Middle East

The Shocking Election That Saved Israel's Economy

It wasn't easy, but the capitalist reforms set in motion by Prime Minister Menachem Begin 40 years ago were transformative.

A capitalist at heart.

Photographer: David Rubinger/Corbis via Getty Images

Forty years ago this week, the dynamic, vibrant, entrepreneurial modern Israeli economy was born, though nobody knew it at the time.

It was May 17, 1977. Israelis crowded around their black-and-white television screens for the national election results. At exactly 10 p.m., the face of Haim Yavin, the normally unflappable anchorman of Israel’s lone TV channel, appeared, looking very flapped indeed. “Ma’hapach!” he intoned, a variation of the usual Hebrew word for “revolution.” It was a softer term Yavin had come up with on his way to the studio. He later explained that he hadn’t wanted to cause panic.

The result was shocking. There had never been a change of governing party before in Israel. For the first time, Mapai, the socialist party founded by David Ben-Gurion and now led by his disciple Shimon Peres, was out of power.

Even more shocking, Menachem Begin was in. Begin, who had lost eight straight elections. Begin, who had been called many terrible things by his political adversaries: “Fascist” (untrue), “rabble rousing street orator” (true), “enemy of democracy” (nonsense) and “former terrorist” (true, but with an explanation).

Perhaps the worst accusation they had leveled against Begin was that he was a capitalist. That was a bit ironic for a man who was born broke and stayed that way all his life. Even as prime minister, Begin bought his suits on a payment plan.

From Israel's founding until the 1977 vote, Mapai or its affiliated Histadrut labor organization tightly controlled most of the country’s agriculture and industry, health care and social welfare, infrastructure and development, education, housing and radio. No detail was too small for the socialists: In 1964, the government banned the Beatles on the grounds that they would subvert the morals of Israel’s pioneering youth.

Begin, who had spent an instructive year in a Siberian Soviet gulag during World War II, was skeptical of such power. He had simple instructions for his finance minister, Simcha Ehrich: Free the economy and make life better for the common people (by which he meant Likud voters).

Ehrlich, who owned a small optics factory in Tel Aviv, was a short, sixtyish man, pinked-cheeked, fastidious and laconic nearly to the point of silence. He had served on the Knesset Finance Committee for many years, but he was at heart a party hack and a dealmaker. Ehrlich was devoid of formal education or economic training. The Israeli media began calling him a follower of Milton Friedman, the free market guru who had recently won the Nobel for economics. But Ehrlich, who couldn’t read or write English, didn’t know Milton Friedman from Kinky Friedman.

A few months before the 1977 election, in an address to a business group, Ehrlich set out his core economic belief: “Israel is too small and too poor to maintain a welfare state.”

He was right about Israel’s size (population at the time: 3.5 million) and its relative poverty. In some ways, the economy had more in common with the Communist satellites of Eastern Europe than with Western countries. But as welfare states went back then, Israel was pretty good. It provided free public schools and cheap university tuition; affordable, high-quality public health care; subsidized food; available work with strong labor protections; and decent social services. But the price for all this was confiscatory income taxes, high tariffs on foreign-made luxury goods (almost anything fancier than a can opener qualified), low incomes and poorly made local products.

Like Begin, Ehrlich thought that Israel’s economic potential was being stifled by misguided ideology and political self-interest of the socialists. His mission was to turn things around. Rarely has anyone been less suited for a task.

When Ehrlich arrived at the Finance Ministry, he came alone. The senior staff, largely Labor Party loyalists trained in Keynesian economics and fond of the status quo, gave him very little help. But Ehrlich plowed ahead with his agenda: deregulating foreign currency, lowering import barriers, allowing the Israeli pound to trade freely, cutting government spending, shrinking the bloated bureaucracy, and weakening the power of the labor by introducing mandatory arbitration.

As a free market plan, this sounded good. As a practical matter, it provoked an epic fiasco. Only a few small reforms were put in place. Foreign currency moves were popular. Small businesses were intoxicated. But the budget cutting didn’t go over well with the Likud’s base of working-class voters. The niceties of fiscal policy and foreign currency didn’t mean much to these folks, and they did not want their subsidies cut just because some Tel Aviv businessmen thought it was inflationary or wasteful. They complained loud enough for Begin to hear. He told his finance minister that government spending cuts were no longer a priority. Shortfalls could be covered at the printing press.

Inflation had been a problem in Israel since the 1973 Yom Kippur War. Rebuilding the army and air force required the kind of money Israel couldn’t print. And, in the wake of the oil boycott, fuel prices drove inflation to about 30 percent -- which helped put the Likud in office in 1977.

Unfortunately, the Likud had no answer. Within two years, the Israeli pound was inflated by 110 percent, and Ehrlich was sent to political Siberia as minister of agriculture.

Things would get worse before they got better. The signature move of the next finance minister, Yigal Horowitz, was to scrap the pound and replace it with the shekel, a Biblical name that didn’t fool anyone. Israeli currency was nearly worthless, by any name. Soon the entire economy was being conducted in dollars, the price of which soared on the black market.

During this time, Begin focused on making peace with Egypt, planning the destruction of the Iraqi nuclear reactor, building settlements and infrastructure in the West Bank, and fighting the Palestinian terrorism emanating from across the northern border. On the eve of the 1982 War in Lebanon, the Ministry of Finance, now under its fourth minister, warned about the economic burden of a military campaign. Begin shrugged, and quoted Napoleon: “The cavalry charges ahead, while the supply mules follow behind.”

The ministry, however, had a point. When Begin retired in 1983, inflation was about 300 percent and rising. After new elections, Labor and Likud finished in a near tie and, in 1985, formed a government of national unity led by Peres, now of Labor. He and Likud Finance Minister Yitzhak Modai put together a bold and politically fraught plan to stabilize the economy. It called for deep budget cuts and a deficit reduction, wage and price controls, and another new currency -- the “new shekel,” which came with 20 percent devaluation and limits on the freedom of the Bank of Israel to print more.

Amazingly, it worked. In its first year, the plan lowered inflation by half, and it reached a manageable 10 percent within a decade. The prospect of social and economic collapse gradually became a memory.

It pained the socialist Peres to make a deal that would, in effect, end the Labor Zionist dream of a centrally controlled egalitarian workers’ democracy. But Peres clearly saw what Ehrlich had dimly perceived -- that free market global capitalism was the irresistible wave of the Israeli future.

The process had been set in motion. In the 1990s, a million Jewish immigrants full of energy and entrepreneurial dreams arrived. Universities and elite military units began turning out a generation of cyber wizards, high-tech innovators and MBAs. Prime Minister Yitzhak Rabin (another son of socialist Mapai) capitalized on this windfall of human capital by offering very generous tax incentives to foreign investors. A few years later, Benjamin Netanyahu, a genuine Friedmanite serving as finance minister, implemented a major round of privatization and cut income and corporate taxes.

But we shouldn't discount Begin's leadership that set up Likud, despite all the economic stumbles and rough patches, to rule the country for most of the last 40 years and rules it still.

In 2010, Israel was accepted into the Organization for Economic Cooperation and Development, the club of prosperous free market nations. Its population now exceeds 8 million. It is neither “too small nor too poor” to be a viable welfare state, as Ehrlich once said, nor too idealistic to brag about its capitalist credentials.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Zev Chafets at zchafets@gmail.com

    To contact the editor responsible for this story:
    Stacey Shick at sshick@bloomberg.net

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