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Steven E. Plaut teaches business administration and economics at the University of Haifa.

From the time when Israel's Prime Minister Yitzhak Rabin and Yasir Arafat of the Palestine Liberation Organization (PLO) signed a Declaration of Principles (DoP) and shook hands on the White House lawn in September 1993, supporters of the Oslo process have argued that it would produce an economic "peace dividend" for Israelis and Palestinians. In the grand thinking of Shimon Peres and Yossi Beilin, economics would replace territorial ambition as the foundation and driving force of a New Middle East. In the more pedestrian analysis of the Labor Party's minister of finance, Avraham Shochat, "economic improvement is part of the fruit of peace and the people in Israel understand that very well."[1] Sober academics agreed: as Steven Spiegel wrote in these pages, in the event of a peaceful settlement,

Israel's economy would prosper.... Israel's high-tech economy would lead to increased trade with Asia, Europe, Latin America and North America.... The Arabs would also gain from a settlement.... The peace process provides an opportunity to enhance the flagging economies of the participating countries, with important implications for domestic stability.

Expected benefits included economic growth, expanded trade, more foreign investments, improvements in productivity, and blossoming capital markets.

While important for both sides, the lure of a peace dividend has special resonance for Israelis, who are the ones giving up tangible assets and taking security risks and who were expected to gain most of the economic blessings. Further, the promise of economic gain has grown in importance as the prospect of an end to terrorism and relaxation of tensions with the Palestinians dims: if terror and conflict continue, many Israelis ask themselves, what good is the Oslo process? Here the peace dividend plays a vital role in their judgment of the diplomacy. Accordingly, the focus here is primarily on Israel.[2]

Just months after the White House encounter, Israeli economist Eliyahu Kanovsky wrote an article that was rare for the skepticism it expressed over the professed economic gains to come from the Palestinian track.[3] In defiance of the accepted wisdom, Kanovsky did not expect Saudi Arabia to prove a supporter of the process, predicted marginal increases of foreign investment in the Middle East, expected little real increase in trade and tourism, and expressed skepticism about economic benefits from reduced defense spending. He concluded that disappointment with the economic benefits of the peace process could ultimately undermine its support. How do Kanovsky's predictions look three years later? More broadly, has Oslo produced a peace dividend especially for Israel?

To judge how Israel might have fared economically in the absence of the peace process requires a comparison of economic trends before the DoP with trends afterwards. We look here at the economic growth, trade, foreign investment, military spending, and capital markets.

ECONOMIC GROWTH?

Did the Oslo process increase real economic output and activity in Israel? The results are ambiguous. During the thirty-two months when the Labor Party was in charge and running Oslo (September 1993-June 1996), Israel's real GDP per capita grew at an annual average rate of about 3.4 percent, a respectable but not spectacular growth rate. For the equivalent period before Oslo, the comparable number was only about 1.3 percent annually. An upturn in growth per capita during the post-Oslo period did take place; did it result from the peace process?

Not likely. First, the spurt after September 1993 had nothing to do with the peace process and everything to do with the absorption of immigrants into the labor force. Immigrants who arrived before Oslo (and in particular during the period 1990-93 had temporarily high unemployment rates as they adjusted to Israeli society and integrated into its work force. Largely due to high unemployment among immigrants, unemployment rose to 11.2 percent of the labor force in 1992. In 1996, by which time many immigrants had found jobs and entered the economy, the Israeli unemployment rate fell to 6.5 percent, which did much to nudge the productivity growth rate from 1 percent to 3 percent. Then, after the labor-force benefits of immigration absorption ended, the growth in productivity seems to have slowed considerably. The spurt in immigration before Oslo had nothing at all to do with Oslo, and the spurt in productivity after 1993 caused by immigrant absorption is thus not attributable to Oslo, and so has nothing to do with the peace process.

Secondly, the growth in productivity was achieved at the expense of a severe deterioration in other parts of the economy, including a sharp deterioration in Israel's balance of payments and an equally sharp growth in its foreign debts. If the national pantry was more full in the post-Oslo era, it had much to do with spiralling debts to the grocer.

