Vol. 4, No. 11 19 December 2004
How is Israel's Economy Affected
by the Security Situation?
Defense expenditures in Israel were less than 10 percent of GDP in the 1950s, climbing to 35 percent after the Yom Kippur War. After Israel signed the peace agreement with Egypt, defense expenditures leveled off while the economy kept growing, so the overall share of defense-related spending declined back down to 10 percent.
In the 1980s, as a result of exposure of Israeli industries to competition, Israel shifted to new industries - moving from agriculture and textiles to high tech.
Economically, Israel does not belong to the Middle East. Israel's clients are in Western Europe, North America, and Asian countries such as India and Japan. Israel's trade with its close neighbors is not high tech, but oil and simple farm and industrial products.
Israel's economic recession in the last three years was more the result of the international failure of the high tech market, which in the years 1990-2000 had become Israel's leading export item, rather than a direct result of the Palestinian violence. Israel's current recovery is, first of all, a reflection of a recovery in the respective world markets.
The market for Palestinian workers in Israel has practically disappeared. While Palestinians once dominated the fields of construction, agriculture, and certain consumer services, today Israelis are reluctant to employ Palestinians. The Erez industrial zone at the northern edge of the Gaza region has been closed due to suicide bombings; five thousand Palestinians lost their jobs.
Employment of Palestinians in Israeli enterprises at other locations in the territories is also at risk. This is the case due to an EU policy to treat Israeli goods produced in the territories differently from goods made either by Israelis in Israel or by Palestinian firms in the Palestinian territories. This is nothing less than a special tax discriminating against Jewish settler-entrepreneurs, but the end product will be a reduction in Palestinian employment.
The Impact of the Arms Race on Israel's Economy
Defense expenditures in Israel were less than 10 percent of GDP in the 1950s, climbing to 35 percent after the Yom Kippur War. When Israel solved its issues with Egypt in the 1970s, it slowly reduced defense expenditures back down to the level that it started with, less than 10 percent, where it stands today. After Israel signed the peace agreement with Egypt, defense expenditures leveled off while the economy kept growing, so the overall share of defense-related spending declined.
For the U.S., the figure for defense expenditures is 6-7 percent, and this at a time when America is in a real conflict. The U.S. figure is double the percentage characteristic of the Europeans. So Israel's 9-10 percent is still relatively high. The point here is that Israel can live and develop with 9 percent, but not with 15 or 20 percent.
See Chart 1 - Defense Expenditure as % of GDP, Israel, 1950-2002
A war between Israel and the Egyptians or a coalition led by Egypt would cost Israel something like an annual GNP - about $125 billion. Israel used to have a war every 4 or 5 years. By breaking that cycle, it could be said that Israel has saved something like half a trillion dollars. Israel no longer has these kinds of costs. The security situation now from an economic standpoint is small potatoes.
See Chart 2 - Defense Expenditure, Israel, 1950-2000
Israel Opts for Globalization
The Israeli economy, being a small economy, depends completely on the ability to export. In the 1970s, Prime Minister Levi Eshkol decided to globalize Israel, though he couldn't know the term back then. He signed a free trade agreement with Europe and exposed Israeli industry to competition within a period of 15 years. The Histadrut labor federation and the Association of Industrialists screamed for help, but somehow it worked.
The Shift to Hi-Tech
In the 1980s, as a result of exposure of Israeli industries to competition and the opportunity to penetrate the European market without paying tariffs, Israel increased both its production and its exports. Much more importantly, Israel shifted to new industries, moving from agriculture and textiles to high tech. The difference between 1990 and 2000 is immense, not only in quantity, which is more than double, but also in the quality of industry.
See Chart 3 - A Shift to Hi-Tech Industries - Israeli Industrial Exports, 1990-2004
See Chart 4 - Israeli Export Composition, 1950-2000
Economically, Israel does not belong to the Middle East in the sense that it does not sell or buy in the Middle East. Israel's clients are in Western Europe, North America, and Asian countries that have money, such as India and Japan.
See Chart 5 - Israel's Trade Partners, 1980-2003
See Chart 6 - Export Destination, 1950-2000
Israel's trade with its neighbors is not high tech, but rather simple farm and industrial products. While the economics of Israel's relationship with its neighbors is a marginal affair from Israel's point of view, this is not the case from the Palestinian point of view. Their economic relationship with Israel is critical for their development, while, from a “purely” economic standpoint, Israel can live without the Palestinians.
The Limited Economic Impact of Palestinian Violence
Three years ago, it appeared that Israel's economy was suffering from the conflict with the Palestinians. It's true that production and exports dropped, but it was more the result of the international failure of the high tech market, which in the years 1990-2000 had become Israel's leading export item, rather than a direct or indirect result of the Palestinian violence. Israel's current recovery is, first of all, a reflection of the recovery in the world market.
Ever since the peace with Egypt, Israel has had more investors than it can accommodate, and has never had a shortage of liquidity. As long as Israel provides opportunities, the international community is going to invest in Israel. But when there is a recession and very few invest in Silicon Valley, California, very few invest in Israel either.
Certainly the violence harmed tourism. Yet Israel has two kinds of tourism: internal and international. Internal tourism is the real business. Since the early 1990s, Israelis have been the dominant client in Israel's tourist resorts. The overflow, hundreds of thousands of Israeli tourists, flood seaside hotels in Turkey and other Mediterranean shores. Israel is, in essence, a net importer of tourist services. In the late 1990s, tourism contributed 3-4% of Israel's GDP. Tourists from abroad accounted for 35-40% of this. Within that framework, Palestinian violence affected 1-1.5% of Israel's GDP.
