ECONOMIC AFFAIRS

the pre-mandate (late ottoman) period

Geography and Borders

In September 1923 a new political entity was formally recognized by the international community. Palestine, or Ereẓ Israel as Jews have continued to refer to it for 2,000 years, officially began its existence as a territory ruled by Britain under a mandate from the League of Nations. Since 1917, Britain had ruled the area as an occupier of territory belonging to a defeated enemy (the Ottoman Empire), and since 1920, under the terms of a mandate assigned by the post-World War i San Remo Conference and ratified by the League in July 1922.

The 27,009-square-kilometer area of Mandatory Palestine stretched from the shore of the Mediterranean Sea east to the Jordan River and the Dead Sea, and to the Aravah Valley to the Gulf of Eilat (Akaba). It was in this territory that Britain had promised the Zionist movement, in the words of the *Balfour Declaration of November 2, 1917, to allow the "establishment in Palestine of a national home for the Jewish People." This language was incorporated into the League Mandate, which also provided for the establishment of the *Jewish Agency. In order to accommodate the British commitment to the Zionists, the Palestine Mandate alone, unlike the other Middle East mandates of the League to the British and French, did not provide for the eventual self-rule and independence of the local population, which at the time was 90 percent Palestinian Arab.

The September 1923 borders of Palestine differed from those of the 1920 mandate, which included the almost 90,000 square kilometers east of the Jordan River. That area remained part of the British Mandate until its independence in 1946, but was split administratively by Britain from Palestine in May 1923 and ruled autonomously as the Emirate of Transjordan. The Mandate was divided in this way in part as the result of the British government's decision, proposed in the Churchill White Paper of 1922, to exclude the area east of the Jordan from the scope of the Balfour Declaration.

The borders shared by Mandatory Palestine with two other newly established political entities – Lebanon and Syria to the north and northeast, both under a League mandate to France – were the result of lengthy negotiations, from 1916 through 1922, between Britain and France. The final border settlement was part of a comprehensive agreement that also involved the creation of Iraq (as a British mandate) and the splitting of its spoils. These included, among other things, the allocation of shares of the Iraq Petroleum Corporation, which held exclusive oil concessions in that territory.

Palestine's border with Egypt, which left the Sinai Peninsula on the Egyptian side, was set along a virtually straight line from Rafa on the Mediterranean to Akaba on the Red Sea. The British, in occupation of Egypt since 1882, had imposed this line on the sultan in 1906 as a border between the two districts, which were both nominally part of the Ottoman Empire.

These borders had great significance for future developments, and not only because of the small size of the Jewish state as it emerged 25 years later. The country is located in a semi-arid zone abutting the desert, and the location of the northern and northeastern borders determined the available water supply, which in turn determined the eventual development and structure of its farming sector.

The Genesis of the Jewish Resettlement Effort

For centuries, the area that formally became known as Palestine in the early 1920s had been an outpost of the declining Ottoman Empire. It had a Jewish community of fewer than 10,000 – in 1800 it was less than three percent of the population. A total of 275,000 people lived in that geographical area by that time, and the very small Jewish communities were in the four "holy cities" of *Jerusalem, *Hebron, *Tiberias, and *Safed, and focused primarily on Torah study and religious activities. For their livelihood, these communities relied almost exclusively on contributions from Jewish communities in the Diaspora.

The late 18^th- and 19^th-century Industrial Revolution in Western and Central Europe that sparked unprecedented economic growth in those countries ultimately spilled over in the closing decades of the 19^th century to Europe's fringes, including the eastern shore of the Mediterranean among other places. It brought in its wake a major transformation in travel and trade in the form of railroad and steamship transport. The construction of the Suez Canal (opened 1869) was a clear expression of that process, which was also stimulated by the growing interest in the area by the European powers and competition among them for a stake there. It put the "Holy Land" on the tourist and pilgrimage maps of Europe, as well as on the political maps of its major powers.

aliyah and the transformation of the social structure of the yishuv

The emergence of the Zionist Movement (see *Zionism) in the closing decades of the 19^th century, and the spread of its message among the rapidly growing Jewish communities in Eastern and Western Europe was, of course, closely linked to the economic growth and political expansion occurring at the time in Europe, which contributed to the mass emigration of Jews from Eastern Europe, mainly from the Russian Empire, which at that time had barely initiated its industrialization drive, to Central and Western Europe, and beyond the Atlantic to the United States. A small portion of this mass emigration, reacting to the first pogroms in southern Russia in the 1880s and inspired by the Zionist notion of a "return to the land of the Patriarchs," reached Palestine. These immigrants to Palestine marked the beginning of the First Aliyah of 1882–1903. The Hebrew term aliyah, dating from the Second Temple period and referring to the pilgrimage to Jerusalem on the three Jewish festivals, was soon adopted to describe the waves of Zionist immigration to Palestine.

The impact of the first stage of that flow appears already in the population data of 1890, which provides the first reliable estimate of Palestine's population: in the 1880s, the Jewish community grew by 80 percent to 43,000, or about eight percent of the total population, compared to a negligible percentage at the beginning of the nineteenth century and just five percent in 1882, when the first wave of Zionist immigration began to reach the country.

Table 1 offers a first glimpse of the rapidly changing structure of the Jewish community in response to the First Aliyah, 1882–1903, when there was an annual average of 1,000–1,500 immigrants during the 20-year period between 1882 and 1903. This shows in terms of change the size of the Jewish population in Jerusalem and in the three other holy cities (Hebron, Tiberias, and Safed, not shown) as a proportion of the total Jewish population. In 1882 the Jewish community in Jerusalem plus 3,000–4,000 Jews living in the three other holy cities consisted of about 20,000 people, of a total of 24,000. Yet during the short eight-year interval between 1882 and 1890, the proportion fell from 71 percent to about 58 percent of the total Jewish community. These figures underline the predominance through 1882 of the old yishuv (Jewish community in Palestine) – the mission of which, as conceived by its members, was to maintain the presence of Jews in Jerusalem in the vicinity of Judaism's holiest site, the Temple Mount, and its Western Wall, the Kotel. Among this sector of the community, the study of the Talmud in the yeshivah was deemed the only worthy activity, a belief that precluded its members from engaging in economic activity. The 1890 population figures show that this sector was still the majority of the Jewish population. However, these figures also indicate that within a very short period – just eight years – its share of the population was significantly reduced.

Table 2 shows the gross and net immigration figures through 1947, the last year before the establishment of Israel.

the first agricultural settlements: 1882–1902

The establishment of *Mikveh Israel as an agricultural boarding school near Jaffa in 1870 signaled a change in the Jewish community's attitude toward the modern world, marking the beginning of its adaptation to the urban-industrial economy rapidly spreading outward from Europe. A full decade passed before Karl *Netter was able, with financing from and on behalf of the *Alliance Israélite Universelle, the organization set up by Jewish notables in France, to transform the school into a functional operation. Under its influence, and following the example of Petaḥ Tikvah (the first modern Jewish settlement, founded in 1878 by an enterprising group from Jerusalem), six agricultural settlements were established near Jaffa and in the eastern Galilee in the first half of the 1880s, populated

by new immigrants from czarist Russia and Romania. These colonies represented an attempt to implement the notion of the "Resettlement of the Land of the Patriarchs" articulated by the new Zionist organizations then surfacing throughout the Russian *Pale of Settlement, following a wave of pogroms in 1881. One of the six settlements was *Gederah, established on the southern coastal plain in 1884 by *Bilu, an organization of Jewish students in Russian universities.

The founding of these rural settlements naturally required substantial capital investment. The first stage of the settlement process involved the acquisition of land. through 1918 this had to be done under the Ottoman land code, which endowed vague property rights in land in most areas subject to its jurisdiction and which did not maintain a systematic method of land registration and property rights. The latter were of a bewildering variety, the legacy of the semifeudal system that had existed for ages. On top of that was the hostility of the Ottoman authorities to Jews' acquisition of land, which raised the cost of purchasing real estate.

With limited means at their disposal, these six settlements, with a population of about 500 (Table 3), soon came to grief. Their survival, and indeed the entire resettlement effort, would soon have collapsed but for the appearance on the scene in 1883 of Baron Edmund *Rothschild. For the ensuing two decades Baron Rothschild offered encouragement, financial support, and expertise to the resettlement effort. His funding of that experiment, which helped increase the number of these settlements to 22 by 1900 (Table 3) was 20 times greater than the funds channeled for that purpose by the other Jewish organizations as "grants in aid" to the resettlement drive.

The teething problems of that experiment were not due only to the shortage of funds to finance the buildup of capital stock. There was also the pioneers' lack of experience and know-how in farming. Furthermore, the French farm experts hired by Baron Rothschild to guide the settlers knew little of local conditions, including the native climate, soil, and pests specific to Palestine.

Given their experience and the vision of Baron Rothschild, who was aware of the biblical image of the "land of corn and wine," their choice of crops focused inevitably on high-cost and time-intensive grapes as the main product of these settlements. Viniculture did not provide year-round employment. Maintaining this kind of farming operation entailed hiring seasonal labor, which in practice meant indigenous Arabs paid the prevailing low wage. Furthermore, though each farming household had its own plot, it had to follow the instructions of an administrator put in charge of the settlements by the Baron, thus eroding personal responsibility and enterprise among the settlers. To absorb the output of these vineyards Rothschild built two major wine cellars, one in *Rishon le-Zion for the southern settlements and the other in *Zikhron Ya'akov for the northern settlements. Subsidized by his funds, these first two industrial enterprises in Palestine paid above European market prices for the grape crop. Europe was the inevitable destination of their output.

These pioneer agricultural settlements experienced severe problems in their early years. The acquisition of farming know-how through "learning-by-doing" required time. And so did the emergence of entrepreneurs and entrepreneurial knowledge, and the accumulation of equity by farm households. These were evidently the necessary conditions for freeing settlers from the shackles of the Baron's bureaucracy and the benefit of his funding.

In spite of these tribulations, the groundwork of the resettlement movement was laid in the last two decades of the 19^th century. This is evident in the number of Jewish rural settlements, which expanded to 22 by 1900, as Baron Rothschild wound up his organization, granting the settlers the land and the two wine cellars and other elements of infrastructure set up by him, thus putting the settlements on an independent footing. By that time, they had a population of 5,000, or ten times the number of settlers in 1882. There was a similar expansion by this time of Jewish-owned land, half of which was in rural areas (Table 3), although the total amount was negligible; indeed it was small even in proportion to size of the Jewish population, which had grown to 50,000.

Despite their shortcomings, the efforts of the first wave of settlers opened the way for things to come. They led to the emergence of a community of experienced farmers and agricultural entrepreneurs and taught some highly significant lessons to Zionist leaders just as the *World Zionist Organization, established in 1897, was coming into its own. They suggested that a near-European living standard was a necessary condition for the survival of Jewish farming in Palestine, and that this required not only substantial capital investment, but also the diversification of the prevailing agricultural economy – the single-crop farming pursued, by and large, by the first generation of Jewish settlements. By the turn of the century these settlements resembled the European colonies in southeast Asia and Africa with their monocultural plantations producing commercial crops for world markets and exclusively dependent on indigenous seasonal labor. The dominance of Arab workers in the Jewish settlements reproduced the situation in the European colonies.

These features were of course inconsistent with the grand scheme formulated by the World Zionist Organization under the leadership of Theodor *Herzl (1897–1904). Its declared ultimate objective – the establishment of a Jewish State in Palestine – was a response to rising overt antisemitism in Europe and the increasing poverty of Jewish communities, especially in Eastern Europe, which had hardly been touched by the Industrial Revolution but were experiencing a population explosion. These conditions induced mass emigration. In pursuit of its ultimate goal, Zionism envisioned the immediate building up of a self-sustaining economy in Palestine, offering a reasonable standard of living as a necessary condition for inducing a significant fraction of the huge Jewish emigration from Eastern Europe to move to Palestine rather than to Western Europe and to the United States. The Zionists called, therefore, for a major revision of the Palestine resettlement strategy.

the second aliyah and the notion of mixed farming

The Second Aliyah started in 1904, in response to another set of pogroms in Russia in 1903–04. In the succeeding decade, ending with the outbreak of World War i in 1914, it brought about 40,000 Jewish immigrants to the shores of Palestine. This was indeed only a small fraction of the Jewish emigration from Eastern Europe during that decade, about three percent, but it was substantially larger than the total inflow of the First Aliyah of 1882–1903 (Table 2).

Students and other young people, many inspired by the socialist ideology spreading at that time in the Jewish communities of Eastern Europe and which they attempted to wed to Zionism, were the dominant group in this wave of immigration. Their arrival in Palestine had an immediate effect on the old settlements, and particularly on the direction and features of the resettlement process. It soon led to a major transformation in the structure of Jewish agriculture, particularly the employment of Jewish labor. The slogan "avodah ivrit" ("Jewish labor"), so much a part of the vocabulary of the post-1903 Socialist Zionist immigrants, reverberated for the next three decades in the politics of the Yishuv, and inspired the restructuring of Zionist settlement policy.

The *Palestine Office set up by the World Zionist Organization in 1908 in Jaffa, under the direction of a new immigrant, Arthur *Ruppin, adopted avodah ivrit as its guiding principle. Ruppin identified the reliance of the late 19^th-century settlements on Arab labor as their Achilles' heel, particularly as it limited their capacity to absorb new immigrants. The employment of Jewish labor was accordingly specified as the instrument to promote Jewish economic viability and growth. The Palestine Office proceeded to implement the avodah ivrit strategy in its chosen first line of activity, forestation, which soon became one of the symbols of the Zionist resettlement effort. With the modest funds at its disposal it initiated the planting of the Herzl Forest in *Ben Shemen and Huldah in 1908, relying exclusively on Jewish labor, as insisted on by the vociferous claims of Jewish workers, whose ranks were by that time swelled by newcomers of the Second Aliyah.

