Israeli entrepreneurs at a Viva technology event in Paris in 2016. ERIC PIERMONT/AFP via Getty Images.
Nearly two years ago, in the middle of the worst of the coronavirus pandemic, Israel found itself with an unexpected and rare problem: the average wage in the country went up. The first lockdown in April 2020 brought the average wage that month to a dramatic monthly peak of about $3,900 (NIS 12,590), up from about $3,200 (NIS 10,319) in January 2020. This seemingly laudatory achievement, however, did not reflect the reality of the Israeli economy, which included tens of thousands of closed businesses, entire industries shut down for months, many of the self-employed on the verge of bankruptcy, and over a million unemployed at the height of the crisis. The dramatic rise in wages turned out to be a mathematical artifact of the pandemic: those who had lost their jobs or been sent on leave were at the bottom of the income scale, while the employees with relatively higher salaries were much less affected by the crisis. Consequently, the average wage increased.
This one account illustrates a deep problem at the heart of the Israeli economy. On the one hand, Israel is considered around the world a remarkable economic success, having transformed itself in the last few decades from a developing country into a technological powerhouse sought after by nations and businesses throughout the world. It is a cliché now to refer to it as the “start-up nation,” but it is true—Israel ranks first in the world in the number of start-ups per capita and is a leader in global innovation indices. Yet these impressive achievements obscure the fact that the country has not one economy but two: the start-up nation, and, well, everything else. And if things don’t change soon, the start-up nation may start to melt away, and the rest of the economy won’t be strong enough to pick up the slack.
Israel’s start-up economy is English-speaking and fully integrated into the global economy. Since it operates in markets beyond Israel, its competitors are not local, nor are most of its sources of funding. It is flush with assets, enjoys rapid growth and expanding exports, and it has been carrying Israel forward for over two decades. It produces an estimated 15 percent of the nation’s GDP, and its exports constitute almost half of the whole country’s. Its employees receive high salaries, reflecting the considerable value they generate for their companies; 25 percent of all income tax paid in Israel is paid by high-tech workers, even as they constitute only 10 percent of the Israeli workforce.
A very different picture emerges when looking at the rest of Israel’s economy. Dominated by traditional industries like manufacturing and service, this economy is characterized by productivity levels about 50 percent lower than the start-up economy. It is primarily a local economy, targeting the Israeli market (with the exception of the tourism industry), and one that produces few exports. In part this last fact is because it has difficulties facing international competition—in particular from countries with cheap labor—and is subject to onerous domestic regulation and heavy taxation. The average wage in this economy is much lower than that in the tech economy, except for industries with strong unions, such as in the banking sector, or in government monopolies like Israel’s electric company, where the high salaries are the result of the leverage that comes with an absence of competition.
There is little connection between the two economies. This is true not only of their differing productivity levels but also of the skill levels required of their employees, their means of financing, their geographical distribution, and their challenges. What’s worse, the two economies have been moving further and further apart. Israel’s high-tech economy is coping well with globalization because it is inherently international; as the world becomes more technologically oriented, technologically literate workers are in high demand. The traditional economy, however, has difficulty coping with today’s rapid changes or adjusting to the relative advantages and different risks among countries.
Until recently, the gap between the two economies has been camouflaged by positive top-line data from the Israeli economy as a whole. But the pandemic has finally destroyed the illusion of a single healthy Israeli economy. It has not only made the distance between the two economies more apparent, it has even widened the gulf between Israel’s manufacturing and service sectors and its high-tech, global firms.
In the wake of travel restrictions and social distancing, more of human life was mediated through the screen. And so demand skyrocketed for video calling, remote interactive learning, video games, live streaming, and online shopping, banking, and food delivery. All of this increased demand for computers and technology services like cloud storage, cybersecurity, information-systems maintenance, data science, and more. Plus the high-tech industry, which has always been distanced from its main customers and investors by oceans and time zones, has extensive experience working remotely, collaborating with large companies overseas, and raising capital through digital means. The full transition to remote work came relatively easily to its workforce. In fact, many high-tech companies now intend to leave this option open to their employees indefinitely. While the rest of the nation and the world ended 2020 in recession, unemployment, and deficit, the high-tech economy continued to expand, and it finishing 2020 with a growth rate of 5.8 percent—higher than the average growth over the previous decade. It finished 2021 even stronger: with an unprecedented number of deals, including IPOs, mergers, and acquisitions at the amount of 82 billion dollars, more than the ten years that preceded it combined. No less than 33 Israeli companies got their “unicorn” status, meaning that these companies were evaluated as worth over a billion dollars.
But while the innovative economy was able to adapt and even flourish through the pandemic, the old economy found itself collapsing. In 2020, many of its industries were stopped by government order; in others, customers shied away. In 2021, most of the government restrictions were removed, but then the fourth and fifth waves of the coronavirus hurt businesses again, and they hurt small businesses most of all, especially in entertainment, tourism, aviation and transportation, and restaurants. These more traditional industries suffered most from the global supply-chain crisis, which both hurt their production levels and raised their costs—costs which were passed along to consumers in the form of higher prices.
How did Israel’s economy become so bifurcated? A leading reason is that the traditional economy is burdened by precisely what does not exist in high-tech: government regulation. While factories, small enterprises, restaurants, electricians, and the like are afflicted by an endless tangle of bureaucracy, the high-tech industry faces very little oversight. An entrepreneur with an idea and a laptop can start a company from his parents’ house. But anyone wishing to set up a falafel stand in the city center will have to obtain certificates in triplicate from half a dozen or more public bodies, each with its own requirements. An exceedingly large number of regulatory entities, regulations, and laws set seemingly endless, often contradictory restrictions that can even be changed and applied retroactively. Regulations define restaurants down to the smallest details, such as the height of the ceiling in the kitchen (2.75 meters), storage of refrigerated food (separate refrigerators for prepared food and raw materials), and trash cans in the restaurant bathrooms (trash bins must be placed in women’s bathrooms but are forbidden in the men’s bathrooms). The same goes for most businesses with physical footprints.
