Lessons from Israel, the Start-Up Nation Part 2

Fiscal Austerity

Things were looking grim for Israel in 1984. Inflation was cresting 450% as the Israeli government attempted to maintain a fully socialist workers state. The government was spending nearly 60% of Israel’s GDP, and worker’s wages were directly tied to the cost of living in the country. This caused a never-ending cycle of hyperinflation as the central bank printed more money, which drove up prices, which then drove up wages, which then drove up prices, ad infinitum. However, they rapidly realized that such a state of affairs would lead toward certain ruin. To avoid this fate, government leaders came together in 1985 and crafted a plan which set Israel on the path to prosperity.

The plan was simple: government spending was massively slashed, and the legal linkage between wages and the cost of living was severed. Israel then continued to reduce government spending year after year, continuing to do so into the present day.

Figure 1: Israeli Government Expenditures since 1984[20]

This fiscal austerity was coupled with targeted deregulation for the industries and facets of the market which the government chose to develop (more on this below). These reforms worked wonders for the Isreali economy, as the graph below makes clear (notice the massively increased growth after these reforms in 1985):

Figure 2: Israeli GDP Growth[21]

The lesson here for a nascent Start-Up Nation is clear: start with government expenditures as low as possible and keep them that way. This formula for success has proven successful not just in Israel, but in every jurisdiction which has attempted it. It is no coincidence that the period of most rapid economic growth and prosperity in the United States was the very same period in which government spending was almost nonexistent: 1870-1910.

Deregulation

Soon after the paradigm shift which occurred in 1985, Israel found that its global comparative advantage lies in the technological development enabled by the high levels of human capital and research and development funding in the nation. However, these industries found themselves stifled by both regulation and a lack of investment capital with which to launch new enterprises.

To facilitate the development of this industry, the Israeli government took two decisive actions: the founding of state-funded venture capital partnership, and the creation of a “tax and regulatory environment that, while favoring technology start-ups and foreign investors, did not offer the same support for the rest of the economy.”[22]

The benefits of deregulation are well known in the field of economics. The intuitive appeal of reducing regulations is obvious: by reducing the barriers and hurdles through which entrepreneurs must pass; they are encouraged to do more, innovate more, and create more, all at a lower cost than is possible with the heavy hand of regulation. Regulation also costs the world economy trillions of dollars per year; some studies have shown that since 1949, regulation in the United States alone has cost the nation almost $40 trillion.[23] This logic applies to Israel as well: so long as there are barriers to entrepreneurs founding and attracting funding for their firms, they will be discouraged from doing so and can only do so at a high cost which must be recouped later.

Israel solved this problem by deregulating only the industries which the government targeted and recognized as high-growth potentials: technology and the venture capital funding needed to facilitate it. This could do much to explain why Israel has the 4th highest level of foreign direct investment in the world and the highest density of start-ups in the world.

This should not be mistaken as an endorsement of such a targeted deregulation regime, however. Deregulation in all industries could compound Israeli’s growth even farther, and insofar as the rest of the economy is tightly regulated, Israel is held back from unleashing its full potential. It is worth noting, however, that if a government is to deregulate, beginning the process in the most high-impact industries where such deregulation will have the highest margin impact and then moving to other, less impactful sectors of the economy is the most rational and efficacious way to achieve deregulation in a gradual, piecemeal process.

The lesson here is simply that deregulation can unleash the latent powers of human ingenuity and innovation, and that this impact is particularly acute if done in the industries where the jurisdiction has the largest natural comparative advantage.

State-Backed Venture Capital: BIRD and Yozma

Israel’s government engineered its economic miracle in a surprising way: by bootstrapping businesses into being with state-backed investment funds.

The first of these programs was called the Binational Industrial Research and Development Foundation (BIRD) and was a joint endowment between the US and Israel. Bird “Gave modest grants of $500,000 to $1,000,000, infused over two to three years, and would recoup funds through small royalties earned from successful projects.”[24] According to one of the founders of BIRD, it acted as a sort of “dating service,” matching Israeli technological developments with American firms that could market and distribute it. “To date, BIRD has invested over $250 million in 780 projects, which has resulted in $8 billion in direct and indirect sales.”[25] By 1992, 75% of the Israeli firms on the NASDAQ exchange were BIRD-funded endeavors.