Furthermore, to promote the success of the new immigrants who out of ideological conviction volunteered to go into agriculture, the Palestine Office determined that it should provide basic training in farming. This decision led to the establishment of Ben Shemen, one of the first settlements founded and financed by the Zionist organizations, as an agricultural experiment and training facility.

A second foundation of the resettlement strategy adopted by the Palestine Office was the promotion of mixed farming, involving grain, fodder, vegetable, dairy and poultry production. This kind of agriculture promised a balanced year-round demand for labor and correspondingly stable employment and income throughout the seasons, unlike single-product plantation farming. The Palestine Office launched an experiment along these lines in two new settlements in the north, Kinneret and Deganyah, established in 1908 and 1909 respectively.

These two settlements opened the door to another venture, which dominated Zionist resettlement policy for decades to come. Deganyah soon became the forerunner of settlements based on the "self-labor" principle: it was to be manned by a group of Jewish workers and run as an autonomous economic entity – operating as a collective of its members. These settlements were allocated land and provided with basic capital – equipment, working capital, and housing – in the form of loans and credit from the Zionist authorities. Running production activity on their own, they were required to pay rent and to repay their debt, including interest, on a long-term schedule. The land was nationalized, the property of the Keren Kayemet Leyisrael (*Jewish National Fund), set up by the World Zionist Organization to purchase and own property. It was to be leased to its cultivators in perpetuity.

The requirement to pay rent and repay loans and credit allocations with interest was a major incentive for agricultural settlements to move into mixed farming, since this structure, involving immediately marketable products in urban markets, offered a cash flow which could provide a current income and the means to meet financial commitments. Thus efficient production made feasible by self-employed labor would assure the settlements' financial viability. The rapid expansion of urban markets, which was indeed a fact of life in the decade preceding the outbreak of World War i, was of course a prerequisite for the success of this strategy.

A score of older late 19^th-century settlements in the coastal plain north and south of Jaffa adopted a diversification strategy on their own, in response to market signals. This transition from viniculture dominance was accelerated by the emergence at the turn of the century of a highly profitable new branch of agriculture, the citrus industry, which benefited from rapidly expanding European markets, which were made more easily reachable by the contemporary steam revolution in the shipping industry, and the much greater frequency of landings in the Port of Jaffa. A simultaneous expansion of almond growing was another component in the move towards diversification. Thanks to the differing times of high season in these three branches, this diversification in the older settlements enabled a much more balanced demand for labor, which offered more leeway for the employment of Jewish labor. The introduction of almond and citrus growing required huge investments, and a longish gestation period, before the first crops, and an even longer interval before they reached their peak productivity levels. The older settlements, some of which had been around for as long as two decades, had by this time nurtured a group of entrepreneurs with sufficient capital and collateral to obtain bank credit on their own, allowing them to embark on these new ventures. Similarly, the rapid expansion of the urban Jewish community in Jaffa and vicinity, with its fast-growing market for fresh food, offered an incentive to farmers in the old settlements to move into dairy and vegetable farming. Thus private agricultural enterprise was encouraged to implement the same diversification strategy, though with a different structure offering employment to high-wage Jewish labor, promoted by the Palestine office in its own settlements.

The mixed farming concept adopted in practice by both old and new settlements in the first decade of the 20^th century; the high cost of Jewish labor, which encouraged the use of labor-saving devices; and a choice of crops and products that did not involve labor-intense cultivation inevitably imposed a highly significant requirement – the use of irrigation as a major farm input. Palestine's short winter season, the moderate rainfall in that season even along the coastal plain and in the northern part of the country and much more so in the semi-arid areas in the south and southeast, imposed this requirement. It was a necessary condition for high yields per unit of land and labor, generating correspondingly high incomes approaching European standards. The development of irrigation in the Jewish sector, which in the last decades of the Ottoman period involved drilling wells all over, soon became a hallmark of the Zionist resettlement effort.

The 25 Jewish agricultural settlements established between 1900 and 1914, increasing the total to 47, meant first and foremost a significant spatial expansion (Table 3). It involved penetration into new regions. Northeastern Galilee, lower Galilee, and the northern Jordan Valley appeared on the map of Jewish settlements. The number of settlements along the southern coastal plain, north and south of Jaffa, was significantly increased. The result was an increase in rural Jewish population. This grew 140 percent to 12,000 between 1900 and 1914 (Table 3). This rate was indeed significantly greater than that of the overall Jewish population, which grew by around 90 percent to approximately 94,000.

The rural demographic expansion affected the older settlements, several of which, with populations over 1,000, had already acquired some urban features. The focus of their contributions to production and employment, however, was still agricultural. The market-driven diversification, providing for increases both in demand and in seasonal stability of demand for labor, was absorbing a growing number of Jewish workers. As the dominant contributors to the Jewish sector's farm production, these settlements became the main battlefields of the struggle for avodah ivrit. This struggle, which started in the previous decade, continued through the mid-1930s, at which time it disappeared from the political agenda.

the development of the urban sector

Though the economic performance of Jewish agricultural settlements was significant, whether compared with 1880, when they started, or with 1900 when they moved into their second stage, they still accounted for only about 13 percent of the Jewish population at the outbreak of World War i in 1914. In that period of a little over three decades, which might be called the "warmup" period of the "Return to Zion," the urban Jewish population increased six times more, in absolute terms, than the agricultural settlements' population. With an 87 percent share in 1914, urban Jews were evidently the dominant group within the Jewish population of Palestine.

These aggregates, however, offer a skewed perspective of the process, in which the dynamic element consisted of immigrants who established the urban version of the Zionist Return to the Land of the Patriarchs, and who established the commercial and industrial infrastructure of a modern economy. By 1914 this element was seemingly more than half of the total Jewish population, which by that time was already close to 100,000 (Table 1). Together with the 12,000 Jews in the rural settlements (Table 3), these made up the new yishuv, about two thirds of the total Jewish population. The static element of the urban population was the old yishuv, in 1914 still about a third of the total.

The rapid growth of both the Jewish and the total population of Jaffa is evidence of the formation of a modern economy. Arthur Ruppin's 1907 estimate of Jaffa's Jewish population in 1882 put it at 1,000. In 1914, Jaffa's Jewish population was already 12,000, and its Jewish suburb, Tel Aviv, founded in 1909, had by that time a population of 1,500. The Jaffa-Tel Aviv urban center already had a Jewish population of slightly more than the total population of the Jewish agricultural settlements. The Jewish population of Haifa, and perhaps a third of the Jewish population of Jerusalem, were by that time involved in economic activity – commerce, finance, even manual labor – and were thus an active component of the new yishuv.

The emergence of Jaffa as the hub of urban development in Palestine in the last decade of the 19^th century signaled a growing linkage of that territory with the European economy. The opening of the Jaffa–Jerusalem single-track railroad in 1892 enhanced Jaffa's standing as Palestine's main port, depot, and leading commercial center and contributed to the rise of commercial and quasi-industrial activity. The growth of shipping services serving, among other activities, the increasing tourist traffic reflected the growing interest of the European powers in the territory, highlighted by the visit of the German Kaiser in 1899. The rapidly growing Jewish community was inevitably the vanguard of the expanding commercial, financial, and administrative activity. The main office of the Anglo-Palestine Bank opened in Jaffa in 1903, followed by the establishment of the Palestine Office of the World Zionist Organization in 1908. The presence of these commercial and financial services made Jaffa the urban center for the Jewish agricultural settlements, most of which were located in the coastal plain in Jaffa's periphery.

The rapid increase of the Jewish population of Jaffa, from a negligible fraction of the total in the early 1880s, to more than a quarter of the town's population by 1914 (Table 1), led in 1907 to an initiative to establish a modern Jewish suburb. In response to the proposal of a group of 60 families, the Zionist organization decided to grant the members of that group credit to finance the purchase of the land north of the city. The actual funds came from the Anglo-Palestine Bank and had to be repaid at the market rate of interest. Though an ad hoc decision, this transaction nevertheless set a precedent: Zionist resettlement policy applied not only to the agricultural sector, but also, occasionally, took into account the requirements of the urban sector as well.

The planned suburb of Jaffa, established in 1909, and with a population of 1,500 in 1914, was the kernel of Tel Aviv, which soon after World War i became the leading center of the Jewish resettlement effort. Though the Zionist Organization did provide the financial launching pad for that initiative, urban resettlement activity was on the whole initiated, financed, and run by private enterprise. It received only marginal financial support, seed money, from the Zionist organization. For better or for worse, the urban sector proved to be, already in its early stages, and even more so later on, the dominant factor in Jewish resettlement of Palestine.

The Arab Sector: Demography, Farming, and Urbanization

In the early 1880s the Arab population consisted of a dominant Muslim community and a much smaller group of Christians, totaling slightly less than half a million people. By 1914 it had grown to approximately 600,000, suggesting an average annual growth rate of about 0.7 percent, not significantly different from that suggested (on the basis of a rough estimate of the population for 1800), during the first 80 years of the 19^th century (Table 1).

The breakdown in Table 1 of the main Arab population in the urban centers in 1890, to which the population of Nazareth and three other small Arab towns should be added, suggest that about ten percent of the Arab population lived in towns. This means that approximately 90 percent of that population lived in rural areas, eking out a meager living from the land by farming.

Traditional agriculture as practiced for a millennium – dry farming exclusively dependent on the rainfall during a short winter season – provided for the livelihood of this population living in small, almost self-sufficient villages, using and exchanging currency only infrequently. Grain provided the staple food, and a few sheep and goats per family supplied milk and meat. Olive trees and grapes exclusively dependent for water on rainfall provided cash crops. These were grown mainly in the mountainous areas of Galilee, Samaria, and the Judean hills. The payment of heavy taxes in cash was required from the middle of the 19^th century onward and made cash crops necessary. The sale of these crops – olive oil and grapes, in particular – provided one of the main economic links with the market towns near clusters of these small villages.

From 1800 on the Ottoman administration attempted to establish registration of land titles. The last vestiges of the feudal system were indeed eliminated during the second quarter of the 19^th century. Nevertheless, the traditional periodic redivision of land among members of the clan living in each of these villages did not disappear as Jewish immigration gained momentum in the 1880s. The periodic redivision of fallow land reduced the incentive of the peasants to make improvements, with long-lasting effect on fertility. It also made it quite difficult to purchase landed property subject to the redivision rule.

Nevertheless, that rather stagnant feature of the Arab sector was subjected to meaningful challenge and change in the three decades from the 1880s onward through the outbreak of World War i. By that time the effects of the industrial revolution in Europe began to penetrate the stagnant system. The rising flow of tourists and pilgrims, the establishment of several German agricultural colonies, and the initiation of Jewish economic activity (the latter two involving capital imports) all helped to provide markets for the cash crops of the Arab fellah (peasant). Furthermore, the Jewish settlements began to offer seasonal employment, providing a rising flow of cash income. Thus the Arab farm sector was pulled more and more into the market orbit.

This process also reflected the emergence of a new agricultural enterprise, initiated by Arab landlords – citriculture. By the turn of the century the Jaffa orange, a mutation which had first appeared in an orange grove in the vicinity of that town in the 1840s, made its entrance into European markets as a specific and superior orange brand. It was the enterprise of Arab growers that initiated the rapid expansion of orange plantations in the 1890s; Jewish entrepreneurs soon followed. Increased shipping services in the Jaffa port reflected the importance of the Jaffa orange as the dominant export of the country, as it remained for four decades to come. The all-out expansion of the citrus groves and the corresponding growth of exports occurred later, though, after World War i.

These developments fostered the transformation of Jaffa into the major commercial and financial center of the Arab sector of Palestine in the ensuing decades, through 1914 and beyond. Simultaneously it became the leading location of the slow but significant process of Arab urbanization. This increased the Arab urban population from some eight to ten percent at the beginning of the 1880s to about 15 percent of a much larger total in 1914. Jaffa was the vibrant center of that process. Its Arab population grew by more than three times in that formative interval, while the total Arab urban population a little more than doubled. The rising importance of Jaffa as a center of Arab population and economic activity in that 40-year period was underlined by the drastic change in the ratio of the Arab population of Jerusalem and Jaffa. in the early 1880s, the Arab population in Jerusalem was 40 percent larger than Jaffa's; by 1914 Jaffa took a clear lead over Jerusalem (Table 1). This was an omen of things to come in the postwar period.

the mandatory period, 1918–1948

Palestine as a Unique Political and Economic Entity

The immediate effect of World War i on Palestine was the transfer of the territory from the authority of the dismembered Ottoman Empire to that of the British Empire. The transfer involved radical changes in the institutional and legal structures, as well as in the economic arrangements, within which the affairs of the territory would be carried on.

First was the establishment of a unitary political authority for the entire territory (there was no such authority under the Ottomans; the territory incorporated into Mandate Palestine was part of several Ottoman provinces). The British established a Palestine government with a high commissioner, responsible to the Colonial Office in London, as its head. An administration divided into departments of state (customs and excise, public works, education, immigration, law, and an independent judicial system staffed by British judges with a sprinkling of locals) were the skeleton of that government. The British government sought and received formal approval for these arrangements at the San Remo Conference of 1920 and the League of Nations in 1922, in the form of a mandate. The population of Palestine was not consulted.

A second highly significant change was the legal definition of the borders of the territory approved by the League of Nations' Mandatory committee, which had formal authority over the ultimate disposition of the territory (see Geography and Borders, above).