This bureaucratic weight, a legacy of Israel’s early socialist roots, has, in turn, fostered a poor and weak Israeli business culture that relies on the benevolence of the government and automatically turns to it when any problem arises. In the more traditional parts of the Israeli economy, there is an underlying assumption that the government should bail businesses out and rescue them if something goes wrong. This too is the heritage of decades of Israeli socialist programs that sent immigrants to live all over the country and only then built cities and factories for them to live in and work at, regardless of geographical or business sense. If a business fails because it is unprofitable and unable to cope with competition from imports—as happens every few years—there are widespread calls to “save the factory” through subsidies, through regulating its competition, or through tariffs.
In the high-tech economy, on the other hand, global competition is not only self-evident but also desirable: the domestic market is too small to sustain large-scale software and technology development. And there the potential for profit is always accompanied by the risk of failure. The main concern is not about maintaining the status quo, but growing, which requires taking risks.
In the long run, the benefits of easing regulations on Israeli businesses would be enormous: the OECD estimates that if Israel would reduce its regulatory burden to the average level of developed countries, it could increase its GDP by 3.75 percent within five years and 5.75 percent in ten years—astonishing numbers that could transform the country. High-tech is already there; the rest of the economy needs to follow suit. It is inevitable that a business that always seeks state assistance in the face of difficulty and loss will not succeed in the long run. Independence, self-reliance, initiative, resourcefulness, and coping with challenges are the cornerstones of any successful industry.
For all its success, Israel’s high-tech economy now faces a serious threat that is rooted in its very strength—its ties with the global economy. High tech’s digital base mean that the physical ties of its workers to Israel are tenuous. These workers are so highly mobile that entire companies can relocate to Silicon Valley for the price of a plane ticket, and even if whole companies don’t do this, individuals do. Foreign companies and governments are willing to pay vast sums of money to attract successful companies and skilled and talented tech employees. Sometimes it’s easier just to move the head of the company and hire everyone else in the new place; it’s usually also easier to get funding when you’re closer to tech capitals. All this means that Israel is in constant danger of losing the very people that form its main economic advantage.
If current high-tech workers fly the coop, what then? There’s already a shortfall in the number of candidates needed for all the high-tech companies currently active in Israel, much less excess talent that could staff new companies or the many talented candidates beyond these who would be needed to replace emigrating tech engineers. Indeed, the number of graduates completing academic studies in professions related to the high-tech industry does not come close to satisfying the huge demand for qualified workers. Even over the past year, despite the high number of unemployed Israelis, the shortage of tech workers still existed.
The most significant challenge facing the high-tech sector thus turns out to be the same challenge that, were Israel to address it, would present a great opportunity to the other, traditional economy: the improvement of the Israeli education system. Israeli schools simply fail to produce enough graduates sufficiently skilled to integrate into the innovative economy—or the old one. Even workers entering other sectors of the economy fail to learn enough to be as productive as they could be—as productive as their international competitors are—and thus often become dependent on the state and its support rather than contributing to its growth.
Just as looking at Israel’s economy in the aggregate suggests a misleadingly healthy picture, the same can be said for looking at some educational data without the right context. Israel has a relatively high percentage of students who earn a bachelor’s degree compared to other countries; the number of high-school graduates has also increased in recent years. These figures present an image of Israel as a highly educated nation. But, though large numbers of Israelis are educated, it turns out they haven’t been educated very well. Israel is now ranked 42nd out of 79 participating countries in science, 37th in reading literacy, and 41st in mathematics, according to the latest Program for International Student Assessment tests. The rate of excellence in Israel is lower than the Organization for Economic Co-operation and Development average, while the rate of failure in these tests is significantly higher (22 percent compared to 13 percent in the 38 OECD countries). Israel also leads the developed world in the dubious achievement of having the largest gap between the strongest students and the weakest students.
Nearly all of these students go through the public school system, though a relative handful of mostly rich parents do manage get their children into independent schools, where they tend to learn much more and which prepares them better for high-tech jobs. Why the Jewish state’s public school system is so poor and what exactly must be done is a matter for another essay. In the meantime, the gap between the lowest levels and the highest levels of students has never been as great as it is now. Those in the upper decile of Israeli society start their careers in elite intelligence units in the Israel Defense Forces and continue from there to the most successful high-tech companies. They do not need the Israeli public education system. Even in 2020, when public institutions were closed, these students were able to learn and progress, while disadvantaged segments of Israeli society were left behind once again. The education system failed to adapt, with teachers’ unions responsible for much of the failure. The unions were against hybrid learning, against putting cameras in the classroom to helps students who were isolated at home, against closing schools during the worst of the virus and making those days up during the summer vacation, and against allowing different virus-related policies for kids of different ages.
Who are these left-behind students? They tend to be from the geographic and social periphery: women, the ultra-Orthodox, or Arab Israelis. High-tech workers are, by contrast, concentrated in the large urban centers in Israel. Those now excluded need to be mobilized. The state of Israel sorely needs to develop a national education system worthy of the Jewish people’s educational patrimony. The commandment to teach your children is not only a religious value but a modern, educational imperative. By ensuring Israel’s most productive sector stays that way and by bringing its less productive sectors closer to a competitive level, education is, along with streamlining regulation, necessary to strengthen the country’s economic future.