In Praise of Lesser Evils
Can Realism Repair Foreign Policy?
With the signing of the Egyptian-Israeli agreement, the focus in the troubled Middle East has turned to the West Bank, and negotiation of a wider peace settlement. What is rarely discussed in the context of these critical talks is the deterioration of the Israeli economy and the increasing economic pressures on the coalition government of Prime Minister Menachem Begin. Plagued with the greatest military burden per capita of any country in the world, pushed by its Zionist mission to perpetuate an inefficient state presence in the economy, and dependent upon American assistance for its basic needs, Israel is entering into the most difficult economic phase in its history.
A brief rundown of Israel's current economic problems highlights the seriousness of the situation. Prices are rising faster than almost anywhere in the world, by almost 50 percent last year and by more this year. The balance-of-payments deficit in 1978 was $3.25 billion, equal to almost one-fourth of the country's gross national product. The government budget last year was almost as large as the national output; in the previous year it was actually bigger, meaning that in both years funds from abroad were necessary to cover the government's commitments.
Hyperinflation in particular has seriously undermined the stability of the coalition Likud government. Public opinion polls in Israel, as in the United States, suggest that the issue of inflation is of greater importance to voters than any foreign policy issue, and surveys taken this past spring indicated that if elections had been held at that time, the Center-Right coalition would have been defeated by the Labor Party opposition for purely domestic policy reasons.
Moreover, the nation's economic vulnerability could place a real restraint on the freedom of action of any Israeli regime, whether of the Right or the Left. The country's growing inability to pay for its civilian as well as military imports has driven Israel further from its dream of economic self-sufficiency than at almost any time in its 30 years of existence. Assistance from the United States, now at unprecedented levels, is essential to the everyday operations of the economy, raising serious questions about Israel's ultimate autonomy from its American ally. As one Middle East scholar has written, the Israelis would do well to ponder the implications of the thought that in the Anglo-Saxon tradition, the power of the sword was always held in check by the power of the purse.
The Egyptian-Israeli treaty, far from easing some of these pressures, will only magnify them. Israeli economic officials do not expect the treaty to make possible any cutbacks in military spending, which eats up almost one-third of the budget and is responsible for much of the imbalance in the country's international payments. On the contrary, what these officials sometimes refer to as the "problems of peace"-primarily relocating the lines of defense from the Sinai to the Negev-will require vast new outlays and a massive new injection of American aid.
Far from being an inevitable part of Israeli history, this kind of dependency is of fairly recent origin. After the first three years following independence, when the state was totally absorbed in the tasks of self-defense and handling a flood of immigration, Israel entered a long boom period. Between 1952 and 1967, economic development was the watchword, and the still-current popular image of the Israeli economy-a hard-working nation of pioneers making the desert bloom-was formed.
This vision was not just a romantic stereotype, for throughout this period the country did have one of the highest growth rates in the world. Only Japan, South Korea and Taiwan have had records roughly comparable to the ten percent annual growth achieved in Israel through most of the 1950s and 1960s. And with this progress, the country was moving steadily toward economic self-sufficiency. The ratio of the trade deficit to national output was steadily declining, from 26 percent in 1952 to about 14 percent in 1966, primarily because of a very successful export performance.
All of this was accomplished with few natural resources, virtually no indigenous energy sources, and a largely unskilled labor force, and despite an economic boycott by the country's closest neighbors. A crucial factor in this growth, of course, was a steady stream of capital from abroad. In his book, Israel, The Embattled Ally, Harvard's Nadav Safran estimates that between 1950 and 1973 Israel received more than $18 billion, primarily from U.S. grants and loans, contributions from world Jewry, bond sales, and German government reparations payments to the Israeli government. This outside assistance notwithstanding, most scholars tend to agree that by the mid-1960s, Israeli exports were growing at such a rate that a moderate increase in tax rates and some restraint in public spending would have enabled the country to completely eliminate its balance-of-payments deficit by the early 1970s.
The June 1967 War shattered that possibility. Between 1966-67, the last full year of peace, and 1971-72, imports of expensive new military hardware surged and production shifted to military uses. Military expenditures as a percentage of GNP jumped from 11.7 percent in 1966 to 24.1 percent in 1972, and military imports increased from $116 million to more than $800 million.
