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  • Erick Brimen

Lessons Learned from Israel, the Start-up Nation

Israel has earned the moniker “Start-Up Nation” for a good reason: it is home to the most start-ups per capita in the world by a large margin and has more companies listed on the Nasdaq exchange than the entire European continent. For a relatively small country of roughly 8,000mi2 that was conjured out of thin air in 1948, this is a mind-blowing achievement. However, possibly even more amazing is the rapidity with which this development occurred: Israel was more similar to Zimbabwe than the United States as recently as 1984 when inflation was averaging around 450% in the small country.[1] This begs the question: what, exactly, is it that has propelled Israel from 3rd-world conditions a mere 35 years ago to the home of the most engineers and the highest research and development spending on the planet today, and can such success be replicated?


Israel’s growth was the result of a unique amalgamation of conditions, some replicable, and some not. There are many factors unique to Israel which do not lend themselves to replication: Massive amounts of aid from extant developed nations (especially the United States), unheard-of levels of high-skilled immigration, a uniquely overdeveloped military research complex, and a total inability to trade with any directly bordering nation because of fractious geopolitics. However, the unique aspect of Israel that many commentators argue is the single biggest factor in Israel’s success can be summed up in a single Hebrew word: chutzpah. These will each be elaborated upon in turn below.


However, there are also a few replicable lessons to be gleaned from a review of Israel’s growth. These include the importance of fiscal austerity, deregulation where it matters, research & development, and the importance of a large state-backed, state-funded venture capital effort to jump-start high-speed growth as Israel has seen. These, too, will be elaborated upon below.


Irreplicable Catalysts for Growth

If extraordinary claims require extraordinary evidence, then Israel’s extraordinary growth requires extraordinary explanations. Many of these are unique to the cultural, historical, and sociological aspects of Israel’s development, and as such do not carry many lessons for the next aspiring “Start-Up Nation.” However, in examining all of these, it should be ever held in mind that social and economic development is startlingly complex, multivariate, and entropic phenomena that often defy unitary explanations. All of the factors mentioned below work together in a dynamic and synergistic fashion to craft Israel into what it is today; as such, none of the factors below should be considered alone, but rather in conjunction with the amalgam of other circumstances which have influenced the unique creation that is modern-day Israel.


Foreign Aid

Foreign aid has played a massive role in the development of Israel, especially when the country was in its infancy and especially in the realm of military and defense. This aide begins as far back as 1952, a mere four years after the creation of Israel when West Germany began paying reparations to the country of Israel for the war crimes committed by the Germans against the Jews in WWII. From 1950 until 1965, Israel’s real GNP grew by an average annual rate of over 11% thanks almost entirely to American aide and German reparations payments.[2] This aide gave Israel the income to become a socialist state, which eventually resulted in the aforementioned economic collapse of 1984. It is important to note that, to date, the Germans have paid over $89 billion in reparations to the Israels since 1952, with payments still ongoing today.[3]


The United States has also given—and continues to give—Israel massive amounts of aid in the form of direct transfers, low-interest loans, and military aid. To date, the United States has given at least $128.9 billion in aid to Israel since 1948, with much more being possible from a collaboration between classified military programs of the two nations.[4] The aide has most likely played a significant role in the economic growth of Israel. This is made apparent by the fact that from 1984-2016, the very years in which the Israeli economy grew to what it is today, America aide averaged $3.1 billion per year split fairly evenly between military and economic aid. That means US aide made up as much as 10% of Israel’s GDP until 1990, at which point the economy began growing so fast that US aide became an ever-shrinking proportion of Israel’s GDP.[5]


Although the overall economic impact of aid remains a hotly contested topic amongst academic economists,[6] aid played a vital role in the development of the Israeli economy. US aid and German reparations have enabled Israel to offload much of the costs of defending itself in one of the most hostile environments on the planet, freeing up its tax revenues for expenditure in other areas such as venture capital and research & development. This will be explained in more detail below.