The text of the League's Mandate to Britain included in its preamble the language of the Balfour Declaration of November 2, 1917, in which the British government stated that "His Majesty's Government views with favour the establishment in Palestine of a national home for the Jewish People." The Zionist movement interpreted that statement as an implied commitment to free immigration of Jews into the territory, as well as an implied promise to make available uncultivated state land to the newcomers. Since Palestine had a total population of less than 800,000 in 1922, of whom some 160,000 lived in urban areas, the Zionist leadership presumed initially that plenty of such land was potentially available even within the 27,000 square kilometers allocated to Palestine under the terms of the Churchill White Paper of 1922 (that is, after it had been separated from Transjordan). This was, however, never the perception of the British officials running the Palestine government; land belonging to the public domain was never made available to Jewish settlers. Yet the acquisition of land by purchase was made much more feasible legally than it had been during Ottoman times.

An immediate measure implemented by the government was the census of 1922, which offered a reliable source of demographic information, including data on the national and religious composition of the population, and of its location. Another was the beginning of a process of land registration, specifying legal ownership of real estate in the urban and rural areas. This process, which was to facilitate real estate transactions, was not completed for the whole territory by the end of the Mandatory period.

The establishment of the British Mandatory government had several beneficial economic effects. Three features of the new political entity had immediate and far-reaching long-term significance for the running of its economy. First, the adoption of the Palestine pound as the local currency. Second, the creation of a unitary customs area within the borders of the British Mandate (thus including Transjordan). Third, the maintenance of a policy of "free trade."

The Palestine pound offered a stable monetary and financial anchor for the economic system. Though formally issued by the Palestine Currency Board (located in London), it was similar to its predecessor – the Egyptian pound, adopted as Palestine's currency temporarily in 1918 – in its relationship to the British pound sterling. It was fully backed by sterling, and the one-on-one exchange rate with the British pound underlined its prestigious status. The creditability endowed by this status and the stable exchange rate regime of sterling with other major world currencies facilitated the flow of capital imports, and was a major support of economic growth.

The second feature, the creation of a territorial customs zone, was curious in that Transjordan, the territory east of the Jordan River, which was included in the British Mandate for Palestine, was governed separately from Palestine but was included in the Palestine customs zone. Likewise, it shared the same currency, the Palestine pound, until 1948. Transjordan was excluded from the provisions of the Balfour Declaration and thus from Jewish immigration (see Geography and Borders) and its direct economic impact. In view of its minuscule economic capacity during the Mandate period, this did not make a meaningful difference to the economy of Palestine.

The distinctive feature of the policy on import duties adopted by the Mandatory government was its focus on revenue. Fiscal considerations were almost the exclusive criterion applied by the Department of Customs and Excises in its setting of duty rates on imports; these were thus quite low – a comprehensive standard rate of 12 percent ad valorem. In the two prewar decades these import duties provided about 50 percent of total government tax revenue. The standard rate was raised to 15 percent in the war years. A low income tax, applicable only to very high-income brackets and to incorporated business, was also imposed in 1941.

Finally, the third feature was the Mandatory Government's free-trade policy. It adamantly refused to impose protective duties even in the worldwide depression of the 1930s, though all other governments – including Britain and its Empire – resorted to such tactics. It thus did not relent under the pressure of the Jewish community, represented by the Jewish Agency, to impose some protective duties to support the recently established domestic (Jewish) industries from the dumping tactics employed by virtually every state. Free trade and free capital mobility within a fixed exchange-rate regime with sterling were the operating rules of Mandatory Palestine's external economic relations for two decades through the outbreak of World War ii.

The Emergence of the Jewish Economy, 1920–1931

immigration and the demographic balance

The 1920s may be identified as the time of the emergence of the Jewish economy, a development triggered primarily by increased immigration. Though much smaller than hoped for by the Zionist leadership, the numbers still signified a major change and a correspondingly significant shift in the balance of the national composition of Palestine's population. During the 12-year period starting in December 1919 with the arrival of the ship Roslan from Russia with almost 700 immigrants and ending in 1931, gross immigration was close to 120,000. This was twice the total number of immigrants to Palestine in the more than three decades of the prewar period from the early 1880s through 1914 (Table 2). In the 1920s, it amounted to about 18 percent of total Jewish emigration in that period, a significantly higher proportion than in the pre-World War i decades (in both periods the United States was the dominant destination of Jewish emigrants). Note also that net immigration figures in Table 2 indicate that close to one quarter of the immigrants to Palestine during the 1920s left for other destinations.

This inflow of immigrants had a clear-cut impact on the national composition of Palestine's population. The 1922 census estimates suggest that Jews were about 11 percent of the total population of Palestine. The 1931 census data indicates that the Jewish population had again grown substantially, to 17 percent of the total (Table 1).

This change in the population balance was even more significant in the main urban areas. Thus Tel Aviv's population was about 30 percent of Jaffa's in 1922; by 1931 it had grown to 85 percent of a greatly increased Jaffa population. Furthermore, the Jewish share of the population of the whole Tel Aviv-Jaffa conurbation had grown from 37 percent in 1922 to 54 percent in 1931. The population balance in Jerusalem and Haifa moved in a similar direction. Only in Haifa was the Arab population still the dominant community in 1939; the Jewish population, which had been growing rapidly, was about one third of the total.

land and the resettlement process

Most of the growth of Jewish population – 90,000 between 1922 and 1931 – occurred in the urban centers, with Tel Aviv as its focus. Yet the major resettlement effort implemented by the Zionist authorities was designed to establish a significant Jewish foothold all over Palestine as soon as possible. To implement that policy most of the resources at the disposal of the Zionist Organization were directed to the rural sector.

This effort shows in terms of population and the number of settlements. Rural population grew by 2.5 times in the 1922–1931 decade, by more than 3 times compared to 1914, the benchmark figure for measuring the post-Balfour Declaration resettlement effort. The comparison of the growth of the whole Jewish population between 1914 and 1931, which did not quite double during that period, is meaningful in that context (Tables 1 and 3).

The effort in terms of the number of settlements, which rose from 47 in 1914 to 129 by 1931, is even more stunning (Table 3). The number itself suggests a major extension of the geographical presence of Jewish settlements in that period, which might be thought of as the time of the "coming out" of the Jewish presence in Palestine. The penetration into the Jezreel Valley – the formation of two groups of agricultural settlements in its eastern and western parts, and of a small urban center, Afula, in the middle – was the vanguard of that effort.

The necessary condition for the success of this effort was the acquisition of large blocks of land in what was a marshy, malaria-ridden (and thus effectively unpopulated) area in 1920–21. The process of land acquisition shows clearly in the land ownership columns of Table 3: the figure for 1922 indicates an expansion of rural land ownership of almost 70 percent by Jewish entities – private entrepreneurs and households, corporate firms, and, mostly, the Jewish National Fund (Keren Kayemet), the land purchasing and holding corporation created and owned by the World Zionist Organization. In the ensuing decade through 1931, Jewish land purchases accelerated; the total amount of land owned by Jews increased by 75 percent, indicating that the rate of increase of rural land possession by Jews was significantly higher. The Haifa bay area and the Hefer Valley in northern coastal Sharon Plain were the focus of the land acquisition effort in the 1920s. later moves to acquire land, particularly the penetration into the Beit She'an Valley and the northeastern and western Galilee, implemented in the 1930s, were inspired by the realization that the allocation of noncultivated "crown" land to Jewish settlers, as envisioned by the Zionist leadership in the early 1920s, was not going to happen.

The drive to acquire land was maintained in the 1930s, though land prices rose rapidly as a result of that very process. The efforts of private entrepreneurs to acquire land in the coastal plain were induced by the high profitability of the thriving citriculture industry from the 1920s through about the early 1930s, and by the acceleration of urbanization resulting from the increase in Jewish immigration in that decade. Thus, though land purchases by the Jewish sector emerged as a major political issue, and were finally restricted by law in 1940 (reflecting the change in British policy expressed in the White Paper of 1939, abandoning partition as a viable future for Palestine, and regarded by Zionists as an official abandonment of the Balfour Declaration commitments), the amount of land owned by the Jewish sector still grew by 50 percent in the decade ending in 1941. Growth was even greater in the rural areas (Table 3). The highly significant feature of the process in that period and through the war years was the penetration into the Negev, the southern and arid part of Palestine, during the war years and in the face of the Land Transfer Regulations of 1940, which restricted land purchases by Jews. This high-priority effort was implemented by the Jewish National Fund.

The 1947 figure for the total land holdings of the Jewish sector suggests that these grew by about four times during the three decades of the British Mandate. A comparison for rural land holdings based similarly on the 1914 data suggests an almost sixfold increase during the period (Table 3). The spread of these rural holdings through 1941 was almost everywhere, exclusive of the Negev; during the war years it was mostly in the Negev. Yet the total of Jewish land holdings on the eve of independence was only about six percent of the total land area of Mandatory Palestine.

This level of acquisition would not have been achieved without the purchase of land by the Jewish private sector, especially for citrus plantations but also for housing and for commercial and industrial use in urban areas. The entries in Table 3 for citrus plantations, whose area grew by 15 times between 1922 and 1939 – a private sector activity absolutely dominated by the profit motive – offer a clear indication of their contribution to the Jewish land acquisition drive. This drive was a joint effort of the Keren Kayemet and the private sector, which financed its acquisitions in significant part by capital imports. Yet it was the "national sector," whose behavior was not subject to profit considerations, that led the way; its share of land ownership in the Jewish sector increased from about 10 percent in 1920 to about 50 percent in the closing years of the Mandate. Land acquisition policy was obviously designed to serve as the springboard of the resettlement process.

prosperity and depression in the

1920S. The employment, capital stock, and national product columns in Tables 4 and 5 indicate vigorous growth in the 1920s through 1931. Employment in the Jewish economy grew by 2.4 times, more than the corresponding growth of population. Due to the substantial growth of the annual investment flow, the capital stock at the end of the period was more than three times greater than at the beginning. This also meant that the capital-labor ratio

was 40 percent higher than in 1922, an increase that generated an almost 80 percent rise in average labor productivity during that period (Table 6). These increases in the major inputs – labor, capital, and land, the last relevant mainly to farm production – and the corresponding increases in productivity generated a more than fourfold increase of the Jewish sector's national product. Thus, though population increased by about two times during that period, the much greater increase in production per capita allowed for a higher standard of living for the Jewish population. This highly significant performance was a feature of the Jewish economy of Palestine even during the last years of this decade (1929–31), in which occurred the advent of the disastrous worldwide economic depression of the 1930s.

Though that final outcome was highly impressive, the going during that decade was not smooth. Its ups and downs were directly linked to the immigration waves of the Third and Fourth Aliyah, which peaked in 1922 and 1925 respectively. The first of these two peaks reflected the entry of 9,000 immigrants in that single year. The second marked the arrival

of 34,000 Jews in Palestine, an event unheard of in the four decades of the Zionist experiment since the early 1880s. This single-year inflow was equal to the total inflow during the entire pre-World War i decade of the Second Aliyah.

These peaks and the following troughs had their inevitable counterparts in terms of employment and unemployment and the level of economic activity. The ups and downs were related to rising waves of immigrants and corresponding waves of increased investment, followed by their significant decline. Thus employment in the Jewish sector was almost 10 percent higher in 1924 than in 1923, and at its peak in 1926 about 65 percent higher than in 1923, a rate that could not be sustained. Corresponding to the ensuing decline in employment, the unemployment rate shot up from a negligible figure at the top of the prosperous year 1925 to almost 7.7 percent in 1927. The inevitable effect of that was a major wave of emigration, almost 75 percent of the (decreased) inflow of new immigrants in 1926–27 (Table 2). It was the collapse of investment, in housing in particular, which generated the cyclical downspin: investment in buildings in 1926 was down to less than one half the 1925 rate, and in 1927 it decreased further to just 20 percent of the peak level. Total investment returned to the 1925 level only after five years in 1930–31. The net product of the Jewish sector, though, kept growing throughout the 1920s, as did the product per capita, which after a short two-year interval of minor decline, passed the previous 1925 peak by 1928, even though the Jewish population grew by 14 percent in the interval.

Both population and product per capita kept growing through 1931, with the latter showing a high annual average growth rate of 8.2 percent (Table 5) in spite of the impact of a "classic" economic recession (1926–27). The well known negative effects of such downturns had in that case a twist specific to the activities in the Jewish sector: it reduced considerably the inflow of immigrants, and owing to a surge of emigration, particularly in the second half of the decade, net immigration was slightly negative in 1927 and 1928. This occurred at a crucial juncture in the Arab-Jewish confrontation and the emerging change of heart of the British government, highlighted by its attempt to impose restrictions on Jewish immigration and land purchase at the turn of the 1930s.

structural changes: an interim summary

These developments were not accidental. They were directly linked to the changing demographic balance and economic power, which were the hallmarks of developments in the first decade of the British Mandate through 1931. The growth of the Yishuv's population to 175,000 by 1931 meant that its share of Palestine's population expanded from 11 percent in 1922 to 17 percent in 1931 (Table 1). This also involved a highly significant and much greater spatial distribution by way of the increase in the number of Jewish settlements since the end of the war (Table 3). The most significant development, probably not fully comprehended by contemporaries, was the dramatic change in the economic performance of the two sectors, measured in terms of national product aggregates. The nnp estimate for 1922 suggests that the nnp of the Jewish sector was about 23 percent of that of the Arab sector. Both sectors expanded in that decade, but the disparity between them (the Jewish sector grew by an almost 18 percent average annual growth rate, while its Arab counterpart grew by only about 4 percent annually) had an inevitable cumulative effect: by 1931 the Jewish sector's national product was already about 70 percent of that of the Arab sector (Table 5).

