Kibbutzim To Capitalism: Israel’s Journey From Socialist State To Startup Nation

“The outliers in any index usually have a wonderful story to tell” is a phrase which a smart relative of mine has a habit of repeating.

The Bloomberg Innovation Report of 2017 has quite a few outliers with the most interesting being the state of Israel. This tiny country, barely the size of the Indian state of Manipur, with a rank of ten, stands ahead of the United Kingdom, Canada, China, France and Norway!

It topped the list on researcher concentration, was runner up on Research and Development (R&D) intensity and ranked number three on hi-tech intensity. Israel is perhaps one of the very few modern economies which, despite having made a transition from developing to a developed one, grew at the rate of four per cent in 2016, according to IMF data, while the Organisation for Economic Co-operation and Development (OECD) countries, according to their own data, had a combined growth rate of 1.7 per cent.

Israel’s leaders are confident of further accelerating economic growth on the back of ever growing technology clusters in the country. The country’s impressively skilled workforce does not suffer from the above-normal unemployment rates that the western European nations do.

How is it that Israel has managed to achieve all this when the founding principles of the nation state, Zionism, came with an inherently socialist form of communal organisation (kibbutzim) is a question that deserves to be discussed, given how many other nation states founded in the same period with similar economic principles as those of Israel haven’t been able to get out of the clutches of socialism.

For example, India. The answer, according to this author, lies in the able leadership that Israel was fortunate to have which understood the importance of changing with the times rather than clinging on to failed ideologies.

Moreover, the leaders of the Jewish state weren’t bound by a specific set of economic principles enshrined in the constitution as it has no written constitution at all. The leaders also had a well defined national purpose i.e. to protect and enhance the freedom of the Jewish people, to use as a tool to help them reorient the national economy.

Israel however couldn’t have become a viable state without kibbutzim because settling the rapidly arriving post-war Jewish immigrants in the widest possible manner was vital to the very existence of the nation state and this wouldn’t have been possible without the socialist setup of kibbutz. The initial years also saw incredibly heavy government investment in national infrastructure to facilitate the settlement process and strengthen national security.

Such actions (many a times funded with donations from Jews around the world) led to decent growth levels despite government control over almost all capital. But Israel’s version of socialism was in no way destructive due to the fact that the populace was small and cohesive. The level of government spending as a percentage of GDP continued to grow until it peaked in 1974 following the Yom Kippur War.

The Lost Decade

Though the Yom Kippur War in 1973 ended almost in a stalemate, Israel claimed victory as the coalition of Arab countries failed to change the status quo established by the decisive Israeli victory in the Six-Day War of 1967. But this symbolic win had its own costs: 2,365 died, more than 6,000 citizens were wounded and hundreds of soldiers got captured. This shattered national confidence.

The ensuing Commission of Inquiry, the resignation of then prime minister Golda Meir and the emergence of the right wing Likud Party and other propitious political changes came at a time when the economy was undergoing severe duress. The increased military expenditure that was required to rebuild the national security infrastructure, the lack of avenues for further civilian infrastructure investment, immense government borrowing to fund the above and the continuously growing Histadrut (Israel’s largest labour union which was in that period a healthcare provider and business owner too) caused hyperinflation and with it, immense economic pain.

Likud chairman Menachem Begin became prime minister in 1977 and began the process of moving the Israeli economy from its socialist superstructure to one which gave its citizenry opportunities to increase their wealth. He appointed Simha Erlich as the finance minister and gave him a free hand to go forward with a plain aiming for “economic transformation” which involved eliminating subsidies for many consumer goods, easing foreign exchange controls, floating the exchange rate and much more.

Before he could complete implementing an important part of the plan (large scale privatisation), he was sent out of the finance ministry by Begin who was fearful of the socio-political consequences of pushing too many changes too quickly. The partial implementation probably contributed to the the continuation of hyperinflation in the economy towards the end of Begin’s prime ministership (1983) and immediately following it.

Dale Senor and Saul Singer, authors of Start-up Nation, an authoritative study of entrepreneurship in Israel, describe the prevailing situation thus:

“As late as the early 1980s, Israel also suffered from hyperinflation: going to the supermarket meant spending thousands of almost worthless shekels. Inflation rose from 13 per cent in 1971 to 111 per cent in 1979. Some of this was due to rising oil prices at this time. But Israeli inflation continued to skyrocket beyond other countries’, rising to 133 per cent in 1980 and to 445 per cent in 1984, and appeared to be on its way to a four-digit figure within a year or two.”

Economic Stabilisation Plan and More

To solve this situation, Knesset, the Israeli Parliament, in 1985 approved the Economic Stabilisation Plan which involved putting in place temporary wage and price controls, putting the government deficit in check by cutting government expenditure and reducing the Israeli central bank’s ability to print more money to take care of government deficits.

The multiple National Unity governments that followed continued “phasing in” of market reforms like liberalisation, privatisation and culling the bureaucracy. This helped Israel get out of the stagflation it had found itself in during the lost decade. The Histadrut too changed radically during this period. The healthcare division and parts of the business division of this organisation, which gave it an out-sized and malign influence on the polity were decoupled from the trade union and sold off.

Technology Clusters

This was also the time when Israel grew to have an enormously important and advanced technology sector, helped in part by the fact that technology and venture capital were the only parts of the economy which did not suffer from the historical over-regulatory cholesterol that prevented the growth of other sectors. The boom was powered in part by government programmes like Yozma, developed and honed in the 1990s.

The influx of Jews from what constituted the remnants of the Soviet Union helped significantly as most of these immigrants were not only politically conservative and disdainful of socialism, but also highly accomplished in technical fields.

Perhaps, the development of the technology clusters was Israel’s version of China’s SEZ-led reforms model which was used by the country’s leaders as an example to push more reforms.

The fact that the Israeli leadership in the very beginning had taken steps to build a military industrial complex helped in no small way in the Jewish state becoming the innovation nation.

Bibi Era and Continued growth

In his first term as prime minister during 1996-99, Benjamin Netanyahu (nicknamed Bibi) deepened the market reforms process by starting to sell shares in government-owned companies on the stock market and further reducing foreign exchange controls. This however was cut short by his loss in the 1999 elections after which he moved to the private sector.

He re-entered politics as the finance minister in Ariel Sharon’s government and restarted the economic reforms that had come to a standstill, by further reducing the public sector, increasing the scope of the privatisation programmes and deregulating industries. He drastically cut taxation rates and helped bring about reforms in the labour code.

The process slowed down after he resigned in 2005. The reforms process picked up pace once again with his return to the prime minister’s post in 2009 and has continued since then with a few hiccups.

What is remarkable about the Israeli growth story is the fact that they have been able to achieve technology-led growth in a tough security environment and despite the very socialist inclinations of a majority of the population and the founding ideology. For this reason, the state of Israel has a lot to teach nations like ours that found themselves under similar if not the same societal, security and economic conditions.

This article is a part of our special series on Israel.