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Thursday, November 30, 2017

We Can Learn from Israel’s Failed Liberalization Efforts

"The Liberalization Reform" of 1977 failed totally, not because the policies were bad, but because they were not fully implemented.

The state of Israel was established as a socialist country. In the first 29 years of its existence, from 1948 to 1977, Israel was ruled by “Mapai”- the Israeli labor party. Many companies were owned by the government, ranging from El Al and Zim, the flagship airline and shipping companies of Israel, respectively, to banks and real estate companies. Many regulations were imposed upon the previously existing private sector.

Since then, many things have changed, but Israel is still very far from economically free. Some 30% of the workers are employed directly by the government, income tax is sorely high and extremely progressive, and the regulatory burden is heavy, especially for retail and production. The government imposes strict regulations ranging from factory size to the number of toilet rooms required to the exact lighting level suitable for every room.

May of 1977 was a turning point in the political history of the state of Israel. In fact, an entrepreneur may need to deal with nearly 15 different government authorities in order to acquire the necessary licenses. These days, the private sector in Israel is gradually moving from traditional industries towards technology for which, naturally, the regulatory burden is less aggressive.

May of 1977 was a turning point in the political history of the state of Israel. For the first time, after 29 years of rule by leftist parties, the right-wing Likud headed by Menachem Begin came into power. Its platform included promises of nothing less than an economic revolution including cutting back the deficit, simplifying the tax system, mitigating governmental involvement in the economy, and reducing public spending among others. And indeed, several months after the political takeover, Simcha Ehrlich, the new Treasury Minister, announced “The Liberalization Reform.”

Its purpose and goals were impressive – freeing the trade of foreign currencies to strengthen the Israeli economy by leveraging its comparative advantage. However, the plan didn’t succeed even with respect to its own operative goals. What had gone wrong?

International Trade Is Good for Everyone

The underlying principle of liberalization was the law of comparative advantage attributed to David Ricardo. It states that when free trade exists between two agents with each wanting to maximize utility, both sides will profit even if one of them has an absolute advantage over the other. How so?

The law of comparative advantage is what brought the “takeover” government to declare the Liberalization Reform. Ricardo demonstrated the principle like this: Assume that it is hard to produce wine in Britain, and a bit easier to produce fabric. In contrast, in Portugal, it is very easy and cheap to produce both of these commodities, more so than in Britain. Seemingly, the best solution for Britain would be to block imports from Portugal, since the latter has advantage over the former in the production of both wine and fabric, allowing the Portuguese products to “defeat” their British counterparts in competition.

Ricardo then pointed out the flaw in this conclusion. If Portugal indeed has an advantage both in wine and in fabric, its rational course of action would be to produce only the more expensive product of the two – thus profiting from its sale, while Britain profits from the sale of the cheaper product back to Portugal.

The Liberalization Reform

Accomplishing this would have increased international trade.The law of comparative advantage is what brought the “takeover” government to declare the Liberalization Reform. Up until that point, the various left-wing governments ignored the principle and chose to artificially warp almost every aspect of international trade in Israel ranging from tight controls on exchange rates to heavy import tariffs and restrictions in order to protect local producers. As explained above, these measures harm the economy rather than protect it.

The Liberalization Reform, according to Ehrlich, was designed for “canceling the controls over foreign currency and turning the Lira into an exchangeable currency as in the most modern countries.” This goal includes, he said, three elements: removing controls on foreign currencies, mobilizing the exchange rate for the Lira, and unifying the rates. Accomplishing this would have allowed Israeli citizens to use foreign currencies as they had seen fit and, in essence, would have increased international trade, leveraging the comparative advantage to allow for growth.

Open Bureaucratic Doors

So long as bureaucrats have authority over economic issues, rent-seekers will pressure them to act for their sake. In fact, the Liberalization plan didn’t fail in light of the consequences. It didn’t achieve its operative goals, meaning it wasn’t even fully implemented. How did this happen? Maybe the best example of failure concerns credit rates.

In his paper “The Economic Reform of 1997 – Executing Operative Goals,” published in The Israeli Economics Association quarterly journal, The Economics Quarterly, in 1988, Imri Tov highlights an interesting case. The plan tax-funded grants for exporters, who then started pressuring decision-makers, mainly in the Bank of Israel. This led to extensive subsidies for exporters through enlarged credit.

So long as bureaucrats have authority over economic issues, rent-seekers and other people with vested interests will pressure them to act for their sake. It isn’t only simple logic, but a required conclusion from analyzing the incentive system. The benefits from measures such as credit subsidies are concentrated, and there are concrete agents profiting from them, while the costs are hidden and distributed, and no agent will profit from pressuring them to be saved.

No Liberalization without Deregulation

Truth be told, even if the Liberalization reform had been fully implemented, it would have somewhat improved the Israeli economy, but it wouldn’t have been enough for a significant move. It concerned itself with foreign trade in order to leverage comparative advantages in producing the relevant commodities. But the essential question is: how do we know what they are?

The lack of information may cause consumers and producers to make wrong decisions. The answer is simple: the price system. A producer chooses to produce a certain product if it pays off to do so. An importer chooses to import it if it pays off to do so. A consumer chooses to consume a product only if it pays off to do so. Prices, as we know, are set by supply and demand. In other words, what affects the price of a product is how much it is valued by consumers and how possible it is to produce it. Thus, the price system in a free market loyally represents consumer preferences as well as material limitations producers have.

But what happens in a less-than-free market? What would occur if price controls or taxations were put in effect on certain products so their prices wouldn’t represent supply and demand? What would be the result of imposing bureaucratic and artificial entry barriers, raising the price unnaturally? And what would come about if government subsidizes an industry, using taxpayer money, so its products can be sold below market prices?

In each and every one of these cases, there will be a certain distortion in market activity, and seeing as prices determined by supply and demand are crucial for the relaying of information, the lack of said information may cause consumers and producers to make wrong decisions.

This is the case of Israel in 1977 and, in fact, of modern Israel as well. Government interferes with the market in a heavy-handed manner, heavily taxing some industries while subsidizing others, imposing bureaucratic entry barriers to the point of absolute bans, and that is just the tip of the iceberg. In this case, the law of comparative advantage will work in our benefit – but not in full force.

Radicalizing Liberalization

The free market does a better job. The almost obligatory conclusion from the last two paragraphs is that minor changes may slightly improve the situation, but will never suffice in the long run. It isn’t enough to decide to play slightly differently still inside the frame of a planned economy; the rulebook must be changed.

The government should set a goal of freeing the market and seek at all times for measures to mitigate its involvement in the economy. Israel needs to question some fundamentals: the central bank, the economics ministry, the standards institute, and every bureaucracy tasked with managing economic life. The free market does a better job. Liberalization should be, in short, radicalized.

  • Mr. Lighterman is an Israeli libertarian activist and vice chairman of the libertarian lobby in the Zehut party.