The comparative growth of national product, of course, had an impact on the patterns of product per capita. Even though the Jewish population grew much more rapidly, Jewish product per capita, which was nearly twice that of its Arab counterpart in 1922, nevertheless leapt to a ratio of 3.5 in 1931 (Table 5). This huge gap was not maintained in the second half of the 1930s and in the 1940s because of the much more rapid increase of the Jewish population. But the ratio at which it settled in the late 1930s – about 3.5 – afforded an altogether different living standard for the Jewish than for the Arab population and the setting of altogether different socioeconomic patterns for the two societies.

The result of the robust economic performance by the Jewish sector in that decade was a highly significant change of structure. One aspect of it was the rapidly changing comparative economic status of the two national sectors described above. Of even greater significance were the rapid urbanization of the Jewish sector, involving the emergence of an industrial manufacturing sector and an extensive commercial sector, and the reorientation of Jewish agriculture in both its branch composition (product mix) and its socioeconomic form of organization. Both of these were linked to the resettlement effort, which really came into its own in the Mandatory period.

This process pushed the old yishuv into a small and relatively declining demographic niche. It became a kind of backwater component of the Jewish national entity, which was forging ahead with the Zionist project. The mechanism of that process shows in the increased number of Jewish settlements, which in the 13 years from the end of the war almost tripled, and more than tripled in terms of the size of the rural population (Table 3). Their very number suggests the penetration of these settlements into locations everywhere, from Galilee in the north and along the central coastal plain to the vicinity of Jerusalem and south toward the line separating the semi-arid and arid zones of the Negev from the rest of the country. Their contribution to production shows in the growth of farm output by more than five times in the 1921–1931 period (Table 3), with corresponding growth of net Jewish farm product by almost 4.7 times in the 1922–31 interval (Table 8).

This growth involved significant changes in the composition of the branch structure of Jewish agriculture and in the techniques of running and managing it. The new settlements set up by the Zionist Organization adopted ab ovo the mixed farming strategy, with fruit plantations and vineyards as part of the mix but neither dominant. The composition of the mix was designed to offer a year-round comparatively balanced demand for labor to assure a steady flow of income to the cultivators.

Irrigation, tractor-driven farm machinery, and improved plant varieties as well as high capital-labor ratios were to serve as the instruments of a meaningful move toward European living standards. The Zionist (later Jewish Agency) authorities would provide financing for the acquisition of these resources and for the cost of purchasing the land. The cultivators would lease the nationalized land for low rents and would repay the long-term credits allocated to them to pay for the investment in capital stock – housing, machinery, and plantations.

They would also pay (low) interest charges on the outstanding debt.

These settlements were established by groups of pioneers inspired by socialist Zionist ideology following the maxim of "self-labor": this excluded the option of hired workers, and involved by definition adherence to the rule of avodah ivrit. The first of these groups, which would soon be organized as legal entities, surfaced in the early 1920s from the "floor" – by the initiative of their members. these self-initiated groupings – there were two types, the kibbutz and the moshav, based on collective and cooperative principles respectively – soon formed the vanguard of the resettlement effort and were at its core for the next four decades. There were already 11 kibbutzim and 2 moshavim in 1921, at the very infancy of the movements; by the end of their formative decade, in 1931, the kibbutz movement counted 30 settlements, and the moshav 10, in locations all over the country, from Galilee and the Jezreel Valley in the north along the coastal plain to the Jerusalem district.

The mixed farm output figures for 1931 (Table 3) indicate that within that decade real output expanded 2.8 times and the corresponding farm product by a lower factor, 2.2. These imply very high growth rates indeed, about nine percent annually, and an even higher figure for mixed farm output (Table 8). This expansion of production was, of course, due not only to the production lines set up in the nascent collective and cooperative settlements, but reflected the vigorous growth of production in the older rural settlements, about 40 in number, already in place by 1914. Rapid urbanization (see below) provided expanding markets for vegetables, dairy products, and poultry from the prewar settlements and postwar private-sector settlements. The latter multiplied in the 1920s and early 1930s in the vicinity of the Tel Aviv-Jaffa urban center. The growth of the Jewish rural population by 2.5 times in the 1922–31 interval, reflecting an almost 11 percent annual growth rate (compared to the 8.4 percent annual rate of the total Jewish population) suggests the extent of new employment resulting from expanding farm production.

This expansion occurred not only in mixed farming, as the farm output and net production figures indicate: total Jewish farm output grew by almost 4.5 times through 1931 while its mixed farming component grew by only 2.8 times. The difference between these two figures is of course the tremendous expansion of citriculture in the two interwar decades. The rapidly increasing demand for Jaffa oranges in Europe in the 1920s generated prices that were highly profitable. Expectations of high profit in the 1920s encouraged private entrepreneurs, Jewish and Arab, to expand citrus orchards rapidly. entrepreneurs in the older settlements and the new private enterprise settlements of the 1920s and early 1930s moved en masse into this line. The Jewish orchard area, which in 1922 was still almost the same as its prewar size, expanded from 10,000 dunams to 70,000 in the decade ending in 1931 (Table 3).

The citrus boom offered rapidly rising employment opportunities, manned to a significant extent by Arab workers, and thus to a sharpened struggle for avodah ivrit. However, it had a positive effect on the Jewish labor market too: this is clearly suggested by the more rapid growth of the rural population than of the total Jewish population in the 1922–31 period. The citrus boom generated a structural change in the economy of the older settlements, particularly those located in the citrus growing belt along the central coastal plain. It also encouraged the acquisition of urban features by some of these older settlements, involving rapid expansion of the commercial, financial, and technical service center in the Tel Aviv-Jaffa conurbation and in the Haifa and Haifa Bay area. The commercial and service sectors of the Jewish economy were effectively manned by Jewish workers only, and thus profit considerations were in these activities fully consistent with the avodah ivrit principle.

The rapid process of urbanization with Tel Aviv as its center of gravity was primarily the product of the crest of the Fourth Aliyah and the building boom it generated in the mid-1920s. Tel Aviv's population, which was 15,000 in 1922, more than doubled within three years; in 1925 it was already 34,000. With the Jewish population of Jaffa at about 8,000, Jews were by that date already the dominant community in the Tel Aviv-Jaffa conurbation. Though the focus of urbanization in that period was Tel Aviv, the process occurred all over: the Jewish population of Haifa grew by 2.7 times to 16,000 in 1922–31, and that of Jerusalem grew by 50 percent.

With net Jewish immigration of about 90,000 in the 1922–31 period, and an expansion of Jewish urban population in the three main towns – Jerusalem, Tel Aviv, and Haifa – by about 60,000 in 1922–31, to which figures in several small urbanizing settlements near Tel Aviv could be added, the main structural transformation of the Jewish community of Palestine was clearly a robust process of urbanization. This was closely linked to another major change, the emergence of manufacturing industry and its transformation into the major component of the Jewish economy (see below, The Economics of the Fifth Aliyah, 1932–1939/The Advent of Manufacturing).

The Arab Sector: Demographic Growth and Economic Expansion, 1920–1947

demographics

One of the significant features of the development of the Arab sector of Palestine was the demographic revolution to which it was subjected through the Mandatory period. This shows clearly in the rapid acceleration of population growth during that period. Population data for the period of 1890–1914 suggests that even at that late stage of the Ottoman period, the annual average growth rate was about 0.8 percent, effectively similar to the 0.7 annual average for the 19^th century. Yet the 1922–1931 population growth rate based on census data and much more reliable than the population estimates through 1914 leapt at once to an average annual rate of 2.6 percent: the annual average for the entire period of the Mandate (1922–1947) was 2.7 percent.

A comparison with the Egyptian annual population growth rate is suggestive. That stood at 1.5 percent in the two decades ending in 1947 and 1.3 percent annually in the three decades between 1917 and 1947, coinciding almost exactly with the three decades of Mandatory rule. The much higher growth rates of Palestine's Arab population reflected improving living standards and health services (producing in particular a dramatic reduction of child mortality), as well as immigration, from Syria in particular and also from Egypt. These developments were clearly due to the highly significant transformation of the Arab economy, involving a rapidly rising national product, which allowed for the notable increase in the standard of living.

the economic aggregates

The patterns of national and per capita product demonstrate this performance, in absolute and comparative terms. They had surfaced already in the 1920s, as shown by the annual average growth rate of national product for 1923–1931, which was 4.1 percent. It accelerated in the 1930s and in spite of a politically imposed standstill in 1936–39, during the Arab Revolt, the Arab sector's national product grew almost fivefold, at an annual average rate of 6.5 percent, in the 25 years ending in 1947, the last full year of the Mandate. The per capita product, which reflects the correspondingly rapid growth of population, grew at a lower rate of about 2.5 times through those 25 years, at an annual average rate of 3.6 percent (Table 5).

This was undoubtedly a good performance by international standards in those years, and even better in comparison to the performance of the neighboring Arab states.

Arab immigration into Palestine from the neighboring countries, quite visible in the marketplace at that time, was close to 50,000 during the 25 years ending in 1947. This inflow, which provided about 7.5 percent of the increase in the Arab population (Table 2), offers quantitative evidence of the significantly better performance of the Arab economy in Mandatory Palestine than the economies of the neighboring Arab countries.

The robust performance of the Palestinian Arab economy in the aggregate was in the 1920s and through 1936 linked directly and indirectly to the outstanding economic growth of the Jewish sector, which in the 1920s through 1931 grew at an annual average rate of about 18 percent. During the war and its aftermath of 1940–47, in which the Arab sector's national product grew even more rapidly at an annual rate of close to 10 percent, it was the British army demand for labor and goods that generated the booming prosperity of Palestine's two national sectors through 1945. This prosperity was sustained in the ensuing two years by the release of the suppressed inflationary pressures accumulated during the war.

arab-jewish economic links

The means by which the Jewish sector's economy had a direct impact on the Arab sector's was the employment of Arab wage labor by Jewish enterprises. The indirect means by which the very rapid growth of the Jewish economy pulled the Arab economy in its wake was its purchasing on capital and current accounts. The latter involved purchases of consumer goods and of inputs such as stone for the building industry. Purchases on capital accounts involved primarily the acquisition of land.

An estimate of the direct impact of the payment of wages to Arab labor by Jewish employers is presented in Table 5a, which reproduces the ratios of net national product to net domestic product in each of the national sectors. This table expresses the increment of wage income earned by Arab labor in the Jewish economy; on the Arab sector line, it is added to the domestic product generated by the Arab economy; on the Jewish sector line, it is deducted from the domestic product generated by the Jewish economy. The ratios for the Arab sector through the 25 years of the Mandatory period are consistently above 100 percent in this series, while that of the Jewish sector is less than 100 percent all the way through 1947. At the height of the boom in 1935, wages paid by Jewish enterprises added six percent to the Arab gdp, suggesting that through the entire first half of the 1930s, the average income added to the domestic product of the Arab economy by employment in the Jewish sector topped 4 percent of gdp.

The Arab boycott against the rapidly expanding Jewish political and economic entity in the spring of 1936, which also involved mass demonstrations that devolved into armed riots against Jewish targets and later clashes with the British army and the Haganah, began in 1936 and continued through early 1939. These events shattered the direct economic link with the Jewish sector almost completely. A fraction of the exogenous wage income, mainly from government and military employment, survived; it revived and grew in the war years, as more and more Arab wage labor was drawn into the market.

The comparisons of national to domestic product in Table 5a indicate that Arab wage labor in the Jewish sector was of much lower significance during the war years than it had been in the 1920s through 1935. The severance of the direct links between the national sectors, initially generated by politics in 1936–39, though not complete, became permanent during the war due mainly to two economic factors: the collapse of the citrus industry – the main employer of Arab labor in the Jewish economy – at the outbreak of the war reduced its demand for labor almost totally; and the corresponding rise of manufacturing industry to be the dominant economic sector of the Jewish economy. Manufacturing required different kinds of labor than farming, insuring that the post-1936 labor situation remained the status quo. By 1945 only 1.2 percent of the Arab labor force was employed in the Jewish economy (Tables 5 and 7).

Indirect links between the two national sectors, however, remained strong. The growth of the Jewish economy inevitably had a highly significant indirect effect on the Arab economy, through their trading links. The demand for goods spilling over from the Jewish sector generated a lively Arab export trade, generating higher output and correspondingly higher productivity and income. Another link between the sectors was land purchase, through which funds flowed from the Jewish to the Arab sector. These financed investment (in citriculture, in particular), which generated employment and growth as well.

The significant positive effect of Jewish activity on the Arab economy can easily be substantiated by the aggregate data at our disposal. The world economy plunged into depression and crisis from 1930 onwards. This should have affected the Arab economy negatively, or at least arrested its growth rate. Yet in that very period, through 1935, the growth rate of the Arab economy as expressed in terms of nnp leapt to an annual average of more than 12 percent, stimulated by the rapid growth of the Jewish economy. Similarly, the direct effect of the Jewish economy on its counterpart can be seen in employment figures: close to five percent of the Arab labor force was employed in the Jewish sector by 1935, compared to three percent in 1931 and an even lower rate in the 1920s.

The succeeding period 1936–39 provides the obverse image of these developments: the reduction in the inflow of Jewish immigrants imposed by the British government in response to the Arab uprising, and the correspondingly lower capital inflow (lower by 50 percent), led to a recession. Jewish sector national product was 13 percent lower in 1939 than in 1935. The Arab sector's nnp also fell, though not as much; it declined by only seven percent, mainly due to a major reduction of employment in the Jewish sector. Thus, Palestine's recession was a special case, due largely to the 1936–39 hostilities, just at the time the world economy was recovering from the worst of the crisis. these developments hit the more industrialized and market-oriented Jewish economy more seriously. Its Arab counterpart followed in the same direction, though at a significantly slower pace (Table 5).

urbanization, wage labor, and industrialization

Through the three decades of the British Mandate the Arab sector had undergone a process of urbanization, involving the emergence of manufacturing, industry, growing intensity of commercial and financial activity, and inevitably a population dependent on wage labor.

