Between 1948 and 1972, Israel's GNP rose by more than 10 percent per annum on average. Thereafter, Israel's growth rate slowed to an annual average of 2 percent. Not only was Israel's economic growth rate much lower after 1972, it was also far less stable. The reasons most often cited for this slowdown include a sharp increase in defense spending, the 1982-83 energy crisis, and increased expenditures on social welfare.

A breakdown of Israel's GNP into categories of consumption, investment, government expenditures, and net exports for the years 1960 through 1986, highlights some of the difficulties experienced by a small, open economy burdened with a massive defense expenditure. During this period, Israel experienced chronic current account deficits and increased government expenditures. The trade deficit, which accounted for an average of 20 percent of annual GNP from 1960 through 1964, reached a high of 35 percent in 1973. It declined to 16 percent in 1986, however, primarily because the real value of exports increased while the real value of imports remained unchanged.

Until the June 1967 War, defense spending ranged from 10 to 16 percent of GNP. Between 1970 and 1982, however, defense spending escalated to over 25 percent of GNP--a high ratio, even for the volatile Middle East. A significant share of defense spending originated from military imports. In the aftermath of the October 1973 War, military imports equaled 17 percent of GNP. About onequarter to one-third of this defense expenditure was paid for by United States aid. After 1984 the increase in United States aid reduced the defense burden in Israel virtually to pre-1967 levels. In 1986, the defense burden declined to 10 percent of GNP.

The sharp upturn in world oil prices in 1973 increased the cost of oil imports by more than 3 percent of GNP in that year. The oil price increases of 1979, which occurred at about the same time as the return to Egypt of the Sinai oil fields, are estimated to have had an even more devastating effect on the Israeli economy. The total direct losses to the Israeli economy caused by the increase in energy prices from 1973 to 1982 have been estimated at US$12 billion--the equivalent of one year's GNP.

In addition to these external shocks, the economy had to accommodate substantial increases in spending on domestic welfare programs in the early 1970s. In response to domestic social unrest, the government introduced large-scale social programs to improve education, housing, and welfare assistance for the urban poor. These programs were designed before 1973, but were implemented after the economy had begun to stagnate.

Slowdown of Economic Growth

The economy's behavior during the 1961-72 and 1973-88 periods was starkly different. The growth of capital stock declined modestly from an 8.9 percent annual increase during the first period to a 6 percent annual increase during the second period. A major decline occurred, however, in gross domestic product (GDP). From a 9.7 percent annual growth rate in the first period, GDP fell to a 3.4 percent annual growth rate in the second period. Furthermore, labor inputs (measured either as employed persons or total hours of work) declined from the first to the second period. The annual increase in employed persons from 1961 through 1972 averaged 3.6 percent; employed persons increased only 1.5 percent annually from 1973 through 1981. Similarly, total hours worked increased by an annual rate of 3.9 percent during the first period as compared to 1 percent during the second period. If the growth of the economy is measured as GDP per employed person, then Israeli performance declined from 6.1 percent to 1.9 percent over the two periods. If GDP per hour of work is used, Israel's performance declined from 5.8 percent to 2.4 percent. Finally, if GDP growth is measured per unit of capital, it declined from 0.8 percent a year between 1961 and 1972 to -2.6 percent a year from 1973 through 1981.

Until 1973 the rise in labor and capital productivity was the major growth-generating ingredient in the Israeli economy, accounting for about 43 percent of total output growth and for 72 percent of the increase in output per worker hour. By contrast, beginning in 1973, increases in capital stock accounted for 64.7 percent of total growth. The contribution of labor and capital productivity to total output declined to 18 percent, and its contribution to the increase in output per worker hour declined to 25 percent. Between 1961 and 1981, the relative contributions of capital per unit of labor and of total labor and capital productivity to the increase in labor productivity were reversed. In large part, this reversal explains the slowdown in Israel's growth after 1972.

Three factors apparently led to a decline in the growth of business sector employment from 1973 through 1981. First, the growth rate of new people entering the labor force dropped, primarily because net immigration declined from an annual increase of 3.8 percent in the 1961-72 period to 2.5 percent in the 1973-81 period. Second, because of the increase in the income tax rate at higher levels of income, the average rate of labor force participation among men declined from 73.6 to 64.9 percent, while the rate for women increased from 29.2 to 33.4 percent. Fewer families found it worthwhile for the husbands to work at highertaxed , high-paying jobs; instead, the wives worked at lower-paying, lower-taxed jobs. Finally, the influx of Arab employees from the West Bank and the Gaza Strip declined in the 1973-81 period. In all, the share of business sector employment relative to the whole economy declined from 77.2 percent in the 1961-72 period to 73.6 percent in the 1973-81 period.

By 1988 the potential sources of large-scale net immigration had almost run dry. Since 1979 (as of 1988, 1979 was the last year during which the Soviet Union had permitted large numbers of Soviet Jews to leave) the rate of net immigration had been low; during several years, it had been surpassed by emigration. In 1987 immigration increased slightly, although this addition to the labor pool was insufficient to increase Israel's growth rate. The immigration of Oriental Jews had also decreased significantly by the 1980s. Given the low probability of sizable immigration from the United States or the Soviet Union, observers concluded that a return to the rapid economic growth of the 1950s and 1960s depended on Israel's ability to substitute alternative sources of sustained growth. Possibilities in this area were the new, science-based and high technology industries.