Immigration

Israel has experienced one of the most prolific levels of high-skilled immigration the world has ever seen, largely as a consequence of its unique position as a haven for oft-persecuted Jewish minorities. Israel’s population has grown ninefold since it’s founding, with the population doubling in the first three years of its existence.[7] In modern Israel, foreign-born citizens are over one-third of the total population.


Although the overall flow of immigration has been sustained since Israel’s founding, it has experienced some bursts of hyperactivity which directly contributed to Israel’s economic miracle. The primary growth-boosting burst came from 1990 to 2000, when over 800,000 Jews from the former Soviet Union fled to Israel after the fall of the Berlin wall. What’s more, 30% of these immigrants were doctors, 20% were engineers, and many were highly educated in other fields. “In fact, according to the Organisation for Economic Co-operation and Development (OECD), 45 percent of Israelis are university-educated, which is among the highest percentages in the world.” According to Singer and Senor, “Russians with PhDs and engineering degrees were arriving in such overwhelming numbers that they could not find jobs in their fields, especially while they were still learning Hebrew.”[8] This could do much to explain the anomalous level of research & development and technological innovation which has sprung forth from Israel in the last 30 years.


This massive and sustained inflow of immigration Israel has received since its inception has undoubtedly played an outsized role in its extraordinary development. One of the most widely accepted empirical findings of the field of economics is the overwhelmingly positive economic impact immigration has on everything from entrepreneurship to wage growth to productivity growth and unemployment.[9] In particular, immigrants have a powerful impact on rates of self-employment, entrepreneurship, innovation (for example, 51% of all US patents in 2013 were filed by immigrants).[10],[11] However, many of those findings are based upon the immigration of low-skilled workers from vastly different cultures. The economic growth potential of immigration is exponentially increased when a majority of those workers are highly educated, have massive amounts of human capital, and are all members of the most productive culture on the planet (more on this later). All these factors came together to create the perfect storm of economic growth in Israel. This completely irreplicable fact of Israel’s past has powerful explanatory power for Israel’s economic miracle of the last 35 years.


There is, however, a lesson in Israel’s history of immigration that does carry over to any nascent Start-Up Nation: focus on attracting high-skilled, highly-educated immigrants to facilitate the development of a robust research & development industry.

Military Research & Development

Israel has the highest spending on research and development of any nation on earth, with 4.5% of its annual GDP going to R&D—double the OECD average.[12] However, 30% of that goes to military R&D, which is double the percentage the US spends on military R&D and is the highest percentage of spending on military R&D on the planet by a factor of four. This explains why Israel has cornered over 60% of the global drone market and is one of the largest exporters of arms on the planet.


However, beyond this direct economic impact, Israeli military R&D has large and immeasurable impacts on overall innovation in the economy. Many revolutionary innovations which changed the landscape of the modern economy originated from military research. Everything from the internet to space travel to commercial jet aviation are spinoffs or direct results of military research efforts in the United States. It follows from this observation that the country which spends the most on military R&D by such a large margin must be seeing great spillover effects into overall innovation and economic growth. This, in combination with all of the other factors listed here, could explain why Israel has the highest number of technology-focused start-ups in the world, is ranked 2nd on Research and Development on Bloomberg’s Innovation Index,[13] and has one of the highest output levels of scientific papers in the world.[14]


Hostile Neighbors

Although Israel’s position amongst a gang of hostile nations may seem on its face to be a detriment for Israel, it is, in fact, a blessing in disguise. First, it has caused Israel to develop robust global trade networks, and second, it has had an indelible impact on Israel’s culture that has uniquely contributed to its productivity.