The urbanization process was visible yet slow. Table 3 suggests that the rural population grew significantly in absolute terms, including a still nomadic group (which however declined in number). In the 22 years ending in 1944 the rural Arab population grew by more than one third. This estimate is based on reliable data – the first (1922) and second (1931) censuses. The rural share of the total Arab population had been declining slowly but consistently, from about 70 percent of the total in 1922 to 67–68 percent in 1931, and 64–65 percent in the very last years of the British Mandate. This process involved a corresponding increase of urban population to almost 35 percent of the total.

Yet this figure seemingly understates the thrust of Arab urbanization, since it is affected by the population figures of Jerusalem. Jerusalem had been the religious center of the Palestinian Arab community for centuries. In the Mandatory era it soon emerged as its political center also, though it lost its priority in demographic terms. Jerusalem was out of the main areas of Arab demographic and economic expansion, which focused on the two ports of Palestine, Jaffa and Haifa. This shows clearly in the population data. Between 1922 and 1944 Jerusalem's Arab population grew by approximately 50 percent; that of Jaffa, already by 1914 larger than Jerusalem's, by more than 60 percent; that of Haifa, where the new deepsea port opened in 1931, by over 200 percent, growing larger than Jerusalem's in the 1930s (Table 1).

Jaffa and Haifa were undoubtedly the centers of gravity of the Arab sector's economic development, and thus also the centers of the industrialization process. They were inevitably the location in which manufacturing, industry, and commercial and financial services expanded most rapidly, generating a long-term process of modernization. Among other things, this was manifested in the rapid growth of wage labor relative to self-employment, the dominant economic category in a traditional farming society, including its urban component.

The robust expansion of production reflected rising employment and a much higher investment rate, which contributed to a continuous increase of the Arab capital stock at a rate higher than the increase of employment. This process was slow in the 1920s; by 1931 the Arab capital stock was 26 percent higher than in 1922. Yet employment grew at a lower rate in that period, which meant that the capital labor ratio in 1931 was eight percent higher than in the early 1920s. Conterminously with the all-time high spurt of investment in the Jewish sector from 1932 to 1935, the Arab sector investment rate leapt as well. Thus, toward the end of the Mandate period the

capital labor ratio was higher by one third than at its beginning (Table 4). This, of course, explains the major improvement of labor productivity – by 1931 it had already improved by 26 percent; in 1945 it was more than two times higher than in 1922 (Table 6). It explains the significant rise of real income per capita and of real wages (Table 5).

The performance of the Arab sector suggested by the aggregate factor inputs, by output and by national product figures, are, however, (weighted) averages of the inputs and of the output and product (value added) of several economic branches. The employment and domestic product series of Table 9 illustrate the dominance of agriculture throughout the Mandatory period. These demonstrate a rather slow process of changing economic and social structure.

Agriculture was indeed the dominant branch in terms of employment throughout the three Mandatory decades. Yet its share in employment declined from about two thirds of the labor force in 1922 to around 55 percent towards the end of that period. The corresponding rise of employment in manufacturing and construction from 7 percent in 1922 to 13–14 percent in the late 1930s and mid-1940s were the obverse of the relative decline of agriculture. Yet these figures do not demonstrate fully the highly significant social change – the emerging importance of the wage-earning strata in Palestinian Arab society. The rise of the citrus industry, a farming branch, had a similar effect in agriculture to that generated by the rise of manufacturing and construction – a significant transition to wage labor. Its major impact on that score is suggested by the tenfold increase of output in citriculture between 1922 and 1935, while that in all other farm branches increased only 40 percent or so (Table 3). The subsequent decline of Arab net product between 1935 and 1939 (Table 5) did not reflect, however, a decline of physical output of citrus products and thus of wage employment: it reflected the collapse of prices in the export markets.

The Arab manufacturing and construction employment figures of Tables (7) and (9) do not represent Arab wage labor employed in the Jewish sector, by the Mandatory government, and in the war years by firms working for the British army. Employment in the Jewish sector increased from two percent of the Arab labor force in 1922 to close to five percent at its peak in 1935, after which it declined significantly. Yet this slack was easily absorbed by the late 1930s and even more so in the war years by wage employment in military-sponsored projects. This of course suggests that the proportion of wage earners in the material production branches of the Arab economy and engaged by these "other" labor markets increased by more than the figure suggested in Table 9. These suggest that this increased from 6.4 percent of total employment in 1922 to almost 14 percent in 1945. If the government, military, and Jewish sectors are added, the figure for the end of the Mandate period appears closer to 20 percent. To this should be added wage employment in services, which suggests that at the end of the Mandatory period in the late 1940s, wage and salary employment was already about 35–40 percent of total Arab employment.

The modernization process of the Arab economy and society, showing in terms of urbanization and the emergence of a major population of wage labor, inevitably involved industrialization, underlined by the comparative growth of manufacturing industry. Even at its peak in 1935, affected by high prices in foreign citrus markets, Arab farm net domestic product was only 80 percent higher than in 1922. In the same period the product of Arab manufacturing increased by about 350 percent; the construction boom involved an even greater leap to an all-time high (Table 8). Manufacturing industry started indeed from a low base: the workshop employing a small number of workers was the prevalent feature of that sector in the early 1920s. The soap industry in Nablus, based on a local raw material, olive oil, was a case in point. Urbanization and growth led to the emergence of manufacturing establishments focusing on the production of consumer goods. Flour mills, cigarette factories, and small textile establishments appeared in the later 1920s and 1930, and so did larger manufacturing establishments, supplying raw materials such as stone, bricks, and lumber to the building industry, which was expanding in the mid-1920s and again in 1932–1935, thanks to a building boom in both national sectors. "Exports" to the Jewish construction market were a dominant component of the demand for quarry output. In the four years ending in 1935 the net product of Arab manufacturing grew accordingly by much more than 50 percent. Agricultural product started to grow again during the war years. Yet by 1945 Arab manufacturing product was almost eight times greater than in 1922, while increase in farm production was less than half of that. This applied similarly to the comparative growth of employment in the two branches (Table 7).

the restructuring of the farm sector

Agricultural employment and product grew substantially in absolute terms through that period. It was clearly citriculture, however, that was the backbone of the Arab agricultural sector through 1939. While between 1922 and 1939 total Arab farm output grew just over twofold, the output of citrus grew by almost eight times and that of noncitrus output, which was subject to cyclical yield features, rose by about only 1.6 times. In its peak year, 1937, noncitrus farm output was almost two times higher than in 1922. The growth rate in terms of value added was similar.

With the closure of foreign markets during World War ii, the citrus industry effectively disappeared from the map. Yet the other components of Arab agriculture, lagging through 1939, benefited from the booming food markets, civilian and military, in Palestine and the Middle East. Net farm product of the Arab sector, effectively the noncitrus branches, more than doubled during the almost six years of the war. This was evidently a much better performance than that shown during the 17-year period ending with the outbreak of the war (Table 8).

Peasant dry farming was the hallmark of Arab agriculture at the advent of the Mandatory period. For the highly self-sufficient farm population, grain growing provided the basic food requirements, with livestock output also mainly for home consumption. This pattern changed substantially during the period of the Mandate. While Arab rural population grew by about 65 percent, the area under grain cultivation grew by only 13 percent; grain output even declined in the 1930s. Yet the area allocated to vegetables, tobacco, olives, and other fruit grew by 5 to 6 times, and the output of vegetables, largely cash crops, increased eightfold and that of fruit fourfold. The mixed farming output obviously responded to the pull of the markets, through the war years especially.

Thus, though land under cultivation hardly increased, farm employment rose by 14 percent and the intensification of cultivation due to a fourfold increase in the area of irrigated land allowed an increase of mixed farm output that compensated for the collapse in citrus production. Yet the use of mechanical equipment in farming was still small. This is underlined by a simple statistic: out of 500 tractors operating in Palestine in the early 1940s, Arab farmers owned and used only 50.

The dominant factor of Arab peasant farming in the three decades of the Mandate, and particularly from the 1930s onward, was clearly its move into the market system. It heralded the disappearance of subsistence farming and its replacement by cash crop production, complemented by seasonal employment in the rapidly expanding Arab and the Jewish citrus industry. In the war years, employment in military projects served as a substitute for the loss of citrus industry employment.

The Economics of the Fifth Aliyah, 1932–1939

immigration, legal and illegal, and palestine's demographic structure

The Jewish population, which was 175,000 at the end of 1931, grew to 650,000 at the time of the Declaration of Independence on May 15, 1948. Thus, during that short interval of some 16 years it grew by about 3.5 times (Table 1), at an average annual rate of 8.2 percent. Although this rather unusual growth of population reflected natural population growth rates in situ, it was dominated by a wave of Jewish immigration in the first half of the 1930s, peaking in 1935 (Table 3). During these four years, more than 160,000 immigrants arrived in Palestine, a figure almost equal in size to the total Jewish population of 1931. That high annual average of about 40,000 was cut drastically to about 21,000 in the next four years, through 1939. In the six war years and the two years immediately thereafter through 1947, this low immigration rate was reduced even more, to an annual average of about 12,000, close to the rate prevailing in the first years of the Mandate through 1931.

A highly significant feature with important implications for the size of the Jewish community in Palestine was the rate of emigration, a common phenomenon of countries absorbing significant numbers of immigrants. In the 1920s this was quite high: emigration was on average 25 percent of the total immigration inflow between 1919 and 1931. In the 1930s this rate was down to only about eight percent, a decrease reflecting the hostile attitude of governments of the time toward Jewish refugees – underlined by the attitude of the participants of the 1938 *Evian Conference on refugees. The emigration rate was similarly about nine percent from 1940–47.

The immigration inflow was not smooth, nor was the outflow of emigration. Ups and downs were due mainly to political factors in Europe on the one hand and the changing policies of the Mandatory government on the other. The short-lived surge of the Fourth Aliyah of 1924–27 was clearly a response to the economic crisis in Poland. It was also affected by the drastic limitations on immigration to the United States imposed by the Immigration Act of 1924, which effectively closed the United States as a destination of immigrants from Eastern Europe, thus redirecting Jewish immigration toward Palestine.

In the 1920s, the first decade after the Balfour Declaration, Palestine was on the whole an open destination to Jewish immigrants, even though Churchill's 1922 White Paper imposed conditions of "economic absorption capacity" for the allocation of immigration certificates to workers, i.e., to potential Jewish immigrants who could not prove ownership of a required minimum (£1,000) of liquid funds. Immigrants who did have such funds, the so-called "capitalist immigrants," were automatically allocated entrance permits for themselves and their families, and work permits. For immigrants in the "workers" category there was a quota. Its size was to be negotiated every six months by the representatives of the Zionist authorities and the Immigration Department of the Mandatory government. These entrance permits – "certificates," as they were known in the Jewish community – were put at the disposal of the Zionist Organization and allocated by its Palestine Office to Jewish applicants, mostly in Europe. In the 1920s most of these permits were allocated to applicants in Eastern European countries; from the early 1930s on, those in Germany, Austria, and Czechoslovakia were given priority.

In the negotiations over the size of the six-month quota of labor entrance permits, differences between the optimistic estimates of the so-called "economic absorption capacity" of Palestine, offered usually by the representatives of the Jewish Agency, and the more conservative estimates of the director of the Immigration Department, were inevitably the rule. In

spite of a short-lived attempt by the British government in 1930 to withdraw from its commitment through 1935, the pace of Jewish immigration was more or less determined by the number of European Jews wanting to emigrate to Palestine. The upsurge of the Fourth Aliyah in 1924–27 was determined by economic and political pressures in Eastern Europe. What could be described as the pre-state wave of mass immigration in 1932–36, which brought almost 200,000 Jews to Palestine, more than doubling the size of the Jewish population within those five years, was evidently the all-out economic crisis in Europe which had led to the rise of the rabidly antisemitic Nazi government of Germany. Its influence in such areas as the elimination of the civil rights of Jewish citizens radiated to Eastern European governments, particularly those of Poland and Romania, which had been long pursuing more covert antisemitic policies of their own, generating a "pushing out" effect on the Jewish communities in those states.

The political dominance of Hitler's Germany in Europe, demonstrated by the appeasement embodied in the Munich Agreement of 1938, led finally to the desperate attempts of Jews to emigrate from Europe to almost any destination open to them. This should have led to another wave of mass immigration to Palestine, given the closed-door policies of the United States, Canada, Australia, and South American countries

which were linked to the high unemployment rates in those places.

Palestine immigration data, however, indicates that this was not the case. In the 1936–39 period, Jewish immigration was cut by an annual average of more than 50 percent compared to 1932–35. The same holds true for the entire war period through 1947, even though Jews in eastern and southern Europe, desperate to save their lives from 1935 onward, were looking for havens to escape to. If an open door to Palestine, or at least the relatively liberal immigration policy through 1935, had continued, this option would have been used by many more Jewish refugees in 1936–39. Indeed about a million Jews living in Romania and the Balkan countries could have made use of such an option as late as 1941 and even 1942. More than 100,000 Jewish refugees attempted to make it to Palestine as illegal immigrants in the immediate aftermath of the war in 1945–47.

