TCS Daily

Exchanges of Violence

By Jim Lederman - August 24, 2006 12:00 AM

JERUSALEM -- Israel's war in Lebanon was unlike any other in history. The uniqueness was a product not just of Hizbollah's ability to fire some 4000 katyusha rockets over the heads of hapless Israeli "defenders", but also because it was the first war that has ever been fought by a globalized non-superpower.

In the past decade and a half, Israel has become one of the most globalized countries on earth. Despite the fact that it has none of the advantages of entrepĂ´ts such as Singapore or Hong Kong, about 45 percent of its GDP comes from exports.

Becoming globalized meant undertaking fundamental economic reforms. Because it freed up its markets, not only did its economy undergo a revolution, so too did its capability to wage war. The policy of market liberalization was a crucial element in thwarting Hizbollah's attempt to break civilian morale through incessant rocket attacks.

It is now safe to say that Fitch's, Moody's and Standard and Poor had more impact on the course of the war than did all the European countries combined. And the International Accounting Standards Board (IASB) had more influence on individual soldiers than did all the negotiations at the U.N.

The Europeans, for all their admonitions, could not stop the war; and the U.N. only voted for a cease-fire when the parties had already agreed to stop hostile activities. However, the ratings companies and, more indirectly, the IASB were extremely important Israeli morale-builders that enabled the government to prosecute the war almost unhindered.

One can go even further and say that the ratings companies and the IASB will have a direct effect on the formation of the next Israeli government -- despite the fact that probably fewer than a quarter of Israelis have ever heard of the ratings companies, and certainly less than one percent has ever heard of the IASB.

It is a lesson that all, modern, globalized countries would do well to keep in mind before embarking on any political or military adventure in the future. This concern was certainly foremost in the minds of Israeli ministers who, throughout the war, kept repeating endlessly that, despite the costs of the war, the country would keep to its deficit and inflation targets. The ministers realized that domestic financial stability is now critical to success on the battlefield.

Israelis, like the citizens of many other industrialized countries, have a deep and abiding distrust of their political leaders. Polls regularly show that only 20-22 percent of Israelis trust their politicians; and, according to a poll by the neutral Israel Democracy Institute, only 17 percent of the public believes that politicians ever keep their promises. There is little faith in government at any level.

The skepticism is warranted. Since the country's founding in 1948, governments have lasted, on average, no longer than 1 year and 11 months. And in the 58 years of statehood, there have been 38 finance ministers. Unsurprisingly, the country has gone through more economic, political and social traumas (from terrorist wars to hyperinflation to economic collapse) than did the short-lived Weimar Republic. During this last war, the Israelis suffered through one appalling government failure after another -- from shortages of equipment and even water for the troops, through constant changes in orders to units under fire, to ill-kept air raid shelters.

Since they so distrust the politicians and the spin the politicians produce, Israelis have sought out other, external ways of measuring how well the politicians do their jobs and how well the country is performing. The most notable of the markers used are not the news reports and op-eds in the foreign press (which are usually ignored as being biased), but the performance of international financial markets as expressed in the Tel Aviv Stock Exchange indexes and the daily dollar/shekel exchange rate -- both of which are very heavily influenced by foreign investors.

This is where the ratings companies and the IASB come in.

Particularly since the collapse of the economy in 2002, when Israel could no longer borrow money on international markets, both the government and public companies have been forced to adopt IASB standards for transparency and clarity in order to satisfy demands by foreign investors. One of the many reasons for the 2002 crisis was the finance ministry's long-standing habit of massaging statistics and making overly-optimistic economic projections.

The way in which the ratings companies can now interpret the reports and assessments based on IASB standards, and the way in which financial markets responded to the ratings published, has become a "gold standard" by which the Israeli public judges the state of their nation. The behavior of free markets is believed to be one of the most objective assessments of the country's strength that is available.

One of the most notable effects of the economic reforms of the past decade has been in the field of mutual, provident and pension funds. Increasingly, Israelis' savings are being channeled from bank savings accounts and government bonds into the stock market and other forms of riskier investment. This, in turn, has led to greater public monitoring of market behavior. Since many everyday contracts such as apartment rentals or car purchases are also denominated in dollars, keeping an eye on financial markets' behavior has become a daily routine for many, if not most Israelis.

