Taking Stock / The Tsunami Is Coming

But Israel's starting point is much better, thanks to our structural reforms.

The U.S. economy is highly likely to experience a sharp downturn, the International Monetary Fund warned last week. The IMF thus joined a long list of economists who have predicted that the financial crisis will mushroom into a crisis in nonfinancial economic activity. The dreadful job figures that America published at the end of last week just goes to show how right they all were.

Israel cannot escape either the financial or the nonfinancial crises enveloping America. The U.S. is too big, Israel is too small and the world is too interconnected. The year 2009 will bring a slowdown, after five years of rapid growth.

Yet neither should we ignore the strength that the Israeli economy has demonstrated this year, in both the financial and the nonfinancial spheres. Unemployment in Israel is at its lowest point in more than a decade. Here, banks are not collapsing. And mainly, there is no feeling of panic like in America.

Why is that? America's economy is much more developed, smarter and stronger than Israel's, isn't it?

The explanation lies in the economic policies the two countries executed over the last five years. It lies in the very different ways Israel and the U.S. chose to handle the collapse of the dot.com bubble and the ensuing recession in 2001.

America's economic leaders were determined to propel the economy out of the recession caused by the high-tech implosion and the terror attack on the Twin Towers. U.S. President George Bush and Alan Greenspan, then chairman of the U.S. Federal Reserve Board, instituted an extraordinarily expansionary economic policy.

Bush cut taxes and stepped up spending, pouring trillions of dollars into the economy. He financed the deficits by raising money from foreign investors. Greenspan, for his part, cut interest rates to their lowest point in 40 years. For most of the next five years, he kept the price of borrowing negative - i.e., below inflation.

That steroid treatment worked for much longer than might have been expected. The cheap money bloated the real estate market. The average American turned his house into a sort of personal cash machine, taking a second mortgage to finance routine consumption.

Why did Washington adopt poisonous policies like that? For several reasons, probably, but the main one is because it could. The international money markets believed in America's might and were willing to finance its gigantic deficits. Central banks in China and Japan willingly bought bonds issued by Fannie Mae and Freddie Mac, the quasi-governmental mortgage behemoths, at especially low interest rates.

Meanwhile, these same financial markets forced Israel to adopt a very different economic regime. To extract itself from recession and shore up its banks, Jerusalem had to behave with fiscal responsibility. The first to make its loans to Israel contingent on a responsible budget policy was the U.S., followed by every other financial market player.

In 2002, at the height of the crisis, I compared Israel to California. The similarity was that both had been hurt by the dot.com bubble. But in California, the pain passed quickly. Real estate prices shot up, cheap money stimulated the economy. The "Governator," Arnold Schwarzenegger, seemed to have terminated another baddie.

Yet two weeks ago, as the bailout blew up in its first attempt to pass Congress, Schwarzenegger told Bush that unless California received $7 billion from the federal government, it would go bankrupt.

We might have succumbed to the temptation to gloat about the difference between Israel's responsible economic policy and America's spendthrift one - if America were not the biggest economy in the world, and also Israel's main shield.

When stocks are tanking and investors are losing money, they want somebody to blame. Here, politicians and weakened bankers are using the financial meltdown in the U.S. to attack former finance minister Benjamin Netanyahu, for "pushing the masses into the stock market."

Netanyahu racked up quite a few achievements during his stint as finance minister - most importantly, instituting a responsible fiscal policy and reducing unemployment by increasing incentives to work. He also made mistakes, such as choosing to cut old-age allowances rather than hack at flab in the system.

But love Netanyahu or loathe him, you cannot accuse him of pushing Israelis' pension money into the capital markets. The capital market reform was based first and foremost on extracting the government from the savings and pensions market. And it began 15 years before Netanyahu entered the Finance Ministry.

Netanyahu's reform, called the "Bachar Reform," detached the provident and mutual funds from the control of the big banks. But by that point, the money in the provident and mutual funds had long since been invested in the capital markets.

Right now, people are probably regretting it. But without a broad, liquid capital market, Israel could not have a developed economy. If the government had continued to control the capital markets as it did until 1985, today we would be much poorer.

The current crisis centers on commercial banks like Washington Mutual and Wachovia and investment banks like Bear Stearns and Lehman Bros, which have been falling like dominoes. In Israel, on the other hand, there has been no concern that the big commercial banks will fall.

During the last financial crisis, six years ago, Israel's banks were practically the only source of credit for businesses, so a protracted recession did threaten them. But this time around, credit is more diversified and the banks' balance sheets are healthier.

If the financial storm worsens, Israel's banks will pay a price, to be sure. But their present strength in the face of the tsunami is a credit to the structural reforms in Israel's financial system.