The Economic Cost of War
By Stanley Reed and Neal Sandler in Jerusalem
April 19, 2002
has ended the rapid growth of the '90s,
scaring off investors and eroding the hard-won gains of economic
These days, a conversation in Benny Gaon's Tel Aviv office about
the situation in the Middle East calls for a bracing glass of wine,
even if it's only 10 a.m. "We are back to square minus one.
We are back to 1948," says the former CEO of conglomerate Koor
Industries Ltd., who now runs his own $1 billion investment company,
B. Gaon Holdings. A close associate of the late Prime Minister Yitzhak
Rabin, Gaon was in the vanguard of Israeli executives who sought
to use business to build peace between Israel and the Arabs.
Now, he's profoundly disappointed about the escalating Israeli-Palestinian
violence. "Four years ago, I was strutting like a peacock at
the World Economic Forum, talking with the Saudis and Jordanians
about the new market of the Middle East," Gaon laments. "Now,
it's all gone."
Not long ago, just about everything seemed to be going Israel's
way, too. That was before the latest Palestinian intifada began
in September, 2000. Signing the 1993 Oslo accords, a framework for
peace with the Palestinians, helped put an end to Israel's isolated
status, opening up closed markets in Asia and Europe to Israeli
companies. A new model seemed to emerge as Israel began to shed
its state-dominated, military-industrial economy to build a middle-class
society based not only on service businesses like construction and
tourism but also, increasingly, on high tech.
IN RUINS. Suddenly, venture capitalists rushed to throw money at
Israeli startups. Tel Aviv became a kind of Silicon Valley on the
Mediterranean, teeming with technology whizzes reaping millions
and even billions of dollars by taking their companies public. The
central bank made the picture more attractive by damping inflation,
ending years of economic instability.
The hope was that Israel would play a pivotal role at the center
of a growing, vibrant regional economy that would lift living standards
in both Israel and the Arab world. Instead, war has combined with
the fallout from the global technology crash to deal Israel a harsh
blow. The country has been in recession for almost two years, and
there is no sign of a respite. Real estate prices have plummeted
30% to 50%; hotel occupancy is running just 7% in Jerusalem during
the usually busy post-Passover season; restaurants are deserted.
Even harder hit is the neighboring Palestinian economy, which the
international community hoped would increasingly blend with Israel's.
It lies in ruins, with half the population living on less than $2
Against this depressing backdrop, Secretary of State Colin L. Powell
in mid-April led the Bush Administration's most intensive diplomatic
effort in the region so far. His mission: to bring an end to the
spiraling violence that has killed 452 Israelis and more than 1,400
Palestinians since September, 2000. But Powell had not secured a
ceasefire when he left Israel on Apr. 17. He said the U.S. would
keep pushing for one, and may organize an international peace conference
on the Middle East. Powell also offered $30 million in new U.S.
aid -- on top of $80 million already pledged -- to repair the damage
to the Palestinian economy.
BLACKENING IMAGE. Sadly, there's a strong chance the violence will
continue. That adds to Israelis' worries about the direction their
economy seems to be heading. Defense spending is rising sharply,
after plunging from 13.5% of gross domestic product (GDP) to 8.5%
in the 1990s. This year, the security burden on Israel's economy
is likely to jump back up to 9.5% of GDP. The danger for Israel
is that its economy could slip back to what amounts to a charity
project sustained by donations of the U.S. and world Jewry. Israel
got by that way in the 1980s, when the currency was a joke, inflation
hit triple digits, and the bank system required a bailout.
To be sure, Israel is still a long way from such dire straits.
While the shekel has declined about 12% against the dollar in the
past year, there are no signs of panic. Still, day by day, it's
increasingly clear that the pillars of Israel's economic strength
are under threat. The conflict with the Palestinians is blackening
Israel's image abroad, scaring off potential foreign investors.
That in turn is darkening the prospects of the high-tech industry,
which accounts for a hefty 15% of GDP. War expenditures and a decline
in budget receipts threaten to undo Israel's hard-won reputation
for fiscal and economic discipline. Higher taxes seem certain, and
the central bank is worried that its inflation-fighting mandate
will be weakened.
