THE ISRAELI ECONOMY: AFTER THE FINANCIAL CRISIS, NEW CHALLENGES

David Rosenberg *

As Israel experienced no more than a mild recession as a result of the global financial crisis that began in 2007, a testament to policies adopted by the government over the previous decade. These policies emphasized fiscal restraint, as well as liberalization and increased competition across most of the economy while strengthening regulatory restrictions on the banking sector. Indeed, the only case of market failure in Israel came in the relatively unregulated non-bank credit sector. However, Israel's recent policy successes by themselves are insufficient for ensuring long-term, sustainable growth for the economy. This article suggests that Israeli policy makers must now focus on measures that expand and deepen its knowledge-based industries--which are too reliant on high-technology start-up companies--and narrow the social and economic imbalances that have emerged since the 1980s.


The most severe economic crisis of the post-World War II era is doing much to recast the world economy both ideologically and in terms of the balance of power. The so-called “Washington consensus” that emphasized the centrality of free markets and smaller government has been undermined by the evident failure of financial markets to assess and regulate risks on their own. China’s status as a rising economic power has been confirmed while the United States and Europe are quite likely to be weighed down for the foreseeable future by debt accumulated before and during the crisis.

For Israel, a tiny player on the world economic stage, the most remarkable development has been its ability to remain largely aloof from the crisis and to manage its limited impact successfully. Israel’s mix of disciplined fiscal and monetary policies, combined with a relatively stern regulatory regime in the years prior to the crisis, served it well. Yet proper economic management alone does not ensure a thriving economy if the underlying social conditions are absent. While Israel has had some marked successes in old-economy industries--such as chemicals, pharmaceuticals, and defense--it lacks most of the critical elements for building on these achievements, namely significant natural resources, relative cost advantages, or economies of scale. Instead, the foundation of Israel’s economy is its high-technology industry. Yet the policies that served it so well through the global financial crisis have had little bearing on the future growth and development of the sector.

Israel’s technology sector is relatively disconnected from broader domestic economic policy, little concerned with local demand, financial markets, or regulatory issues, not only because it is so deeply rooted in the global market but because of the unusual way it is structured. Since the mid-1990s, the sector has developed into an industry of perpetual innovation characterized by a recurrent cycle of start-up companies that conceive and develop new technology, finance it with venture capital, and prove it in the marketplace before selling themselves to bigger, overseas companies with the finance and marketing, manufacturing, and management skills to exploit the innovation fully. This process began with the information technology industry and is now being duplicated by Israel’s emergent biotechnology and clean technologies sectors.

Israel’s technology industry has been criticized for its failure to spawn major multinational companies as its peers in Finland (Nokia), Taiwan (Taiwan Semiconductor), and India (TAT Consultancy, Wipro, Infosys) have done. Yet those criticisms are misplaced. Israel is a small economy with a limited labor supply, is distant from key markets, and subject to security concerns and regional political instability that deter customers, partners, and investors. If Israel can in fact sustain its model of perpetual innovation, there is no reason for the industry to abandon it. In that regard, Israel’s policymakers face two challenges. The first is to ensure that Israeli society can continue to produce the kind of people and sustain the institutional structures that have enabled the technology industry to grow and develop. The second is to ensure that a greater proportion of the labor force participates in the technology industry and to foster the development of other knowledge-intensive industries--design, medical services, education, and media/entertainment to name a few--capable of creating more jobs than the technology sector alone can do. In respect of the two goals, there are a host of worrying trends that policymakers have only dealt with in a tentative fashion and that have serious implications for the sustainability of the Israeli knowledge economy over the longterm.



A SHORT, PAINLESS RECESSION



The Israeli economy was the last among 29 economies surveyed by the Organization for Economic Cooperation and Development (OECD) to enter into a recession (fourth quarter 2008) and among the first to exit (second quarter 2009), making it by far the shortest downturn among the group.[i] Israeli GDP contracted 1.2 percent in the two quarters, [ii] but in fact, the recession lasted longer than that. Measured in per capita terms, which is a more telling measure of performance given Israel’s relatively high rate of population growth (about 1.7 percent annually), the recession effectively started in the third quarter of 2008 and only came to an end only in the second quarter of 2009. Over that one-year period, per capita GDP contracted 2.5 percent. Using the Bank of Israel’s (BOI) forecast for 2010,[iii] which sees GDP expanding 3.5 percent, per capita GDP will not recover to its prerecession levels until 2011.

Moreover, Israel’s unemployment rate rose with the onset of the recession but has not tracked the subsequent recovery. The rate peaked in May 2009 at 7.9 percent but as of November 2009 was still 7.4 percent; it will likely remain high in 2010 as well, averaging 7.1 percent, compared with an estimated average of 7.7 percent in 2009, according to the Bank of Israel forecast. The high unemployment rate is a cause for worry not only because it weighs down on the recovery but because it is indicative of Israel’s persistent problem of high levels of joblessness even when it is expanding. During the growth years of 2003-2008, the unemployment rate only succeeded in dropping below the 2009 recession-year average in the fourth quarter of 2007.

The impact of the global credit crisis on Israel’s financial markets was similarly limited. Israel’s real estate market never experienced the kind of bubble that left lenders overseas with large losses, and Israeli banks largely shunned the exotic financial instruments that brought down so many U.S. and European lenders and insurers. The Israeli credit crisis, such as it was, was felt principally in the non-bank credit sector, which had emerged in the years prior to the crisis as a major source of corporate finance (from 2002 to 2008 it grew to 20 percent of total corporate credit from 8 percent). Equity and debt raised on the Tel Aviv Stock Exchange declined steadily from the fourth quarter of 2007 and dried up almost entirely in the final four months of 2008, threatening to create a credit crunch similar to what was occurring in other developed economies at the time.

The proximate cause for the failure of the non-bank credit market was exogenous--the collapse of Lehman Brothers in September 2008, which caused investors to pull their capital out of pension funds and other institutional investors. Yet the rapid expansion of the market and the absence of well-developed mechanisms for regulating it certainly undermined confidence as well. In other words, the one serious case of market failure in Israel occurred in an area where the market was least regulated. Nevertheless, the non-bank credit crisis was very constrained. While there were instances of corporate borrowers unable to service their debt (principally in the property sector where Israeli companies had invested heavily overseas during the global property boom), the problem was chiefly on the supply side, namely that able borrowers were unable to obtain capital. As it turned out, the crisis was short-lived and fundraising activity began to rebound in the first quarter of 2009.
The experience of the technology sector demonstrated just how disconnected it is from domestic developments or policy....

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