The 1973 October War accelerated the country's growing economic plight. The conflict decimated the nation's weapons arsenal and necessitated another vast arms program which sent defense expenditures abroad soaring to more than two billion dollars in 1975. At the same time, the global inflation of 1974-75 hit Israel, which imports virtually all of its raw materials, particularly hard. As a result, balance-of-payments deficits, which had been in the manageable $500-million to $1-billion range before 1973, jumped to a $3-4 billion level in the years thereafter. These deficits were financed only with the help of American aid, which shot up dramatically as the economic squeeze on Israel tightened.
Concerned about the country's deepening dependency in the wake of the 1973 War, the Labor government tried to exert some discipline over the economy. A series of policy measures designed to curb consumption-including tax increases, cuts in subsidies, and devaluation of the Israeli pound-did slow the economy and reduce imports in 1975-76. As a result, the payments deficit declined slightly-from a peak of four billion dollars in 1975 to $3.3 billion in 1976.
But there were limits to what the coalition government, dominated by workers' parties and heavily influenced by the Histadrut, Israel's powerful trade union movement, could do. In the end, though its policies actually produced a recession, Labor failed to cut consumption significantly or to improve productivity in the swollen public sector.
When it first took office in early 1977, the Likud coalition, like the Labor government, hoped to revitalize the sluggish bureaucratic economy and to reduce Israel's appetite for American aid. But also like Labor, the Likud tried to avoid the painful remedies of slashing consumption and curbing government spending. The new government's strategy was based on a laissez-faire monetary program designed to stimulate exports and encourage foreign investment. The "New Economic Policy," launched in the fall of 1977, liberalized the country's financial sector. The Israeli pound was allowed to find its own level in the foreign exchange markets, cumbersome currency controls were eliminated, export subsidies slashed, and many of the subsidies on basic commodities reduced. It was anticipated that the reforms would attract foreign investment and encourage the flow of capital back into the country, would force Israeli industry into a more competitive position by removing its shield of protection, and would stimulate the sale of Israeli goods abroad, as they became cheaper through the devaluation of the pound. The government estimated that, if all went well, by 1984 Israel would no longer need the roughly one billion dollars a year in economic aid that it had been receiving from the United States since 1975.
The policy was successful as far as it went. Exports last year did jump by 25 percent, and industrial exports were up at an even faster rate. The increase was not without its controversial perspective, however, for much of the surge represented stepped-up arms shipments. Last year these totaled $500 million, or roughly 20 percent of Israel's industrial exports, and Defense Minister Ezer Weizman has said that sales will rise to $600 million this year. Many of these goods are shipped to countries like Chile, Nicaragua, and South Africa, which have a hard time filling their orders elsewhere.
The Begin government's monetary policies have also encouraged foreign investment, which increased by more than 50 percent last year, to $165 million. (This was still below the level reached in 1973, before the October War frightened foreigners and slowed the inflow of investment capital to a trickle.)
Nevertheless, the Likud's policies have clearly failed in a larger sense, primarily because the government neglected to accompany its free market monetary policies with a tight fiscal policy reducing government spending, which is widely viewed as the primary source of inflation. As Meir Merhav, the economic columnist for the English-language Jerusalem Post, has written, the government instead pursued policies "designed to placate every vested interest and every departmental whim of every ministry." The result, he concluded, in a reference to the conservative American economist whose ideas had inspired the monetary reforms, was a policy of "Milton, without the Friedman."
Virtually as soon as he took office, Mr. Begin informed Finance Minister Simha Ehrlich that neither defense-related expenditures nor welfare and social services, which together account for well over half of the budget, could be touched. Since other fixed expenditures, such as debt repayment, eat up most of the rest of the budget, that left economic officials with virtually no opportunity to exercise restraint.
Not surprisingly, within two years after the Begin regime had taken office, public expenditures had increased, the number of public employees had grown, and wages had risen faster than productivity or inflation. (Productivity is lower than in the United States or Western Europe, primarily because almost half of the labor force is in inefficient state enterprises and in the services sector. Only some 25 percent of workers are in industry.) The recession induced by the Labor government had given way to a resurgence of economic growth, which, in turn, sucked in more imports, pushing the balance-of-payments deficit up again from $2.6 billion in 1977 to $3.25 billion in 1978.
The central bank, forced to print money to finance the growing budget deficit, fueled the money supply by 39 percent in 1977 and 45 percent in 1978. Partly as a result, domestic prices have soared. The extreme inflation now gripping Israel has stifled investment in productive activities, diverted funds into speculation (particularly in real estate), and widened the gap between property holders and the poor.
