Start-up Nation (29 page)

Finally, a perhaps even larger factor in the limit on high-growth entrepreneurial economies is the role of women. Harvard
University’s David Landes, author of the seminal book
The Wealth and Poverty of Nations
, argues that the best barometer of an economy’s growth potential lies in the legal rights and status of its women. “To deny
women is to deprive a country of labor and talent . . . [and]
to undermine the drive to achievement of boys and men
,” he writes. Landes believes that nothing is more dilutive to drive and ambition than a sense of entitlement. Every society
has elites, and a number of them were born into their upper-echelon status. But there is no more widely dispersed sense of
entitlement than ingraining in the minds of half the population that they are superior, which, he argues, reduces their “need
to learn and do.” This kind of distortion makes an economy inherently uncompetitive, and it is the result of the subordinated
economic status of women in the Arab world.
²⁰

The economy of Israel and many of those in the Arab world are living laboratories for the economic theory of clusters and,
more broadly, what it takes for nations to generate—or stifle—innovation. The contrast between the two models demonstrates
that a simplistic view of clusters—one that maintains that a collection of institutions can be mechanically assembled and
out will pop a Silicon Valley—is flawed. Moreover, it seems that a stake in the country, Tuchman’s “motive,” provides an essential
glue that helps encourage entrepreneurs to build and take risks.

We’re using fewer and fewer of the cylinders to move this machine forward.

—D
AN
B
EN
-D
AVID

T
HE
I
SRAELI ECONOMY
is still in its infancy. The start-up scene that seems so established today was born at roughly the same
time as the Internet economy itself, just over a decade ago. The dawn of Israel’s tech boom coincided not only with a global
surge in information technology but with the American tech-stock bubble, the jump-starting of Israel’s venture capital industry
through the Yozma program, the massive wave of immigration from the former Soviet Union, and the 1993 Oslo peace accords,
bringing what seemed to be the prospect of peace and stability. What if Israel’s economic miracle were simply built on a rare
confluence of events and would disappear under less favorable circumstances? Even if Israel’s new economy is not just the
product of happenstance, what are the real threats to Israel’s long-term economic success?

One need not speculate about what would happen if the positive factors that launched Israel’s tech boom in the late 1990s
were to disappear. Most of them have.

In 2000, the tech-stock bubble burst. In 2001, the Oslo peace process crumbled, as a wave of suicide bombings in Israel’s
cities temporarily wiped out the tourism industry and contributed to an economic recession. And the massive flow of immigrants
from the former Soviet Union, which swelled the Jewish population of the country by one-fifth, exhausted itself by the end
of the 1990s.

These negative developments happened about as rapidly and simultaneously as their positive counterparts had just a few years
earlier. And yet the new state of affairs didn’t bring an end to the boom that was only about five years old. From 1996 to
2000, Israeli technology exports more than doubled, from $5.5 billion to $13 billion. When the tech bubble burst, exports
dropped slightly, to a low of less than $11 billion in 2002 and 2003, but then surged again to almost $18.1 billion in 2008.
In other words, Israel’s technology engine was barely slowed by the multiple hits it took between 2000 and 2004 and managed
not just to recover but to exceed the 2000 boom level of exports by almost 40 percent in 2008.

A similar picture can be seen in venture capital funding. When the VC bubble burst in 2000, investments in Israel dropped
dramatically. But Israel’s market share of the global VC flow increased from 15 to 30 percent over the next three years, even
as the Israeli economy came under increasing stress.

Israel may not, however, fare as well in the current global economic slowdown, which, unlike that of 2000, is not limited
to international tech stocks and venture capital funding but is being dramatically felt in the global banking system as well.

That said, the breakdown in international finance has infected almost every nation’s banking system, with two notable exceptions:
neither Canada nor Israel has faced a single bank failure. Since Israel’s hyperinflation and banking crisis of the early 1980s—which
culminated in 1985 with the trilateral intervention of the Israeli and U.S. governments and the IMF—tight restrictions have
been in place. Israel’s financial institutions adhere to conservative lending policies, typically leveraged 5 to 1. U.S. banks,
on the other hand—precrisis—were leveraged at 26 to 1, and some European banks at a staggering 61 to 1. There were no subprime
mortgages in Israel, and a secondary mortgage market never came into existence. If anything, a shortage of financing—even
before the crisis—for small businesses in Israel drove even more people into the technology sector, where taxes and regulations
were more friendly and venture capital was available.

As Israeli financial analyst Eytan Avriel put it, “Israeli banks were horse-drawn carts and U.S. banks were racing cars. But
those racing cars crashed badly whereas the carts traveled more slowly and stayed on course.”
¹

This is the good news for Israel. Yet while Israel’s economy was not exposed to bad lending practices or complex credit products,
it may be overexposed to venture finance, which could soon be in scarce supply. Venture capital firms are funded largely by
institutional investors such as pension funds, endowments, and sovereign wealth funds. These investors set aside a specific
allocation for what are called alternative investments (venture capital, private equity, hedge funds), typically in the range
of 3 to 5 percent of their overall portfolios. But as the dollar value of their public equity (stock market) allocations has
shrunk—due in large measure to crashing markets globally—it has shrunk the absolute dollar amount available for alternative
investments. The overall pie has been downsized, reducing available funds for venture capital investments.

A diminished supply of venture capital dollars could mean less “innovation finance” for Israel’s economy. Thousands of workers
in Israel’s tech scene have already lost their jobs, and many tech companies have shifted to four-day workweeks to avoid further
layoffs.
²
In the absence of new financing, many Israeli start-ups have been forced to close.

