The trouble with Israel

Reforming Israel
Evelyn Gordon — October 2011, COMMENTARY

As they observed the massive economic protests that convulsed Israel this summer, Americans and Europeans had reason to wonder why Israelis would have cause to complain about their economic situation. Israel’s economy grew by 5.6 percent last year, and the Bank of Israel is predicting 4.8 percent growth this year. Unemployment fell to 5.7 percent in May, its lowest level in 27 years. With much of the West still suffering from anemic growth and high unemployment, Israel’s situation seems enviable by comparison.

Yet hiding behind these impressive macroeconomic statistics are significant domestic problems, problems that successive Israeli governments, preoccupied as they have been with the peace process and its attendant terrorism, simply ignored for the better part of two decades. These problems ignited the protests. And while many of the solutions proposed by the protesters would make things worse, their success in finally moving these issues to the top of the national agenda has provided a welcome impetus for genuine reform. As such, the protests pose both risk and opportunity. If the government simply capitulates to protesters’ demands, Israel’s economy will suffer. But if it seizes the chance to enact the reforms that Israel really needs, Israel will be a better place to live in—and the protests will have been a triumph.

The primary issue is the high cost of living. A study published by the BDO Ziv Haft consulting company in 2010 found that an average Israeli home costs the equivalent of 114 average monthly salaries—as compared to 90 in France, 71 in Britain, 60 in the United States, 54 in Germany, 42 in Switzerland, and 30 in Sweden. Rents are similarly high in terms of purchasing power, as are car prices: BDO found that a Mazda 3, one of Israel’s most popular cars, costs an Israeli 14 average monthly salaries, compared to only four monthly salaries in the United States and six in western Europe. Even basic foods are expensive: the Wall Street Journal reported in June that cottage cheese (an Israeli staple) was more than twice as expensive in Israel than at a British supermarket. Consequently, even middle-class families often find it hard to get through the month, and 13.4 percent of working families found themselves under the poverty line last year—almost double the 7.6 percent rate in 1995, according to Tel Aviv University’s Taub Center for Social Policy Studies.

But high prices aren’t the only domestic issue worrying Israelis. Failing schools are another major concern. On the Program for International Student Assessment’s last global exam in 2009, Israeli 15-year-olds ranked below the OECD average in all three subjects. Out of 64 countries, Israel placed 36th in reading and 41st in math and science. Consequently, students enter university poorly prepared: as Technion President Peretz Lavie told Ha’aretz last year, there has been a “huge decline in [college] applicants’ level of scientific knowledge,” as well as in their writing skills. This requires universities to devote more time to remedial instruction rather than imparting new knowledge, so students graduate at a lower level. Israel’s economy depends almost exclusively on its human capital, so this clearly doesn’t bode well.

It also increases the cost of living, as parents who can afford it typically spend thousands of shekels a year on private tutoring to compensate for what their children aren’t learning in school. And that’s on top of the thousands of shekels required by their “free” public education. Israeli public schools don’t provide textbooks, so parents have to buy them; there are also mandatory fees for “extras” such as field trips and class parties.

Health care is a concern as well. An OECD report found that Israeli hospitals have the highest average occupancy rate in the West: 96.3 percent, due mainly to the shortage of hospital beds (only 1.9 per 1,000 people, the third-lowest ratio in the OECD). This means that certain wards, especially pediatrics and internal medicine, are perennially overcrowded. In January, for instance, the Israel Medical Association reported that wards at several hospitals were operating at almost 200 percent capacity. Israel also has only 4.5 nurses per 1,000 people, less than half the OECD average (9.1 per 1,000). Back in 1999, Ehud Barak was elected prime minister in a landslide after promising to “get the old woman out of the hospital corridor,” where overflow patients are routinely stashed. Twelve years later, she’s still there.

