During a span of less than two decades – between 1952 and 1966 – Israel transformed itself from a third-world economy into a first-world one. Given where the country started, the economic transformation in the first decade was nothing short of a miracle. If anything, the conditions were conducive to young Israel’s collapse. How did it achieve the opposite?
From 1950 to 1952 Israel’s population doubled from 650,000 to 1.4 million. By the decade’s end, 2 million people would be living in the country. Unlike the immigrants who arrived before the establishment of the state, those who came after Israel was established in 1948 were often impoverished refugees. During the six years of Holocaust, the Jews in Europe were preoccupied with survival, not education, and Jewish immigrants from Arab nations, especially those from Yemen, tended to be less educated than those who came earlier.
The doubling of the population over the course of two years would be a terrible strain on any country, let alone one lacking resources, like Israel at the time. On top of absorbing and integrating desperate immigrants, it also had to build infrastructure to serve the people and the military. In 1950, investment as a function of GDP was 44.6%.
True, earlier immigrants had begun creating institutions for the state, including the Histadrut labor federation, a health maintenance organization, Bank Hapoalim, the Technion – Israel Institute of Technology in Haifa and Hebrew University in Jerusalem, and the Haganah, which would become the Israel Defense Forces. But nothing could prepare the nation for the tidal wave of immigration. Not only was there nowhere to house the newcomers, for whom tent cities were hastily erected, but the school and healthcare systems were also inadequate. There wasn’t even enough food.
To feed the people, the state had to import food, but it didn’t have the resources to do so. From the day it was established, Israel had a chronic shortage of foreign currency reserves as well as a large deficit because it imported significantly more than it exported.
According to Prof. Rafi Melnick of the Interdisciplinary Center in Herzliya, imports as a function of GDP in those first years ran at 25%. Exports were 3.5%.
That gap of over 20% in the balance of payments brought young Israel to the brink. Haim Ben-Shahar, professor emeritus of economics at Tel Aviv University, recalls foreign currency reserves of $11,000 at the Bank of Israel. In order to unload $50,000 worth of imported fuel or sugar from ships, Golda Meir would be sent to the United States to beg Jewish philanthropists for donations.
The conditions were so difficult that the government had to impose austerity measures, which meant rationing so there would be enough for everyone. “I am a huge supporter of the austerity policy,” says Nadav Halevi, professor emeritus of economics at Hebrew University. “The population doubled, yet nobody starved. We shared out fairly the little there was. Without it, we wouldn’t have survived.”
The Zionist dream in peril
Yet austerity didn’t last more than a year. During the second year, a black market developed, and with it, public resentment. The government, headed by Prime Minister David Ben-Gurion and with Levy Eshkol as finance minister, realized a crunch had come. “We spiraled into a chronic problem that would stay with Israel until the 2000s: the twin deficits in the balance of payments because of the surplus of imports over exports, and a budget deficit, because of the huge investments without enough tax income and foreign capital to cover them,” Melnick says. “Israel was on the verge of economic collapse.” As this was happening, unemployment rose to 11%.
This led to the economic plan of 1952-1953, dubbed the 1950s Stabilization Plan. To eradicate the deficits, the government adopted economic restraint. It depreciated the exchange rate and slapped heavy constraints on imports, which gave birth to the never-ending government control over imports and exports through a complicated system involving dozens of different exchange rates, which were separately and arbitrarily set for each branch of industry.
The defense budget was slashed and hundreds of career officers were laid off. Following the cuts, Chief of Staff Yigael Yadin told Ben-Gurion that he couldn’t be responsible for Israel’s security. Ben-Gurion responded by firing him. With no choice in the matter, immigration to Israel was also restricted.
Many economists believe the Stabilization Plan did reduce the twin deficits and boosted Israel past the austerity period. But the political and social price associated with it, especially the budget cuts and constraints on immigration, was unbearable.
“Ben-Gurion understood that this was the end of the Zionist project,” says economist Joseph Zeira. “The purpose of the State of Israel was to be a home for the Jewish people and suddenly the waves of immigration were being blocked because of economic distress.”
The entrance into the Reparations Agreement with the Federal Republic of Germany in 1952, which came into effect on March 27, 1953, was a watershed moment for the Israeli economy. The economic bottleneck choking Israel’s economic development opened all at once, and there was capital for investments.
The country became accustomed to running a chronic deficit – a surplus over imports over exports – because the reparations helped pay the bill (they were later augmented by compensation for Holocaust survivors, which increased private consumption).
