By Gabriel M. Scheinmann
Gabriel M. Scheinmann ’08, a Government concentrator from Eliot House, graduates from Harvard this year.
In sharp contrast to the rest of the Middle East, Israel has experienced unprecedented economic growth and has even outperformed much of the developing world, based on multiple financial indicators. According to the International Monetary Fund World Economic Database, Israel has the highest Gross Domestic Product (GDP) per capita of all Eastern Mediterranean countries. Its financial ranking was upgraded recently to an A by the world’s leading credit agencies.  Furthermore, Israel, after the United States, has the second largest number of companies listed on the U.S. stock exchange.  Prominent American venture capitalists, such as Warren Buffet, have invested heavily in the Holy Land, instilling high confidence in the future growth of the country.  Few scholars have focused on the causes driving Israel’s economic success. Some historians have falsely argued that Israel’s success is a direct result of a reduction in defense spending as a percentage of GDP. However, a close examination of the statistical record demonstrates that the periods of greatest economic growth in Israel follow the implementation of liberal market reforms. As witnessed in the 1980s and the early 2000s, the roots of Israel’s blooming economy lie in liberalization policies that have started to free the Israel economy from direct government control.
Economic Growth and Military Strength
Historian Paul Kennedy was the first to put forth the argument that a powerful state cannot maintain strong economic growth if it has committed significant national resources to its military. Documenting the rises and falls of the great powers in modern history, Kennedy concludes that great powers decline when security and military ambitions take precedence over economic growth. He calls this situation military “over-stretch.” As an increasingly powerful nation with high economic growth and a significant military budget, Israel has become a great regional power, with an economy and a military on a European scale. However, the causal relationship Kennedy draws between military spending and financial decline does not accord with Israel’s continued economic success. An application of Kennedy’s analysis to the modern Middle East would suggest that Israel’s economic growth would only be sustainable if accompanied by a substantial decrease in defense spending.
Kennedy’s theory, published in 1987, maintains that it is impossible for a country, such as Israel, to maintain high GDP growth and high military spending. His theory rests on the idea that, in any country, “allocating over the long term more than 10 per cent (and in some cases—when it is structurally weak—more than 5%) of GNP to armaments…is likely to limit its growth rate.”  At first glance, the theory seems to explain the meteoric rise of the Israeli economy and the continued decrepit state of most Arab economies. While Israel has sharply reduced the percentage of GDP spent on defense from 21 percent in 1980 to 8 percent in 2006, Arab states have maintained relatively large armies and their economies have stagnated. The chilling of the Arab-Israeli conflict  and the end of the Cold War permitted Israel to cut military spending and allowed it to avert “over-stretch.” Israel could then start to reallocate military spending towards internal growth and development, and thereby spur economic growth.
However, Israel’s defense spending has remained far above the 5 percent threshold Kennedy claims necessary for economic growth. His theory states that “if, however, too large a proportion of the state’s resources is diverted from wealth creation and allocated instead to military purposes, then that is likely to lead to a weakening of national power over the long term.”  In high-performing Western countries, military expenditures never exceeded 5 percent—except during World War I and World War II. However, Israel devoted nearly 10 percent of its GDP to military spending in the periods of highest economic growth between 1988 and 1992, and 2005 to the present. Contrary to Kennedy’s otherwise compelling thesis, Israel has not experienced the economic decline predicted by its comparatively large defense spending.
As Appendix C demonstrates, Israel reduced the percentage of GDP devoted to military spending from 23.1% in 1981 to 8.1% in 2006. During this period, Israel also witnessed a nearly 400% increase in GDP per capita. This data appears to support the simplistic relationship between GDP growth and military spending. Financial historian Niall Ferguson, though disagreeing with Kennedy’s thesis, supports the idea “that there is a close correlation between democracy and defense/GDP ratios: less democratic states tend to spend significantly more on the military.”  While there seems to be a general correlation between democratic and economic development and a reduction in military spending, there is no evidence that reduced spending caused such advances in Israel.
Kennedy’s argument fails to explain the nuances in the link between military spending and economic growth. His theory does not address the patters of the Israeli economy in the past 20 years. From 1986 to 1992, Israel doubled its GDP per capita while only modestly decreasing military spending as a percentage of GDP from 14.2% to 10.7%.  Kennedy’s theory would have predicted a far smaller economic boost. Second, from 1995 to 2002, Israeli GDP per capita actually shrank, while military spending as a percentage of GDP remained constant. Third, the Israeli economy has exhibited dramatic growth since 2002, reaching Western levels of prosperity. However, Israeli military spending as a percentage of GDP has stayed between 7.9% and 9.5% since 1994 while GDP per capita has risen nearly 50%, from $15,567 to $22,975 in 2008.  Since 2002, the figures are even more striking. While military spending has declined by only 1.4%, GDP per capita has grown 33% from $17,267 to $22,975. The Israeli case has defied Kennedy’s theory.
