The most severe economic crisis of the post-World War II era is doing much to recast the world economy both ideologically and in terms of the balance of power. The so-called “Washington consensus” that emphasized the centrality of free markets and smaller government has been undermined by the evident failure of financial markets to assess and regulate risks on their own. China’s status as a rising economic power has been confirmed while the United States and Europe are quite likely to be weighed down for the foreseeable future by debt accumulated before and during the crisis.
For Israel, a tiny player on the world economic stage, the most remarkable development has been its ability to remain largely aloof from the crisis and to manage its limited impact successfully. Israel’s mix of disciplined fiscal and monetary policies, combined with a relatively stern regulatory regime in the years prior to the crisis, served it well. Yet proper economic management alone does not ensure a thriving economy if the underlying social conditions are absent. While Israel has had some marked successes in old-economy industries–such as chemicals, pharmaceuticals, and defense–it lacks most of the critical elements for building on these achievements, namely significant natural resources, relative cost advantages, or economies of scale. Instead, the foundation of Israel’s economy is its high-technology industry. Yet the policies that served it so well through the global financial crisis have had little bearing on the future growth and development of the sector.
Israel’s technology sector is relatively disconnected from broader domestic economic policy, little concerned with local demand, financial markets, or regulatory issues, not only because it is so deeply rooted in the global market but because of the unusual way it is structured. Since the mid-1990s, the sector has developed into an industry of perpetual innovation characterized by a recurrent cycle of start-up companies that conceive and develop new technology, finance it with venture capital, and prove it in the marketplace before selling themselves to bigger, overseas companies with the finance and marketing, manufacturing, and management skills to exploit the innovation fully. This process began with the information technology industry and is now being duplicated by Israel’s emergent biotechnology and clean technologies sectors.
Israel’s technology industry has been criticized for its failure to spawn major multinational companies as its peers in Finland (Nokia), Taiwan (Taiwan Semiconductor), and India (TAT Consultancy, Wipro, Infosys) have done. Yet those criticisms are misplaced. Israel is a small economy with a limited labor supply, is distant from key markets, and subject to security concerns and regional political instability that deter customers, partners, and investors. If Israel can in fact sustain its model of perpetual innovation, there is no reason for the industry to abandon it. In that regard, Israel’s policymakers face two challenges. The first is to ensure that Israeli society can continue to produce the kind of people and sustain the institutional structures that have enabled the technology industry to grow and develop. The second is to ensure that a greater proportion of the labor force participates in the technology industry and to foster the development of other knowledge-intensive industries–design, medical services, education, and media/entertainment to name a few–capable of creating more jobs than the technology sector alone can do. In respect of the two goals, there are a host of worrying trends that policymakers have only dealt with in a tentative fashion and that have serious implications for the sustainability of the Israeli knowledge economy over the longterm.
A SHORT, PAINLESS RECESSION
The Israeli economy was the last among 29 economies surveyed by the Organization for Economic Cooperation and Development (OECD) to enter into a recession (fourth quarter 2008) and among the first to exit (second quarter 2009), making it by far the shortest downturn among the group. Israeli GDP contracted 1.2 percent in the two quarters,  but in fact, the recession lasted longer than that. Measured in per capita terms, which is a more telling measure of performance given Israel’s relatively high rate of population growth (about 1.7 percent annually), the recession effectively started in the third quarter of 2008 and only came to an end only in the second quarter of 2009. Over that one-year period, per capita GDP contracted 2.5 percent. Using the Bank of Israel’s (BOI) forecast for 2010, which sees GDP expanding 3.5 percent, per capita GDP will not recover to its prerecession levels until 2011.
Moreover, Israel’s unemployment rate rose with the onset of the recession but has not tracked the subsequent recovery. The rate peaked in May 2009 at 7.9 percent but as of November 2009 was still 7.4 percent; it will likely remain high in 2010 as well, averaging 7.1 percent, compared with an estimated average of 7.7 percent in 2009, according to the Bank of Israel forecast. The high unemployment rate is a cause for worry not only because it weighs down on the recovery but because it is indicative of Israel’s persistent problem of high levels of joblessness even when it is expanding. During the growth years of 2003-2008, the unemployment rate only succeeded in dropping below the 2009 recession-year average in the fourth quarter of 2007.