The war in Lebanon was a "popular" war in the truest sense of the word. On the Israeli side, it was fought primarily by the working middle class, whether it was the salaried employees, small businessmen, artisans or homeowners in the north of the country who came under fire from katyusha rockets, or middle class reservists and students who had been called up to fight. The Israelis' remarkable morale and psychological stamina under fire can be attributed in no small part to the performance of the country's financial markets. Israelis came to believe that despite the threats they faced, the country was strong and its economy was basically sound.

In the past, when there had been strict market and foreign exchange controls and a war had broken out, the black market in dollars had sprung to life and the stock market had suffered. Savings were wiped out overnight. This time, when the war broke out, as a result of the economic reforms, Israel had virtually no exchange controls in place. As expected, because of the fears of instability and concern that foreign investors would pull their money out of the country, the stock market fell more than 8 percent in the two days after the fighting, and the dollar began to shoot upwards.

However, to the surprise of all the pundits, the stock market stabilized and began to creep upwards, while the dollar began to fall. Transparency had led to confidence that when the fighting was over, the country would return to normal. By the end of the war, the stock market was only two percent below its pre-war level, and the shekel had recovered almost completely. That was a major key to maintaining national morale. Civilians could hunker down in their air raid shelters, and middle-aged men could go off to fight knowing that their nest eggs were intact and that they would have the wherewithal to rebuild their lives come what may.

In the days after the cease-fire, despite the fact that soldiers were still in Lebanon and there were sporadic clashes between them and Hizbollah fighters, and despite the billions of dollars in property damage, losses in income from tourism, and losses in salaries, the markets advanced strongly. One of the keys to this optimism was the assessment that had been made, not by naturally-supportive Jews, but by foreign investors taking a cold look at the IASB-based bottom lines of companies and government accounts. Among the most important assessments published during the war were those of the ratings companies that left their pre-war ratings untouched.

Now that the war has ended, there has been a massive national popular revolt demanding that the government and the country's senior military officers be held accountable for their wartime failings. These have included not just letters to the editor in newspapers, but also protest marches and even hunger strikes by army reservists. It now seems likely that the government will have to bow to these public demands for the establishment of a full-blown judicial state commission of inquiry into the handling of the war. In the past, when such commissions have been set up, political heads have rolled.

It is unlikely that the protests would have mobilized so quickly, had the reservists not been able to take time off from work to organize and participate in the protests. They could only do so because they had their savings cushion intact. This is the sort of political impact of their work that no ratings company, no matter how skilled its risk assessors are, could have imagined.

Jim Lederman is a foreign correspondent in Jerusalem and is the Senior Israel Analyst for Oxford Analytica.



changes from bad policies
Great article! Let's not forget that many of the original zionist guys that formed israel were actually very socialistic minded, thus very dirigist in terms of the economy; and look at those kibbutzim, etc. So here's an object lesson, and more evidence, from yet another country that the economy improves the less the govn't interferes.

an interesting point embedded in this article
Among many good points the author implies that the kind of political instability which Israel has experienced is a bad thing.

Would he rather that Israel had experienced the political stability of, for instance, Cuba? Would he rather Israel had experienced the political stabilty of France?

It is a good thing, a crucial thing, that the Israeli populace mistrusts its politicians. People who spend their whole lives seeking political power should never be trusted. Never! At best they are a necessary evil.

Perhaps Israel is strong in part because it's politics are a constant wrangle.

A Piece of the future
this writer has spotted something that will very likely be a permentent piece of the future, financial market warfare. this time it was innocent, now that it has been pointed out, it will become another salient field of battle.

with respect
"Among many good points the author implies that the kind of political instability which Israel has experienced is a bad thing."

I understood it as the

popular perception

of political instability as a bad thing

appears to be in error.

I had no idea what so ever
Thank you.

Exchanges of Violence
Dear author,
Without getting into the substance of the article, I just wanted to point out that Israeli exports' contribution to GDP is 31%, not 45% as you state.
Yakir Plessner.

Exchanges of Violence
The figure I used was taken from the latest "Economist" survey of 27 emerging markets, which put the precise figure at 44.7 percent of GDP. See also "Globes" newspaper August 6, 2006.

Jim Lederman

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