The government also funded some enterprises through a more direct and piecemeal fashion. After the flood of high-skilled immigrants came in from the former Soviet Union in the 1990’s, the Israeli government tried to find some way to help these immigrants become entrepreneurs themselves. To that end, the Israeli government-funded “hundreds” of small companies based on the technological innovations of these immigrants. Although this was helpful, it still was not seen as good enough; after all, the government could give these entrepreneurs funding, but not the business acumen needed to make a start-up successful.

Yozma was created to fill this gap. The government of Israel invested $100 million in 10 new venture capital funds. “Each fund had to be represented by three parties: Israeli venture capitalists in training, a foreign venture capital firm [with experience], and an Israeli investment company or bank.” These ten funds were rounded out by one, final fund of $20 million that would invest directly into tech companies. Senor and Singer explain how the funds operated:

By providing government funding to buttress VC firm selection, the Israeli government kick-started the entire start-up industry in Israel. The method by which they did this was particularly clever: recognizing that governments will never be as adept as VC firms at identifying which start-ups have potential and which do not, the government allowed the market to pick the “good” firms by forcing the Israeli VC partners to raise a substantial amount of funds before the government money was added. In this way, the market mechanisms of VC firm selection and guidance still works unabated, but are simply aided by a larger pool of state funds.

This lesson echoes the experiences seen in Singapore as well, with the tiny nation bootstrapping its way to prosperity with the massive Temasek investment fund. The trend is clear: the most successful geographically limited new jurisdictions utilize state funds to strike the match which then lights the fires of economic development and prosperity (provided that a good institutional and regulatory environment does not choke out the fire of prosperity before in can grow).

Conclusion

Israel has had a meteoric and unique ascension among the world’s most rapidly developing and competitive economies. Surrounded by enemies and filled with a historically persecuted people, Israel has become the world’s most innovative nation in spite of seemingly insurmountable hardships. Many of the catalysts which drove this economic growth are unique accidents and coincidence of history which do not provide many lessons for the nascent Start-Up Nation wishing to emulate Israel’s growth.

However, a few lessons can be gleaned from Israel’s economic miracle: the importance of fiscal austerity, the lightest regulatory burden possible, the importance of state-backed venture funds for new jurisdictions, the importance of high-skilled, highly-educated immigrants, and the importance of developing a culture of innovation and entrepreneurship.

It may be impossible to exactly replicate the unique amalgam of circumstances which catalyzed Israeli growth, but application of these lessons will almost certainly put any aspiring Start-Up Nation on the path to prosperity and human flourishing.

[1] https://www.theatlantic.com/business/archive/2012/08/its-not-just-the-culture-stupid-4-reasons-why-israels-economy-is-so-strong/260610/

[2] https://eh.net/encyclopedia/a-brief-economic-history-of-modern-israel/

[3] https://www.timesofisrael.com/germany-increases-reparations-for-holocaust-survivors/

[4] http://www.jewishvirtuallibrary.org/total-u-s-foreign-aid-to-israel-1949-present

[5] https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?end=2016&locations=IL&start=1984

[6] See The Tyranny of Experts by William Easterly for more.

[7] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 7

[8] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 7

[9] Clemens, Michael, Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?, Journal of Economic Perspectives, 2011

[10] https://www.inc.com/jeremy-quittner/foreign-patents-and-united-states-innovation.html

[11] Fairlie, Robert W.; Lofstrom, Magnus (2015) : Immigration and Entrepreneurship, CESifo Working Paper, No. 5298, Center for Economic Studies and IfoInstitute (CESifo), Munich

[12] https://nypost.com/2017/01/29/why-israel-has-the-most-technologically-advanced-military-on-earth/

[13] https://www.bloomberg.com/graphics/2015-innovative-countries/

[14] https://www.haaretz.com/.premium-israeli-scientific-studies-declining-1.5328140

[15] https://atlas.media.mit.edu/en/profile/country/isr/

[16] https://globaledge.msu.edu/countries/israel/tradestats

[17] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 9

[18] North, Douglass C. 1991. "Institutions." Journal of Economic Perspectives, 5 (1): 97-112. https://www.aeaweb.org/articles?id=10.1257/jep.5.1.97

[19] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 2

[20] https://www.theatlantic.com/business/archive/2012/08/its-not-just-the-culture-stupid-4-reasons-why-israels-economy-is-so-strong/260610/

[21] https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?end=2016&locations=IL&start=1960

[22] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 10

[23] Dawson, John, and Seater, John, Federal Regulation and Aggregate Economic Growth, 2013. http://www4.ncsu.edu/~jjseater/regulationandgrowth.pdf

[24] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 10

[25] Ibid.