Nadav Halevi, Hebrew University
The Pre-state Background
The history of modern Israel begins in the 1880s, when the first Zionist immigrants came to Palestine, then under Ottoman rule, to join the small existing Jewish community, establishing agricultural settlements and some industry, restoring Hebrew as the spoken national language, and creating new economic and social institutions. The ravages of World War I reduced the Jewish population by a third, to 56,000, about what it had been at the beginning of the century.
As a result of the war, Palestine came under the control of Great Britain, whose Balfour Declaration had called for a Jewish National Home in Palestine. Britain’s control was formalized in 1920, when it was given the Mandate for Palestine by the League of Nations. During the Mandatory period, which lasted until May 1948, the social, political and economic structure for the future state of Israel was developed. Though the government of Palestine had a single economic policy, the Jewish and Arab economies developed separately, with relatively little connection.
Two factors were instrumental in fostering rapid economic growth of the Jewish sector: immigration and capital inflows. The Jewish population increased mainly through immigration; by the end of 1947 it had reached 630,000, about 35 percent of the total population. Immigrants came in waves, particularly large in the mid 1920s and mid 1930s. They consisted of ideological Zionists and refugees, economic and political, from Central and Eastern Europe. Capital inflows included public funds, collected by Zionist institutions, but were for the most part private funds. National product grew rapidly during periods of large immigration, but both waves of mass immigration were followed by recessions, periods of adjustment and consolidation.
In the period from 1922 to 1947 real net domestic product (NDP) of the Jewish sector grew at an average rate of 13.2 percent, and in 1947 accounted for 54 percent of the NDP of the Jewish and Arab economies together. NDP per capita in the Jewish sector grew at a rate of 4.8 percent; by the end of the period it was 8.5 times larger in than in 1922, and 2.5 times larger than in the Arab sector (Metzer, 1998). Though agricultural development – an ideological objective – was substantial, this sector never accounted for more than 15 percent of total net domestic product of the Jewish economy. Manufacturing grew slowly for most of the period, but very rapidly during World War II, when Palestine was cut off from foreign competition and was a major provider to the British armed forces in the Middle East. By the end of the period, manufacturing accounted for a quarter of NDP. Housing construction, though a smaller component of NDP, was the most volatile sector, and contributed to sharp business cycle movements. A salient feature of the Jewish economy during the Mandatory period, which carried over into later periods, was the dominant size of the services sector – more than half of total NDP. This included a relatively modern educational and health sector, efficient financial and business sectors, and semi-governmental Jewish institutions, which later were ready to take on governmental duties.
The Formative Years: 1948-1965
The state of Israel came into being, in mid May 1948, in the midst of a war with its Arab neighbors. The immediate economic problems were formidable: to finance and wage a war, to take in as many immigrants as possible (first the refugees kept in camps in Europe and on Cyprus), to provide basic commodities to the old and new population, and to create a government bureaucracy to cope with all these challenges. The creation of a government went relatively smoothly, as semi-governmental Jewish institutions which had developed during the Mandatory period now became government departments.
Cease-fire agreements were signed during 1949. By the end of that year a total of 340,000 immigrants had arrived, and by the end of 1951 an additional 345,000 (the latter including immigrants from Arab countries), thus doubling the Jewish population. Immediate needs were met by a strict austerity program and inflationary government finance, repressed by price controls and rationing of basic commodities. However, the problems of providing housing and employment for the new population were solved only gradually. A New Economic Policy was introduced in early 1952. It consisted of exchange rate devaluation, the gradual relaxation of price controls and rationing, and curbing of monetary expansion, primarily by budgetary restraint. Active immigration encouragement was curtailed, to await the absorption of the earlier mass immigration.
From 1950 until 1965, Israel achieved a high rate of growth: Real GNP (gross national product) grew by an average annual rate of over 11 percent, and per capita GNP by greater than 6 percent. What made this possible? Israel was fortunate in receiving large sums of capital inflows: U.S. aid in the forms of unilateral transfers and loans, German reparations and restitutions to individuals, sale of State of Israel Bonds abroad, and unilateral transfers to public institutions, mainly the Jewish Agency, which retained responsibility for immigration absorption and agricultural settlement. Thus, Israel had resources available for domestic use – for public and private consumption and investment – about 25 percent more than its own GNP. This made possible a massive investment program, mainly financed through a special government budget. Both the enormity of needs and the socialist philosophy of the main political party in the government coalitions led to extreme government intervention in the economy.