The reduction of Jewish immigration to Palestine from 1936 on was the result of the policy of the British government, in breach of its 1922 commitment to the League of Nations. It was made in response to the Arab uprising of 1936–39, and during the war years, particularly from 1942 onward, reflecting a cynical reading of the expected relative political power of the Arabs and the Jews in the postwar era. The British Foreign Office, headed by Foreign Secretary Anthony Eden, advocated this policy. The first attempt to adopt such a policy came in 1930–31 from the Labour government's colonial secretary, Lord Passfield (Sidney Webb), but at that time it was revoked by Prime Minister Ramsay MacDonald before being implemented. In 1937, when only 10,000 immigrants were allowed into Palestine, it was finally implemented on the spot on grounds of insufficient "economic absorption capacity." The representative of the Mandatory government argued that a very low base reading of the absorption capacity was warranted, apparently in view of the recession phase of the business cycle, a well-known feature of market economies. In the wake of the roaring Fifth Aliyah-driven prosperity of 1932–35, a short downturn of the level of economic activity was indeed in the offing.

This justification for limiting Jewish immigration was soon superseded. The British government adopted the policy announced in the White Paper of 1939, revoking the commitment to "facilitate Jewish immigration" (and to the eventual partition of Palestine that had been its official solution for the growing strife between the Jewish and Arab communities). The White Paper envisioned an independent Palestinian state after a period of ten years. During this time Jewish immigration would be limited to a quota of 75,000, who would be allowed to enter within five years, after which Jewish immigration would end. It also limited drastically the area of Palestine where Jews would be allowed to purchase land. This policy was adamantly pursued by the Conservative government in power, and later by the coalition government through the years of the war. It was also adopted by the postwar Labour government, which used the British Navy to pursue ships loaded with European Jewish refugees attempting to make it to Palestine illegally. They caught most of the ships while still on the high seas. The refugees were held in camps on Cyprus until the emergence of the state of Israel in 1948.

About 120–150,000 ma'pilim (*"illegal" immigrants) made it to the shores of Palestine – i.e., without an entry permit. Transport was organized and financed by the Zionist authorities and Jewish organizations. Some 20–25,000 of these illegal immigrants arrived before the war, between 1934, when the first ship from Europe, the Welos, made it to a hidden landing spot, and 1940. About 100,000 were involved in the illegal immigration drive during the war years and especially in the all-out efforts to breach the British embargo after the war. Ha'palah was the Hebrew term coined for that entire campaign. This operation was part of the last stage of the struggle for the establishment of the state of Israel, and involved in 1941 and 1942 two accidents that cost hundreds of refugees their lives.

Nevertheless, the Aliyah brought close to half a million immigrants to Palestine during the three decades of the Mandatory period. As is true of mass migrations to any country, some of the immigrants – after 1930, very few – returned to their home countries or went to other destinations. Estimates of Jewish immigration to Palestine for 1936–45, during which the preliminary stage of the illegal immigration effort took place, suggest that about 20 percent of the total of 130,000 immigrants in that period came illegally. They arrived by ship from Europe or through the northern land border with Lebanon and Syria. Those who arrived via the latter route were mostly from the Jewish communities of Iran, Iraq, and Syria.

In the 1920s, the Zionist movement faced an uphill struggle with the Jewish communities in Europe to convince them to use the opportunity of the "free Aliyah" option available in those years and follow the Zionist message of the Return to the Land of the Patriarchs. From the mid-1930s onward the struggle was with the British government, which attempted to implement a closed-door policy while hundreds of thousands of Jews were by that time knocking on the gates. The half a million immigrants who made it to Palestine during these three decades changed the demographic landscape and thus the economic and inevitably the political structure of Palestine. The Jewish community was only 11 percent of the total population in the first Mandatory census of 1922. At the second and final Mandatory census in 1931, it was already about 17 percent. in the following four years, with the mass immigration of 1932–35, it grew to 27 percent of the total population. By May 1948, at the time of the declaration of statehood, the Jewish population was about one third of the total of about two million people living in Palestine.

the breakthrough in the jewish economy, 1932–1939

Labor Force, Employment, Investment, and Capital Stock

The almost 250,000 Jewish immigrants of the 1930s, two-thirds of whom had arrived by 1935 before the British government began to implement the closed-door policy, represented a major enlargement of the Jewish labor force. By the end of 1935 the labor force was two times greater than in 1931. The significant reduction in immigration reduced its rate of expansion in the next four years through 1939 to only 40 percent, but this meant that by the outbreak of the war it was still close to three times greater than at the beginning of the decade. Employment grew correspondingly by two times through 1935, but at a significantly lower rate than the growth of the labor force in the second half of the 1930s, reflecting the downturn in the business cycle and rising unemployment. Though the rate of unemployment increased to 4.2 percent, employment in the Jewish sector was by 1939 still higher by about 25 percent than in 1935 (Tables 4 and 7).

This rising trend of employment and of production would have been impossible without a major increase of the capital stock of the Jewish economy and the buildup of the infrastructure of Palestine – the "Government Capital Stock" (roads, railroads, ports, telephone and radio facilities, etc.), in the terms used in Table 4. The Jewish sector investment figures show the extraordinary bulge of investment in 1935, which represents the peak of the rising trend of investment from 1932 onward. Though declining afterward through 1939, the lowered investment level of that year was still higher than investment levels in each year previously through 1931.

This means that capital stock kept accumulating through the second half of the 1930s, though at a significantly lower rate than in the 1931–35 interval. The major upswing of the Jewish economy within these four years involved an expansion by more than two times of the reproducible net capital stock of the Jewish economy; at the end of the 1930s it was more than three times greater than at its beginning. The expansion rate of the infrastructure capital stock (the so-called Government Capital Stock) was lower, though it still grew by a factor of 2.5 in the 1930s. The highly significant more rapid increase of the capital stock than of the labor force and employment meant that the capital-labor ratio and the capital-employment ratio, displayed in Table 4, rose at a very high rate of 20 percent in the 1920s, and kept rising in the 1930s at an even higher rate. This pattern was maintained even though, with the growth of immigration, the Jewish labor force and employment grew at a much higher rate than in the 1920s.

Furthermore, the levels of education and expertise displayed by the immigrants of the 1920s and especially the 1930s reflected the state of the art in the industrial countries from which they came and contributed immensely to the human capital of the Jewish community. This feature, among others, underlines the considerable relative decline of the old yishuv component of the community. It can also be seen in the establishment of a comprehensive elementary school system, financed and run by the Jewish sector's own political authorities, even though there was no legal enforcement of attendance. A significant secondary school system, initially small in terms of attendance rates of the relevant age group, assured the education of the coming generations.

Production and Living Standards

The expansion of the labor force and of employment, and even the higher growth of capital stock, supported by rising productivity show inevitably in rising production and living standards. The 1939 national product was 2.3 times greater than that of 1931, on the eve of the arrival of the Fifth Aliyah. This means that Jewish national product grew at the enormous annual average of 11 percent through these eight prewar years (Table 5).

The national product of 1939 was indeed significantly smaller than the all-time high of 1935, to which it had risen at a spectacular rate in the four-year period since 1932. This was an expression of the major slowdown of the economy, related to the outbreak of the 1936 Arab revolt, and particularly to the recurring prewar political crises in Europe. These had started with the breach of the Versailles Treaty by Hitler's Germany and Mussolini's invasion of Abyssinia toward the end of 1935, followed by the Anschluss in Austria and the succeeding Munich Crisis, both in 1938, and finally the outbreak of the war in 1939. The specific domestic reason for the downturn of the Palestine economy in the second half of the 1930s was the major reduction by about 50 percent of the inflow of Jewish immigrants and the corresponding reduced inflow of Jewish capital imports – effectively the total capital inflow into the Palestinian economy. This inflow was lower by about 23 percent in the four-year period 1936–39, relative to the all-time high in the preceding four-year period, with investment following suit.

Living standards measured in terms of per capita product, or of real wages, rose at a significantly lower rate than that of total product. At the height of prosperity in 1935, before the emergence of the 1936–40 slowdown, per capita product was higher by 45 percent than in 1931, and real wages grew by close to 10 percent (Tables 5 and 6). These very rapid rising trends were achieved even though the Jewish population grew in these four years by two times, and the labor force by a similar factor. The ensuing slowdown changed the direction of these two indicators of the Jewish sector's average living standards. But by the depth of the depression in 1939, which can be seen in the 4.3 percent unemployment rate (Table 7), per capita product and real wages were about 90 percent and 50 percent higher, respectively, than they had been in 1922. This means that per capita product and real wages had risen at an annual average of 3.8 percent and 2.4 respectively since the early 1920s. This was thus quite a performance in view of the world economic crisis of the 1930s, and the weak, or at best mediocre, performances of the European economies in the late 1920s, with the Mandatory power, Britain, itself in the doldrums.

the jewish and arab economies: comparative trends and links

Measures of living standard (product per capita), and productivity (product per employee), which grew by annual averages of 3.8 and 2.8 percent respectively through 1939 (Tables 5 and 6), suggest that during the first two decades of the Mandate the Jewish economy made a major stride into industrialization. The growth of its real economic aggregates, in particular labor force, capital stock, national product, and trade, as well as the considerable and highly significant capital imports, suggest that the Jewish economy at the outbreak of World War ii was an altogether different entity than at the advent of the Mandate era.

This conclusion is underlined by the comparative trends in the products of the two national economies. The Jewish national product was less than one quarter of the Arab national product in 1922; by 1935 it was already greater, and about 53 percent of the total product of Palestine, even though the share of the Jewish population was only 27 percent at that time (Tables 5 and 6). The economic slowdown of the late 1930s inevitably had a greater impact on the comparatively more industrialized and urban Jewish economy than on the Arab, still dominated by its farming sector. Thus, by 1939 the ratio between the two economies' products equalized somewhat, with the Jewish share slightly above 50 percent, while its share of the population had reached 30 percent.

These differences between national product and population ratios also show in per capita national product ratios. The advantage of the Jewish sector, indicating a much higher average living standard, emerges already in the 1922 figures; the Jewish per capita product was almost two times greater than its Arab counterpart. This soared to a ratio above three during the first half of the 1930s. The slowdown of the late 1930s and the continuing, though much lower, Jewish immigration, reduced somewhat the gap between the two economies' per capita products to a factor of about 2.5 through the last decade of the Mandatory era.

The gap between the national product and per capita figures for the two economies was greater in terms of domestic product, which relates more to productivity, than in national product, which offers a better index of living standards. This is because the Jewish economy offered employment to Arab labor, while Jewish workers were not willing to work for the wages prevalent in the Arab sector. Another feature of this relationship that boosted the net product of the Arab economy was the sale of Arab farm produce to Jewish urban populations. An estimate of the quantitative effect of that linkage on Arab gross domestic product and net national product is unavailable.

The outbreak of the Arab rebellion in 1936 led to a widespread severing of links between the two economies. Most importantly, it reduced the employment of Arab labor, both in absolute terms and, even more, relative to total employment in the Jewish economy. The war, which after 1939 shut off the main export markets of Palestine's citrus industry, prevented a major revival of employment of Arab labor in the Jewish economy during what was a relatively peaceful time in Palestine. At its peak in 1935 the share of Arab labor of employment in the Jewish sector was 8.4 percent; by 1945 it had fallen to only 1.7 percent, involving only about 1.2 percent of the total Arab labor force. These developments – the Arab rebellion and the impact of war conditions – show clearly in the nnp to ndp ratios of Table 5a. By 1939 the direct contribution to Arab net national product by employment in the Jewish sector was down from 6.2 in 1935 to only 1.6 percent. This ratio was effectively maintained through the end of the Mandate period.

These figures indicate that although the severance of the economic links between the Arab and Jewish economies in Mandatory Palestine became permanent only with the outbreak of the Israeli War of Independence in December 1947, it had already become a fait accompli over the preceding decade, starting in 1936.

The Business Cycle of the 1930s

The rapid transformation of the Jewish economy into industrialization was demonstrated by the duration and intensity of the business cycle to which it had been subject in the 1930s: the effects of this cycle characterized the performance of Palestine's economy as a whole, though they were not as great on the Arab economy. At the very time at which the world's economy plunged into the disastrous economic crisis of the 1930s, the Jewish economy of Palestine, and that of the country as a whole, benefited from overall prosperity and full employment. In spite of a growth in the size of the labor force of the Jewish sector by about 32 percent between 1929 and 1933 the unemployment rate was less than one percent (Table 7), and the national product had grown by close to 145 percent. That rising trend continued through 1935, at which time the wave of mass immigration peaked, with net domestic product almost four times higher than in 1929. Palestine's national product grew inevitably at a lower rate, yet still by a robust rate of about 2.6 times, which indicates a prosperous six-year period through 1935 for Palestine's economy as a whole (Table 5).

In market economies, the "prosperity stage," a term that undoubtedly applies to the Jewish economy of the early 1930s, in a business cycle is usually followed by a recession. This is true especially in a case in which the rising trend of economic activity is as vigorous as it was in the first half of the 1930s in Palestine: an annual average growth rate of 28 percent in the ndp of the Jewish economy in 1931–35, and of 12 percent in Palestine's economy as a whole.

A declining rate of investment is usually the trigger for a slowdown. This was indeed the case in Palestine; that leading economic determinant of a downturn in industrialized economies surfaced at the peak in 1935. The key branches involved were those which had prospered most during the rising pattern of the 1928–35 cycle – the building and citrus industries. At the aggregate level, total investment still increased in the Jewish sector in 1935 to its peak for the entire decade (Table 4): but its rate of increase in that year was only 12 percent, much lower than the almost 50 percent rate of the preceding year, 1934, and even lower than that of 1932. A similar pattern was followed by the building industry; the peak of investment in housing for the decade was reached in 1935 as well. The slowdown of the Jewish population growth rate, which had doubled in the four years from 1932 to 1935, inevitably reduced the increase in demand for living space, with a corresponding lag effect on investment in housing, and thus on the level of activity in the building industry.