Thirdly, the spurt in productivity growth in 1994-95 was treated as a windfall by the Labor government, which used it to inflate and expand Israel's already bloated public sector -- rather than get the country's fiscal house in order. Israel during those years showed the world what might be called a reverse Hanukkah miracle. The Maccabis found that oil sufficient to keep the flame burning in the Temple for only one day actually lasted for eight; the Knesset (parliament) passed a fiscal budget sufficient for twelve months but it ran out after eight or nine months. It then required a "supplemental budget" to see the government through to the end of the fiscal year. This occurred in 1994, when the spurt in economic activity produced a temporary increase in tax revenues. Instead of cutting tax rates or reducing the government's enormous debts, the parliament pocketed the tax revenues and went on a spending binge, distributing pork barrel largesse to assorted special interests. It spent billions of dollars bailing out farm debts (especially of kibbutzim) and assumed the enormous deficits of insolvent pension funds run by the Histadrut (the trade union federation). Worse, while the tax revenue increase was temporary, the pork and "supplemental budgets" create precedents difficult to cut back later. The result? In 1996, the government's budget deficit rose to 4.5 percent of the GDP, twice what is usually considered to be the highest tolerable level. So while growth was up a bit, it was accompanied by a set of policies that was unsustainable and producing harm in other areas of the economy.

INCREASED TRADE?

Has trade flowered, particularly with Muslim countries, as was anticipated by Oslo optimists? Israel's exports have indeed expanded, from an annual level of $14.8 billion in 1993, exports increased to about $20 billion in 1996. This comes to about a 11 percent growth rate per year since Oslo, which is higher than the 7 percent rate of growth in exports during the comparable pre-Oslo yeras. Unfortunately, the export growth rate was far less than the post-Oslo import growth rate, which grew about 13.5 percent per year (or double the growth rate from the comparable period before Oslo). Accordingly, the post-Oslo era has seen a sharp deterioration in Israel's balance of trade. The annual trade deficit was about $4.9 billion in both 1991 and 1992; by 1996 it rose to about $11 billion dollars. If Oslo had any effect on Israel's trade balance, it was in the direction of a serious deterioration.

Further, Israel's trade continues to be predominantly with Europe and North America, the same partners as pre-Oslo. Each of them takes about a third of Israel's exports, while Europe provides 53 percent of the Israeli import market and North America has 20 percent. Trade with Japan has expanded, mainly due to increased imports of motor vehicles into Israel. Some of this expansion may be related to Oslo, for Japanese companies traditionally respected the Arab League's boycott of Israel. Trade with Communist China is rumored to have expanded (official data on China trade is not revealed), but economic ties between Israel and China existed before Oslo, and it is not clear how much of the expansion is Oslo-related.

After nearly two decades of peace with Egypt, Israeli exports there never rose above $31 million per year, a pittance for a country that exports in total about $20 billion, and have not risen since the beginning of the Oslo process. The one real expectation of post-Oslo Israel-Arab trade was an anticipated gas deal between Israel and Qatar, but it never materialized. Indeed, Qatar has recently renewed its boycott of Israel and Oman recently closed both its trade liaison offices in Israel and the Israeli office in Oman.[4] In sum, there is hardly any evidence that Israeli foreign trade has been blessed with a significant peace dividend.

FOREIGN INVESTMENTS?

The peace process was supposed to bring in investments from abroad as optimistic investors "voted with their dollars" for the New Middle East. Peres and Beilin were euphoric, Kanovsky skeptical. Who was right? The answer is complex. There has indeed been an inflow of capital from overseas but there are several reasons to believe this has nothing at all to do with politics and everything to do with irresponsible Israeli fiscal policies. Ironically, the inflow of capital was not a vote of confidence in Israeli economics but, in some senses, the very opposite.

Foreign investment can only be understood in the framework of the overall balance of payments. Israel imports far more than it exports. This gap, the trade deficit in the balance of payments, is not necessarily harmful, and could well be something good; that depends in large part on how the deficit is financed. By analogy, if a family spends more than its current income, this "deficit overspending" is good if the gap is being covered by gifts from someone outside the family. The same holds for states; in 1985-92, aid and gifts (or "transfer payments," in economic jargon) covered the entire Israeli trade deficit each year (except for small residual uncovered amounts in 1987 and 1991). The country was living within its national household budget, spending only what it earned or received as aid. After Oslo, the deficit in the sum of trade, service flows, and aid (called the current account balance) suddenly jumped to minus $1.1 billion in 1993, $2.3 billion in 1994, $3.9 billion in 1995, and a staggering $4.6 billion in 1996. Just as a household must somehow pay its bills, so must a country; these deficits must be paid for.