Crime is another growing worry. Although Israel’s crime rate isn’t high by international standards (its murder rate, for instance, is similar to Europe’s and lower than America’s), rising organized crime and gross police incompetence have produced rising anxiety. The organized-crime problem grabbed public notice in 2008, when Margarita Lautin was killed while sitting on a beach with her husband and children because a professional hit man’s bullet missed his underworld target. And police incompetence makes headlines repeatedly, as when serial rapist Benny Sela escaped police custody in 2006, or when a policeman stood and watched as a terrorist gunned down high-school students at a Jerusalem yeshiva in 2008. As for property crime, it’s a standing joke in Israel that police complaints are filed only to collect the insurance. Indeed, police admit they solve only 1 in 100 break-ins.

Corruption? Israel ranks in the bottom third of the OECD on Transparency International’s index. Stifling bureaucracy? An OECD study published in July ranked Israel 29 out of 37 countries in terms of the bureaucratic burden on start-ups, behind such luminaries as Italy and Russia. There’s the low workforce participation rate: 57.4 percent last year, compared to an OECD average of 72.4 percent. And the list could go on and on.

_____________

Most of these problems have been decades in the making. Yet with few exceptions, successive Israeli governments have largely ignored domestic issues for the last 18 years, because their agendas, whether by choice or compelled by circumstance, have been overwhelmed by the peace process and its discontents. As Avi Ben-Bassat, of Hebrew University, who served as finance ministry director-general under a Labor government from 1999 to 2001, told Ha’aretz this year, “Everyone is tired out from dealing with the dispute with our neighbors, and not enough energy is left for domestic issues.” Nor is this really surprising: governments are made up of human beings with finite amounts of time and energy; thus any government can cope with only so many major issues at a time.

Yitzhak Rabin (1992–1995) signed the Oslo Accord and two subsequent agreements with the Palestinians, all of which generated massive domestic controversy. His territorial transfers to the Palestinians also sharply increased terrorism: in the two and a half years after Oslo was signed in 1993, Palestinians killed more Israelis than in the entire preceding decade.

Benjamin Netanyahu (1996–1999) was elected mainly to suppress the Oslo terror. Under heavy international pressure, he also signed two further agreements with the Palestinians and withdrew from additional territory. Ehud Barak (1999–2001) unilaterally withdrew from Lebanon and conducted final-status negotiations with both Syria and the Palestinians. The second intifada erupted during his term. Ariel Sharon (2001–2005) was elected primarily to suppress the intifada, which entailed a major counterterrorism offensive. In 2005, he also withdrew unilaterally from Gaza, uprooting 25 settlements; this controversial move produced domestic unrest on a scale not seen since Rabin’s term. Ehud Olmert (2006–2009) fought two wars while conducting final-status negotiations with both Syria and the Palestinians.

One can understand why these prime ministers had little time and energy to spare on domestic issues. Yet even had they wanted to engage, the foreign-policy focus also created coalitions peculiarly unfavorable to domestic reform. The Kadima and Likud parties, for instance, have similar views on the economy. But instead of forming coalitions with each other, they form coalitions with smaller parties willing to support their diplomatic agendas, and those smaller parties often have radically opposing domestic agendas. Thus four of the six parties in Netanyahu’s current coalition favor increased government spending and state intervention in the economy, whereas Netanyahu favors decreased spending and intervention. Similarly, while Kadima and Likud both favor electoral reform, their smaller coalition partners adamantly oppose it, fearing it would reduce their own power.

Hence the most significant domestic reforms of the last 18 years—those instituted by Netanyahu as finance minister in 2003, which included slashing welfare payments to encourage the voluntarily unemployed to get jobs, creating a welfare-to-work program, and reforming the country’s pension system to keep it solvent—unsurprisingly occurred at a rare moment with neither foreign-policy nor coalition distractions. In early 2003, the intifada still raged with enough force that Prime Minister Ariel Sharon felt little pressure, either domestically or internationally, to resume peace talks. Yet because the counterterrorism offensive he had launched a year prior was working, defense could also be relegated to automatic pilot. Moreover, his sweeping reelection victory in 2003, coupled with the unexpected success of the pro–free market Shinui party (now defunct), enabled him to form a coalition without the ultra-Orthodox parties, which vehemently opposed Netanyahu’s reforms. And the fruits were impressive: five straight years of 5.4 percent average growth in 2004–2008, followed by quick recovery from the global financial crisis of 2008–2009.