It is no exaggeration to say that every nation bordering Israel harbors deep hostility for the small nation ranging from a simple desire for ostracization all the way to a fervent desire for the destruction of the nation of Israel. This has caused Israel to be perpetually plagued by security fears from the day of its inception. One obvious and direct implication of this fact is that Israel cannot trade with its neighbors in any way. However, the health and prosperity of nations are largely dependent upon their capacity to trade. Realizing this fact, Israel has from an early stage in its development focused on creating robust trade networks with nations around the globe to make up for its lack of trade with neighboring nations. The fruits of this are borne out in Israel’s trade figures: it runs an annual trade surplus with the rest of the world of nearly $5.5 billion, and exports make up 31% of the Israeli economy.[15],[16] Israel would not have so deeply entrenched itself in global trade networks were it not forced to by the hostile environment in which the nation finds itself.


Israel’s hostile neighbors are also partially responsible for the creation of the very culture which has enabled the small Jewish nation to be so economically successful. The hostility of their neighbors forced Israelis to become largely self-sufficient and develop a sense of self-reliance that is still powerfully felt in the culture today. A story more easily conveys this concept than aggregate economic and statistical data.[17]


Israeli Intel employee Dov Frohman had a tough decision to make in January of 1991. The Intel chip manufacturing plant he oversaw had recently become the backbone of Intel’s world-leading chip production. However, Saddam Hussein had started the year by launching numerous missile and gas attacks on Israel. In response, the Israeli government had ordered that no Israelis leave their homes until the attacks abated. Frohman, however, knew that Intel’s trust in him specifically and Israel more broadly would be weakened if the plant were to shut down because of these attacks. As such, he did the only thing a chutzpah-filled Israeli could do in the situation: kept the plant running while the missiles rained down around it. Frohman announced to his employees that work was to continue as usual, but that no one would be punished for not showing up to work amidst an ongoing missile barrage.

80% of his employees showed up to work on time and as expected, and the plant’s output continued unabated.


As Dov Frohman’s story makes clear, Israel’s hostile neighbors have instilled in the Israeli’s a sense of toughness, diligence, and tenacity that makes Israel’s some of the hardest and most productive workers on the planet. Israel's enemies are inadvertently responsible for inculcating in Israel the very cultural factors which are responsible for its astounding economic growth and prosperity.


Culture: Chutzpah and Davka

Cultural institutions are, according to some economists such as Nobel Prize-winning Douglas North, the single most crucial factors which determine the success or failure of a nation.[18] However, cultural institutions are also notoriously hard to quantify and measure, so economists have often shied away from studying their effects on economic growth. Once all other variables are controlled for, the only factor left to explain Israel’s economic miracle lies in the culture of its people.


Israeli culture is defined by chutzpah. Chutzpah does not have a perfectly direct translation to English, but it is similar to “shameless, audacious, gutsy, bold, or impudent.” To have chutzpah is the have the boldness and confidence to do that which is right or needed regardless of how it may seem to others. Chutzpah is characterized by a constant questioning, constant evaluation, and constant challenging of ideas, notions, and hierarchies without regard for custom or deference. To have chutzpah is to tell the CEO of your company he is wrong in front of everyone while you are merely an engineer. To have chutzpah is to refuse to “go along to get along,” but instead to fight for the absolute best outcome of any given scenario. Chutzpah is to defy all social and cultural norms and pursue that which is dear to you irrespective of the judgment of others. It is a norm of norm-violation. Hierarchy is nigh nonexistent in Israeli society precisely because Israeli society is defined by chutzpah. “Assertiveness versus insolence; critical, independent thinking versus insubordination; ambition and vision versus arrogance—the words you choose depend on your perspective, but collectively they describe the typical Israeli entrepreneur.”[19]


Chutzpah celebrates innovative failure. In fact, in the Israeli military, failure is not punished in most cases—lack of effort or action is the only that brings swift and powerful recrimination. Israeli culture is not concerned with credentials or titles, but instead in one’s history of “doing;” Israelis want to hear what you have created, not what title’s you’ve earned or boxes you’ve checked. Chutzpah is not confined to any one demographic or sector of the population, either; the entirety of the Israeli population is defined by chutzpah.