In 1979 the government has taken some steps to cool the economy, notably by allowing food and fuel prices to rise close to market levels. As a result, the budget introduced in March of this year has been held in real terms to the same level as last year. In addition, Finance Minister Ehrlich in May proposed a plan to cut the budget in all government ministries, to impose a freeze on government hiring, and to curtail subsidized credits to industry and agriculture. If the plan is not implemented, he warned, the country could be suffering triple digit inflation by the end of 1979.
But the Likud government has still been unable to alter a wage system that has raised workers' incomes faster than the rate of inflation. After discounting for price increases, the average wage still went up by one percent in 1976, ten percent in 1977, and two percent last year. In addition to wage indexation, a host of other ways to hedge inflation are available, including government bonds pegged to the consumer price index and yielding an additional three percent, and housing loans at fixed interest rates. The result of these devices, as Arnon Gafney, Governor of the Bank of Israel, explained in mid-1978, is that "nobody suffers much from inflation, so it is hard for us to argue the need for restraint."
What does suffer is investment in the future. Capital investment has declined in recent years, and the "buy now, pay later" psychology so familiar in the United States is even more common in Israel. Remarkably, real consumption per capita has increased by an average of 1.7 percent a year since 1973, despite the staggering increase in the military burden and the sluggish growth rates before 1978. When asked what impact Israel's recent economic problems have had on the public, businessmen invariably reply that the man on the street has never had it so good. This is possible only because of American assistance, which now supplies Israel's butter as well as its guns. Speaking bluntly, a leading Israeli banker, Ephraim Rainer, told a reporter in early 1979 that "the public here doesn't pay the price of inflation. The United States and the Jewish people around the world do that."
To a degree, the government's miscalculations can be traced to the economic inexperience of the Likud coalition. Finance Minister Ehrlich is a politician whose previous economic experience consisted of managing a small optical company. As for the Prime Minister, in the words of a high economic official, "Mr. Begin knows less about economics than the man on the street," and what he does know, it is said, ranks well below politics in his priorities.
But no amount of economic sophistication can conjure away two fundamental constants that have been part of Israeli history since the beginning, and that lie at the root of her current predicament. These are the ever-present threat of war and the military burden it implies, and Israel's Zionist mission, which requires the existence of a vast social welfare state to cushion the adjustment of immigrants to their new land. In order to serve both Zionism and national security, the Israeli government since 1948 has been involved in the economy to a degree unmatched in any other non-communist country.
The state operates such sectors as the railroads and the telecommunications industries; it manages huge public works projects in irrigation, afforestation and community construction; and it owns more than 50 percent of nearly 200 public corporations producing hundreds of products. In all, such state activities account for about one-fourth of the nation's GNP. In addition, the private sector of the economy is tightly bound by a web of government regulations, controls, and subsidies.
Many of these constraints have been dictated by the requirement that Israel, as the Zionist homeland, must offer all those who choose to settle there not only work but a minimum standard of living as well. The state, as a matter of basic social policy, has to maintain close to full employment and one of the most generous welfare programs in the world. The Likud, whose Zionist commitment is even stronger than its faith in free enterprise, has been unwilling to cut back on this vast public administration and its cornucopia of social services.
Maintaining full employment in practice can frequently mean subsidizing unprofitable enterprises. An example of the kind of difficult decisions facing the current leadership was provided last year when the government was called upon to assist a textile company in order to prevent the closing of an unprofitable factory in the town of Beit She'an. The plant was the largest employer in a community settled by numbers of new immigrants and exposed to frequent terrorist attacks. In the end the government felt that it had to give greater priority to the health of such a town than to rationalizing the economy. The sum of many such decisions over the years explains much of Israel's economic dilemma.
Israel's security also plays a part in the failure of the government to make the hard choices necessary if the economy is to be made more productive. According to Israeli officials, a country which faces the possibility of war every day cannot risk undertaking any economic policies that might weaken the cohesiveness of the society. Finance Minister Ehrlich is very explicit on this point. "We have a unique social structure," he said in an interview last fall. "We live under intense psychological tension. It means our ability to trim social services and employment is very limited."
Constant war encourages the Israeli government to cushion its citizens against sacrifices, which takes its own economic toll in return. The country allocates more of its resources to the military-almost 30 percent of its total output-than any other nation in the world. (Most industrialized countries spend four to eight percent of their GNP on defense; the United States, with six percent, falls in the middle of that range.) In the last 12 years, defense outlays have increased annually by more than 20 percent. By 1978 the military budget came to about $1,000 per capita, compared to an average of about $100 per capita in the Arab states of Egypt, Jordan and Syria.