Financial Reforms: Credit Creation and Fiscal Competence
In 1985, the Israeli government instituted a series of drastic financial reforms known as the 1985 Economic Stabilization Plan to stimulate the economy, which had experienced three consecutive years of low growth rates: 1%, 2.6%, and then 2.3%.  Immediately prior to 1985, the annual inflation rate had exceeded 400% and net external debt had reached 80% of GDP.  The stabilization plan introduced fiscal discipline, increased central bank independence, reduced government intervention in the capital, labor, and financial markets, and enhanced competition in markets that were previously dominated by monopolies.  The government liberalized capital flows, allowing increased foreign investment, enabling investment to exceed national savings, and making financial and capital markets more competitive.  Israel also adopted a fixed exchange rate, originally at NIS 1.5 per U.S. dollar, in order to stabilize the currency and quell inflation. 
The liberalization program produced an explosion of credit for Israeli citizens, encouraging investment and consumption levels that were previously impossible. Direct government involvement in the form of directed credit and earmarked deposits decreased from 65% in 1985 to 5% in 1998.  Israeli households received new lines of credit following the liberalization of mortgage lenders. The percentage of homes financed with unrestricted credit increased 40% between 1984 to 1998. For the first time, Israelis could invest freely, sparking a housing boom.
Following the implementation of the reforms, the Israeli economy emerged from its “stagnation.” The share of government expenditure as a percentage of GDP declined 20% in the following ten years.  GDP per capita doubled in 7 years, from $7,518 in 1986 to $14,636 in 1992.  Net external debt as a percentage of GDP declined from 72% in 1985 to 35% in 1989, with further reduction to 16% in 1998. 
By 2002, however, the Israeli economy had plunged under the weight of economic and security concerns. In 2002 alone, Israel suffered 60 suicide bombs. A major pension fund defaulted, unemployment reached 10%, and the economy shrank for two consecutive years, sliding into recession.  Further financial reforms were necessary.
Menaced by an unrelenting economic downturn, Israel overhauled its economy with major banking and market reforms. The 2005 Bachar banking reforms, shepherded by former-Finance Minister Binyamin Netanyahu, corrected the massive misallocation of credit administered by Bank Leumi and Bank Hapoalim, Israel’s two leading banks. The reforms liberalized the banking industry by breaking the banking giants’ duopolistic control on the market. Specifically, the reforms obliged Bank Leumi and Bank Hapoalim to sell all provident and mutual funds by 2008,  thereby opening Israel to fair competition. Prior to these reforms, the three largest Israeli banks controlled more than 80% of national savings.  Bank Leumi and Bank Hapoalim made 70% of all loans to only 1% of borrowers. Netanyahu also sought to eliminate the fiscal deficit by cutting government spending, which immediately dropped from 53% of GDP in 2003 to 47% of GDP in 2006. GDP per capita increased from $17,267 in 2002 to $22,975 in 2008, an increase of 33%. 
The Netanyahu-led financial reforms, which expanded the amount of credit available to Israeli citizens and reduced government involvement in the market, are the clearest drivers of Israel’s growth in the last five years. These liberalization efforts mimicked the 1985 Stabilization Plan, which similarly led to an explosion of GDP growth. Following the reforms, Israeli capital markets have issued more than NIS 100 billion of non-banking credit, leading to job creation, productivity enhancement, and growth.  Unemployment has decreased from 11% in 2004 to 6.9% in late 2007.  The only other Middle Eastern countries experiencing similar booms are Libya and Saudi Arabia,  petro-states which have reaped the benefits of the staggering recent increases in oil prices.
The Israeli economy has now experienced 20 years of near-uninterrupted economic growth. In 1980, GDP per capita stood at $6,356 while in 2007 it was at $22,975—on par with several European countries.  In 2008, per capita income adjusted for purchasing power parity (PPP) in Israel is projected to exceed that in France, Italy, and Germany.  Israel is the only Middle Eastern country considered an “advanced economy” by the IMF  and it was recently the first Middle Eastern country to be invited to join the Organization for Economic Cooperation and Development (OECD).  Israel is currently enjoying its fourth consecutive year of real GDP growth of over 5%.  With inflation low, unemployment dropping, and exports increasing, Israel’s market is doing better than ever, defying expectations that a state can succeed economically while facing real and imminent threats to its own survival.
Strategic Lift: A New World Outlook
As Israel continues to face growing and constantly adapting security threats, from the nuclear threats posed by Iran and Syria to the activities of terrorist groups at its borders, the country now finds itself in a vastly different geopolitical environment from that 30 years ago. Though it is still not at peace with the vast majority of the countries in its region, three major geopolitical events have transformed the Israeli economy and military, reducing military spending and spurring confidence in a once-fragile economy. A peace agreement with Egypt in 1979 neutralized Israel’s greatest threat and prevented future regional wars. In addition, the 1994 peace agreement with eastern neighbor Jordan legitimated Israel’s permanent status in the region. This period also witnessed the early negotiations between Israel and the Palestinian Authority. These peace-building efforts loosened the Arab economic boycott and permitted Israel to trade fully and freely with some of its neighbors.
