The government has learned from economic disaster, embraced high-skilled immigrants, played venture capitalist, and imported one heck of a good central banker.
In case it wasn't clear the first time he said it, Mitt Romney is certain that "culture" is the reason Israelis are relatively rich today, while Palestinians are quite poor. Much of the world -- including the authors Romney cited -- responded to his analysis with a collective "oy."
But Romney's stand does raise a few good questions. Among them: How on earth has Israel become so successful? Sure, its economy has no shortage of problems -- in particular, a startling degree of income inequality. But in the span of just a few decades, the Jewish state has "transformed itself from a semisocialist backwater into a high-tech superpower," as The Economist put it in 2010. Per capita, it gives birth to more technology startups and is the destination for more venture capital than any other country in the world. Its economy barely flinched during the financial crisis.
Here are four big reasons (though by no means the only ones) Israel is in the strong shape it is today.
IT LEARNED FROM DISASTER
It may now be known as the Silicon Valley of the Middle East, but back in 1984, Israel's story had much more in common with modern-day Zimbabwe. That year, the inflation rate averaged 450 percent, and for a few months reached vertigo-inducing highs of around 950 percent. The economy, in short, was eating itself alive. But the crisis had an upside, in that it sparked reforms that would lay the groundwork for Israel's present-day prosperity.
Like any nasty bout of hyperinflation, this one had a few culprits. But here's the streamlined version of what happened: Starting with the massive military buildup that followed the 1973 Yom Kippur war, Israel began ratcheting up its public sector spending. By the end of the decade, the government was consuming three quarters of the economy and leaving behind huge budget deficits, which it tried to finance by having the Bank of Israel print money. The fact that Israeli workers' wages rose with the cost of living only made the situation worse.
Fighting severe inflation usually means suffering through some unemployment, and so Israeli policy makers, who were obsessively focused on providing the country with jobs, did little to fix their metastasizing problem. But as the economy's health deteriorated -- on top of the inflation problem, there was a banking crisis -- investors began evacuating their money from the country, and it became unclear if Israel would be able to pay its foreign debts. In 1985, government leaders met for a marathon, one-day summit where they crafted a grand bargain that slashed government spending, massively devalued the currency, and severed the tie between wages and prices. It also set new rules for a more independent central bank.
This was, in many ways, the beginning of the modern Israeli economy, a step away from the early workers' state, and towards something more akin to mainline modern capitalism. Although public spending in Israel is still high, the government has gradually eased up its role in the economy, while focusing on keeping inflation low and its deficits manageable.
IT WELCOMED BRILLIANT IMMIGRANTS
Israel's economy started getting healthy when the government started practicing mainstream economics. But it also benefited from a once-in-a-century stroke of luck. When the Soviet Union began to collapse, American immigration policy prevented a large number of Russian Jews from coming to the United States. Instead, they chose Israel. Between 1990 and 1997, more than 710,000 Soviet immigrants landed in the country, boosting the working age population by 15 percent. Around 60 percent of the new arrivals had a college education, versus 30 to 40 percent of the native population. Immigration, in general, is good for growth. There are more people to work, buy houses, shop at malls, and pay taxes. When those immigrants are engineers, managers, and college professors, it's even better for growth. The Russian influx gave Israel a booster shot of both bodies and brains.
THE GOVERNMENT PLAYED VENTURE CAPITALIST (BRIEFLY)
These days, you'll often hear Israel referred to as "the start-up nation." The nickname comes from the title of a book co-authored by Romney adviser Dan Senor, which argues that the country's brash, ambitious culture, and its citizens' ability to overcome adversity, is the secret to its success as a high-tech incubator. The Washington Post's Zach Goldfarb has dubbed this theory the "chutzpah thesis."