Has Israel’s regional isolation helped protect its economy?

JERUSALEM — With Spain, Italy and Greece's financial systems tottering, Israel's buoyant and growing economy, alone among those of the Mediterranean basin, remains something of a startling apparition.

It is “a mystery or an enigma,” in the words of Omer Moav, a professor of economics at the Hebrew University of Jerusalem.

The paradox of Israel's economy is all the more mystifying given the country's small size — Israel is smaller than Rhode Island, with a population of only 7.5 million — the nation's diplomatic and economic isolation from its neighbors, its lack of natural resources, and the unstable regional context burbling around it.

The facts: Israel’s gross domestic product has seen steady growth in all but two quarters of the last five years. The third quarter of 2011— the last for which statistics are available — shows a market expansion of 0.8 percent over the previous quarter.

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In some ways, Israel has been just plain lucky. Spain, for example, now facing a possible default, comprises only 2 percent of its export market. Also, several of its industries are relatively immune to market fluctuations, including armaments and defense technologies, of which Israel is among the three leading nations on earth. Medical equipment and diamond manufacturing are also strong factors.

But it is not simply a tale of good fortune. A pattern can be discerned when trying to unravel the knot. Overwhelmingly, Israel's conservative and cautious banking system is highlighted as a principal reason for the economy's apparent immunity. A second basis always mentioned is the country's robust and vibrant entrepreneurial spirit, especially visible in the high-tech sector.

“The central explanation I have is that Israel has a very developed private sector, including sophisticated high tech,” said Gil Feiler, an economist at the BESA Center at Bar Ilan University. “If you look at it, a week doesn’t go by without some leading international company buying an Israeli start-up. But even more importantly, the banking sector has shown tremendous responsibility compared to its counterparts in the United States and Europe. In Israel, you never saw the kind of negligence you saw in their real-estate sectors.”

Almost every economist falls back on the banking sector as a principal support of the stable economy.

Israelis have long been famed for their endless carping about the near-impossibility, in relation to other nations, of securing a mortgage. Yet this very inconvenience, it turns out, is a key reason for the apparent immunity that has protected Israel from the global crises.

“We’ve always complained and we still complain that our banking system is very cartelistic in nature, that there is insufficient competitiveness in the financial sector, which allows it to obtain high profits without taking unnecessary risks, like mortgages of 100 percent or more of the home’s value that you saw in the US and Europe,” Moav said.

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“In Israel this simply doesn’t exist, so we never had that mortgage crisis or the financial crisis. For once, the fact that there is ‘over-profit’ and a lack of competition, went well. We were lucky. In a way, regulation of the financial sector simply paid off.”

In Israel, getting a mortgage involves an exhaustive series of trials, disclosures and financial commitments undertaken by the principal and by a long list of co-signatories who are often pursued by legal authorities if even a single payment is not presented on time.

In addition, in Moav’s words, “Here the debt is personal. You cannot just walk out on your mortgage and leave the house behind. The debt will follow you.”

Another economic policy that has helped is an expanding but controlled free-market approach. Over the past 30 years, Israel has transformed itself from an economy with massive government involvement, a relic of its socialist, post-war beginnings, to an economy “more free-market than the nations of southern Europe that are now in crisis,” Feiler said.

The economic crises that hit both the US and Europe in recent years had “both internal and external sources,” said Michel Strawczynsky, deputy director of the research department at the Bank of Israel.

“The internal sources were related to the housing sectors, which collapsed in many countries, including Spain, Ireland the UK and even, to a certain extent, the United States.”

In Israel, the external source — loss of export opportunities as other economies suffered — was contained to a two quarter period in early 2009, after which came a hearty and immediate rebound.

“At no point has any Israeli bank faced the risk of collapse,” Strawczynsky said.

Ironically, Israel’s relative isolation may have helped inure it from greater harm.

“The Israeli government did not need to bailout banks, and also, despite a slight reduction in its tax income due to a light recession in 2008-2009, it was able to overcome the crisis without increasing the public debt,” said Joseph Zeira, a professor at the Hebrew University. “Note, that since Israel is a small, open economy, it is affected by global events and cannot fully escape global recessions. But it can isolate itself to some extent.”

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Significantly, the reasons for Israel’s financial caution and conservatism are borne in previous errors and crises buried in its history, “where both the banking sector and the fiscal authorities experienced severe episodes of malfunctioning bordering on disaster,” Zeira said.

“During the years 1967-1985, mainly due to increased defense costs, the fiscal expenditures rose significantly, to around 75 percent of GDP, deficit increased to around 15 percent of GDP, and that lead to increased debt (up to 160 percent of GDP) and to inflation, which at the end was as high as 400 percent annually.”

The trauma was significant and multi-faceted. “During the 70s and early 80s the banks manipulated their shares and gradually started to raise their value above market prices, in a pure Ponzi (or Madoff) scheme,” Zeira said, sparing no words.

“Finally they could not support it any longer, and in 1983 the government bailed them out. This bailout cost the public a lot of money and as a result the banks belonged to the government for a long time until it succeeded to sell them. Actually one of the large banks, Bank Leumi, has not yet been fully privatized.”

However glowing and vigorous the Israeli miracle, it remains subject to numerous potentially grave contingencies, not the least of them the possibility of major regional upheaval or war.

Moav listed five significant vulnerabilities: A lack of competition in certain segments of the economy, which has led to elevated prices on numerous goods and services; powerful labor unions in essential services such as sea and airports — Israel has seen 10 national rail strikes in the past six months; the ultra-orthodox, an “unsustainable situation” of a large and growing population with low labor force participation and high fertility; settlements, including “an entire political security situation making any arrangement between Israel and the Palestinians hard to obtain,” and defense costs.

Zeira sees two potential points of exposure. The first: rising social inequality.

“In the last decade, the GDP per worker rose by 9 percent, while real wages did not rise at all. This means that all the growth was concentrated at the hands of a small elite, the 1 percent, and did not go to the 99 percent. Today Israel is at the top of the OECD in its measures of inequality, just below the USA. Such a rise in inequality is dangerous to the social fabric of the society, as shown in the recent wave of protests. But high inequality is also detrimental to the economy. It means that access to education becomes less common, and social mobility is reduced significantly.”

The second risk is what Strawczynsky refers to generically as “the missile factor,” and what Zeira prefers to call “the lack of peace.”

“An outbreak of war can have significant negative economic effects. This is clear if we have a large conventional war. Such a war is usually very expensive, increases public expenditures and can lead to a fiscal crisis, just as in the 70s and early 80s. It is true that the chances for such a conventional war have been very low for many years, since the peace with Egypt [which took place in 1980.]”

“But the situation today is much riskier. There is a chance for a war with Iran. Also, the peace with Egypt is facing serious challenges as a result of the Arab Spring. Hence the chances for such a large-scale war are quite higher recently … promoting peace is important not only to save lives, but also to improve the econ-omy significantly.”