That, at its core, is what has driven such innovation, creation, and entrepreneurship in Israel. It’s as if the culture of a select few hyper-productive Silicon Valley firms were magnified and amplified, then applied to a population of over 8 million people.


This chutzpah is then, in turn, complemented by davka. Davka has no direct English translation either but is something along the lines “the more they attack us, the more we will succeed.” Davka is a unique aspect of Israeli culture that is borne of out of decades of direct and active hostility by all of Israel’s neighbors. Davka could be said to drive some of the force behind chutzpah in Israel.


A keen-eyed observer may object that other factors here neglected have caused Israel’s growth, and not its culture. For instance, some commentators have stated that it is Israel’s mandatory military service and not its culture which creates the innovative atmosphere in Tel Aviv. However, this does not hold up to scrutiny: if that were the case, then why aren’t Scandinavian countries which also have mandatory military service as innovative and rapidly growing as Israel?


Or maybe the massive amounts of aid money Israel have received is responsible for its growth. However, if that were the case and it were only aide which propelled Israel’s growth, then why hasn’t massive amounts of aid caused Israel-like growth across Africa or South America?


This exercise could be repeated ad nauseum, but the outcome will always be the same: after controlling for all other possible explanatory variables, the only thing left that differentiates Israel is its incredibly unique culture of chutzpah and davka.


The combination of all of those above unique historical and economic aspects of Israel’s development combined with Israel’s culture has created the perfect (and irreplicable) storm for miraculous economic growth and innovation.


Replicable Catalysts for Growth

Although many of the factors which drove the exponential growth of Israel are impossible to replicate, there are still many lessons to be learned that can be transferred to an aspiring Start-Up Nation. These include fiscal austerity, deregulation in targeted industries, research & development, and state-backed venture capital funds.


Fiscal Austerity

Things were looking grim for Israel in 1984. Inflation was cresting 450% as the Israeli government attempted to maintain a fully socialist workers state. The government was spending nearly 60% of Israel’s GDP, and worker’s wages were directly tied to the cost of living in the country. This caused a never-ending cycle of hyperinflation as the central bank printed more money, which drove up prices, which then drove up wages, which then drove up prices, ad infinitum. However, they rapidly realized that such a state of affairs would lead toward certain ruin. To avoid this fate, government leaders came together in 1985 and crafted a plan which set Israel on the path to prosperity.

The plan was simple: government spending was massively slashed, and the legal linkage between wages and the cost of living was severed. Israel then continued to reduce government spending year after year, continuing to do so into the present day.



Figure 1: Israeli Government Expenditures since 1984[20]


This fiscal austerity was coupled with targeted deregulation for the industries and facets of the market which the government chose to develop (more on this below). These reforms worked wonders for the Isreali economy, as the graph below makes clear (notice the massively increased growth after these reforms in 1985):



Figure 2: Israeli GDP Growth[21]


The lesson here for a nascent Start-Up Nation is clear: start with government expenditures as low as possible and keep them that way. This formula for success has proven successful not just in Israel, but in every jurisdiction which has attempted it. It is no coincidence that the period of most rapid economic growth and prosperity in the United States was the very same period in which government spending was almost nonexistent: 1870-1910.


Deregulation

Soon after the paradigm shift which occurred in 1985, Israel found that its global comparative advantage lies in the technological development enabled by the high levels of human capital and research and development funding in the nation. However, these industries found themselves stifled by both regulation and a lack of investment capital with which to launch new enterprises.


To facilitate the development of this industry, the Israeli government took two decisive actions: the founding of state-funded venture capital partnership, and the creation of a “tax and regulatory environment that, while favoring technology start-ups and foreign investors, did not offer the same support for the rest of the economy.”[22]


The benefits of deregulation are well known in the field of economics. The intuitive appeal of reducing regulations is obvious: by reducing the barriers and hurdles through which entrepreneurs must pass; they are encouraged to do more, innovate more, and create more, all at a lower cost than is possible with the heavy hand of regulation. Regulation also costs the world economy trillions of dollars per year; some studies have shown that since 1949, regulation in the United States alone has cost the nation almost $40 trillion.[23] This logic applies to Israel as well: so long as there are barriers to entrepreneurs founding and attracting funding for their firms, they will be discouraged from doing so and can only do so at a high cost which must be recouped later.