The impact of the global credit crisis on Israel’s financial markets was similarly limited. Israel’s real estate market never experienced the kind of bubble that left lenders overseas with large losses, and Israeli banks largely shunned the exotic financial instruments that brought down so many U.S. and European lenders and insurers. The Israeli credit crisis, such as it was, was felt principally in the non-bank credit sector, which had emerged in the years prior to the crisis as a major source of corporate finance (from 2002 to 2008 it grew to 20 percent of total corporate credit from 8 percent). Equity and debt raised on the Tel Aviv Stock Exchange declined steadily from the fourth quarter of 2007 and dried up almost entirely in the final four months of 2008, threatening to create a credit crunch similar to what was occurring in other developed economies at the time.
The proximate cause for the failure of the non-bank credit market was exogenous–the collapse of Lehman Brothers in September 2008, which caused investors to pull their capital out of pension funds and other institutional investors. Yet the rapid expansion of the market and the absence of well-developed mechanisms for regulating it certainly undermined confidence as well. In other words, the one serious case of market failure in Israel occurred in an area where the market was least regulated. Nevertheless, the non-bank credit crisis was very constrained. While there were instances of corporate borrowers unable to service their debt (principally in the property sector where Israeli companies had invested heavily overseas during the global property boom), the problem was chiefly on the supply side, namely that able borrowers were unable to obtain capital. As it turned out, the crisis was short-lived and fundraising activity began to rebound in the first quarter of 2009.
The experience of the technology sector demonstrated just how disconnected it is from domestic developments or policy. On the finance side, the sector experienced a worse slump than it suffered in 2001-2003 in the wake of the global technology bubble. Venture capital investing in technology companies fell to $735 million in 2009, a decline of almost half from $1.4 billion the year before and below the previous nadir of $768 million in 2003 when the technology industry was smaller. Investment in seed-stage companies amounted to just 5 percent of the total, less than a third the proportion in 2006. The lack of seed capital will almost certainly reduce the stream of start-ups going forward, a trend akin to a resource-based economy neglecting to invest in exploration. Exports of technology declined sharply, although that fact was largely hidden by the new Intel plant in Kiryat Gat, which began commercial production during 2009. Excluding electronic components (which grew almost three-fold in 2009 from 2008 because of Intel), exports of information technology (IT) products declined close to 14 percent in 2009 despite an improvement in the trade picture in the last third of the year–about the same rate of decline for overall manufactured exports.
A RESTRAINED RESPONSE FROM POLICYMAKERS
The Israeli government’s response to the deteriorating situation in the economy and financial markets in the final months of 2008 was appropriately modest in comparison to steps taken elsewhere in the developed world. Most of the measures were directed at the financial sector rather than at the real economy, and over time they proved to be unnecessary. The government offered as much as 12 billion shekels in guarantees to commercial banks to help them raise capital, but the banks in the end had no need of the assistance. It allocated 1.1 billion shekels in support of private investment funds buying corporate bonds from issuers facing difficulties rolling over debt. As of January 2010, only about 10 percent of the amount had been used. Likewise, only about 700 million shekels of a 2.6-billion-shekel fund for small and medium-sized business had been taken up.
For the broader economy, the government boosted research and development assistance to the technology sector, improved unemployment terms, and allocated 6 billion shekels for export guarantees. In fact, the government adopted some measures antithetical to a stimulus, raising the value-added and other taxes and increasing employers’ National Insurance Institute contributions. The OECD estimated in January 2010 that the total cost of these stimulus measures to date, including the cost of tax increases, had been no more than 0.5 percent of GDP. Israel’s fiscal deficit, slated to reach 6.0 percent of GDP under the 2009/2010 budget, was actually 5.15 percent.
The very limited scope of the stimulus was due mainly to political paralysis rather than prophecy. Elections were called in October 2008, just as Israel’s brief credit crisis was at its worst, and the government had difficulty winning parliamentary approval for the most elementary of economic measures, including passage of the 2009 budget. By the time the government of Benjamin Netanyahu was seated in March 2009, the domestic financial crisis had receded and the economy was beginning to show signs of recovery. In retrospect, government inaction during the critical autumn/winter months of 2008-2009 worked in Israel’s favor. The crisis atmosphere might have prompted more expansive measures that hindsight shows would have been unnecessary and might have saddled the government with a larger debt burden, thereby constraining fiscal policy and growth in the years ahead as will likely be the case in much of the West.
The brunt of the stimulus instead fell on the Bank of Israel, which undertook a package of conventional monetary-easing measures as well as unprecedented steps in the form of quantitative easing. The central bank pursued a restrictive monetary policy as late as September 2008, even as its peers were lowering rates and Israeli output growth was slowing. However, when the bank did change direction in the following months, it acted quickly and decisively. This included two rare, unscheduled reductions in October and November 2008, bringing the base lending rate down to a record low 0.5 percent by April 2009 from 4.25 percent a half a year earlier. As room for further rate cuts diminished, the Bank of Israel undertook special measures to loosen credit. The Bank of Israel eased terms for banks borrowing money from the central bank, pared back the issue of Makams (treasury bills) and bought Treasury bonds in the secondary market at a rate of 200 million shekels daily from March 2009, with the aim of creating additional liquidity. Although the program preceded Israel’s credit crisis and the economy’s downturn, the central bank aided exporters by embarking on a program of buying dollars to stem the appreciation of the shekel.