A similar development was facing the dominant agricultural branch, and the mainstay of Palestine's exports, the citrus industry. Jewish sector investments in that branch peaked in 1934; investments were lower by about 16 percent in 1935 and by 1937 were only 50 percent of what they had been in 1934. They collapsed altogether in the successive prewar years. Arab peak investment in that branch lagged by two years; its peak was reached in 1936. Yet owing to the dominance of Jewish sector investments, the tide for the citrus industry as a whole, both in terms of investment and of planted area, was turned

by the end of 1934, at the peak of Palestine's prosperity. This significant reduction in investment was a lagging response to market signals: the decline of orange prices in the main European export markets. This trend emerged from the beginning of the decade: by 1934 they were 10 percent lower than in 1931. They declined significantly further, in 1936, even though exports of competing Spanish oranges declined abruptly due to the outbreak of the Spanish Civil War.

The slowdown of the flow of investment in the two leading branches of the economy, the building industry (in the Jewish sector in particular) and citriculture, was triggered by market signals. Inevitably its effects led to a downturn of the business cycle beginning early in 1936. Yet the severity of the downturn, the awareness of which surfaced only later in that year – Jewish ndp declined by 6.3 percent – was due to ominous political developments. The world political crisis, which began late in 1935 with the Italian invasion of Ethiopia, and led finally to the outbreak of World War ii in 1939, inevitably had a negative effect on Palestine's economic activity. Its direct impact was compounded by the outbreak of the Arab revolt in April 1936, involving initially a boycott of the Jewish economy, supported by violence against Jews and later by an armed insurgency against the British army. The political response of the British government to that challenge was a drastic curtailment of Jewish immigration (see Immigration, Legal and Illegal, and Palestine's Demographic Structure above). This entailed an inevitable slowdown of Jewish capital imports (by 25 percent), and affected consumption immediately (Table 13). Capital imports were, of course, the main source of investment finance, which declined consequently, and together with lower consumer expenditures, reduced aggregate demand.

Thus, following the 6.3 percent decline of Jewish domestic product in 1936, the three succeeding years through 1939 saw a further cumulative decline of 16.4 percent from what had been an extraordinarily high domestic product in 1935. In terms of national product, which netted out wages paid to Arab workers, the rate of decline was lower, about 13.4 percent. That loss of national product entailed a corresponding reduction of per capita product by 35 percent from 1935, reflecting also the continuing growth of Jewish population due to immigration, which temporarily rose again in 1939, and natural increase (Table 5).

The Jewish economy's per capita product for 1939 was thus down by 35 percent from that of 1935, and regained only toward the end of the war. Similarly, real wages in 1939 were down by 13 percent from 1935, indicating the strain in the labor market. This showed in terms of the growth of unemployment: the rate in the Jewish sector, only about one percent in 1935, rose to 4.3 percent in 1939. This significant growth in unemployment resulted not only from the downturn of the business cycle but from the growth of the Jewish labor force by about 50 percent in the second half of the 1930s, owing to the immigration of about 100,000 additional immigrants.

The social and economic implications of this situation soon led to the establishment of the rudiments of a social security system – unemployment benefits in particular – run by the *Histadrut (the general federation of Jewish labor, founded in the 1920s as a means to establish the institutions of a Jewish national economy; see below, The Histadrut and the Economics of the Yishuv) with significant funding from the Jewish Agency. This added a second welfare state element to its first pioneering effort, the compulsory "sick fund" which all members of the Histadrut had to join; indeed it provided coverage to members only. Reorganized in the 1930s, it was financed almost exclusively by union membership fees, with some support from the Jewish Agency, though none from the Mandatory government. The virtual welfare state, which by the late 1930s was well established, was for the benefit of the Jewish community only. It is another indicator supporting the claim that the Jewish community – the yishuv – of close to 450,000 people by that time, was by then already a socioeconomic entity belonging to the industrialized group of countries. In more than one sense, this emerging character was an expression of the Fifth Aliyah's influence.

the advent of manufacturing

The Buildup of Infrastructure: Power, Communities, and Ports.

The history of manufacturing in Palestine emerges only in the Mandatory period. This is underlined by the fact that electricity generation on a commercial scale began only in 1923 by the Palestine (later Israel) Electric Corporation, which received in September 1921 exclusive concessions to exploit the Yarkon and Jordan rivers for irrigation and electricity and which eventually supplied electricity to the whole country excluding Jerusalem. It was Pinchas Rutenberg whose enterprise, stamina, and persistence overcame the major political obstacles and financial risks involved in the founding of this basic infrastructure facility. The pec was rightly identified as a Zionist undertaking, even though it was a corporation whose shares were traded on the London Stock Exchange and paid dividends to shareholders.

Electricity consumption by manufacturing industries was only one million kilowatt hours (kwh) in 1926. It grew to 20 million in 1938 and to 86 million kwh in 1947, the last full year of the Mandate. This clearly warrants tracing the first steps of manufacturing to the early 1920s. Although the employment and product figures for 1922, presented in Tables 7 and 8, refer to manufacturing as one of the three standard branch breakdowns for analysis of economic structure, the approximately 4,000 employees classified as working in the "handicraft and manufacturing" branch of the Jewish sector (Table 7) that year were working in handicraft workshops – small entities having not more than two or three hired employees, offering services to urban consumers and businesses. This was equally true of the Arab sector, in which at that time the number of employees in handicrafts was lower than in the Jewish sector.

The development of manufacturing and large-scale irrigation in Jewish agriculture, and thus the economic growth of the country as a whole, were interwoven with that of the production capacity of pec. Its first diesel generator power station, set up in Tel Aviv in 1923, had a capacity of 750 kilowatts. By 1926 its generating capacity was 2,250 kw; in 1932, after the opening of its major hydroelectric project (Jordan-Kinneret) its capacity was increased to 16,200 kw; on the eve of the war in 1938 it was already at 63,000 kw; and in 1947, at the end of the Mandatory period, it was 75,000 kw. The running of the system, the continuing expansion of generating capacity, and the extension of the electricity network across the country required the building up and training of a sizable labor force, supported by a rapidly expanding group of specialists, including engineers, accountants, and managers.

The pec, the railroad system, and the Public Works Department, which was in charge of building and maintaining the road network (the latter two were departments of the Mandatory government), provided the basic necessities for the rapidly expanding economic infrastructure. The major demand for their services was generated by the rapid growth of Jewish manufacturing industries and the Jewish sector as a whole. Large enterprises employing sizable staffs are a typical feature of an evolving industrial system, and in the 1930s the pec had more than 1,000 on payroll and the railroad and the works department even more – a sign of Palestine's industrialization by the outbreak of World War ii in 1939.

The Emergence of Manufacturing

A manufacturing industry involving state-of-the-art machinery and technology, a significant number of employees, a relatively high capital-labor ratio, requiring heavy long-term capital investment and producing for the mass market, began to appear in Palestine in the 1920s. This industry depended on the existence of a modern infrastructure of transportation and communication facilities, electric power, and a modern port (the deepwater port of Haifa opened in 1931). The proliferation of manufacturing firms in a significant variety of economic areas was quite clearly the dominant activity in the Jewish economy from the mid-1920s onward. It accelerated during the highly prosperous first half of the 1930s, through 1935, and declined during the downturn of the business cycle in the second half of that decade, which were years of consolidation. It reaccelerated strongly during the war years and in the war's aftermath through 1947.

This pattern can be discerned in the manufacturing employment, net product, and output figures in Tables 7 and 8. Employment in 1931 was 2.8 times higher than that of 1922, and real product (and output) of industry had almost trebled. The rapid expansion during the high tide of the Fifth Aliyah years of 1932–35 shows in terms of a roughly 2.5 times growth of net manufacturing product and output during that very short period, an incredible average annual growth rate of about 25 percent. The abrupt downturn of the cycle between 1936 and 1939 is demonstrated by the very slight growth rate of manufacturing product at an annual average of only about one percent for that period. The growth of employment and of capital stock slowed down too, but not by that much. Thus during the decade of the 1930s, ending with the outbreak of the war in 1939, employment in manufacturing grew at an annual average of about 11 percent and net product by about 13 percent (Tables 7 and 8). This means that by the end of that decade and in spite of the downturn of 1936–39, the Jewish economy's manufacturing sector (essentially, by that time, the whole of Palestine's manufacturing sector), was an altogether different and much larger entity than at the beginning.

This can be seen in the number and size of the manufacturing establishments, the kinds and quality of equipment used, the technologies of production, and the diversity of the industrial branches in which they specialized. The number of handicraft and manufacturing establishments, fewer than 2,000 in 1922, grew only to about 2,500 in the decade ending in 1931. By 1935 they were already twice that number – more than 5,000. The number of manufacturing establishments grew rapidly and by the end of the war in 1946 amounted to about 7,000.

An indicator of the rising capital vs. labor intensity and particularly the transformation of manufacturing technology is the rapid increase of the average horsepower of the machinery in use in manufacturing establishments. This was negligible in 1922 (800 hp), about 6,000 in 1930, and 40,000 by 1939. The far-reaching transformation undergone by the technology of production in the 1930s is also suggested by the data on the import of industrial machinery in the 1930s; in the peak year, 1935, the value of these imports was six times higher than in 1932, the year in which these imports increased 40 percent. This corresponded to the increase in Jewish immigration of the Fifth Aliyah.

The immigration inflow of Jews from Germany, which soon turned from a trickle into a flood, also brought a major increase in private capital imports, but only in the form of goods. This was the only way in which the German emigrants were allowed to transfer capital, under the *Haavara agreement of 1933 with the German government (see below). These imports of German equipment and raw materials were the point on which that agreement hinged. Due to the restrictions on immigration imposed by the British from 1936 onward, the flow of capital transfers in general slowed from its 1935 peak. Yet from 1936 through 1939 the import of machinery was still sustained on a level of three to four times that of 1932. This circumstance had a far-reaching impact on the technology, capacity, and volume of production of Jewish manufacturing industry later on. Only after the outbreak of the war, though, was the capacity fully utilized (see above, The Business Cycle of the 1930s).

Clearly the 1920s were the infancy period of manufacturing in Palestine, and the 1930s saw its emergence as a major component of the Jewish economy – effectively, of the economy of the whole of Palestine. This reading of the events is sustained by the data on the average number of workers per establishment, which grew from only 2.6 in 1922, to 5.1 in 1937, and to about 10 by the end of the war. The 1930s averages reflect the appearance of factories of significant size. There were 50 or so firms that employed more than 50 workers; 13 of them even employed more than 100 workers, or about 25 percent of the total employment in manufacturing in 1937. Almost all of these firms were founded only in the 1930s. Two such firms, the Potash Corporation, established in 1929, and the Palestine Electric Corporation were the only business establishments that employed more than 1,000 workers by that time.

The small size of the markets in an economy with a population of less than one million in the 1920s was of course a major constraint on the establishment of manufacturing capacity in Palestine. The only enterprises free of this constraint were those that could produce for export. A case in point was the Potash Company, based on the exclusive concession for Dead Sea minerals acquired by Moshe Novomeisky, a pioneer of the Palestine chemical industry. Its first output came in 1935, and it soon employed several hundred workers, reaching almost 1,000 by 1939; it continued to grow rapidly through the war years. But the dominant group of industrial firms, most of which were established in the 1930s, produced for domestic markets, where they were subject to competition from imports.

In the 1930s, the era of the worldwide economic crisis, governments imposed tariffs to protect their home markets, and assisted domestic firms in dumping their goods on foreign markets. The Mandatory government, which according to paragraph 18 of the Mandate was not allowed to impose discriminatory tariffs, was reluctant to interfere with free trade principles in support of local industry, even though Palestine, as an open market, suffered from dumping and universal (nondiscriminatory) tariffs would have been allowed. This passive attitude was underlined by the British refusal to allow Palestine to join the Imperial preference system established for the Empire in 1931, which offered a modicum of protection to those within. This arrangement thus discriminated against Palestine's exports, yet offered free access to its markets. Another reason for the British reluctance to impose tariffs on imports of manufactured goods was partly political – their expected effect on prices. Such a measure, it was thought, would offer support to a sector of the economy dominated by the Jewish firms, while forcing consumers, most of whom were Arabs, to pay higher prices.

Under these constraints manufacturers could face the competition of imports only if they operated in industries in which distance, and thus transportation costs, and local tastes and style preferences, offered "natural" protection. Construction materials such as cement, stone, and sand, which involve heavy transportation costs per unit of value, fall clearly into this category. This rule applied similarly to major consumer goods, particularly fresh food products, clothing, and furniture. Thus, the major manufacturing enterprises established in the mid-1920s, such as the Nesher cement factory, which for the next seven decades of the 20^th century monopolized the domestic market, and the Shemen oil factory, belonged clearly to that category. The latter, though, soon had to face domestic competition from new enterprises that appeared in the 1930s.

The breakthrough of manufacturing occurred with the advent of the Fifth Aliyah in the 1930s. It shows in a twofold increase in manufacturing employment within a period of only four years by 1935 (Table 7), and in a similar increase in the total capital stock of the Jewish economy (Table 4). It was in this decade that Dead Sea potash manufacturing began, and similarly the textile, clothing, and shoemaking industries were established. Several manufacturing firms, competing with each other, appeared in the textile and clothing industries. The new enterprises of the 1930s founded by manufacturers who had been running similar firms in Central Europe followed the trail opened by manufacturers who had arrived from Poland with the Fourth Aliyah in 1924–25, who had been running what was considered at that time the Jewish textile industry in Lodz. Several firms producing chemicals, pharmaceuticals, cigarettes, and chocolate were founded in the late 1930s, as the flow of Jewish capital imports, which rose rapidly (Table 11), provided the financing, and immigrants, especially from Central Europe, provided the expertise and enterprise.