Governmental budgets and strong protectionist measures to foster import-substitution enabled the development of new industries, chief among them textiles, and subsidies were given to help the development of exports, additional to the traditional exports of citrus products and cut diamonds.
During the four decades from the mid 1960s until the present, Israel’s economy developed and changed, as did economic policy. A major factor affecting these developments has been the Arab-Israeli conflict. Its influence is discussed first, and is followed by brief descriptions of economic growth and fluctuations, and evolution of economic policy.
The Arab-Israel Conflict
The most dramatic event of the 1960s was the Six Day War of 1967, at the end of which Israel controlled the West Bank (of the Jordan River) – the area of Palestine absorbed by the Jordan since 1949 – and the Gaza Strip, controlled until then by Egypt.
As a consequence of the occupation of these territories Israel was responsible for the economic as well as the political life in the areas taken over. The Arab sections of Jerusalem were united with the Jewish section. Jewish settlements were established in parts of the occupied territories. As hostilities intensified, special investments in infrastructure were made to protect Jewish settlers. The allocation of resources to Jewish settlements in the occupied territories has been a political and economic issue ever since.
The economies of Israel and the occupied territories were partially integrated. Trade in goods and services developed, with restrictions placed on exports to Israel of products deemed too competitive, and Palestinian workers were employed in Israel particularly in construction and agriculture. At its peak, in 1996, Palestinian employment in Israel reached 115,000 to 120,000, about 40 percent of the Palestinian labor force, but never more than 6.5 percent of total Israeli employment. Thus, while employment in Israel was a major contributor to the economy of the Palestinians, its effects on the Israeli economy, except for the sectors of construction and agriculture, were not large.
The Palestinian economy developed rapidly – real per capita national income grew at an annual rate of close to 20 percent in 1969-1972 and 5 percent in 1973-1980 – but fluctuated widely thereafter, and actually decreased in times of hostilities. Palestinian per capita income equaled 10.2 percent of Israeli per capita income in 1968, 22.8 percent in 1986, and declined to 9.7 percent in 1998 (Kleiman, 2003).
As part of the peace process between Israel and the Palestinians initiated in the 1990s, an economic agreement was signed between the parties in 1994, which in effect transformed what had been essentially a one-sided customs agreement (which gave Israel full freedom to export to the Territories but put restrictions on Palestinian exports to Israel) into a more equal customs union: the uniform external trade policy was actually Israel’s, but the Palestinians were given limited sovereignty regarding imports of certain commodities.
Arab uprisings (intifadas), in the 1980s, and especially the more violent one beginning in 2000 and continuing into 2005, led to severe Israeli restrictions on interaction between the two economies, particularly employment of Palestinians in Israel, and even to military reoccupation of some areas given over earlier to Palestinian control. These measures set the Palestinian economy back many years, wiping out much of the gains in income which had been achieved since 1967 – per capita GNP in 2004 was $932, compared to about $1500 in 1999. Palestinian workers in Israel were replaced by foreign workers.
An important economic implication of the Arab-Israel conflict is that Israel must allocate a major part of its budget to defense. The size of the defense budget has varied, rising during wars and armed hostilities. The total defense burden (including expenses not in the budget) reached its maximum relative size during and after the Yom Kippur War of 1973, close to 30 percent of GNP in 1974-1978. In the 2000-2004 period, the defense budget alone reached about 22 to 25 percent of GDP. Israel has been fortunate in receiving generous amounts of U.S. aid. Until 1972 most of this came in the form of grants and loans, primarily for purchases of U.S. agricultural surpluses. But since 1973 U.S. aid has been closely connected to Israel’s defense needs. During 1973-1982 annual loans and grants averaged $1.9 billion, and covered some 60 percent of total defense imports. But even in more tranquil periods, the defense burden, exclusive of U.S. aid, has been much larger than usual in industrial countries during peace time.