Reflecting the mildness of the Israeli recession, the Bank of Israel was also the first among developed-country central banks to reverse its policies. It ceased buying government bonds in July 2009 and a month later was the first to raise its base lending rate. As of April 2010, it had followed up the initial rise with increases totaling 100 basis points. While the bank has continued its policy of intervening in the foreign currency market, it transitioned from a regular, set rate to a discretionary policy in August 2009.
ISRAEL’S EXCEPTIONALISM IN THE FACE OF CRISIS
Israel’s ability to ride out the global recession so easily was principally due to three factors.
GDP grew an average of 5.2 percent annually over the 2004-2007 period, the eighth-fastest among OECD countries. If on a per capita basis the rate was a less impressive 3.4 percent annually (ranking only No. 12 in the OECD), Israel’s growth was more balanced and sustainable than that of many others–led by exports rather than from credit-infused expansion of property or financial services, two industries that prompted the global financial crisis. Israeli exports of technology (IT equipment and software, electronics, etc.) grew by 72 percent during the period.
On the other hand, Israeli growth was even stronger in two other sectors that are almost certainly unsustainable over the long term and should be cause for concern over Israel’s long-term prospects. Exports of pharmaceuticals–which are dominated by Teva, the world’s largest manufacturer of generic drugs–grew more than four-fold in the period. Exports of the chemicals industry, which are dominated by Israel Chemicals (ICL), increased by a factor of three. While Teva has had a long and consistent history of growth and expansion, it is a single company more vulnerable to changes in management quality and market conditions than an industry. ICL, meanwhile, enjoyed unusually high prices for its potash during the period, thanks to rising agricultural-commodity prices. Yet commodities prices are subject to sharp swings, and in 2009 chemicals exports fell by a third in dollar terms. The experience of the pre-crisis years demonstrates that Israel needs to ensure the foundation of its technology industry–its most promising sector for long-term growth–and to develop other knowledge-intensive sectors.
Fiscal and Monetary Policy
Since the 1990s, a near consensus has existed among Israel’s policymakers to reduce the country’s debt, contain annual budget deficits, and reduce the tax burden–a stance that became more disciplined during Netanyahu’s term as finance minster in 2003-2005. In contrast to many developed economies, Israel exploited the years of strong growth to reduce debt to 78.5 percent of GDP in 2008 from 99.8 percent in 2003. The budget deficit, meanwhile, fell to as low as 0.02 percent of GDP in 2007 from 5.3 percent in 2003. The Bank of Israel retained a relatively hawkish stance throughout the period, as evidenced by the tightening of its monetary stance until the onset of the Lehman crisis. Even though the economy was expanding quickly in comparison to its OECD peers, credit growth was constrained, averaging 4.2 percent annually, versus 5.9 percent in Europe and 9.4 percent in the United States.
Although the main policy thrust since the 1990s has been toward deregulation, the fact remains that two key sectors–banking and property–remain heavily regulated. The state controls nearly all of the country’s land and allocates it to private developers slowly and cautiously, which has created a high barrier to speculative development. Mortgage lending is severely constrained by regulation. Even as the economy was growing strongly, Israeli home prices fell an average of 1.4 percent annually in 2003-2007 while rising 5.7 percent in OECD-member European countries and 7.4 percent in the United States. In addition, Israeli banks are far more reliant on deposits for capital as against wholesale funds and on the whole avoided taking significant positions in the complex financial products that ultimately bedeviled American and European financial institutions. Since the recession of 2000-2003, the Bank of Israel has imposed increased restrictions on lending and discouraged the efforts of banks to expand abroad. The 2005 Bachar Reforms took the banks out of the institutional investment, a measure that was aimed at increasing competition in the financial-services industry but had the effect of distancing the banks from the difficulties that would later emerge in the non-bank sector as the global financial crisis reached Israel. Thus, in the sphere of financial-service regulation, Israel did not fully abide by the Washington Consensus. Policymakers must now direct their efforts toward creating effective supervision mechanisms over non-bank finance, a process that got underway in 2009.