Israel solved this problem by deregulating only the industries which the government targeted and recognized as high-growth potentials: technology and the venture capital funding needed to facilitate it. This could do much to explain why Israel has the 4th highest level of foreign direct investment in the world and the highest density of start-ups in the world.

This should not be mistaken as an endorsement of such a targeted deregulation regime, however. Deregulation in all industries could compound Israeli’s growth even farther, and insofar as the rest of the economy is tightly regulated, Israel is held back from unleashing its full potential. It is worth noting, however, that if a government is to deregulate, beginning the process in the most high-impact industries where such deregulation will have the highest margin impact and then moving to other, less impactful sectors of the economy is the most rational and efficacious way to achieve deregulation in a gradual, piecemeal process.

The lesson here is simply that deregulation can unleash the latent powers of human ingenuity and innovation, and that this impact is particularly acute if done in the industries where the jurisdiction has the largest natural comparative advantage.


State-Backed Venture Capital: BIRD and Yozma

Israel’s government engineered its economic miracle in a surprising way: by bootstrapping businesses into being with state-backed investment funds.


The first of these programs was called the Binational Industrial Research and Development Foundation (BIRD) and was a joint endowment between the US and Israel. Bird “Gave modest grants of $500,000 to $1,000,000, infused over two to three years, and would recoup funds through small royalties earned from successful projects.”[24] According to one of the founders of BIRD, it acted as a sort of “dating service,” matching Israeli technological developments with American firms that could market and distribute it. “To date, BIRD has invested over $250 million in 780 projects, which has resulted in $8 billion in direct and indirect sales.”[25] By 1992, 75% of the Israeli firms on the NASDAQ exchange were BIRD-funded endeavors.


The government also funded some enterprises through a more direct and piecemeal fashion. After the flood of high-skilled immigrants came in from the former Soviet Union in the 1990’s, the Israeli government tried to find some way to help these immigrants become entrepreneurs themselves. To that end, the Israeli government-funded “hundreds” of small companies based on the technological innovations of these immigrants. Although this was helpful, it still was not seen as good enough; after all, the government could give these entrepreneurs funding, but not the business acumen needed to make a start-up successful.

Yozma was created to fill this gap. The government of Israel invested $100 million in 10 new venture capital funds. “Each fund had to be represented by three parties: Israeli venture capitalists in training, a foreign venture capital firm [with experience], and an Israeli investment company or bank.” These ten funds were rounded out by one, final fund of $20 million that would invest directly into tech companies. Senor and Singer explain how the funds operated:

“The Yozma program initially offered an almost one-and-a-half-to-one match. If the Israeli partners could raise $12 million to invest in new Israeli technologies, the government would give the fund $8 million. There was a line around the corner. So the government raised the bar. It required VC firms to raise $16 million in order to get the government’s $8 million. The real allure for foreign VCs, however, was the potential upside built into this program. The government would retain a 40 percent equity stake in the new fund but would offer the partners the option to cheaply buy out that equity stake—plus annual interest—after five years, if the fund was successful. This meant that while the government shared the risk, it offered investors all of the rewards. From an investor’s perspective, it was an unusually good deal….
The ten Yozma funds created between 1992 and 1997 raised just over $200 million with the help of government funding. Those funds were bought out or privatized within five years, and today they manage nearly $3 billion of capital and support hundreds of new Israeli companies. The results were clear. As Erel Margalit put it, “Venture capital was the match that sparked the fire.”

