Proclaiming freedom: Israel's prime minister talks seriously about economic reform.

As a result of last fall's violence and the ensuing efforts to rescue the peace process, security concerns have once again eclipsed all other public policy issues in Israel. Despite years of talk about the need for economic reform, therefore, major changes are not likely in the near future. But once the government of Prime Minister Benjamin Netanyahu has some breathing space, there is reason to hope he will do more than talk.

In his June 1 victory speech, Netanyahu put security at the top of his agenda, like every prime minister before him. But he went on to discuss economic issues with equal fervor and conviction: "We shall establish in Israel - listen well to my words - we shall establish in Israel a truly free economy that is not governed by political operatives or by bureaucrats, an economy that does not hinder enterprise. I am confident that in this way we shall liberate the creativity, the genius of this nation, so that the Israeli economy will progress, will soar, will prosper and flourish. I am convinced that Israel can become one of the leading economies, prosperous and advanced."

No previous prime minister had thought economics worthy of mention on such an occasion, certainly not on a par with security concerns and certainly not as a vision to mobilize the energy and capture the imagination of the Israeli public. But no previous prime minister had been so influenced by America's entrepreneurial, pro-market ethos. Though born in Israel, Netanyahu spent most of his adolescence in the United States, where his father, a distinguished historian, held a teaching post. After five years of military service in Israel, he returned to America for college, earning a business administration degree from MIT. In the 1980s he served as a minister in Israel's Washington embassy and as Israel's ambassador to the United Nations. Later, as a Knesset member, Netanyahu did not pay much attention to economic affairs, concentrating on rebuilding the strife-torn Likud Party and positioning himself as its leader. He nevertheless always stressed the need for "a change toward freer markets." During his election campaign, which focused mainly on the vote-getting issues of security and peace, he talked about tax cuts and mass privatization of state-owned businesses.

Of course, Likud has paid lip service to economic reform in the past without accomplishing much after gaining power. One reason for optimism is that Netanyahu is Israel's first directly elected prime minister, which makes him less dependent on favor-seeking coalition partners. Furthermore, his statements and actions since the election suggest he is serious about cutting back the government's role in the economy. His cabinet has endorsed $1.5 billion in cuts from next year's $32.6 billion budget, and he has targeted more than 100 state-owned enterprises for privatization. The spending cuts and the privatization program are part of what he calls a "sweeping liberalization policy for the Israeli economy." While "Israel has had incremental structural reforms since 1986," he said in July, "we intend to do a lot more in a compressed time. It is privatization and liberalization and deregulation, especially the deregulation program, that will bring the economic growth that I envision."

On its face, the Israeli economy has boomed in recent years, with average annual growth of about 5 percent. But this growth has not been due to significant increases in productivity, which has been inhibited by monopolies and protectionism. The last Labor government induced much of the growth by spending about $7 billion of $10 billion in U.S. loan guarantees, money intended to help absorb the recent wave of immigrants from the former Soviet Union. The standard of living has risen dramatically because of big wage hikes in the public sector, which employs two out of every three Israelis. Many public-sector employees, especially in the utilities and the state-owned banks, earn five times the average wage of about $1,500 a month, while managers' salaries can reach $30,000 a month. The country is bursting with new cars, designer shops, and expensive restaurants, but these reflect the growing riches of the elites that govern Israel. Despite huge transfer payments (more than a quarter of GNP), the gap between rich and poor, among the widest in the Western world, keeps growing.

In the 1995 Economic Freedom of the World index, Israel ranked 70th, after Pakistan, Bangladesh, and Tunisia. Taxes amounted to 41 percent of GDP in 1995 (the total budget, including deficit spending, was about half of GDP). Along with a 17 percent value-added tax, Israelis pay steep income taxes. A worker who earns the equivalent of about $27,000 a year, for example, is subject to a marginal rate of 45 percent. Because of taxes, trade barriers, and monopolies, consumers pay inordinately high prices for clothing, electronics, and other durable goods. Cars and appliances cost two to three times as much as they do in the United States. Tariffs on building materials and state control of real estate inflate the cost of housing, so that most young couples cannot buy an apartment without massive assistance from their parents. Making ends meet is so hard that Israelis typically moonlight in several jobs and live on overdrafts. More than 1 million wage earners receive income supplements from the government. Starting a business is very difficult. On top of high taxes and heavy regulation, entrepreneurs have trouble borrowing money, since credit is usually available only to the well-connected.