Nevertheless, the Israeli economy remains prone to risk. Part of that is external, namely the prospects for a slow recovery in the developed economies as they contend with the high levels of debt accumulated in the pre-crisis period as well as from the stimulus measures they undertook to contain the crisis. Israel can redirect more of its exports to the stronger economies of Asia, a process that has already begun. The transition will, however, take time, and the economy will remain closely linked to the U.S. and European markets in the sensitive period ahead.
Israel has domestic vulnerabilities as well. Its ratio of debt to GDP remains high compared to many developed economies, and the geopolitical risk Israel contends with is more severe than any other developed economy. The government’s official targets are not expected to reach the 60 percent level widely regarded as desirable until 2020. Israel’s banking sector and the economy’s growth prospects are strong, but geopolitical uncertainty–the threats of fighting on Israel’s Gaza and Lebanon borders, not to mention Iran’s nuclear program–stand to grow in the foreseeable future. These risks are magnified by Israel’s history of weak and divided governments. The Netanyahu coalition was spared divisive budget politics for 2010 because it adopted a two-year budget in 2009 and on the broader political front has so far avoided undertaking controversial strategic moves that might undermine the coalition. The fiscal debate will, nonetheless, resume over the 2011/12 budget later this year, and there were disturbing signals during the 2009/2010 process (the last-minute intervention of the Prime Minister’s Office and the Histadrut labor federation) that suggest Netanyahu may be prepared to sacrifice correct fiscal policy to achieve other political ends. Over the longer term, Netanyahu’s successors will face continued political challenges so long as electorate is divided and refuses to award leading parties big enough mandates to form more stable coalitions.
AN INDUSTRY OF PERPETUAL INNOVATION
Israel’s high-technology industry is unusual by world standards because of its focus on start-up companies and on research and development. Israel counts 140 scientists and technicians and 135 engineers for every 10,000 people, the highest ratio in the world. It spends more on R&D than its developed-country peers, or about 4.7 percent of GDP in 2007, compared with 3.0 percent to 3.6 percent for the next three biggest-spending economies. Moreover, Israeli researchers are developing technology with commercial applications, as evidenced by the number of utility patents per million. Israel ranks fourth in the world on a per capita basis (166.6 per million people in 2008), behind only Taiwan, Japan, and the United States.From the perspective of venture capital investment, another barometer for how much of academic and other research is being transformed into commercial applications, Israel has by far the largest industry in relation to its economy. In 2008, venture investment came to just under $1.4 billion, or 0.69 percent of GDP, compared with 0.2 percent to 0.3 percent for the next highest-ranking countries (Denmark, Finland and the UK) and 0.12 percent for the United States. This start-up industry, however, creates two problems for the economy.
The first is that it does not translate its R&D achievements into long-term generators of revenue or profit as illustrated by the relatively low contribution of high-tech exports to total industrial exports. In 2007, they accounted for 25 percent, which put Israel in tenth place among OECD countries and only slightly ahead of the average of 22.6 percent for member countries. Israel has succeeded at innovating and moving innovations out of the lab and into lasting business enterprises. It has been less successful at getting innovation onto the manufacturing floor or into customers’ hands. Israel counts some larger companies pursuing a long-term strategy in a major market, such as Check Point, Nice Systems, and Amdocs, but the industry’s R&D resources are principally put to the use of start-ups. More typical of the Israeli industry are companies that opt to be acquired at an early stage than continue as independent enterprises, such Power Dsine (acquired by Microsemi in 2006), Mediguide (medical devices, acquired by St. Jude in 2008), and Solel (solar power, acquired by Siemens in 2009). The technology industry in Israel should really be termed a “start-up industry” whose principal product is small, technology-driven companies.
A survey of outcomes for venture capital-backed start-ups in Israel, the United States, and Europe bears out this point. Among companies formed from 2000 through 2006, the survey found that only a tiny fraction had gone public by 2008 (2 percent in Israel, 3 percent in the United States, and 5 percent in Europe). About half in all three regions remained in business as independent, closely held enterprises. Where the critical difference lay was in those that were acquired by another company or had ceased operations altogether by the end of the period. Among Israeli start-ups, 31 percent had gone out of business by the end of 2008, compared with 22 percent and 25 percent, respectively, for their U.S. and European counterparts. About 14 percent had been acquired through a merger or acquisition, fewer than the 17 percent in Europe and 23 percent in the United States.
