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June 20, 2012 3:27 pm

Israel’s Economic Model: A Relative Success Story

avatar by Gabriel Martindale

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Stanley Fischer, Governor of the Central Bank of Israel. Photo: wiki commons.

The financial crisis of 2008 and all the economic troubles that have followed on from it have widely been interpreted as representing the famed ‘Crisis of Capitalism’ that leftists of all stripes have been predicting since there was such a thing as ‘Capitalism’ whose doom could be predicted. On the face of it, they have a semi-plausible case. After all, Reagan and Thatcher came along, took on the unions, privatised everything, unleashed the forces of competition and now, twenty years later, everything is in the toilet. The ‘neoliberal’ dogmas that drove policy since the 1980s have clearly been falsified by events and what is needed is a return, at least, to social democracy, or perhaps something even more red-blooded.

Beleaguered defenders of capitalism have tried to parry this intellectual onslaught by pointing out that, during the era of ultra laissez-faire hyper-turbo-ultra capitalism (or whatever the latest term is), the welfare state ballooned and state spending in all western nations hovered between 40%-50% of the economy (even in America, if you take into account state as well as federal spending, which you would unless you were just trying to con people for some reason). Though western economies were relatively freer in this period than in the dark days of the 1970s when an Englishman had to request a telephone from the government and could not take more than £30.00 out of the country at any one time (for real), they were hardly free in the sense that a Victorian, let alone a real libertarian, would recognise. Nevertheless, those who make such arguments are in a somewhat awkward rhetorical position because they tend to come across like the sort of diehard enthusiasts who responded to the fall of the Berlin Wall by saying “but that wasn’t real Communism”. If everyone keeps saying the free-market has failed then you’ve got a tough job convincing them that it’s just because it wasn’t free enough.

So let’s approach the issue from a slightly different tack. Imagine there was as a country that, like Britain and America, went through significant liberalizing reforms to an inefficient, union-riddled economy. Imagine that this country, quite unlike Britain and America, maintained fiscal restraint in the ensuing decades and, instead of experimenting with third way triangulation in the form of “New Labour” or “Compassionate Conservatism” pressed on with its hard-nosed free market policies. Well, you don’t have to imagine, because that country is called Israel.

Now, though things there are far from perfect, everyone pretty much agrees that, not only did Israel experience no problems in its financial system in 2008, but that it has weathered the storms of the past years much better than Europe or America. While people there may go out and march to complain, perhaps with justification, that their rent or yogurt costs too much, the Israeli population has not been subjected to permanently high unemployment of the sort that plagues the U.S., let alone basket-cases like Greece or Spain.

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So, we have empirical evidence that where free market policies are implemented more consistently than they have been in the rest of the western world, the results are better. Case closed.

Or not quite, because there’s another side to the story that requires explanation. While Israel, in line with the rest of the West, has a financial system based upon fractional-reserve banking propped up and controlled by a central bank with the aim of fostering credit expansion, it is undeniably true that the banks were kept on a much shorter leash there than elsewhere. No 110% mortgages to low income families, re-packaged and sold on as AAA securities by mathmowhiz kids in Tel Aviv, no sirreee Bob.  While American and British banks were allowed to earn billion dollar bonuses on the back of what has subsequently proved to be a house of cards, Israeli bankers were much more strictly controlled. So perhaps Israel shows that economic intervention does work, at least in the financial sector.

However, such an argument demonstrates a fundamental, and tragically common, misunderstanding of what free markets and economic interventionism mean. Fractional reserve banking is an inherently fraudulent activity that requires the suspension of normal laws of property ownership, embezzlement and fraud, laws on which a free market rests. Even so, banks operating with a legal license to lend out at interest what they don’t have can never be a product of ‘capitalism’, because in a free market they would inevitably and quickly go bust. Only constant government intervention and, most importantly, the creation of the ultimate anti-capitalist institution, the central bank, can make them long-term profitable enterprises. Banking regulation is not so much an intervention in itself, but a stopgap measure to try and limit the disastrous consequences of the economic intervention that created the banks in the first place.

The problem with banking regulation is that it’s like sticking tape on a balloon to stop it bursting whilst you continue pumping ever more air into it. Governments want banks to flood the market with artificially cheap credit both because it means low borrowing costs for the ultimate debtor, the welfare-warfare state, and because it creates short term, superficial prosperity. On the other hand, they want to avoid the terrible consequences of too much cheap credit: economic crises, inflation, and depressions. These two aims are directly and completely opposite to each other. In the long term, the only “regulation” that will work is for governments to destroy the financial golems they have created for their own aims and allow truly free markets to set interest rates and allocate scarce capital, undistorted by fraction reserve banking. The granddaddy of free-market fundamentalism, Ludwig von Mises put it like this:

Government interference with the present state of banking affairs could be justified if its aims were to liquidate the unsatisfactory conditions by preventing or at least serious restricting any further credit expansion. In fact, the chief objective of present-day interference is to intensify further credit expansion. This policy is doomed to failure. Sooner or later it must result in catastrophe.

That said, whilst fractional reserve banks are still with us, restrictive legislation, even confusing and incompetently written legislation, is better than simply allowing the state-supported fraudsters free rein. If you are going to get your teenage son drunk and give him the keys to the car, at least try and set him a speed limit.

So, we see that the case of Israel vindicates the free market in two ways. A country that has (relatively) low taxation and spending, de-regulated markets and few state owned industries, but also keeps the banks on a (relatively) tight leash has clearly outperformed its peers who don’t. Of course, Israel itself is a still very far from being a free-market exemplar in either respect and, if it doesn’t sort out its act more consistently, it will share in the misery of the collapse of the credit-bubble welfare-state looming on the horizon. Nevertheless, it’s in a better position than most and shows us, once again that more free market is always better than less.

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  • Reuven

    Love this. I don’t know why more pro-free market commentators don’t use Israel as an example.

    The snag is that living conditions there are tough as prices do not correspond to wages. I would argue two things:
    (i) If you take away the abnormal security situation, there’d have been sufficiently more foreign trade that Israel’s average wages would be a lot higher;
    (ii) Something is preventing proper competition in Israel which would help to lower prices. This may be the small population size, or perhaps a remnant of the socialist era.
    What are your thoughts?

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