The military consumes 15 percent of industrial output, and 20 percent of the labor force, and demands that every man from the ages of 22 to 55 put in one month of reserve duty a year, with a loss of output and productivity that is impossible to measure. The country spent $1.85 billion abroad for defense last year, more than half of it in the United States. Domestic expenditures on defense, largely wages and procurement, have increased by 38 percent in real terms since 1972.
As long as the nation remains in this state of siege, it seems unlikely that any Israeli government, of the Right or the Left, will alter the current economic policies significantly. As indicated, these are based on avoiding drastic cuts in either consumption or military spending, and keeping the external deficit as low as possible by stimulating earnings from abroad. Nevertheless, several recent developments on the international scene appear to make this strategy far more risky than it has been in the past.
The current magnitude of the payments deficits-civilian as well as military-makes it doubtful whether enough resources can be generated through exports or investments to make a major dent in the gap. As long as the country is still at war, and subject to continuing terrorist attacks, foreign investment is unlikely to increase much beyond its present modest levels. Finally, a policy resting heavily on exports becomes more and more problematic as the international environment moves increasingly toward protectionism and trading blocs. The Iranian market, which used to absorb some $200 million in Israeli exports, is now closed. And the entry of Greece, Spain and Portugal into the European Economic Community by the early 1980s could threaten Israel's all-important sales to that market, for many of Israel's products, such as citrus fruit, are directly competitive with those from southern Europe.
It has been calculated that in the first 19 years of Israel's existence, official American assistance amounted to nearly $1.5 billion. Even then the level represented the highest rate of assistance, on a per capita basis, that the United States had ever provided to any nation. From an annual level of less than $100 million between 1948 and 1962, grants and loans from the United States leaped to around $500 million a year after the 1967 War. Following the even worse crisis of 1973-74, American assistance jumped again-to more than $2.5 billion in economic and military support in 1974. Under the Sinai II agreement, negotiated in 1975 by Secretary of State Henry Kissinger, the United States committed itself to continuing aid levels of about two billion dollars a year. In the five years since the 1973 War, the United States has transferred more than ten billion dollars in official assistance to the Jewish state, more than half of it in outright grants. By 1978, fully one-fourth of American economic assistance was going to Israel.
For their part, the confrontation states of Egypt, Syria and Jordan have received since 1973 about half of the sum sent to Israel. As a memorandum circulated within the State Department last summer pointed out, the Middle East was receiving annual assistance per capita comparable to the Marshall Plan even before the Egyptian-Israeli treaty was signed.
Now, in the wake of the treaty, the annual economic and military assistance package to Israel is a record $2.8 billion. The total consists of a regular aid program of one billion dollars in military sales credits, one-half of which are forgiven, and $785 million in economic assistance. (This aid, two-thirds grants and the rest in concessional loans, is in the form of a cash transfer.) In addition, Israel will receive three billion dollars over three years as part of the $4.8 billion peace package. Most of this total will be spent on imports from the United States.
In addition to official aid, Israel also receives vast amounts of private money from the world Jewish community. Since the beginning of the Israeli bond drives in 1951, almost $4.3 billion has been raised around the world, including $370 million during 1978. A total of two billion dollars in Israeli bonds are held by American financial institutions and individuals, making them one of the three most widely distributed securities in the United States. Each year the bonds provide more than one-third of the Israeli development budget, representing capital investment in the economy from industrial, agricultural and energy projects to investment in communications and transportation.
In all, private contributions from the United States, including bond sales and giving through the United Jewish Appeal and other fund-raising organizations, are estimated at almost $600 million a year. With official assistance, that works out to more than $1,000 a year per person in Israel, an impressive sum in a country with a per capita income of about $2,100.
This flow of funds is deepening Israel's growing reliance upon the United States at a time when the American electorate is becoming increasingly disenchanted with foreign aid. Coincidentally, American policymakers are equally disenchanted with many of the political positions taken by the Likud coalition government. The implications, as some Israeli officials privately admit, are potentially severe limitations on the country's freedom of political maneuver.
Moreover, the American credits will add to Israel's growing national debt, which, at $12.5 billion is already the biggest per capita in the world. The military sales credits extended to Israel this year will probably carry interest rates of between nine and ten percent a year, and therefore will only increase the nation's burden of debt service. This year, some two billion dollars will have to be set aside by the Finance Ministry just to pay interest on the debt.