While the rate of M&A is lower in Israel, the long-term impact of M&A on the country’s technology industry is quite different than it is on the two other economies in that it stifles the development of large, multinational enterprises. In contrast to the United States and Europe, where acquisition M&A activity usually leads to consolidation among domestic companies, the great majority of takeovers of Israeli start-ups are by foreign buyers. If the Israeli start-up continues to exist as a separate entity (branch office or subsidiary), its employees are left principally to serve in research and development roles and perhaps some mid-level marketing functions. Israelis do not get the opportunity to develop the skills in marketing, finance, and managing a large organization.
The second problem relates to the contribution of high-technology start-ups to the broad economy. It is difficult to measure the contribution of start-ups to economic output, because they do not generate revenue, or do so at a fraction of their potential, by virtue of the fact that they concentrate on research and development. Nevertheless, their value as potential generators of value-added can be roughly measured by the valuations placed on them by investors. As an example, seven start-up companies sold during 2008 had valuations that ranged between $1.9 million and $11.3 million per employee. None of these start-ups employed more than 150 people, and one–Fraud Science–had just 15 people on its payroll.
By comparison, among publicly traded companies on the Tel Aviv Stock Exchange in 2008, the market capitalization per employee for the biggest manufacturing and service companies was mainly in the range of $120,000 and $700,000. Employment in these companies ranged in the period from about 1,500 to (in the case of Teva) 38,000 employees. Among more mature technology companies, the ratios are about in the range of old-economy industries, but few of Israel’s mature, standalone companies in high-technology have become market leaders in a major segment. (One company that has done so is Check Point Software Technologies, which has a relatively large 1,900 people on its payroll and generated a market capitalization per employee of approximately $2.5 million in 2008.)
Looking at it a second way, namely the technology industry’s relative contribution from the prospective of employment and wages, the sector accounted for 9 percent of business sector jobs in 2007 (4.3 percentage points of that from computer services and research and development and the rest from manufacturing) while accounting for 22.4 percent of business sector wage compensation (12.2 points from computer services and research and development).
In short, start-ups do generate considerable value-added; the problem is that the wealth they create is concentrated among a small group of shareholders and employees. Nevertheless, there are good reasons why the start-up industry benefits Israel, even if it does not produce the kind of national champions favored by politicians and the press. The reliance on a small number of large companies would leave Israel’s high-technology sector and its economy in general vulnerable to the changing fortunes of individual enterprises, their markets and managers. This is especially the case in the technology industry, where markets change rapidly and unexpectedly. Although the start-up industry by its very nature is volatile and risk prone, Israel has developed the support mechanisms for creating, financing, and selling start-ups (technology incubators, university technology-transfer companies, venture capital, foreign investment banks, and a cadre of serial entrepreneurs) that moderate this risk and should enable the start-up industry to endure and even expand.
Of course, there are many factors contributing to poverty and inequality in Israel. As old-economy companies adapt increasingly sophisticated technology, they naturally rely on fewer and better-educated workers and more highly skilled labor–compensating it accordingly. This is a global phenomenon that Israel has certainly experienced as well. In Israel, the problem of poverty and inequality has been exacerbated by the country’s failure to integrate its large population of Israeli Arabs and ultra-orthodox Jews. Nevertheless, Israel’s start-up industry, as it is currently structured, does carry social costs for the economy. Due to the way it is structured, it has not provided, and cannot provide, the same broad base of jobs and compensation it might if the sector spawned more companies like Nokia or Oracle, which combine research and development with all the other functions of a large corporation. So long as Israel’s knowledge economy is concentrated narrowly on technology start-ups, it will continue to face problems of high unemployment, poverty, and income inequality.
SUSTAINING AND EXPANDING THE KNOWLEDGE ECONOMY
Nevertheless, in lieu of significant natural resources, low labor costs, or economies of scale, Israel must rely on knowledge-intensive sectors. The challenge is therefore to develop them in a way that will encompass a bigger share of the population. One way certainly is to encourage technology companies to remain independent and grow and to develop the management skills such enterprises require. The start-up industry is an asset to the economy and needs to be encouraged, but more start-up companies should be encouraged to mature into sustainable business enterprises. Israel doesn’t necessarily need multiple companies on the size and scale of Teva (2009 revenue of $13.9 billion), but it would benefit from more companies on the order of Nice Systems (2009 revenue of $590 million). Just as well, Israel should be emphasizing other branches of the knowledge economy. Before the onset of the global financial crisis, the government was examining how to develop a financial services industry. That still has bearing in the post-crisis world, even if the global industry will take time to recover. Industries engaged in medical services, education, and media/entertainment are other candidates as are those based on quality design. All these segments of the knowledge economy can and should be encouraged, not through direct government programs but by expanding and improving the environment that enables these industries to develop. Specifically, policy makers should be addressing four areas:
Primary and Secondary Education
There is virtually nothing that can be said in favor of Israel’s educational system. Students perform poorly by international standards, including Israel’s top students, vis-à-vis their peers. Money and human resources are poorly allocated and the system is resistant to reform. Teacher pay is low relative to other developed countries; and classroom sizes are above average even though on a per capita basis Israeli education spending is close to the OECD average. From the viewpoint of its impact on economic growth and development, however, it is difficult to find a strong correlation between the country’s poor education achievements and its economic performance. Indeed, the system has been performing badly for years without any evidently adverse effect.
