud Plan? The unemployment rate dropped to the lowest in a decade in 2006 at 7.7% and 4.9% in 2016. Exports exceeded imports for the first time in 2007 and did so by $66 billion, and by 2007 public expenditure accounted for only 15% of total GDP. The ethical benefits of free market economic theory are evident clearly in the transformation of the Israeli economy. Big government economics claims a morally superior position in arguing the state should act as a charity and not be driven by economic rationalism. However as evidenced, good economic management produced moral outcomes including a reduction in unemployment and a lower tax rate. Israel is a case study for the economic and ethical benefits of free market thinking.