In addition to an overdependence on global venture capital, Israeli companies are also overdependent on export markets. Over
half of Israel’s
GDP
comes from exports to Europe, North America, and Asia. When those economies slow down or collapse, Israeli start-ups have
fewer customers. Because of the Arab boycott, Israel does not have access to most regional markets. And the domestic market
is far too small to serve as a substitute.

Israeli companies will also find it harder to negotiate exits—like Given Imaging’s
IPO
on the NASDAQ or Fraud Sciences’ sale to PayPal—which are often the means by which Israeli entrepreneurs and investors ultimately
make their money. A global slowdown will coincide with fewer IPOs and acquisitions.

And a continued deterioration of the regional security situation could also threaten Israel’s economic success. In 2006 and
at the turn of 2008 to 2009, Israel fought wars against two groups trained and funded by Iran. While these wars had little
effect on the Israeli economy, and Israeli companies have become adept at upholding their commitments to customers and investors
regardless of security threats large and small, the next iteration of the Iranian threat could be different from anything
Israel has ever experienced.

Iran, as is widely reported by international regulatory bodies and news organizations, is in pursuit of a nuclear capability.
If the Iranian government establishes a nuclear-weaponization program, it could spark a nuclear arms race throughout the Arab
world. This could freeze foreign investment in the region.

While much of the international focus is on the potential threat of an Iranian nuclear missile strike on Israel, the political
and security leadership of Israel warns against the effect of an Iranian nuclear capability on the region even if it is never
directly used. As Prime Minister Benjamin Netanyahu told us, “The first-stage Iranian goal is to terrify Israel’s most talented
citizens into leaving.”
³

Clearly, if the Iranian threat is not somehow addressed, the Israeli economy could be affected. So far, however, the presence
or potential of such threats has not deterred foreign companies and venture funds from increasing their investments in Israel.

Indeed, when it comes to threats to the economy, discussion within Israel centers more on domestic factors. Maybe because
Israel has inoculated itself against security threats to its economy in the past, or maybe because the prospect of a nuclear
threat is too grave to ponder, Tel Aviv University economist Dan Ben-David is fixated on another threat—the “brain drain”
from the faculties of Israeli universities.

To be sure, Israel is a leader in the international academic community. A global 2008 survey by
Scientist
magazine named two Israeli institutions—the Weizmann Institute and the Hebrew University of Jerusalem—as the top two “best
places to work in academia” outside the United States.
⁴

Economist Dan Ben-David pointed us to a study by two French academics that ranks nations outside the United States according
to publications in top economic journals between 1971 and 2000. The United Kingdom—including the London School of Economics,
Oxford, and Cambridge—came in at number two. Germany had fewer than half as many publications per faculty member as the British
had. And Israel was number one. “Not five or ten percent more, but seven times more—in a league of our own,” Ben-David crowed
to us. “And as good as Israel’s economists are, our computer scientists are apparently even better, relative to their field.
We have two Nobel Prizes recently in economics, and one or two in chemistry.”
⁵

But despite all this success, Ben-David is worried. He told us that Israel’s academic lead has lessened in recent years, and
will fall further as older faculty members retire and many of the rising stars leave to teach abroad. In his own field, economics,
Ben-David pointed to a study that found that of the top thousand economists in the world, as measured by citations of their
work between 1990 and 2000, twenty-five were Israelis, thirteen of whom were actually based in Israel. Since that study was
published, only four of these have remained in Israel full-time. And none of the twelve Israelis working abroad in 2000 have
returned to Israel. In total, an estimated three thousand tenured Israeli professors have relocated to universities abroad.

Ben-David is one of those four top economists who remain in Israel. And he is sounding the alarm on Israel’s continued economic
growth. From 2005 through 2008, Israel grew substantially faster than most developed countries. But there was a recession
the previous few years so, Ben-David argues, “all we’ve done is return to the long-term path. We’re not in uncharted territory;
we are where we should have been had we not had the recession.”

The problem, according to Ben-David, is that while the tech sector has been surging ahead and becoming more productive, the
rest of the economy has not been keeping up. “It’s like an engine,” he says. “You have all the cylinders in the engine. You
have all the population in the country. But we’re using fewer and fewer of the cylinders to move this machine forward.” In
essence, the tech sector is financing the rest of the country, which is “not getting the tools or the conditions to work in
a modern economy.”

This underutilization brings us to what we believe is the biggest threat to Israel’s continued economic growth: low participation
in the economy. A little over half of Israel’s workforce contributes to the economy in a productive way, compared to a 65
percent rate in the United States. The low Israeli workforce participation rate is chiefly attributable to two minority communities:
haredim
, or ultra-Orthodox Jews, and Israeli Arabs.
⁶

Among mainstream Israeli Jewish civilians aged twenty-five to sixty-four, to take one metric, 84 percent of men and 75 percent
of women are employed. Among Arab women and
haredi
men, these percentages are almost flipped: 79 percent and 73 percent, respectively, are
not
employed.
⁷

The ultra-Orthodox, or
haredim
, generally do not serve in the military. Indeed, to qualify for the exemption from military service,
haredim
have to show that they are engaged in full-time study in Jewish seminaries (yeshivot). This arrangement was created by David
Ben-Gurion to obtain
haredi
political support at the time of Israel’s founding. But while the “yeshiva exemption” first applied to just four hundred
students, it has since ballooned to tens of thousands who go to yeshiva instead of the army.

The result of this has been triply harmful to the economy.
Haredim
are socially isolated from the workforce because of their lack of army experience; plus, since they are not
allowed
to work if they want a military exemption—they have to be studying—as young adults they receive neither private-sector nor
military (entrepreneurial) experience; and thus
haredi
society becomes increasingly dependent on government welfare payments for survival.