Structural Problems of the Palestinian Economy
The injured party from the Palestinian violence is the Palestinian economy. The Israeli economy is one of $125 billion, while the Palestinian economy at its best - in 1997-1998 - was $4.5 billion. The Palestinians have the same problem Israel has. They are a small economy and cannot survive without exporting. If they want to develop and raise their standard of living, they have to export. But exporting is not simple. It took Israel 25 years to break through and Israel had two strategic assets: connections all over the world and a brain drain in its favor, first from Eastern Europe and the Near East, and then from the Soviet and ex-Soviet republics.
The Palestinian strategic asset is Israel. For the Palestinians, Israel in itself is a large potential market. More important, Israel is an indispensable gateway to the West. For example, “industrialized” agriculture in the Gaza region is a very large industry with Palestinian entrepreneurs employing 35,000 Palestinians. Thanks to their relations with Israel over decades, the Palestinians have had easy access to state-of-the-art technology, carried over by experienced farm hands as well as outstanding graduates of the Faculty of Agriculture at Hebrew University. By now, the Palestinians can produce without Israel's intimate assistance, but their problem is one of access to their market in Europe. One serious problem is flying the produce at a reasonable cost. The key difficulty is the issue of the return cargo. Israel, with a relatively large economy, fills the planes returning from Europe with imported items. Since the Palestinians have no similar return cargo, the air-freight costs for exporting their products from Gaza will come out to at least twice as much as for Israelis.
In order to fly their goods from Gaza, the Palestinians will require a specialized terminal here and a terminal in the destination country. In addition, they have to be able to market their produce, establish their brand names, and build a reputation. All this can be done, but it requires a certain size, capacity, and experience accumulated over a long period of time. At present, and for the foreseeable future, if for some reason the Israeli channel doesn't work for the Palestinians, then either some donor must provide a heavy subsidy or the industry will disappear.
The Palestinians can do many things and they can do them well, but if they want to reach greater magnitudes quickly, they have to have the support of Israel's business community. The Oslo Accords raised hopes for cooperation and greater support of Israel's business community for the Palestinian economy. In reality, events moved in the opposite direction.
See Chart 7 - Palestinian GNP per Capita, 1968-2002
From the Palestinian standpoint, economically, Oslo was a disaster because of a series of events that occurred afterwards that reduced the sources of added value in the Palestinian economy and its capacity to develop.
The Market for Palestinian Workers in Israel Has Disappeared
We discuss the future almost weekly with our Palestinian counterparts. We tell them that a recovery of the Palestinian position in Israel's labor market is close to impossible. It's not a question of work permits and hasn't been for the last two years. Quite often Palestinians have had tens of thousands of permits and only thousands of jobs materialized. The reason is that the grass-roots demand for Palestinian labor in Israel has deteriorated. Israelis, for the time being, do not want to employ Palestinians.
The large construction firms want cheap labor, but opt for Chinese and Romanians. Farming requires 20,000 people, and farm operators opt for workers from Thailand. In Israel, domestic workers are not Palestinian, they are from the Philippines, South and Central America, or Africa.
Now the Erez industrial zone at the northern edge of the Gaza region has been closed, the largest attempt to employ Palestinians in Israeli industries on a wide scale. Frankly, we're not expecting a new Middle East. We're not even expecting a mini-new Middle East that includes us and the Palestinians.
A European Tax on Jews that Penalizes Palestinians
If the loss of 125,000-150,000 jobs as an immediate outcome of the Palestinian violence were not enough, Palestinian employment is also bound to be penalized due to new measures by the European Union. A year and a half ago I was asked by Israel's Ministry of Foreign Affairs to go to Scandinavia to explain the real implications of the EU policy to treat goods from the territories differently from goods made in Israel. At issue is 2-3 percent of the gross value of farm exports from Israel. However, the Europeans have forgotten that there is a third partner, the Palestinians. Bluntly, the Europeans are asking Israel to take flowers produced by Arabs and mark them differently from those produced by Jews. They didn't say that produce coming from the territories would be taxed. They said goods coming from the territories produced by certain people, identified in this case as Jews, will be taxed. In the same spirit, radicals in Europe have been talking about outright boycotting of these goods.
But boycotts and economic discrimination work in “mysterious” ways. Considering the latest measures and the measures contemplated by radicals with regard to farm goods, the potential victims stand to be the Palestinian producers and farm hands. For example, what happens if the Germans or the French decide not to consume Israeli strawberries? These strawberries are grown by Palestinian entrepreneurs in the Gaza region, or by Palestinian farm hands in Israel proper.
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Prof. Ezra Sadan has served as Director General of the Ministry of Finance and the Ministry of Agriculture. He also chaired a commission appointed by the Minister of Defense on programs to develop the Palestinian economy (1989-1992), and participated in national, binational, and international mediation and study panels hosted by the Office of the Prime Minister, the World Bank, Harvard University, the University of California, Scandinavian governments, and the EU to inquire into the economics and financing of peace in the Middle East (1992-2004). This Jerusalem Issue Brief is based on his presentation at the Institute for Contemporary Affairs in Jerusalem on September 22, 2004.
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