From where does the money come? From borrowing and running up debts (or using up past savings).[5] Like a spendthrift household going deeper and deeper into hock, the Israeli government went on a post-Oslo borrowing binge to pay for its spending binge. This is not necessarily the wrong thing to do. Whether or not it is harmful depends upon what the borrowed money is being used for. If used for investments like education, durables, or financial assets, no one would argue that debts are harmful. When a household increases its debts and assets in tandem, household equity or net worth stays the same or might even increase. A similar argument could be made for the whole country. It makes sense for a country to borrow from abroad to invest in assets, industrial capacity, or real productivity growth. In this case, the country acts like a giant corporation, taking out a loan to expand capacity and become more profitable later on.

Were this the story behind the sharp increase in Israel's foreign debts, one could plausibly argue that this is a benefit from Oslo. It is not, however, the case. The sharp run-up in foreign debt after 1993 resulted almost entirely from Israeli government actions, with very little invested productively. The government borrowed to finance public consumption, budget deficits, and pork barrel patronage. In 1994-96, the Israeli government racked up new foreign debts of $5 billion; in contrast, the private sector borrowed less than $900 million during the same period. And of this net inflow, 42 percent went into accounts by aliens in Israeli banks.[6] In other words, the cumulative net foreign investment in the Israeli private sector -- ignoring changes in bank deposits -- was only about half a billion dollars during the first three post-Oslo years. In the comparable pre-Oslo period, foreign investment in Israel was close to zero, while Israeli investments overseas increased by about $2 billion, so that the sum of the two numbers was a $2 billion outflow of capital from Israel. Does this point to things improving after Oslo? Hardly.

DIRECT FOREIGN INVESTMENT?

Direct foreign investment -- money invested in the private sector for at least a year that comes from overseas -- offers a better indication of investor attitudes to Oslo. A marked increase occured compared with the three pre-Oslo years, when there was vitually no net direct foreign investment. In the period 1993-95, a total of $3.3 billion of these funds flowed into Israel. But during this same period, Israel experienced an outward movement of $2.2 billion in direct investment -- in other words, overseas investors who cashed out their earlier investments, or Israeli investors who moved investments overseas. Thus, the net inflow of foreign direct investment money to the private sector was about $370 million per year after Oslo -- hardly a flood of Noanic proportions.

Even this number needs be taken with several grains of salt. Much of what looks like direct investment may really be speculative capital that takes advantage of Israel's distorted exchange rate, making it a paradise for overseas speculators. Every year, the Israeli monetary authorities generally have to reduce the value of the shekel relative to the dollar because Israel's high inflation makes it worth less. In recent years, the value of the shekel has not been reduced fast enough to keep up with inflation, a consequence in part of the Bank of Israel's attempts to suppress inflation by slowing down the depreciation of the shekel. This results in Israel's goods and services' being overvalued (in terms of foreign purchasing power), and makes foreign goods too cheap. The result? A steady, serious deterioration in the trade deficit, as imports outstrip exports.[7]

The exchange rate of the shekel has depreciated very slowly, whereas Israeli shekel interest rates have been very high, much higher than those in other Western countries. Speculators have found they can earn a greater rate of return on capital in Israel than elsewhere, in fact probably more than double what they can get at home. As long as no sharp devaluation of the shekel is imminent and Israeli nominal interest rates remain high, speculators can make fast money by investing cash in shekel-denominated interest-bearing instruments, then pulling out with handsome profits. They must pull the money out before the Israeli exchange rate takes a quantum jump upward, which seems far off -- the Bank of Israel is pledged not to do this so long as the government's fiscal affairs are a mess. In other words, much of the recent inflow of foreign capital into Israel is less a peace dividend than an inflow of hot capital making a windfall at the expense of Israelis. At the first whisperings of steps to correct the exchange rate distortion, or a sharp drop in nominal interest rates, this hot inflow can quickly become a hot speculative outflow.

The peace process did lead to a surge in net foreign investment, so Kanovsky's prediction here was wrong. At the same time, those who predicted a flow of investment into the Israeli private non-banking sector inspired by the peace process were also wrong.

FOREIGN FUNDING FOR FISCAL IRRESPONSIBILITY

There is another way to look at the inflow of overseas investment into Israel, by seeing it as a consequence of the growing fiscal irresponsibility of Israel's bloated government.