Growth and Economic Fluctuations
The high rates of growth of income and income per capita which characterized Israel until 1973 were not achieved thereafter. GDP growth fluctuated, generally between 2 and 5 percent, reaching as high as 7.5 percent in 2000, but falling below zero in the recession years from 2001 to mid 2003. By the end of the twentieth century income per capita reached about $20,000, similar to many of the more developed industrialized countries.
Economic fluctuations in Israel have usually been associated with waves of immigration: a large flow of immigrants which abruptly increases the population requires an adjustment period until it is absorbed productively, with the investments for its absorption in employment and housing stimulating economic activity. Immigration never again reached the relative size of the first years after statehood, but again gained importance with the loosening of restrictions on emigration from the Soviet Union. The total number of immigrants in 1972-1982 was 325,000, and after the collapse of the Soviet Union immigration totaled 1,050,000 in 1990-1999, mostly from the former Soviet Union. Unlike the earlier period, these immigrants were gradually absorbed in productive employment (though often not in the same activity as abroad) without resort to make-work projects. By the end of the century the population of Israel passed 6,300,000, with the Jewish population being 78 percent of the total. The immigrants from the former Soviet Union were equal to about one-fifth of the Jewish population, and were a significant and important addition of human capital to the labor force.
As the economy developed, the structure of output changed. Though the service sectors are still relatively large – trade and services contributing 46 percent of the business sector’s product – agriculture has declined in importance, and industry makes up over a quarter of the total. The structure of manufacturing has also changed: both in total production and in exports the share of traditional, low-tech industries has declined, with sophisticated, high-tech products, particularly electronics, achieving primary importance.
Fluctuations in output were marked by periods of inflation and periods of unemployment. After a change in exchange rate policy in the late 1970s (discussed below), an inflationary spiral was unleashed. Hyperinflation rates were reached in the early 1980s, about 400 percent per year by the time a drastic stabilization policy was imposed in 1985. Exchange rate stabilization, budgetary and monetary restraint, and wage and price freezes sharply reduced the rate of inflation to less than 20 percent, and then to about 16 percent in the late 1980s. Very drastic monetary policy, from the late 1990s, finally reduced the inflation to zero by 2005. However, this policy, combined with external factors such as the bursting of the high-tech bubble, recession abroad, and domestic insecurity resulting from the intifada, led to unemployment levels above 10 percent at the beginning of the new century. The economic improvements since the latter half of 2003 have, as yet (February 2005), not significantly reduced the level of unemployment.
Policy Changes
The Israeli economy was initially subject to extensive government controls. Only gradually was the economy converted into a fairly free (though still not completely so) market economy. This process began in the 1960s. In response to a realization by policy makers that government intervention in the economy was excessive, and to the challenge posed by the creation in Europe of a customs union (which gradually progressed into the present European Union), Israel embarked upon a very gradual process of economic liberalization. This appeared first in foreign trade: quantitative restrictions on imports were replaced by tariff protection, which was slowly reduced, and both import-substitution and exports were encouraged by more realistic exchange rates rather than by protection and subsidies. Several partial trade agreements with the European Economic Community (EEC), starting in 1964, culminated in a free trade area agreement (FTA) in industrial goods in 1975, and an FTA agreement with the U.S. came into force in 1985.
By late 1977 a considerable degree of trade liberalization had taken place. In October of that year, Israel moved from a fixed exchange rate system to a floating rate system, and restrictions on capital movements were considerably liberalized. However, there followed a disastrous inflationary spiral which curbed the capital liberalization process. Capital flows were not completely liberalized until the beginning of the new century.
Throughout the 1980s and the 1990s there were additional liberalization measures: in monetary policy, in domestic capital markets, and in various instruments of governmental interference in economic activity. The role of government in the economy was considerably decreased. On the other hand, some governmental economic functions were increased: a national health insurance system was introduced, though private health providers continued to provide health services within the national system. Social welfare payments, such as unemployment benefits, child allowances, old age pensions and minimum income support, were expanded continuously, until they formed a major budgetary expenditure. These transfer payments compensated, to a large extent, for the continuous growth of income inequality, which had moved Israel from among the developed countries with the least income inequality to those with the most. By 2003, 15 percent of the government’s budget went to health services, 15 percent to education, and an additional 20 percent were transfer payments through the National Insurance Agency.