Why is that? One likely answer is that the army fulfills a critical formal and informal education function. Another is that social factors—the Israeli proclivity for risk-taking and team work, for instance–play a major role in the country’s ability to generate new technology and start-up companies, thereby compensating for poor classroom-acquired skills. Yet the technology industry is very narrowly based, relying on a relatively small number of entrepreneurs and researchers to generate value. It doesn’t need legions of people to fulfill more routine functions in marketing, production, and finance that are less reliant on creative thinking as they are on conventional skill sets. The educational system’s failure to create large numbers of graduates with strong basic skills may well be a factor in holding back Israel’s ability to develop larger, sustainable enterprises both in high-technology and other knowledge-intensive industries. More than extra spending, the educational system is desperately in need of reform.
Universities play two roles in supporting the knowledge economy, the first being to supply people with advanced skills for the labor force and the second being to conduct research and development. With the development of colleges alongside the older, established universities, the system has succeeded to produce increasing numbers of graduates, even as the country’s population grew unusually fast from the 1990s. Among Israelis aged 25-34, 42 percent have tertiary degrees, compared with an OECD average of 34 percent. Yet the number of graduates produced doesn’t address the equally critical question about the quality of the education they are getting. Quality cannot be measured simply by the financial or human resources devoted to it, but, given the history of sharply deteriorating parameters over the last decades, it is reasonable to assume the quality of Israeli higher education has deteriorated, especially as the number of degrees awarded has grown.
Vis-à-vis academic research, the data are more clearly discouraging. The number of senior faculty per capita has declined by approximately 50 percent since 1973 to 71 researchers for every 100,000 people. In the Technion, the number of faculty positions rose by just one researcher. At the Hebrew University and Tel Aviv University, the number of research academics declined 14 percent and 21 percent, respectively. In 1978, public expenditure per student in the universities was equal to 61 percent of GDP per capita; in 2005, 29 percent, less than the average among OECD countries. This kind of disinvestment in academic research may have been tolerated by the first wave of Israeli high-technology companies, which were focused on telecommunications and information technology–two areas where innovations typically arise in corporate R&D labs quickly and at relatively low cost. The emerging generation of technology start-ups, however, is more heavily weighted toward biotechnology and clean technology, where innovation is a longer and more complicated process, more reliant on universities and scientific institutions. Israel’s universities require greater resources to meet the challenge.
The contraction of the government/Histadrut sector and the opening of the Israeli economy to global trade and investment since the 1980s have contributed to Israel’s economic growth but have also created severe social disequilibrium. The industries that once provided low-skill jobs with relatively good pay have disappeared, and the new growth sectors of the economy have no need for such labor. At about 21 percent, Israel’s relative poverty rate (defined as 50 percent or less of median income for the whole population) was highest among all OECD countries in 2005. In addition, income inequality in Israel was among the highest in the OECD, with only the United States, Portugal, Turkey, and Mexico exceeding it. As noted earlier, Israel’s unemployment rate has remained high even during years when the economy was growing quickly.
Aside from undermining the foundations of a democratic and fair society, long-term unemployment, poverty, and income inequality impose an economic cost by depriving society of the full potential of its labor resources. They prevent large segments of Israeli society from obtaining the tools necessary to play a role in high technology and the knowledge economy generally by depriving it of a large pool of human resources. To cite one example, Israel ranked only twenty-fifth globally in 2008-2009 for what the World Economic Forum calls “network readiness” (the ability of the country to make use of advances in technology and telecommunications), down from twenty-second in 2001-2002. Among its lowest marks was for individual readiness (thirty-fourth) and individual usage (twenty-eighth). Both are indicators of the extent to which a large part of Israel’s population stands outside the knowledge economy.