There is a close relationship between a deficit in the balance of payments and a government budget deficit. When the government budget is in the red, the government must attract money, and that often means pulling in money from abroad.[8] What appears at first glance to be a peace dividend of inflowing capital and international investments is in fact nothing more than an aspirin for the balance of payments trade deficit headache caused by the Israeli government's budget deficit. Indeed, if private savings more or less equal domestic investment, then the government's only choice is to use funds from abroad. In Israel's case, the private savings are not even enough to finance private investment, so the problem is all the worse. To be sure, part of the private savings gap and Israeli government budget deficit is covered by aid and gifts, but that is not enough. Israel must in effect attract foreign investment to pay for part of the government budget deficit. This foreign investment results directly from the fiscal irresponsibility of the Israeli government; it amounts to a figleaf covering the budget irresponsibility of the Israeli government. A few more years of such blessings and Israel will be bankrupt.

One last point regarding fiscal irresponsibility: even in those cases where the post-Oslo capital inflow into Israel consists of real direct investment, the kind that creates jobs and industrial capacity, this inflow too is connected to fiscal folly. Israel has one of the most ludicrous programs of corporate welfare on the face of the planet. Investors in approved projects get up to 38 percent of their investment returned to them as a cash gift, as well as other tax breaks and cheap loans, by the Israeli government under Israel's unneeded "Encouragement of Capital Investment Law."[9] In the largest post-Oslo foreign direct investment project, Intel was given over $600 million for building a factory in Israel -- even though Intel had a large operation in Israel long before Oslo. Foreign direct investment in Israel is a decidedly mixed blessing for the Israeli taxpayer.

LOWERED DEFENSE EXPENDITURES?

The peace process was supposed to decrease Israeli defense expenditures, releasing resources that can be used for civilian purposes and industrial development. Has this occurred? It certainly appears so, for defense expenditures are sharply down, from about 26 percent of the government's ordinary budget in 1993 to about 20 percent in 1996. But the picture is more complex. First, real defense expenditures have decreased steadily since 1987, long before Oslo (and about the time that the intifada began). Real defense spending in 1996 is about one-third less than in 1987. When combined with the rise in the country's real (deflated) gross domestic product (GDP) -- the size of the national economy and national output -- of about 55 percent during the same decade, it becomes clear that the proportion of resources devoted to defense has dropped by more than half during the past decade.

Secondly, it is not clear whether this partial unilateral disarmament is judicious at a time when Arab countries are amassing arms.[10] If the peace process proves successful, the verdict will be positive; but if it does not, it will have been one of mankind's greatest follies.

BOOMING STOCK MARKET?

Gauging the health of a society or the success of a government's diplomacy by following the stock market's ups and downs is at best a shaky methodology. Still, while small fluctuations cannot be considered market judgments on a country's leadership, larger market swings do indicate something about investors' level of confidence in a country's industrial base.

From the Rabin election in June 1992 until shortly before the DoP, the Meshtanim index (Israel's rough parallel to the Standard and Poor 500) showed the Tel Aviv Stock Exchange plodding along at about 185. The four months following the Handshake saw the market in a euphoria, peaking at about 256, or a nearly 40 percent nominal increase in average stock prices. This clearly reflected investor optimism in light of the diplomatic breakthrough. A couple of months of stability were then, starting in March 1994, followed by tumbling prices, a trend that has continued for the next three years.

The immediate trigger for this profound shift seems to have been Arafat's May 10, 1994, speech in Johannesburg, in the course of which he called for a jihad [sacred war] "to liberate Jerusalem,"[11] the first such call to arms made public after the Handshake.[12] As public-opinion polls indicated, such talk eroded Israeli confidence in the peace process. By mid-1994, the Tel Aviv stock market was at a lower nominal value than before the Handshake in September 1993, and at a level considerably lower in real (deflated) terms.

The Israeli stock market subsequently remained within the narrow range of 185-205 until December 1996, a level far below the one that existed pre-DoP in real terms. Then, at the end of 1996, the market suddenly and sharply rose, gaining about 20 percent and returning at last to the real pre-DoP levels, although this might have been nothing more than an Israeli echo of similar increases internationally. Commentators disagree about the cause of this newest rise, with most of them connecting it to the Hebron agreement that Prime Minister Binyamin Netanyahu signed with Arafat in January 1997, though it could just as plausibly have been caused by the Netanyahu government's proposals for economic reforms and privatizations, announced in the late 1996.

