On Sunday, November 14th, the Israeli government passed a resolution to finally reform its regressive financial markets. If ratified by the Knesset and implemented, despite the present political crisis, the reform will break up the destructive bank duopoly of Hapoalim and Leumi that has strangled the Israeli economy worse than did the banks in Japan.

Israel – with excellent human capital, and with sizeable foreign investments (over $100 billion) – is economically laggard because after sixty years of socialism and statism, it is dominated by highly concentrated, inefficient monopolies, especially in financial markets, where over 44% of tradable assets are controlled by three families and a bank. Israel’s labor and physical capital market are also poorly utilized due in large part to punishing government regulations and massive government ownership of land, water, ports and communication.

The costs are tremendous, both economically and socially. Israel has been suffering from years of low per capita productivity growth (0.6% average), and from intermittent, prolonged recessions. Participation in the labor force is low. Still, Israel suffers from high (10%) unemployment. Most of those employed earn only $1200 monthly, but prices in Israel are 30% above international prices because of monopolies. Small wonder then, that most families cannot make ends meet.

A critical cause for Israel’s economic malaise is the total failure of its financial intermediation system. Governed by bureaucrats and oligarchs who are accountable to no one, Israeli banks have inflicted on Israel a series of economic calamities – starting with the notorious 1980s bank share manipulation and collapse. Trice they brought the economy to the verge of collapse.

The banker’s folly and ineptitude cost the Israeli taxpayer at least $10 billion directly, and hundreds of billions of dollars more in lack of growth. Urgent reforms, proposed 20 years ago by a prestigious judicial commission, were never implemented. The powerful bank lobby managed to stop them.

The banks continued despoiling the Israeli public and squandering its hard earned savings while making huge profits. With all interest earned on bank savings tax exempt, 80% of all savings went to them. The banks paid savers below market interest rates (their financial spread is over 5%!), causing an annual transfer of wealth in the hundreds of billions of shekels from productive Israeli savers to the dozen or so families that control the banks. Out of 1.4 trillion shekels in savings, the banks manage 1.2, over 800 billion in their provident and mutual funds. Returns are abysmally low, about 3-4% on average, costing the Israeli economy many billions annually.

On the lending side, 70% of loans went on “favorable terms” to 1% of borrowers, mostly bankers’ cronies. Loans were invested in very speculative, highly leveraged deals in real estate and entertainment, at the peak of a stock market bubble. Most of these loans went sour, the banks now admitting to 61.4 billion shekels in questionable debts (their own capital is only 47 billion!).

To compensate for high loan losses, the banks have exacted usurious interest rates from household and small businesses, making most of their profits from these fees.

The banks deprived the Israeli economy of productive investment, especially in medium and small businesses. The credit crunch they created forced 70,000 of these to close. Discriminatory credit allocation has had grave national consequences. The Negev and the Galilee, where mostly small or medium businesses operate, were starved for credit and stagnated. But bank anti-growth credit policy had, as we already mentioned, far wider catastrophic consequences.

The banks were able to maintain their stranglehold because the two major parties, Labor and Likud, owed them large sums. Knesset members were warned not to cross the banks if they wanted loans for their primaries. So the banks were confident that they could continue fending off any reform, even when Finance Minister Benjamin Netanyahu – the first high level Israeli politician to understand economics – embarked on a courageous reform to revolutionize financial markets by breaking up the banks’ monopoly position and by introducing competition and new players into the market.

The banks have put together a several million-dollar war chest and are waging a campaign of disinformation and enormous political pressure against the reform. They flew in Lou Ranieri and a group of hired experts (the Promontory Group) to frighten the government with imagined disastrous consequences.

But to no avail. Netanyahu, with strong support from a significant segment of Israel’s economic media and from independent pro-market think tanks and over 60 Knesset members (organized, surprisingly, by 2 Shas members), stood firm. A Treasury task force, headed by its Director General, Yossi Bachar faithfully translated the reform proposals into operational directives. After considerable political push and shove, Prime Minister Ariel Sharon was convinced by some of his knowledgeable aides that the government had no choice but to go ahead with the reform, because the alternative was not just a return to economic stagnation, which is bad enough, but the risk of an Argentina-like financial collapse.

The reason the revolutionary reform pushed through by a remarkable Sharon-Netanyahu collaboration drew so little attention is that in a country justly preoccupied by security concerns, economic developments, even if they may have the greatest impact on the country’s well being and security, usually get ignored. Still, if despite the present political crisis the reform will go through and the Israeli economy will finally perform to its full potential, November 14 will be remembered as an historical turning point.

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