By providing government funding to buttress VC firm selection, the Israeli government kick-started the entire start-up industry in Israel. The method by which they did this was particularly clever: recognizing that governments will never be as adept as VC firms at identifying which start-ups have potential and which do not, the government allowed the market to pick the “good” firms by forcing the Israeli VC partners to raise a substantial amount of funds before the government money was added. In this way, the market mechanisms of VC firm selection and guidance still works unabated, but are simply aided by a larger pool of state funds.


This lesson echoes the experiences seen in Singapore as well, with the tiny nation bootstrapping its way to prosperity with the massive Temasek investment fund. The trend is clear: the most successful geographically limited new jurisdictions utilize state funds to strike the match which then lights the fires of economic development and prosperity (provided that a good institutional and regulatory environment does not choke out the fire of prosperity before in can grow).


Conclusion

Israel has had a meteoric and unique ascension among the world’s most rapidly developing and competitive economies. Surrounded by enemies and filled with a historically persecuted people, Israel has become the world’s most innovative nation in spite of seemingly insurmountable hardships. Many of the catalysts which drove this economic growth are unique accidents and coincidence of history which do not provide many lessons for the nascent Start-Up Nation wishing to emulate Israel’s growth.


However, a few lessons can be gleaned from Israel’s economic miracle: the importance of fiscal austerity, the lightest regulatory burden possible, the importance of state-backed venture funds for new jurisdictions, the importance of high-skilled, highly-educated immigrants, and the importance of developing a culture of innovation and entrepreneurship.

It may be impossible to exactly replicate the unique amalgam of circumstances which catalyzed Israeli growth, but application of these lessons will almost certainly put any aspiring Start-Up Nation on the path to prosperity and human flourishing.

[1] https://www.theatlantic.com/business/archive/2012/08/its-not-just-the-culture-stupid-4-reasons-why-israels-economy-is-so-strong/260610/


[2] https://eh.net/encyclopedia/a-brief-economic-history-of-modern-israel/


[3] https://www.timesofisrael.com/germany-increases-reparations-for-holocaust-survivors/


[4] http://www.jewishvirtuallibrary.org/total-u-s-foreign-aid-to-israel-1949-present


[5] https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?end=2016&locations=IL&start=1984


[6] See The Tyranny of Experts by William Easterly for more.


[7] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 7


[8] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 7


[9] Clemens, Michael, Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?, Journal of Economic Perspectives, 2011


[10] https://www.inc.com/jeremy-quittner/foreign-patents-and-united-states-innovation.html


[11] Fairlie, Robert W.; Lofstrom, Magnus (2015) : Immigration and Entrepreneurship, CESifo Working Paper, No. 5298, Center for Economic Studies and IfoInstitute (CESifo), Munich


[12] https://nypost.com/2017/01/29/why-israel-has-the-most-technologically-advanced-military-on-earth/


[13] https://www.bloomberg.com/graphics/2015-innovative-countries/


[14] https://www.haaretz.com/.premium-israeli-scientific-studies-declining-1.5328140


[15] https://atlas.media.mit.edu/en/profile/country/isr/


[16] https://globaledge.msu.edu/countries/israel/tradestats


[17] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 9


[18] North, Douglass C. 1991. "Institutions." Journal of Economic Perspectives, 5 (1): 97-112. https://www.aeaweb.org/articles?id=10.1257/jep.5.1.97


[19] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 2


[20] https://www.theatlantic.com/business/archive/2012/08/its-not-just-the-culture-stupid-4-reasons-why-israels-economy-is-so-strong/260610/


[21] https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?end=2016&locations=IL&start=1960


[22] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 10


[23] Dawson, John, and Seater, John, Federal Regulation and Aggregate Economic Growth, 2013. http://www4.ncsu.edu/~jjseater/regulationandgrowth.pdf


[24] Senor, Dan, and Singer, Saul, Start-Up Nation: The Story of Israel’s Economic Miracle, Chapter 10


[25] Ibid.

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