Does the Israeli economy really need peace? The Prime Minister's Office routinely boasts that growth has outpaced that of other "developed" countries for the past five years, even during 2006, when the country went to war. Business journals report on the more than 80 Israeli and global venture capital funds financing hundreds of start-ups. The April 5 issue of The Economist questions Israel's economic fundamentals, but expresses doubts about such things as the comparatively thin research budgets of its universities, and the transparency of its bureaucracy. "The most serious threat," the magazine writes, is not political violence, but "the state of the education system." The Bank of Israel projects a slowdown to 3.5 percent growth in 2008, but the governor quickly adds that this is still better than the Western average, and blames sluggishness in the U.S. economy. The sluggishness of the peace process, such as it is, doesn't feature in his speeches anymore.

It seems that almost everyone has bought into Benjamin Netanyahu's argument that Israel can enjoy the fruit of its brainpower irrespective of its conflicts; that genius technology incubated by the Israel Defense Forces, and coupled with greater market freedom is the only economic driver Israel really needs. "High-tech" is impervious to war, Bibi once told me in an interview, because "real assets are carried around in people's heads."

And Netanyahu's argument is reassuring, even vaguely hip. It implies that smart people win, markets require no moral apologies, and preparing for war can spur creativity. It therefore suggests - and this is really nice for Netanyahu - that Israelis need not choose between the occupation and their living standards. Alas, that argument is ridiculous.

First, Israel should not compare itself to the average developed country, such as France. Israel is a kind of city-state, with the highest rate of research investment to GDP in the world; its leading businesses compete in the most advanced and globalized parts of the knowledge economy. You have to compare its performance to, say, that of Singapore, or Silicon Valley. On that score, its performance since recovering from the Al-Aqsa Intifada has been disappointing. Singapore is projected to grow by about 6 percent through the approaching global downturn. Since 2000, Israel has seriously lagged behind Ireland, which also suffered from the burst high-tech bubble, but put its "troubles" behind it.

Second, Israel has economic burdens its real competitors do not. A fifth of its budget goes to the military - a source for technology, to be sure, and a finishing school for critical team skills, but also a huge drain on infrastructure budgets. If Israel were a member of the EU, its ratio of national debt to GDP would put it in violation of Maastricht agreements. At least a fifth of the budget goes to servicing the national debt.

The rate of participation in Israel's labor force is among the lowest of Western countries, about 56 percent, due largely to the low employment levels among the ultra-Orthodox and still marginalized Israeli Arabs. The Economist is right to note that Israel's high school students score among the lowest of OECD countries. As things stand, the government is now at a loss to rebuild public education, or even elevate university salaries to an international standard to stem the brain drain. The country has one of the world's highest rates of inequality, yet there are no added investments to further integrate Israeli Arabs. A third of Israel's children continue to live below the poverty line.

These problems are explosive. Only much higher levels of growth can mitigate them. But that kind of growth requires peace. Israel needs to focus on lower-tech, high-employment industries, the same ones that Palestinian entrepreneurs will be counting on, and counting on Israeli partners to learn from - that is, if a political settlement is finally reached: infrastructure, housing construction, food processing, tourism. Jerusalem gets two million tourists a year; Prague, nine million.

But even for high-tech, peace is essential. To grow fast, Israel must engender not just dozens of start-ups, employing a few thousand bright youngsters, but also big businesses, employing tens of thousands of sales managers, office personnel, custodians, drivers. We need more companies like Amdocs, Iscar, Teva and Keter. Netanyahu is right that such companies never mass-produced global commodities, like low-wage Chinese companies do. Israelis compete on smarts, developing unique software solutions, process technologies, and specialized, high-quality components for other global businesses.

But to offer solutions, Israelis need to know what the problems are. They need to build personal relationships all over Europe and Asia, which begins with enticing the Global 1000 to operate in Israel. They need networks upon networks, references from the relevant partners.

Israelis, in other words, can't have an economy like Singapore's and an ethnic war like Serbia's. Intel's multi-billion dollar production facility in Kiryat Gat is now in range of Gaza missiles. Corporate boards notice such things. None of the 36 largest foreign companies currently operating in Israel (from Intel to Siemens) established operations here during the violent years of 2000-2004. By the way, if "genius" is the only thing that matters, then India has more geniuses than the whole Israeli population. And in case of endless war, what is carried "in people's heads" can be carried to other places. Already, over 30,000 Israelis live in the Bay area of California.

I do not mean to rub it in. The violence has not been Israel's fault alone. But the complacency is. The urgent fact is this: continued occupation will lead to greater diplomatic isolation, which will mean, in turn, gradual economic decline. Israelis cannot eat algorithms. Isn't it time the country's high-tech managers and peace activists got to know each other better?

Bernard Avishai is consulting editor of Harvard Business Review, and the author of "The Hebrew Republic," published this month by Harcourt. He blogs at www.bernardavishai.com.