The peace agreement will worsen Israel's economic plight in other ways as well. The redeployment of the defense line is expected to aggravate inflation, particularly in housing, as equipment and manpower in the construction industry are shifted to the Negev. The treaty will also mean the loss of the offshore Alma oil field in the Gulf of Suez. Opened up by the Israelis in 1977, the field is now producing more than 30,000 barrels of oil per day, or some 20 percent of the nation's oil needs. Israel failed to gain a formal U.S. commitment in the treaty that oil from the Sinai and the offshore fields would be made available to it, although Egyptian President Anwar Sadat did pledge that Egypt would sell Sinai oil to Israel after the evacuation of the fields.
In addition to the loss of fuel from the Sinai, Israel has been deprived of its access to Iranian oil, which, before the fall of the Shah, was supplying more than half of Israel's needs. Although the Israeli Energy Ministry has found some new sources of supply, particularly in Mexico, the loss of two important fuel sources close to home could well throw the country into even greater dependence upon the United States. For, as part of the peace agreement, the United States has extended to 15 years a pledge made in 1975 to meet Israel's oil requirements for up to five years if it is unable to buy from its normal suppliers.
A fascinating insight into how galling-and worrisome-this reliance is to Israeli leaders was provided during a trip to the United States last March by Prime Minister Begin. In a speech in New York before the Israeli-U.S. Business Council, he said that Israel would do whatever it could to avoid bringing the U.S. guarantee on oil supplies into operation. "You already have a problem of energy," he explained. "Some airlines have cut their flights. Perhaps in the future you will be asked to do a terrible thing. Instead of driving your cars at the speed of 70 miles, to do so at 50 miles. . . . And who knows? Perhaps you wouldn't be able every Sunday of the summer to use a racing boat. These are very difficult decisions to make in this country or to be carried out. And in such a situation, if somebody would come up and say, 'We have such difficulties and we have to give oil to the Israelis,' I don't know what would happen to public opinion and the relations between America and Israel."
It is far from clear whether Israel can count on an indefinite continuation of American support at current levels. Public opinion polls taken in the wake of the Middle East treaty indicate widespread opposition to the economic aid accompanying the agreement. One survey, conducted by the New York Times-CBS polling group, even showed a majority opposed to selling oil to Israel if Jerusalem cannot buy it elsewhere.
What alternatives are available to deal with these seemingly intractable problems? The most frequently discussed option focuses on cutting, not the military budget, but spending on social services and on inefficient enterprises, whether publicly or privately owned. The Bank of Israel's Arnon Gafney has fought for years for a reduction of consumption and public sector expenditures, arguing that careful pruning and a reallocation of resources toward the more productive export sector would reduce the civilian payments deficit to levels that could be covered by private capital flows by the mid-1980s. (It is assumed that the military-related payments deficit will continue and will have to be met by continuing military assistance.) This choice would not eliminate Israel's dependency upon others, but would at least keep it within manageable limits.
Moreover, the traditional Zionist argument against tough economic measures may have been vitiated by the fact that the tensions of war and inflation have already weakened Israel's appeal to Jewish immigrants. More than half of the Jews coming out of the Soviet Union wind up in the United States rather than Israel. Of the roughly 40 percent that do go to the Middle East, many are elderly people seeking a place of retirement. According to the Israeli government, more than 400,000 Israelis are now living in the United States and Canada, including 200,000 in New York alone. One can assume that many of those people may choose to remain.
Just as the fall-off in immigration weakens the case against belt-tightening in Israel, the current rate of inflation gives those urging cutbacks a powerful boost. The blistering pace of price increases could provoke the government into taking drastic deflationary measures and provide the nation's leadership with an opportunity to rally public support around its belated efforts to deflate the economy. Such an appeal may not bring the emigrants home, and might even encourage others to leave, but it could also spark a revival of the country's old pioneering spirit. The subterranean fear and resentment of dependence upon the United States could even be used to advantage in such a call for austerity.
In the end, however, it may well be that the only lasting solution to Israel's economic dilemma, and its only hope of becoming a substantially self-sustaining state, lies in an overall peace settlement. Only a generalized peace could permit the gradual reduction of defense spending. And it is possible that only a normalization of political relations could provide the necessary psychological framework for the difficult task of restructuring the economy. Yet this proposition-that the key to Israel's economic survival lies in a more aggressive pursuit of peace-is almost never heard in Israel. The reason, of course, is that no one wants to be accused of putting a price tag on the nation's security, even if that price is already too high.