Israel took other steps to contend with its need for funding. Halevi notes the assets of hundreds of thousands of Palestinians who fled the country during the War of Independence, leaving behind land and homes; the state later seized territory from Israeli Arabs, bringing it rich real estate assets. To this day the government owns more than 90% of the land in Israel. Assaf Razin, professor emeritus in economics at Tel Aviv University, also notes the heavy taxes imposed on the domestic population and points to the nationalization of the capital market, which brought the government more income. Israel also tapped Jewish philanthropists and took out some foreign loans.
The creative fundraising enabled Israel to pursue and sustain a practically unprecedented policy for such a young, impoverished country. It entered into an investment boom based on the chronic deficit in its balance of payments, which persisted for years. Any other country would have imploded, but Israel had the privilege of capital streaming in from overseas.
“It was a period of mad investing without consideration of the deficits it was creating,” Melnick says. “The government took a terrific risk, assuming that things would somehow work out in the future. Apparently, there was no other way to finance it.”
And somehow, they did work out. From 1952 to 1966, Israel entered a period of economic growth of 11% per year and a per capita growth of 5% or more. With sufficient foreign capital, all the growth drivers joined together to make the economy fly.
That investment in infrastructure was one massive driver of growth; another was construction and arming the IDF, including building the nuclear reactor in Dimona.
But the main driver of growth was absorption of the immigrants. Zeira quotes studies conducted around the world showing how at first, immigration diminishes a nation’s human capital. They don’t speak the language, can’t find work in their professions, and so on. But after two decades, the gaps close. In young Israel, which tripled its population within a decade, the acclimatization apparently went even faster. In addition, immigrants who arrived later tended to be better off and better educated, which lifted domestic productivity.
Israel invested in bettering its human capital by building schools and universities. The effort paid off: Zeira shows figures on young nation’s rapid adoption of technology and the closing of the technological gap.
The policy was directed from above. The Mapai governments ran the economy centrally, focusing on momentum in infrastructure and employment development.
The man leading the employment policy was the minister of industry and later the finance minister, Pinchas Sapir (1906-1975), who wooed foreign Jews, persuading them to come to Israel and build industries, mainly textile. Sapir took care of work and import permits for their factories with his notorious system of notes, which wouldn’t pass the state comptroller today but was based on his intense desire to build a local industry that would create jobs, mainly beyond central Israel.
Bring on the recession
Concentrated management, oriented toward investments and employment, was key to Israel’s success in its first decade. But the concentration arguably stifled initiative. Building a factory in the south required a note from Sapir and not everybody had the right contacts. Establishing a plant without help was practically impossible because of the nightmarish bureaucratic system to obtain import and export permits, which involved dozens of exchange rates. Israel’s first 15 years were an economic miracle, but it failed in allowing advanced export industries to develop in order to balance the deficit. The main exports were diamonds and Jaffa oranges.
Sapir’s focus on textiles ultimately proved misguided: Some of the companies he had encouraged later collapsed.
During the 1960s, the government slowly loosened its choke hold on the economy. But back then, during Israel’s second decade, the economy was centralized and had the same childhood problems, including the twin deficits and mounting inflation.
Israel’s inability to overcome these malaises resulted in one of the strangest, most dramatic decisions in its economic history: forcing a recession. In 1966, the government decided the economy had overheated and Sapir decided to cut government spending, raise taxes and broaden restrictions on imports. He hoped to tame inflation and narrow the deficit.
However, with the recession demon out of the bottle, the self-confidence of the young state was shattered and Israel found itself on the verge of a downward economic spiral, at which point came a historic turning point: the Six-Day War, which spurred economic growth for six years. Israel’s rapid economic growth would finally end, never to return, with the Yom Kippur War.
In retrospect, the 1966 recession was wasted and has to be chalked up to an impulsive policy by the Eshkol government.
This leads us to the second reason for Israel’s economic miracle during its first two decades, despite the challenges: political stability. “Young Israel was the only country in the world, other than India, which had been founded as a democratic state. Democracy was a defense against corruption,” says Razin.
“Mapai believed it was leading the Zionist revolution,” says Zeira. “They were superb achievers. They knew how to adapt to changing needs; when it turned out not to be suitable any more, they ditched socialism and in effect ran a capitalist economy. Granted, policy was concentrated, but the economy was free.”