The vaunted «start-up nation» could turn into a «fall-down nation»

My current visit to Israel has coincided with a period of unprecedented political turmoil. A radical right-wing government’s package of legislation to disempower the judiciary has started to be adopted, leading many to worry that this great country’s robust liberal democracy is being eroded.

Since Israel lacks a formal written constitution, it is crucial that it maintains an independent Supreme Court and judiciary. That, after all, is what makes a democracy liberal – not just free and fair elections but also rule of law, protections for minorities, and appropriate checks and balances on executive and legislative power.

The government’s «reforms» will gradually move Israel closer to becoming an illiberal democracy of the kind one finds in Turkey and Hungary. The long-term damage to the economy could be so severe that, if the governing coalition’s judicial coup continues, this vaunted «start-up nation» could turn into a «fall-down nation» with severely diminishing economic prospects.

The opposition to the «reforms» comprises not just the half of the population on the left and center-left, but also many within the ruling conservative Likud Party. It also includes the most dynamic segments of the Israeli economy: the tech firms that account for 50% of exports, 25% of government revenues, 400,000 well-paid jobs, and over 20% of GDP (when accounting for their effects on other sectors).

Most Israeli tech leaders and workers are secular liberals, and many are now planning to move their operations abroad over time. This is easily done, because they use little physical capital and rely more on knowledge, intangible assets, and highly mobile tech-savvy workers.

At the same time, foreign venture-capital firms have pulled back from making new investments in Israel, and even many ordinary citizens are considering moving their savings out of the country. The «reforms» are also likely to discourage many Jews in the United States, Europe, and around the world from moving to, or retiring in, Israel – and many Israelis who are working or studying abroad may decide not to return. But most alarmingly, the government’s agenda is even putting Israel’s security at risk, with CNN reporting that, «thousands of Israeli army reservists – the backbone of the Israeli military – are threatening not to show up for work» in protest.

The composition of these protests matters, because the extreme ultra-orthodox men who support the governing coalition do not serve in the armed forces, do not study scientific subjects, are not important members of the labor force, and hardly pay taxes. On the contrary, they receive large transfer payments that grow with the size of their families.

If Israel had a proper, fair system of transfers financed by progressive taxation, beneficiaries would be induced to participate in civil service (if not the military), pursue marketable courses of study, join the labor force, and thus pay taxes. There are plenty of Likud members who would support such sensible reforms. But as matters stand, most ultra-orthodox are trapped in a cycle of poverty and dependency on the state.  

Israel is also divided economically between tech and other large and medium-size businesses, on one hand, and local governments and smaller businesses, on the other. While the first group is generally corruption-free, the latter is rife with graft and nepotism in the permitting of construction, business operations, and other locally regulated activities. Worse, other proposed reforms would have the effect of replacing capable civil servants with incompetent, corrupt lackeys, further sapping the economy of dynamism and innovation.

The government’s plans thus amount to a time bomb, because rating agencies could soon see fit to downgrade Israel’s creditworthiness. If tech and other firms move abroad, the government’s revenue base will shrink, making the growing transfer payments to the ultra-orthodox unsustainable.

Over time, a deteriorating fiscal and public-debt outlook, combined with the erosion of the rule of law, will add to the current temptation to challenge the central bank’s independence, so that growing deficits can be monetized. If Israel heads down this road, the outcome will be predictable. Just look at what is happening in autocratic Turkey, where inflation is expected to hit 58% this year.

All these factors will curtail growth, perhaps leading eventually to economic stagnation and even eventual recession. Those who will suffer the most will be the extremist poor communities that are clamoring for the government’s radical legal reforms. If the stock market falls, interest-rate costs for the public and private sectors will increase, and a declining currency will fuel inflation, which is already rising.

Israel may well need some judicial reforms. But given the lack of a formal constitution, such changes would need to command the support of a large coalition of forces, not a narrow parliamentary majority that is controlled by extremist anti-democratic and theocratic parties. One hopes that Likud and its leader, Prime Minister Binyamin Netanyahu, will recognize that they are undermining not only Israel’s democracy but also its economy, labor market, national wealth, and security.

The damage has only started, so there is still time to reverse course. But if the ruling coalition continues to pass extreme legislation over the next three and a half years of its term, the «start-up nation» will grind to a halt.

Copyright: Project Syndicate, 2023. www.project-syndicate.org

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