Indeed, real private business is more the exception than the rule in Israel. The government owns 93 percent of the land, along with all water, natural resources, energy, and telecommunications. It runs the education, health, pension, and insurance systems. To finance large budget deficits, Labor governments have dominated financial markets since the state's creation in 1948, absorbing 90 percent of savings and allocating credit through the three major banks: the Labor-affiliated Ha'poalim, Leumi, and Discount. These institutions, which were effectively nationalized in 1984 after a taxpayer-funded bailout, control almost 87 percent of all banking assets, estimated at more than $100 billion. (Israel's 1994 GNP was $70 billion.) The three banks also control $37 billion in affiliated financial intermediaries, representing 24 percent of all savings, and scores of billions in nonbanking assets.

The Israeli economy is so concentrated in the hands of interlocking political and economic elites that any effort to change the rules of the game will encounter fierce resistance. Before the election, more than 350 of Israel's economic movers and shakers participated in a rally and financed an ad campaign for Labor Prime Minister Shimon Peres. It is not hard to imagine their attitude toward anything approaching "a sweeping liberalization policy." In an August interview with The Jerusalem Post, Finance Minister Dan Meridor was asked about ending subsidies for Egged and Dan, two major transportation monopolies. He laughed and said, "You want to unleash at me all the sleeping dogs?"

Though virtually bankrupt and discredited after decades of political corruption, the Histadrut, the trade union federation closely associated with the Labor Party, still claims 750,000 members, almost 40 percent of Israel's work force. In July it staged a 10-hour, nationwide strike to protest Netanyahu's proposed budget cuts, which include reductions in family allowances and benefits for the elderly. "The government has declared war on the weak," said Ra'anan Cohen, a Labor member of the Knesset. Yossi Sarid, leader of the leftist Meretz Party, said "Netanyahu's government has betrayed the trust placed in it by imposing cruel economic edicts."

Formidable as it is, the resistance from opposition parties and economic interests is at least open. Not so the reluctance of Israel's technocrats, the economists who staff the Bank of Israel and the Ministry of Finance. Ideologically committed to "equality" and "social justice," they are instinctively suspicious of free markets. These bureaucrats sincerely believe that they have to constantly interfere in the economy for the public good. They are generally recruited straight from school and soon achieve great power, which they are naturally reluctant to give up. They tend to be extremely cautious and wary of treading on the toes of powerful vested interests, so they reject any reform that seems politically risky. They also retire early, taking lucrative jobs in the public or quasi-public sector, another reason they may not want to rock the boat. As a result, the reforms they put forward are likely to be half-hearted and ineffectual. It is hardly surprising, then, that the Treasury has yet to offer plans for deregulation or for basic reform of financial markets.

Public opinion is another barrier to liberalization. Despite a general recognition that the government is bloated and inefficient, this is a country long dominated by socialists, where capitalism is commonly called "cutthroat competition" and there is no word for deregulation. Making the case for an open economy, Finance Minister Meridor felt a need to assure readers of The Jerusalem Post that "we should not be ashamed to import what we cannot produce better than others." When Netanyahu proposed a means test for the allowances that the government pays to every family based on the number of children, even affluent Israelis complained. A mother of two with a family income of $60,000 told The New York Times that she didn't need the money, but she worried that the cuts would "create a new barrier between rich and poor." Similarly, a columnist for the newspaper Ha'aretz complained that Netanyahu was "stubbornly insisting on playing the requiem of the welfare state, striking the death chord of social solidarity in Israel."

To counter such appeals, advocates of reform need to emphasize how government hurts the average Israeli. At the same time that the government seeks to encourage large families through cash subsidies, for example, it makes life harder for them. They are forced to pay exorbitant monopolistic or protected prices for the most basic goods, for food and clothing. Services, such as health and education, are supposed to be "free" (financed by taxes), but the quality is often so poor or deficient that families have to purchase supplemental services (private tutoring, school supplies, and medical attention) at additional high cost. The lower-income groups are hit hardest by this "system," their life made inordinately difficult, so they should welcome any reform that will offer them relief.

But even if he gains popular backing, Netanyahu faces a daunting task. In recent decades every Israeli government has promised to reform the country's backward, anti-productive system. None, right or left, has delivered. Statism is too entrenched, too attractive to Israel's political class and too lucrative for the country's economic elites. Consequently, while the determination that Netanyahu has demonstrated so far is no guarantee of success, it is a minimum requirement. Netanyahu will have to exhibit great political savvy, bargaining and marketing skills, and executive ability if his ambitious goals are to be even partially realized.

Daniel Doron is the director of the Israel Center for Social and Economic Progress, an independent think tank. Susan Doron contributed to this article.