Israeli-Arabs and ultra-orthodox Jews participate little, if at all, in Israel’s knowledge economy, either from the perspective of education, lifestyle or employment. That situation cannot continue because both groups are becoming an ever greater proportion of the country’s population. In the 2008-2009 school year, the Central Bureau of Statistics estimates that 17.5 percent of those entering first grade were ultra-orthodox Jews and another 28.4 percent Israeli Arabs. That amounted to almost half the entering class and was about 18 points higher than the two groups’ share of the total population. While both sectors suffer from low labor force participation rate and the tendency to large families, thereby contributing disproportionately to Israel’s high rates of poverty and income inequality, the principal challenge they pose to policymakers is the issue of social exclusion. Both groups have been failed by the education system, but just as critically neither group fully participates in the social mechanisms that have worked to create Israel’s high-technology sector, whether it is the army, the universities, or the values shared by mainstream Israeli society. While the national and religious sensitivities of these two populations will make integrating them an especially difficult challenge, the government has no choice but to develop policies that bring them into the Israeli social constellation as much as possible.
Having succeeded in mastering the correct macroeconomic policies and seeing itself through the most severe global economic crisis of the post-war era, Israel must embark on the more difficult and longer-term process of developing its human resources. The challenges are immense. They will demand increased government spending on education and social welfare programs, which from a purely fiscal perspective runs counter to the policy trend of the last two decades. They will entail political and social conflicts with large and powerful constituencies, ranging from the ultra-orthodox establishment to the teachers unions. They will impose short-term political and fiscal costs, and the return they yield will take years to achieve, perhaps even to observe. It is a pathway that presents daunting obstacles to a democratic system like Israel’s. Yet Israel was able to create since the late 1980s the macroeconomic framework that enabled it to cope with the global financial crisis because a broad political and ideological consensus emerged that supported it through changes in government and a host of political traumas. In the Israeli context, the business of devising and implementing economic policy has the advantage of being remote from society’s greatest ideological divide, namely the Palestinian issue. That being the case, there is some reason to be optimistic that establishing a consensus on a policy pathway toward developing Israel’s knowledge economy is possible.
*David Rosenberg has written about Israeli economics, business, and technology for the past two decades, and served as economics editor of The Jerusalem Post and Israel bureau chief for Bloomberg News. He is the author of Cloning Silicon Valley (Pearson-Prentice-Hall, 2001).
 Staff Report for the 2009 Article IV Consultation (Washington: International Monetary Fund, 2009), p. 48. The survey includes all OECD members except Greece and Mexico and covers the period through second-quarter 2009.
 This and all domestic economic data that follow are from the Israel Central Bureau of Statistics unless cited otherwise.
 Bank of Israel, “Update of Macro-Economic Forecasts for 2010,” January 11, 2010, http://www.bankisrael.gov.il/press/heb/100111/100111h.htm.
 Kesselman & Kesselman PriceWaterhouseCoopers Fourth-Quarter and Annual 2009 MoneyTree Report, http://www.pwc.com/en_IL/il/venture-capital-israel/moneytree-home/assets/MoneyTreeQ42009.pdf.
 “Intel reports that Exports Rose 145% to $3.4 Billion in 2009,” Ha’aretz, February 9, 2010.
 IMF Staff Report, p. 12.
 OECD Economic Surveys: Israel, Volume 2009/21 January 2010 (Paris: Organization for Economic Cooperation and Development), p. 32.
 Israel Finance Ministry, announcement, January 12, 2009.
 OECD data.
 IMF Staff Report, p. 49.
Office of the Chief Scientist, Israel Ministry of Industry, Trade and Employment.
 OECD Factbook 2009: Economic, Environmental and Social Statistics (Paris: Organization for Economic Cooperation and Development, January 2010), p. 54. The next three countries are Sweden (3.63 percent), Finland (3.47 percent), and Japan (3.39 percent, 2006).
 Klaus Schwab (ed.), The Global Competitiveness Report, 2009-2010 (Geneva: World Economic Forum), p. 472. The WEF uses U.S. Patent Office data, which gives the U.S. patent applications a home-bias advantage over Europe.
 OECD Science, Technology and Industry Scoreboard 2009 (Paris: Organization for Economic Cooperation and Development, December 2009), p. 5
 OECD Science, Technology and Industry Scoreboard 2009, p. 37. The biggest exporters on a percentage basis fall into two broad categories: countries such as China and Ireland that export technology mostly developed elsewhere and countries such as Switzerland with large pharmaceuticals sectors. Israel also has a very big pharmaceuticals sector, accounting for about 29 percent of its total high-technology exports in 2008. Israeli Central Bureau Statistics data show that if exports of services are added, computer services and research and development typically add another eight to nine percentage points to the total.
 The Venture Capital Industry in Israel: An Empirical Analysis of Economic Potential, prepared for the Israel Venture Association by EGP Applied Economics, May 2009.