_____________

Yet even under these favorable conditions, an outside stimulus was needed to push the government to act: the intifada and the deep recession it caused had dried up global credit, creating a solvency threat the country could no longer ignore. This raises an obvious question: If domestic problems really bother Israelis as much as the magnitude of the protests would seem to indicate (one protest brought out more than 3 percent of the population), then why hasn’t public pressure provided the necessary stimulus for reform? After all, democratic governments are supposed to be attentive to voter concerns, lest retribution follow at the polls. Did Israelis discover their domestic problems only this summer?

For much of the period since 1993, raging terror or controversial peace agreements trumped domestic concerns in voters’ calculations; the protests erupted this summer precisely because security and the peace process were both on the back burner. Yet if you believe opinion polls, domestic issues have actually been the public’s priority for several years now. A January 2007 Peace Index poll, for instance, found that voters’ number-one concern was government corruption, which received a weighted grade of 31.5 out of 100. That was followed by rehabilitating the army after the previous summer’s war in Lebanon (22.1), narrowing economic gaps (20.1), and fighting crime (15.4). Making peace with the Palestinians came in last, at 10.8. An October 2010 Peace Index poll similarly found that only one fifth of Jewish Israelis deemed Israeli-Palestinian peace their top priority; the other four fifths chose various domestic concerns. Such polls, moreover, probably underestimate concern over domestic issues by omitting some of the most important: the education system, for instance, wasn’t offered as an option in either survey, even though it is a crucial issue for many parents.

Nor is this focus on domestic issues shocking: terror has been quiescent for the last few years, while most Israelis have concluded that peace is currently impossible. An October 2007 Peace Index poll found that 65 percent of Israeli Jews thought most Palestinians “have not accepted Israel’s existence and would destroy it if they could”; by October 2010, this figure had risen to 80.4 percent. And if peace is unobtainable, Israelis would naturally prefer their government to focus on issues where it can make a difference, like the economy.

But until now, this silent majority has largely been drowned out by two far more vocal constituencies: the Israeli media and the international community. The latter is obviously uninterested in Israel’s domestic problems, but it relentlessly demands “progress” in the peace process, i.e., further Israeli concessions. Thus even prime ministers who, like Netanyahu, understand that an agreement is unobtainable must devote time and energy to staving off this pressure.

The Israeli media, in contrast, ought to care about domestic affairs. But in practice, much of the media still considers the peace process the top priority, often even insisting that Israel’s domestic problems can’t be solved without progress toward peace. On July 29, for instance, with the economic protests in full swing, Ha’aretz editor-at-large Aluf Benn (now its editor-in-chief) published a New York Times op-ed declaring that Netanyahu’s most urgent task just then was not domestic reform, but “to pursue a stable peace with the Palestinians.” Similarly, two days after Israel’s admission to the OECD last year, a Ha’aretz editorial headlined “There will be no economic prosperity without peace” asserted that without peace it was impossible to have “sustained economic growth” (never mind there having been 62 years of exactly that), so peace must be the government’s top priority.

In consequence, politicians who focus mainly on domestic issues reap savage media coverage, and those who focus on the peace process become media darlings. Sharon, for instance, was under relentless media attacks before announcing the disengagement, for both alleged corruption and the frozen peace process, despite his success in suppressing the intifada and reviving the economy. Yet the moment he announced the disengagement, the corruption stories disappeared and the media, as television journalist Amnon Abramovich famously put it, decided to protect him “like an etrog” (a citron fruit that must be kept from bruising to be fit for use on the holiday of Sukkot) until the withdrawal was complete. The same treatment was accorded to Olmert, as the Ha’aretz journalist Ari Shavit later acknowledged: during the 2006 election campaign, the media concealed his suspected corruption (for which he is now on trial), wrapped him in “a thick layer of cotton wool,” and “marketed [him] to the public like a worthy, glowing etrog, a fruit to be treasured,” because he was seen as the “pro-peace” candidate.

But the recent protests have reshuffled the cards dramatically. For the first time in two decades, hundreds of thousands of Israelis demanded that the government finally address domestic issues. Granted, domestic concerns would likely recede again if the diplomatic and security fronts heated up. Yet the protests’ sheer size and the fact that they drew support from across Israel’s political spectrum sent an unmistakable message that politicians will henceforth ignore domestic issues at their peril. They therefore present a golden opportunity for the government to institute desperately needed reforms.