To the extent that the stock market reflects how investors view the peace process and the economic peace dividend, the vote is pretty clear: there is no significant peace dividend.

CONCLUSIONS

As Kanovsky argued soon after the Oslo process started, supporters of the peace process must depend on showing that strategic and diplomatic benefits accrued to Israel from that process. But its economy has sputtered along with modest growth rates and spiralling foreign debts. The economic spurt that did take place had more to do with sharp cuts in military expenditure and the inflow of immigrants than with the peace process. The inflow of foreign investment was primarily caused by the government budget deficit and fiscal irresponsibility. In short, there has been no significant economic peace dividend.

This fact has great bearing on the prospects of the peace process and the willingness of the Israeli public to see it continue. As Israelis become more skeptical of the security benefits deriving from the peace process, the need for it to produce economic benefits grows in importance. But if these too turn out to be illusory, Israeli willingness to go on making concessions will surely erode.

1 The Jerusalem Post, Feb. 7, 1996. Other Labor Party leaders made similar statements, for eample The Jerusalem Post, Dec. 21, 1993, and Feb. 13, 1995.
2 The peace dividend was supposed to benefit Arab countries as well, but they never suffered trade constraints similar to the Arab boycott of Israel, and so their international trade patterns and their attractiveness for international investments were expected to be less affected by the peace process than was the case for Israel. Arab countries were mainly expected to gain from reduced military spending -- the beating of swords into plowshares. But the Arab states neighboring Israel have not made any sizable military cuts; more broadly, little economic change has transpired since Oslo. Indeed, in the Palestinian case they have been net losers. In what are still called the Occupied Territories, per capita GDP has dropped every year since 1993; it was $2,700 in 1992 and $1,700 in 1996. In 1996 alone, per capita GDP went down by a whopping 8.6 percent. See Haaretz, Apr. 3, 1997.
3 Eliyahu Kanovsky, "Will Arab-Israeli Peace Bring Prosperity?" Middle East Quarterly, June 1994, pp. 3-10.
4 Globes, March 28 and 31, 1997.
5 It is also temporarily possible to cover the deficit out of foreign currency reserves but the Israeli Central Bank did not attempt to do so in the post-DoP years; in fact, reserves were built up steadily from 1993 through 1996.
6 Netting out growth of Israeli deposits in overseas banks. Actually even this number is misleading. Of the foreign investments in Israeli bank deposits, some of the dollars are then re-lent by the banks to the Israeli government, and so these funds deposited in the banks are for all intents and purposes additional (indirect) borrowings by the government.
7 Curiously, the same exchange rate distortion may be the main cause of the huge growth in the presence of foreign "guest workers" in Israel. Wages in Israeli shekel, like everything else in Israel, are distorted and "too high" in terms of foreign currency due to the exchange rate distortion, making Israel an attractive place for foreign workers. The frequent closures on the Gaza Strip and West Bank that prevent Palestinian day workers from commuting to their jobs also play a role of course. But the closures explain the demand for guest workers, not their supply.
8 For national accounting reasons that only a macroeconomist can fully explain, a close relationship exists between the size of the government's fiscal deficit and its balance of payments deficit: a balance of payments deficit cannot be corrected without at the same time reducing the government's budget deficit. In other words, a large balance of payments deficit reflects a fiscal budget deficit. This in turn implies that the inflow of investment funds from abroad must necessary equal, and indeed may be caused by, the trade deficit.
9 The Netanyahu government is now considering sharp cuts in this welfare for corporations program. In Hebrew, the term "approved factory" is identical to "happy factory," and so this law has been known by wags as the "Happy Factory Law."
10 As a percentage of GDP, Arab military spending has dropped somewhat since Oslo but Arab states (and Egypt in particular) continue to build large arsenals.
11 For the text of the speech, see Middle East Quarterly, June 1994, p. 50.
12 Some (including the Labor Party leadership) attributed the drop in share prices to investigations and indictments against stock market insiders by Israel's securities commission (Harashut L'niyarot Erech) for trading abuses; but these indictments started weeks before the drop, and in any case should arguably have caused the stock index to rise and not fall, as the crooks were being weeded out.