Beginning in 2003, the Ministry of Finance embarked upon a major effort to decrease welfare payments, induce greater participation in the labor force, privatize enterprises still owned by government, and reduce both the relative size of the government deficit and the government sector itself. These activities are the result of an ideological acceptance by the present policy makers of the concept that a truly free market economy is needed to fit into and compete in the modern world of globalization.
An important economic institution is the Histadrut, a federation of labor unions. What had made this institution unique is that, in addition to normal labor union functions, it encompassed agricultural and other cooperatives, major construction and industrial enterprises, and social welfare institutions, including the main health care provider. During the Mandatory period, and for many years thereafter, the Histadrut was an important factor in economic development and in influencing economic policy. During the 1990s, the Histadrut was divested of many of its non-union activities, and its influence in the economy has greatly declined. The major unions associated with it still have much say in wage and employment issues.
The Challenges Ahead
As it moves into the new century, the Israeli economy has proven to be prosperous, as it continuously introduces and applies economic innovation, and to be capable of dealing with economic fluctuations. However, it faces some serious challenges. Some of these are the same as those faced by most industrial economies: how to reconcile innovation, the switch from traditional activities which are no longer competitive, to more sophisticated, skill-intensive products, with the dislocation of labor it involves, and the income inequality it intensifies. Like other small economies, Israel has to see how it fits into the new global economy, marked by the two major markets of the EU and the U.S., and the emergence of China as a major economic factor.
Special issues relate to the relations of Israel with its Arab neighbors. First are the financial implications of continuous hostilities and military threats. Clearly, if peace can come to the region, resources can be transferred to more productive uses. Furthermore, foreign investment, so important for Israel’s future growth, is very responsive to political security. Other issues depend on the type of relations established: will there be the free movement of goods and workers between Israel and a Palestinian state? Will relatively free economic relations with other Arab countries lead to a greater integration of Israel in the immediate region, or, as is more likely, will Israel’s trade orientation continue to be directed mainly to the present major industrial countries? If the latter proves true, Israel will have to carefully maneuver between the two giants: the U.S. and the EU.
References and Recommended Reading
Ben-Bassat, Avi, editor. The Israeli Economy, 1985-1998: From Government Intervention to Market Economics. Cambridge, MA: MIT Press, 2002.
Ben-Porath, Yoram, editor. The Israeli Economy: Maturing through Crisis. Cambridge, MA: Harvard University Press, 1986.
Fischer, Stanley, Dani Rodrik and Elias Tuma, editors. The Economics of Middle East Peace. Cambridge, MA: MIT Press, 1993.
Halevi, Nadav and Ruth Klinov-Malul, The Economic Development of Israel. New York: Praeger, 1968.
Kleiman, Ephraim. “Palestinian Economic Viability and Vulnerability.” Paper presented at the UCLA Burkle Conference in Athens, August 2003. (Available at www.international.ucla.edu.)
Metz, Helen Chapin, editor. Israel: A Country Study. Washington: Library of Congress Country Studies, 1986.
Metzer, Jacob, The Divided Economy of Mandatory Palestine. Cambridge: Cambridge University Press, 1998.
Patinkin, Don. The Israel Economy: The First Decade. Jerusalem: Maurice Falk Institute for Economic Research in Israel, 1967.
Razin, Assaf and Efraim Sadka, The Economy of Modern Israel: Malaise and Promise. London: Chicago University Press, 1993.
World Bank. Developing the Occupied Territories: An Investment in Peace. Washington D.C.: The World Bank, September, 1993.
Citation: Halevi, Nadav. “A Brief Economic History of Modern Israel”. EH.Net Encyclopedia, edited by Robert Whaples. March 16, 2008. URL http://eh.net/encyclopedia/a-brief-economic-history-of-modern-israel/