 Why are Israeli start-ups more likely to go out of business than their U.S. and European peers? It is unlikely to be solely a consequence of more difficult domestic business conditions, since the combined proportion of start-ups that ceased to exist (either because they were either acquired or because they went out of business) is approximately the same in Israel and the United States. The lower rate of acquisitions is most likely due to the fact that the barrier to Israeli companies being acquired is higher. According to the survey, Israel generated 578 start-ups in the period, compared with 7,792 for the United States and 5,764 for Europe. This suggests that Israeli companies have a more difficult time finding companies to acquire them. The domestic pool of potential buyers is so small, because the prospects of finding a fellow Israeli company with the right strategic fit for a merger or acquisition are tiny. At the same time, the barrier to being acquired by a buyer overseas is very high because of the geographical and cultural differences. In other words, the proportion of Israeli companies that would like to be acquired is probably much greater than the outcomes indicate and expresses itself in the high rate of company failures relative to the United States and Europe.
 Source: Israel High-Tech and Venture Capital Directory (Tel Aviv: Israel Venture Research) and news reports. The companies acquired in 2008 were: Diligent, $1.9 million; Mediguide, $4.7 million; Fraud Sciences, $11.3 million; Onaro, $2 million; Kidaro, $3.7 million; Qumranet, $3.1 million. Employment data were derived from news reports and government agencies.
 Source: Tel Aviv Stock Exchange and company financial reports based on average market capitalization for the year and year-end payroll reports. The companies surveyed are: Bezeq, $309,000; Makhteshim Agan, $1.03 million; Elbit Systems, $207,000; Osem Investments, $286,000; Israel Chemicals, $1.7 million; Paz Oil, $617,000; Oil Refineries, $967,000; Teva Pharmaceuticals, $962,000. It should be noted that the petroleum and chemicals sectors enjoyed particularly strong profits in 2008 because of higher agricultural-commodities prices, thus their market valuations were commensurately high as well.
 The Venture Capital Industry in Israel: An Empirical Analysis of Economic Potential. Data originate from the Israel Central Bureau of Statistics.
 Companies cannot rely on a steady stream of revenue from an existing customer base, a market-proven line of products, or services or goodwill arising from a long operating history and brand recognition.
 I.V.S. Mullis, M.O. Martin, and P. Foy, TIMSS 2007 International Mathematics Report: Findings from IEA’s Trends in International Mathematics and Science Study at the Fourth and Eighth Grade (Chestnut Hill, MA: TIMSS & PIRLS International Study Center, Boston College, 2008).
M.O. Martin, I.V.S. Mullis, and P. Foy (with J.F. Olson, e. Erberber, c. Preuschoff, C. and J. Galia, J.), TIMSS 2007 International Science Report: Findings from IEA’s Trends in International Mathematics and Science Study at the Fourth and Eighth Grades (Chestnut Hill, MA: TIMSS & PIRLS International Study Center, Boston College, 2008).
 OECD Economic Surveys: Israel, p. 81.
 There seems to be little correlation between test scores on the TIMSS and economic performance except that the top-performing Asian economies routinely score the highest on science and math tests. The next group of top-scoring students typically comes from a mélange of European and Asian countries, many of which have not demonstrated any particular success at developing knowledge economies that high scores should be expected to foster. For instance, Russian, Lithuanian, Serbian, Cypriot, and Bulgarian eighth graders had higher scores than Israelis taking the 2007 test. On the science test, eighth graders from Russia, Slovenia, Lithuania, Armenia, Jordan, and Serbia outscored Israel.
 OECD Economic Surveys: Israel, p. 85. The report cites testing conducted in the early 1960s, which it says was restricted to a limited number of students with “strong family backgrounds.”
 Dan Ben-David, Brain Drained: A Tale of Two Countries (London: Centre for Economic Policy Research, 2009).
 OECD Reviews of Labor Market and Social Policies: Israel. Israel’s poverty rate declined after 2005, according to the National Insurance Institute, but the rate remains at historically high levels.
 Soumitra Dutta and Irene Mia, The Global Information Technology Report 2008-2009: Mobility in a Networked World (Geneva: Insead and the World Economic Forum), pp. 12-13. The individual readiness sub-index measures the quality of the education system (in particular math and science), availability of internet access in schools, and telecommunications charges. The usage sub-index measures information-technology penetration, such as the number of broadband internet subscribers.
 Miri Endeweld et al., The Dimensions of Poverty and Income Inequality, 2008 Annual Report (Jerusalem: Israel National Insurance Institute, October 2009), p. 37. The labor force participation rate among Israeli Arabs was about 26 percentage points below that of Israeli Jews in 2008.