_____________

Nevertheless, the protests also present a danger. For while the rank-and-file protesters indeed span the political spectrum, the leaders are militant leftists who adamantly oppose Netanyahu’s free-market policies; they favor anti-market policies such as rent control, price controls, and an end to privatization. As one, Pesach Hausfater, bluntly said, they demand nothing less than that Netanyahu “get up and say, ‘I understand I need to change my religion.’”

Yet what Israel really needs is more competition and less government control, not the opposite. This is most obvious with regard to the protesters’ main gripe, the high cost of living. Housing prices, for instance, are high largely because the state owns 93 percent of Israel’s land, which it doles out for construction stingily. This is Economics 101: with land in short supply, prices soar. Hence the only economically viable way to reduce housing prices is for the government to free up the land supply. Car prices, too, are high mainly because of government intervention: combined, the various taxes slapped on cars total more than 100 percent of a vehicle’s base price.

The same goes for food. A recent report by Business Data Israel found that at every stage of the production and sales cycle, Israel is more expensive than Europe: tariffs are higher, as are the profit margins of importers, manufacturers, and retailers. Data from the Ministry of Agriculture reveals positively outrageous markups: 683 percent on imported tea, for instance, or 348 percent on imported rice. Such high markups are possible for three reasons. First, Israeli food manufacturers and supermarket chains function as cartels; three local dairy companies, for instance, dominate the dairy market. Second, extremely high tariffs often preclude competition from imports (250 percent on honey, 230 percent on potatoes, 190 percent on beef, etc.). Third, when imports are not loaded with punitive tariffs, the government’s standard practice is to license a sole importer, who then faces no pressure from competitors to sell his product more cheaply. Even worse, this sole importer is often a local manufacturer that makes similar products and thus has no desire to undersell its own brands.

Israel’s entire economy is dominated by cartels. The Bank of Israel’s annual report for 2010 found that “some 20 business groups, nearly all of a family nature and structured in a pronounced pyramid form, continue to control a large proportion of public firms (some 25 percent of firms listed for trading) and about half of market share.” And the World Economic Forum’s Global Competitiveness Report for 2010–2011 ranked Israel 117 out of 139 countries in “extent of market dominance,” right between Mauritius and Burkina Faso. Government monopolies then jack up prices even further: at the state-owned water and power monopolies, for instance, employees’ average salary is 2.5 times the economy-wide average. The unions obtained this exorbitant benefit, which obviously necessitates higher utility rates, by threatening to shut down the nation’s water and power supply.

But lack of competition and excessive government intervention are no less problematic in other fields, such as health care. In July, for instance, Ha’aretz reported that only 60 percent of patients who need inpatient geriatric rehabilitation receive it, because Israel’s public hospitals lack sufficient geriatric rehab beds. Yet a state-of-the-art geriatric rehabilitation ward has been standing empty in a private hospital because the Health Ministry won’t let HMOs send their patients there—even though the public hospitals charge 50 percent more than the private facility does. The ministry also refused to let two other private facilities open geriatric rehab wards in recent years, insisting the beds should instead be added to public facilities. Both health-care professionals and treasury officials told Ha’aretz this policy is apparently aimed at protecting public hospitals from competition that would force them to lower their own rates. Meanwhile, not a single public-hospital bed has been added. So many patients simply go untreated, while HMOs pay 50 percent too much for those who are treated—money that could instead fund other types of care.

Or take education, where the Education Ministry’s agreements with the teachers’ unions make it nearly impossible to fire incompetent teachers. A recent Central Bureau of Statistics study found that more than 50 percent of high-school math teachers don’t have degrees in math or any related field, meaning they are unqualified to teach the subject by the ministry’s own standards. Yet replacing them would be virtually impossible even if qualified replacements could be found, because they can’t be fired. They would have to transfer to jobs elsewhere in the public school system, which would thereby be forced to pay hundreds or thousands of extraneous teachers.