Israeli businesspeople are alarmed. They are beginning to make
their views known privately in a country where politicians from
military backgrounds traditionally call the shots. "We are
eager to see the day when this is over," says a senior executive
at a top Israeli company. "If it continues and people feel
we are using power not just for defense but to show we are stronger,
then you will hear screaming from the business community."
WARY INVESTORS. Business is already deeply anxious about the high-tech
sector. After explosive growth for a decade, high-tech exports of
software and other goods went into decline last year for the first
time, by about 10%, to $10 billion. Israeli industry is still cleaning
up the mess left after the high-tech bubble burst. The year 2000
was the peak of the boom, with startups gaining an extraordinary
$3.1 billion in venture money. Companies may not get more than $1
billion this year, estimates Tobias Fischbein, high-tech analyst
at Lehman Brothers Inc. in Tel Aviv. Some 500 of Israel's 3,000
fledgling companies closed last year, and industry sources think
more than 100 will vanish this year.
Since the beginning of 2001, Fischbein's own index of Israeli tech
stocks has fallen by 63.5%, vs. 29% for the Nasdaq in the same period.
Until recently, most damage to Israel-based stocks was due to the
overall Nasdaq collapse. But now, analysts say, Israeli companies
are being singled out. The market capitalizations of the three major
tech companies -- Check Point Software Technologies (CHKP ), Amdocs
(DOX ), and Comverse Technology (CMVT ) -- are each down more than
30% this year alone. Check Point and Comverse have recently issued
The sudden shift in Israel's standing abroad is touching companies
of all sizes. "We're not going to see any foreign money in
the venture-capital industry this year," says Zeev Holtzman,
chairman and CEO of Giza Venture Capital. Yanki Margalit, CEO of
Aladdin Knowledge Systems Ltd. (ALDN ), a software and Internet
security company with $50 million in annual sales, says his company
was due to sign a deal with a major Japanese company last year when
a Palestinian suicide bomber killed 21 Israelis at a Tel Aviv disco.
"They called and said: 'We are not going to do it because of
price issues,' but that was nonsense," says Margalit. The company
clearly grew wary of dealing with an Israeli company, he adds.
SHIFTING OPERATIONS. Such attitudes mark a big change, says a senior
executive at one of Israel's top tech companies. A few years ago,
customers chose to ignore the situation in Israel as they focused
on getting new tech products quickly. "Now, they are more concerned
and looking to find reasons to be concerned," he says. "They
ask: 'What happens if you can't deliver?' I believe at the end of
the day this has cost us orders."
Executives say they spend a lot of time discussing "the security
situation" in Israel rather than business. Some customers and
board members from abroad are unwilling to visit the country for
meetings. Many companies find it wise to hold board meetings in
Cyprus or New York. "It's not easy to find strategic partners,"
says analyst Fischbein. "Would you invest in a company you
The upshot is that Israeli companies are setting up extensive operations
outside the country. Such shifts are partly to protect themselves
from possible disruptions. But Israel, with only 6.5 million people,
is also too small a market in which to fully develop products. And
earlier visions of a regional market with Arab countries have evaporated
"LACK OF VISION." Some Israelis find this a big loss.
"The lack of a regional market makes it very hard for companies
to build globally," says Chemi Peres, managing director of
Pitango Venture Capital, Israel's largest homegrown venture firm.
"The risk is that [once this crisis is over] entrepreneurs
will leave the country. The more we postpone building a regional
market, the more we lose."
Meanwhile, Sharon's government is struggling to cope with a budget
squeeze. Finance Minister Silvan Shalom told BusinessWeek the war
has cost Israel about $1 billion in direct expenditures since early
March, and some $5 billion in lost tourism and other business since
September, 2000. "Investors are not coming," he says.
"In Israel, people are afraid to go out to malls and restaurants
like they used to. This brings high unemployment and makes the recession
deeper. It is a cycle we are trying to escape."
Some of the official response to the slump smacks of desperation.
A recent government campaign, for example, urges Israelis to buy
blue and white, meaning home-produced products. "This takes
us back to the 1960s, when we even tried to produce our own cars,"
says Eytan Sheshinski, a Hebrew University economist. "It shows
a complete lack of vision."
