Israel Gets a Taste of Friedman


Addressing foreign journalists in a Knesset conference room last fall, Ehud Rassabi began his talk with the following statement: "I am a fan of Milton Friedman." As the parliamentarian went on to detail his plans to cut Israel's public sector, slash taxes, draw down entitlements and privatize state assets, several reporters looked around in confusion, wondering if they were still in the land of the kibbutz.

But it definitely was Israel, and even as the world has focused more attention on the Palestinian issue, it has overlooked a significant story. The land once labeled the "last remaining socialist state in Eastern Europe," has seen its governing coalition embark on what could be the most important economic reform in the country's history. The impetus for change has come via a popular mandate that helped propel reformers like Mr. Rassabi to the Knesset in the last elections. The will to see it through comes via Benjamin "Bibi" Netanyahu, the firebrand former prime minister who surprised everyone a year ago in agreeing to become finance minister. The next few months will decide whether he and his fellow free-marketers have the political wherewithal to succeed.

This stab at transformation couldn't have come too soon. When Mr. Netanyahu took over, Israel was years into a steep recession. Tax revenues were in a free-fall even as the country handed over more money to welfare programs (with some 30% of its $70 billion budget going to transfer payments). The Bank of Israel, worried about inflation, had kept interest rates high, strangling an economy that the financial community was worried could collapse.

Even a year into Mr. Netanyahu's emergency economic reforms, GDP growth has remained anemic -- just 1.3% in 2003. Some 10% of the work force is unemployed, despite the government employing one out of every three workers. And Israel's government expenditures total a startling 55% of GDP. U.S. expenditures, both federal and state, are less than one-third.

Economic turmoil isn't exactly new in Israel, but what has changed is the public's toleration of it. The country has seen a growing divide between private workers, who continue to float Israeli society on their overtaxed backs, and public-sector employees who earn many times the average Israeli salary. A fed-up middle class, weary of the inflation, layoffs, and a growing tax burden, has flowered into a movement that bears more than passing resemblance to the American tax revolt that preceded and carried through the Reagan era.

That movement found its feet in Israel's January 2003 elections. The party to which Mr. Rassabi belongs, Shinui (which stands for "Change"), had muddled along for years, a small player in Israeli politics. But this time Shinui's platforms of secularization (a reference to growing discontent with the country's ultra-Orthodox Jews who refuse to work, and live on entitlements) as well as a freer economy, hit home. Shinui went from seven Knesset seats to 15, making it the third largest party after Likud (40 seats) and Labor (19). It became part of Likud's governing coalition, where it has since been doggedly pushing its economic reform agenda.

And it found a powerful ally in Mr. Netanyahu. Bibi's appointment was originally met with skepticism; financial watchers worried he'd simply mind the economic store until he could launch another bid for prime minister. Instead, Mr. Netanyahu has tackled economic reform with the zeal and single-mindedness that has marked his career, drawing comparisons to New Zealand's Roger Douglas, the finance minister who liberated his own nation's economy in the 1980s.

Mr. Netanyahu's emergency economic plan spared no holy cows: It included cuts in government expenditures, welfare entitlements and public-sector jobs. It also sought to lower taxes and jump-start a stalled privatization program. While he's levered through a fair amount of reform already, now comes the hard question of whether he can break the backs of the country's most entrenched institutions.

In one corner, he's wrapped in a showdown with Israel's labor organization, Histadrut, and the leader of that massive body, Amir Peretz, makes U.S union bosses look cuddly. Histadrut's response to possible layoffs or wage cuts has been to do what it always does in the face of threats to its protected fiefdom: strike. While Histadrut strikes have not materialized to the huge degree promised, they have damaged Israel's fragile economy and already forced certain reform concessions.

Similarly, Mr. Netanyahu is facing off against monopolies that have dominated the economy for decades. The Israeli government owns almost all of the country's land, along with water, energy, telecommunications and natural resources. It also holds stakes in major banking institutions, a handful of which control financial markets and distort the allocation of credit. Private industry is also besieged by monopolies, raising consumer prices by an average of 30%. Many of these organizations (run, again, by organized labor) have been pushing hard to delay Mr. Netanyahu's privatization plans.

There are positive signs that reforms are working. Mr. Netanyahu has managed to bring the top marginal tax rate in Israel down to below 50%. He's cut two consecutive budgets and is set to restrain spending increases to 1% a year in real terms in 2005 to 2010. He's also managed reductions in the public work-force and salaries. The Bank of Israel has in turn brought interest rates down, unleashing needed capital, and the economy is predicted to grow by 2.8% this year.

But there are also worrying signs that Mr. Netanyahu is losing momentum. He recently agreed to let the Knesset meddle with his budget, and bowed to a freeze in planned public-sector layoffs. His loud calls for privatization of key parts of the Israeli economy, such as the ports, have faded. Part of the problem is that his own party, under fire on the peace issue, has been increasingly reluctant to court criticism on the economy and has failed to give Mr. Netanyahu the backing he needs.

It might consider that a strong Israeli economy is vital not only to the country's security needs now, but also to underpin any future peace deal with economically disadvantaged Palestinians. Should Mr. Netanyahu gain his government's backing and see this fight through, he'll have arguably done as much for Israel as he did, or could do, as prime minister.

Ms. Strassel is a senior editorial writer at The Wall Street Journal.


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