Changes in Investment Patterns

Gross investment reached an exceptionally high level of 30 percent of GNP in the period ending in the early 1970s, but subsequently dropped to 20 percent of GNP in 1986. While this figure is substantially lower than that achieved by earlier Israeli performance, it is internationally an acceptable standard of investment and private savings.

Nonetheless, concern existed in Israel about the extent of public-sector debt. Since 1973 the government has incurred a substantial domestic and foreign debt that has resulted in a significant reduction in the proportion of private savings available for investment. From 1970 through 1983, private savings averaged slightly above 10 percent of GNP. The success of the Economic Stabilization Program adopted in July 1985 in order to cut back on government spending led to an increase in private saving, however; by 1986, private savings stood at 21 percent of GNP.

Unlike the unstable trend in private savings recorded in the banking sector, investment in housing has taken a consistently high share of GNP, hitting a 40 percent peak in 1980. This high level of investment in housing, which many economists argue is not justified economically, further constrained the rise of gross business investment. For example, despite the rise of the share in GNP of gross investment in manufacturing during the 1970s, Israel's 1982- 86 average share of 4 percent clearly is below international norms.

The lack of uniformity in government investment incentives and in the rate of return on capital within the manufacturing sector may be responsible for the mix of Israeli investments. Economists generally agree that inefficiencies have arisen as a result of excessive substitution of capital for labor, underused capacity, and inappropriate project selection. Government policy has been identified as the primary factor causing capital market inefficiencies by crowding out business investment, creating excessively high average investment subsidies, and introducing capital market controls based on inefficient discretionary policy.

The 1967 Law for the Encouragement of Capital Investment provided for the following incentives to "approved-type" enterprises: cash grants, unlinked long-term loans at 6.5 percent interest, and reduced taxes. The Treasury assumed full responsibility for any discrepancy between the linked rates paid to savers and the unlinked rates charged to investors. Because inflation in the mid-1970s reached levels close to 40 percent, the real interest rate paid on long-term loans was close to -30 percent per annum, with a total subsidy on long-term loans reaching a high of 35 percent in 1977. These extremely favorable interest rates and implied subsidies led to an excessive substitution of capital for labor.

The investment system has been characterized by the following factors: private firms generally are not allowed to issue bonds, the government establishes the real interest paid to savers and the nominal interest paid by investors, and the economy is plagued by high and unpredictable rates of inflation. These conditions have maintained an excess demand for investment. The result has been a continuous need to ration loans--and an implicit role for government discretion in project approval. Thus, since the late 1960s, as a result of capital market controls, the government has been making industrial policy.

Changes in Industrial Structure

The industrial structure of the economy can be seen in terms of the allocation of GDP, employment, and foreign capital among the tradable, nontradable, semitradable, and service sectors. The tradable sector includes agriculture, manufacturing, and transportation; nontradables include public services and construction; and semitradables include business and financial services, commerce, tourism, and personal services. Public services include the activities of government, national institutions, and local authorities; education, research, and scientific organizations; health, religious, political, and trade-union groups; and defense.

Up to 1981, the economy allocated approximately 40 percent of its GDP to the tradable sector and about 33 to 35 percent to the nontradable sector. This distribution was mirrored in the allocation of civilian employment across the two sectors. The size of the public service sector in 1981 was 21 percent of GDP and 28 percent of civilian employment. Some economists argue that this latter figure is very high relative to the international norms for a developing country. They are not high, however, when compared to developed socialist countries in Europe. Some economists also argue that Israel's high level of nontradables can be explained by the high level of capital inflows from abroad, by a high demand for public services and construction as a result of immigration, and by defense needs.

From 1955 through 1972, the real output of tradables increased relative to that of nontradables. Most of this increase was attributable to the importance of physical capital in the form of machinery and increased productivity. After 1972 the importance of machinery declined, while that of labor increased. Educated workers were being absorbed into the public and financial services; simultaneously, manufacturing productivity was declining. Increased demand favored nontradables, and the share of tradables in both employment and output further declined. The overriding factor remained the rapid increase in the educated labor force.

Changes in Labor Force

In the 1950s and 1960s, through a state effort to absorb the large number of immigrant children into the public school system, the government assured itself of a future supply of educated workers. The demand for more educated workers was provided by the rapid expansion of public services, which are inherently humancapital intensive. Growth in public services resulted from the rapid and sustained economic growth that lasted until the early 1970s, and from the high rate of population growth.

In the 1970s, the education level of the labor force continued to rise markedly. Unlike the experience of other Western economies, the increased supply of educated workers in Israel did not, on average, depress the relative wage level of those with more schooling; nor did it markedly worsen the employment condition of more educated workers as compared with workers with a secondary education. The continued increase in demand for education-intensive services and for more sophisticated goods and services generally have so far precluded the negative effects experienced in other countries. The widespread high level of human capital is expected to continue into the twenty-first century as long as investment in education continues to be profitable.

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Source: U.S. Library of Congress