BACK TO THE '80s? There are even worries about Israel's financial
stability. The rating agency Standard & Poor's recently moved
its outlook on Israel from stable to negative in response to the
violence and fiscal pressures. Adding to the unease is a dispute
between the government and David Klein, the central bank's governor.
At issue: proposed revisions to the central bank law that Klein
worries will water down Israel's commitment to fight inflation.
"When you have a growing financial deficit, if at the same
time you say to the markets you don't care about price stability,
you have lost two major fundamentals of economic policy," Klein
The central bank governor also opposes the Finance Ministry's likely
plan to raise taxes. "We are in a world where we compete on
tax regimes against other countries," Klein says. "We
can't afford to be at a tax disadvantage." Instead, Klein thinks
the government should focus on pruning back the public sector, which
still accounts for 54% of GDP -- one of the highest rates in the
world. Despite Klein's warnings, executives such as Eitan Raff,
chairman of Bank Leumi, figure inflation will rise this year--perhaps
as high as 4%, compared with zero in 2000.
So is it back to the bad old days of the 1980s? Then, hard economic
conditions drove many talented Israelis to seek their fortunes elsewhere.
That doesn't seem to be happening this time, at least not yet. In
fact, Israelis living abroad are returning home to serve in their
reserve units. For now, the suicide bombers have unified the country.
"This is a strong country, a moral country, building something
real; it is not going to give up," says Peres, a son of Foreign
Minister Shimon Peres, an architect of the Oslo process.
WILD SWINGS. But there is also fear. With investments in their
own country looking like a bad bet, Israelis have been putting money
into Toronto as well as Prague and Budapest, which are appealing
to Israelis of Eastern European origin. Big real estate players
such as Africa-Israel Investments Ltd. are investing in shopping
malls and residential housing abroad, while small fry are buying
apartments to rent out. An estimated $500 million has left the country
or been transferred into foreign currency accounts in the first
quarter of 2002, analysts say. Recently, Israelis have snapped up
second homes on nearby Cyprus -- an insurance policy in case of
all-out war. "They can send their families there," says
Stanley Finkelstein, a Tel Aviv real estate consultant. "It
is only a half-hour flight."
With suicide bombers blowing people to bits on an almost daily
basis, most executives think Sharon had little choice but to go
after the sources of the attacks. Yet many of them doubt Sharon
has an effective strategy to create a more secure environment over
the long run. And they are dismayed by the wild swings in policy
in recent years. The government's approach to its Arab neighbors
has whipped back and forth between such hard-liners as Benjamin
Netanyahu and Sharon, and Ehud Barak, who pursued peace in almost
Gaon heads a group of executives and academics who aim to propose
an alternative to these policy gyrations. They want to build up
the enfeebled Labor Party, an uneasy partner in Sharon's government,
into a viable alternative for general elections that must take place
by the fall of 2003. They also want to continue economic liberalization
and put an end to the national malaise that has taken hold. "We
have made huge progress in business," says Gaon. "Why
aren't we doing the same in politics?"
HEALING THE WOUNDS. As Gaon and other executives look for solutions,
support is growing on the left and right for separating the Israelis
and Palestinians. A fence with electronic sensors already largely
walls Gaza off from Israel. Recently, the Israeli security cabinet
gave the go-ahead to begin work on such a barrier between parts
of the West Bank and Israel, including Jerusalem.
Some Palestinians hope a physical separation from Israel could
spur them to integrate their economy more closely with regional
neighbors such as Jordan and Syria. There, the standard of living
is similar to that of the territories. But the danger is that the
Israelis could keep the Palestinians cooped up in their enclaves
with little ability to trade with the outside world. Despair and
radicalism would be bound to grow regardless of how high Israel
builds its fences.
Clearly, the status quo makes it impossible for Palestinians to
reach their potential -- economic or otherwise -- and increasingly
hampers Israelis' ability to reach theirs. Prosperity on both sides
could help heal the wounds of war and build a lasting peace. Instead,
the wealth of Israel is trickling away, bit by bit, in a deadly
war of attrition.