The dissolution of the Soviet Union in 1991 also had a remarkable effect on Israel’s economic and strategic outlook. First, the immigration of over 1 million, largely skilled, Soviet Jews to Israel boosted the total output of the economy. Second, the reemergence of Eastern European countries and former Soviet republics created new outposts for Israeli exports. Furthermore, the disappearance of the Soviet Union, and its material and financial support for Israel’s enemies, such as Syria, Libya, and the Palestine Liberation Organization, changed Israel’s strategic stance dramatically. The tiny state was no longer threatened by a nuclear superpower or by her proxies. At the same time, Israel’s relationship with the U.S. has grown ever stronger. The “New World Order” has allowed Israel to reorient its military and no longer tremble at the prospect of nuclear destruction, allowing it to reduce military spending slightly. 
The dazzling success of the Israeli economy is not the result of a reduction in defense spending. Rather, it is primarily driven by the adoption of liberal market reforms meant to stimulate the economy and release it from government control. Liberalizing financial reforms preceded the two periods of economic growth. In 1985, the introduction of free capital flows, the adoption of a fixed exchange rate, and a reduction in the fiscal deficit liberated the Israeli economy from its stagnant state. Similarly, in 2002, a liberalization of banking laws, which heralded an unprecedented creation of credit, and a reduction in government expenditure galvanized the new market economy. With current Israeli defense spending at 8.1% of GDP, Israel has managed to achieve Western levels of economic success while still maintaining Middle Eastern levels of military spending, contrary to Kennedy’s expectations.
The percentage of national income Israel expends on its military is unlikely to change in the near future. The 2006 Second Lebanon War, Israel’s largest conflict in 25 years, barely increased military expenditures, while the economy continued to grow rapidly. Israel’s economic outlook is encouraging: tax burdens are decreasing, national debt is decreasing and the savings rate is still rising. Not only will Israel free itself from dependence on foreign investment, but it will also become a major foreign investor. Israel has managed to avoid Kennedy’s prediction of “over-stretch” casting doubt on the future applicability of the theory. More research must be done to examine the relationship between economic growth and defense spending, and the mechanisms through which defense spending slows the economy.
More importantly, Israel’s ability to maintain high military spending while developing a flourishing economy could serve as a model to the United States, which has increased its own military spending over the past few years. Though rhetoric of an “Israeli Empire” is usually reserved for the far-left, Israel is in the unique position to extend both its political and economic influence far beyond its borders.
1. Gad Lior, “Israel’s Credit Ranking to be Upgraded.” Ynet News, November 25, 2007.
2. Shirley Yom Tov, “The Nasdaq Loves Israel.” Haaretz, September 17, 2006.
3. Sharon Wrobel, “Buffet: Berkshire in Israel Forever.” The Jerusalem Post, September 18, 2006.
4. Paul Kennedy, The Rise and Fall of Great Powers (New York: Random House, 1987), 799
5. There have been no regional Arab-Israel wara since 1973. Moreover, Middle Eastern wars have shifted away from the Levant and into the Gulf.
6. Kennedy, xvi
7. Niall Ferguson, The Cash Nexus (New York: Basic Books, 2001), 405.
8. See Appendix C. Economic data from all appendices is from the International Monetary Fund, World Economic Outlook Database. Data on Israeli military spending is from the Israeli Central Bureau of Statistics.
9. See Appendix C
10. See Appendix D
11. Avi Ben-Bassat, The Israeli Economy, 1985-1998 (Cambridge, MA: MIT Press, 2002), 1.
12. Ben-Bassat, xiii.
13. Ben-Bassat, 15.
14. Joseph Djivre and Daniel Tsiddon, “A Monetary Labyrinth: Instruments and the Conduct of Monetary Policy in Israel 1987-1998,” in The Israeli Economy, 1985-1998 (Cambridge, MA: MIT Press, 2002), 96.
15. Ben-Bassat, 18.
16. Ben-Bassat, 2.
17. See Appendix C
18. Ben-Bassat, 42.
19. See Appendix D
20. Ido Efrati, “Bachar Reform clears Knesset,” Ynet News, July 26, 2005.
22. See Appendix C
24. “Unemployment Falls to 6.9% in October,” Ynet News, December 19, 2007.
25. See Appendix A
26. See Appendix A.
27. See Appendix B
28. IMF World Economic Outlook Database. http://www.imf.org/external/pubs/ft/weo/2006/01/data/dbginim.cfm
29. “Israel Invited to Join OECD.” Ynet News, May 16, 2007.
30. Economist Intelligence Unit. http://economist.com/countries/Israel/profile.cfm?folder=Profile%2DEconomic%20Structure
31. See Appendix C