The disconnect between the protesters’ demand for more government control of the economy and Israel’s actual need for a freer market poses several dangers. First, to placate the protesters, the government might adopt some of their problematic proposals. It won’t subject Tel Aviv to rent control or agree to fund free “education” from the age of three months (a wildly expensive benefit that even Europe’s most generous welfare states do not offer), but it might, for instance, increase mortgage subsidies to needy families. This proposal, which many ministers and members of the Knesset favor, wouldn’t create a new benefit; it would merely expand an existing one. But it has been tried repeatedly, with predictable results. Contractors increase housing prices by roughly the amount of the subsidy increase and reap windfall profits at the taxpayer’s expense, while needy families still can’t afford to buy.

The second reason to worry is that even sensible measures won’t be financed properly. For instance, the protesters’ demand for lower indirect taxes is eminently proper. Israel’s indirect tax burden totals 17.4 percent of GDP, compared with an OECD average of 10.3 percent. Lowering tariffs enough to make artificially high-priced items competitive, moreover, would presumably boost import volumes, and in turn boost tax revenues. But the protesters specifically want a lower value-added tax, and previous VAT reductions generally haven’t paid for themselves. The retail and manufacturing cartels typically lower prices by only a fraction of the tax reduction, so sales volume doesn’t increase enough to compensate for the lower rate.

Similarly, the government recently agreed to boost the pay of starting policemen—something it had apparently been planning for some time, but that protesters could claim as a success. This, too, is sensible: policing is a core governmental function, and Israel’s understaffed force (2.7 policemen per 1,000 residents, compared with 5 in Europe) is a major barrier to effective policing. Low starting salaries were a serious impediment to recruiting and keeping good people. Still, it must be paid for, and the risk is that the government will finance such measures either by counterproductive tax increases or by increasing the deficit. The latter, a perennial favorite of Israeli parliamentarians, would be particularly dangerous. Israel’s debt-to-GDP ratio, 75 percent in 2010, is already high, and Israel faces much greater diplomatic and security risks than other OECD countries. What’s more, debt servicing is already slated to account for 11 percent of the government’s budget this year, making it the second-largest line item after defense. A higher deficit means even higher debt-servicing costs, which means either higher taxes or lower spending on productive purposes—hardly a recipe for improving the standard of living.

The third danger is that the government will simply fail to seize this opportunity to enact the kind of reforms Israel truly needs, due either to fear of defying the anti-free-market ethos of the protesters or to disagreements within the coalition, many of whose members support big-government solutions. If that happens, not only will Israel have wasted a golden opportunity that may not soon be repeated, but also the next prime minister (who will almost certainly be less pro-market than Netanyahu) may well adopt precisely the kind of tax-and-spend policies that nearly bankrupted Israel in the past.

So far, Netanyahu seems to understand that his political future depends on enacting the right kind of reforms quickly enough to have an impact before the next election. The most impressive sign of his determination was a law to streamline the permit process for residential construction. Until now, all construction required approval from several different planning committees, an expensive process that often took years and contributed to the high cost of housing. Netanyahu wanted to replace these committees with a single agency, but the bill had languished in the Knesset for two years. Astonishingly, when the protests erupted, the protesters made killing the Netanyahu plan their number-one demand. They claimed the streamlined process would give less weight to environmental concerns and reduce ordinary citizens’ ability to oppose new construction. Yet in early August, Netanyahu defied them and pressured his coalition to finally enact it into law.

Other, smaller signs of positive change are visible. That same week, for instance, the finance minister signed an order liberalizing cheese imports, while the treasury started preparing legislation to remove restrictions on imports of cement, a major construction need that also contributes to high housing prices. Israel’s cement monopoly, which controls 85 percent of the market, charges far more than Romanian and Turkish competitors do; it even brazenly charges Israelis more than it charges Palestinians.

In recent weeks, Netanyahu has repeatedly promised to break up monopolies and cartels, increase competition, lower indirect taxes, and ease bureaucracy without increasing the deficit. If he follows through on these promises, Israel will have a stronger, freer economy that will provide its citizens with better goods and services at lower cost. And if so, the protesters will have done their country a signal service.