By the outbreak of the war, the Jewish sector had accordingly established a meaningful manufacturing industry. It was heavily oriented toward consumer goods and housing – about three-quarters of the gainfully employed in manufacturing worked in these sectors. It already included, however, some enterprises with significant spare capacity in the metal, machinery, and electrical equipment industries. Yet, though growing rapidly in terms of employment, capital stock, and production – employment grew at an annual average of 13 percent in the eight years ending in 1939 (Table 7), and net product of manufacturing by a similar rate – a meaningful portion of the existing capacity which had been created in the second half of the 1930s was not being utilized. That excess capacity and the high unemployment rate, 4.3 percent, reflected market demand constraint: inability to compete with imports. It made available a production potential, however, that could be used given higher demand.

urbanization and socioeconomic structure

The industrialization process initiated in the 1920s, and accelerated as the Fifth Aliyah progressed in the 1930s, entailed simultaneously a clear-cut process of urbanization and a structural change in the Jewish economy, and thus in the economy of Palestine as a whole. As in any country undergoing industrialization, manufacturing activity in Palestine was located mainly in urban centers, and inevitably stimulated the expansion of those centers. The great increase of Tel Aviv's population – actually the emergence of the Jaffa-Tel Aviv conurbation stretching, initially, towards the north, was part of this process. By 1939 the population of Tel Aviv and the Jewish population of Jaffa together were already 175,000. By this date the several urban centers between Tel Aviv and Petaḥ Tikvah to the north already totaled close to 20,000 people. This means that at the outbreak of the war the Jaffa-Tel Aviv conurbation contained a population of around 200,000 Jews, about 45 percent of the Jewish population of Palestine. The official 1944 estimate in Table 1 suggests that by that time the population of that area was about 250,000. During the last decade of the Mandate through 1947 it was thus the center of gravity of the Jewish population, and even more so of the Jewish community's economy, especially manufacturing industry.

Haifa and its Jewish satellite suburbs emerged in the 1930s as a similar northern urban center for the Jewish population. Though smaller than Jaffa-Tel Aviv, it was a mixed town with an Arab population similar in size. The completion in the early 1930s of Haifa's deepwater port, the only one in Palestine; the building of Iraq Petroleum's major pipeline, terminating at Haifa, in the mid-1930s; and finally the opening in 1939 of the ipc Refinery, whose capacity was many times larger than Palestine's own requirements, made Haifa a hub of major Jewish and Arab manufacturing activity. Jewish entrepreneurs and the Zionist authorities had discovered its potential by the mid-1920s, when private entrepreneurs located two major factories (the Nesher cement factory and the Shemen Oil and Food Products firm) in the Haifa Bay area, and the Jewish National Fund participated in 1935 in the purchase of a major tract of land there to serve as a manufacturing zone. By 1939 this zone was home to many Jewish manufacturing. Haifa and its satellite suburbs in the Haifa Bay area had by 1939 a Jewish population of 48,000 (Table 1).

No significant development of Jewish manufacturing took place in Jerusalem. But the growth of the Jewish population to some 80,000 by 1939 involved mostly those belonging to the new yishuv. Its labor force was employed in commerce, services, and public sector employment – the Jewish Agency and its subsidiaries – and finally in Palestine Mandatory and municipal government. The old yishuv, sticking to its traditional mission of maintaining a presence near the holy sites and engaging in Torah study at the yeshivot, became a proportionately declining component of the Jewish community.

The major structural change generated by the appearance of manufacturing industry and its growing impact on the Jewish economy and on Palestine's economic system as a whole is demonstrated by the figures in Table 9. The contribution of "handicraft and manufacturing," at that time entirely in handicraft workshops, to Jewish national net product in 1922 was somewhat less than 20 percent, and accounted for about 17 percent of employment in the Jewish economy. A decade later, reflecting the effects of the Third and Fourth Aliyah, the contribution rose slightly to 21 percent of the total net product, and employment in manufacturing rose too, to about 20 percent of the total. The 1930s and the war years, especially the latter (see the figure for 1945 in Table 9), brought a major increase: manufacturing employment rose to close to 31 percent of the total in the Jewish economy.

The contribution of agriculture followed an opposite trend: employment fell drastically, to 13 percent of total employment in the Jewish economy, while relative contribution to Jewish ndp fell only slightly, to roughly 11 percent of total product in 1945, compared to 13 percent in 1922. These figures indicate that labor productivity in Jewish farming, which in 1931 was only about one half of that of manufacturing, improved considerably: in 1945 it was up to about 77 percent. The effective disappearance of the citrus industry during the war contributed to this pattern. The major improvement in absolute and in relative terms of labor productivity in farming is a clear expression of the success of the mixed farming strategy adopted by the rapidly growing Jewish self-employed farming community.

The population figures in Table 1, supported by information about Jewish suburbs in the Tel Aviv and Haifa area and several newly urbanized centers, indicate that by 1939 about 80 percent of the Jewish population was living in these conurbations. They had become the Jewish population's centers of gravity as well as of manufacturing, by then the dominant sector of the economy, developments that had obvious political ramifications. The basic socioeconomic character of the Jewish community, which would have to fight for its survival in the War of Independence, was in place by the beginning of World War ii.

agriculture and the major zionist resettlement effort

The Evolving Map of Jewish Settlement Blocs

Industrialization and urbanization, which inevitably entailed also the rapid expansion of the service sector, dominated the Jewish economy in the 1930s and through World War ii. Yet it was the Zionist resettlement effort that was at the core of the drive to establish a Jewish polity and was the focal point of the political and armed clashes with the Arabs. This effort also involved a political struggle with Britain, the Mandatory power, which in attempting to accommodate the national rights of the Palestinian Arabs, was gradually withdrawing from its commitments to the Zionists embodied in the Mandate (see above, Palestine as a Unique Political and Economic Entity).

The expansion of the Jewish settlement effort resulted in a growing number of settlements over an expanding geographical area and of an increase in rural population. The impact of this increased significantly over time. Thirty-nine new Jewish settlements appeared on the map of Palestine in the decade ending in 1931. Within the next five years through 1936, there were more than twice that many – a total of 89. In the so-called *stockade-and-watchtower settlement drive, launched in December 1936 – the name referred to the defensive measures necessitated by the attacks on Jews and Jewish settlements during the Arab Revolt of 1936–39 – 82 new settlements were established, most of the them by 1939.

In the immediate aftermath of the war, the number of settlements grew again and finally reached a total of almost 300 (Table 3). Most of the 22 new settlements founded in that final period of the Mandate came into being during 1946–47, when a campaign was launched to settle the arid southern region hitherto hardly touched by the Zionist settlement drive – the Negev.

Eleven of these settlements, or rather outposts – nuclei of settlements – were quickly set up at the conclusion of Yom Kippur, in early October 1946. The timing was designed to surprise the British authorities, whom it was feared would attempt to prevent the establishment of a Jewish foothold in the Negev. The political future of the area was then under discussion at the United Nations. Two more outposts, the last two settlements founded in the Mandate era, provided a link between the western Negev group of settlements established in 1946 and Revivim in the east. Revivim was the oldest of these outposts, set up in 1943 as a foothold and an agricultural experimental station. These last two settlements were set up on November 19, 1947, just ten days before the final vote in the United Nations General Assembly on the proposed un Special Committee on Palestine (unscop) partition plan calling for the establishment of two states, one Jewish and one Arab, in Palestine. This move underlined the strategic target of the Resettlement effort, which had been underway for about 70 years – to lay claim to the maximum territory for the intended Jewish State.

In the 1920s, though, the locations of the approximately 50 settlements set up between 1921 and 1931 were not chosen primarily for political reasons. They reflected more the availability of land in large blocs for sale by absentee Arab landowners. The bloc technique had nevertheless been consistently pursued ever since, based on considerations of economies of scale. Common provision of services to and purchase of goods for several settlements as a unit cut the cost of technical support and advisory services, purchase of materials and supplies, marketing of products, schooling, and health services for these small rural entities. The relevance of defense considerations grew over time and from the late 1920s was inevitably high on the settlement planning agenda.

The colonizing of the Jezreel Valley in that decade with about 20 settlements in its eastern and western sections, with a small town, Afula, in its center, was the first example of that policy. The bloc settlement technique is also evident in the mostly private enterprises set up in the 1920s in the citriculture belt of the central coastal plain. This did not exclude the establishment of isolated settlements also. Yet, the deliberate effort to establish a formidable Jewish presence in strategic locations all over Palestine became Zionist policy in the 1930s, as the Arab political pressures expressed by the 1929 riots and the 1936–39 uprising induced the British government to withdraw stepwise from the Balfour Declaration, and even from the more restricted 1922 Churchill White Paper commitment to the Zionist cause. This policy required large-bloc land acquisitions allowing the implementation of the stockade-and-watchtower policy, in the northeastern and northwestern Galilee, the Beit She'an area and the mid-Jordan Valley.

Not all the 55 settlements founded from December 1936 through 1939 were located in these three clusters of stockade-and-watchtower settlements (such as Ḥanitah, established in March 1938 on the Lebanese border in the western Galilee). The two settlements set up in the mountains near Jerusalem to increase the hitherto small Jewish presence along the winding road up to Jerusalem from the coastal plain were a case in point. During World War ii, the bloc-forming strategy was maintained, but shifted location towards southern Palestine. Most of the approximately 20 settlements set up between 1940 and 1945 were located in the southern coastal plain penetrating east along the edge of the arid Negev. These settlements served as the springboard for the last resettlement campaign of the Mandatory era, culminating in the 1946–47 effort to establish outposts in the Negev.

Production, Productivity, and Living Standards

The expansion of the rural population by about ten times to 153,000 between 1922 and 1947 (Table 3) and the accompanying growth of employment were the results of the resettlement effort. The corresponding increases in output and national product were just as great. The output figures, available only through 1939, indicate a growth of mixed farming output by more than six times and a tremendous 20-fold expansion of citrus output. Total agricultural production of the Jewish economy grew by 12.5 times between 1922 and 1939 (Table 3). National product figures, which are available for a longer period, through 1947, indicate that net farm product grew by approximately 20 times during those 25 years at an average annual rate of close to 14 percent, a somewhat higher rate than in the 1920s and 1930s.

The closing of shipping routes at the outbreak of the war dealt the citrus industry a severe blow. Yet this very development, which also reduced the competition of imports, generated a prosperous market, invigorated by the British army's demand for the output of domestic mixed farming: the net product figures, the only series available for the War and the postwar years (Table 8), indicate that mixed farm product grew by two times during the six-year period of the war, at an average annual rate of 12 percent. This represents a significant acceleration compared to the 1922–39 period, when growth, though robust, was only 9 percent (Table 8).

This performance is quite interesting in view of the employment data, which indicates a reduction of employment in Jewish farming by significant factor of 20 percent between 1939 and 1945 (Table 7). This reflects mostly and perhaps exclusively the drastic reduction in employment in the highly labor-intensive citrus industry. Most, if not all, of the reduced labor input was thus due to the reduction in the number of hired Arab laborers in the Jewish economy. Jewish farm employment was hardly affected. These figures suggest that the growth of net farm production in the Jewish economy by two times during the war years was created by the same level of, or at most by a small increase in, labor input. This of course means that average labor productivity in farming soared upward during these years, carrying per capita income in that branch with it. The real wage and per capita income for the whole economy, which grew by almost 40 percent in the 1939–45 period, offers supporting evidence for the growth of mixed farming productivity (Tables 5 and 6).

Mixed Farming, Citriculture, Capital Investment, and Irrigation

The performance of Jewish agriculture during the period of the Mandate through 1947, which in the longer run assured the viability of the farming entities set up by the resettlement process, would not have succeeded without heavy capital investment. This allowed major expansion of irrigation, acquisition of state-of-the-art farm machinery, and heavy expenditure on research leading to the development of crop varieties adapted to the climate and specific soil conditions.

The rising capital-labor ratios – capital grew at an annual rate of 11.6 percent while labor at 8.8 percent (Table 4) – were reflected materially in the workshop and in the field (these figures apply to the Jewish economy as a whole, and therefore to manufacturing as well). They clearly reflect developments in the Jewish agricultural sector, one of the most important of which was the mechanization of cultivation. Between 1920 and 1940 Palestine's tractor fleet grew from zero to 500; 450 of these were owned and operated on Jewish farms (because of the war these could not be added to through 1946). Similarly, animal husbandry underwent a major transformation owing to the adoption of modern breeding techniques; average milk production per cow increased by 40 percent in the short period from 1937 to 1941, and grew further through 1947.

Dairy production requires year-round fodder growing. Thus, like poultry, vegetable, and fruit production, the main elements of Jewish mixed farming were from their very beginning highly dependent on irrigation. For citrus cultivation as well, which was not a component of mixed farming but was conducted on monocultural plantations, irrigation was the necessary condition for its existence. The development of water-extraction and water-saving technology was accordingly a life-and-death issue for the Zionist resettlement endeavor. The extension of the irrigation of land was therefore given top priority, and became a symbol of the whole project.

The rapid expansion of the citrus industry in the 1920s and its acceleration in the first half of the 1930s was fully consistent with the rationale of the resettlement policy. High prices in the dominant British market and in other European markets in the 1920s and early 1930s promised high profitability from investment in citrus groves. Citriculture thus attracted a major portion of Jewish capital imports and of funds at the disposal of Jewish entrepreneurs to investment in that branch, which imposed the necessity of digging wells to tap into groundwater. The expansion of the area of citrus groves by about seven times in the decade through 1931, and by more than two times in the short 1931–35 period – thus by 16 times altogether between 1922 and 1935 – meant, of course, a corresponding extension of the irrigated area of the Jewish farming sector.

Though 1935 was the peak year of Jewish immigration and prosperity, the collapse of orange prices in export markets that year effectively stopped for good the further expansion of citrus groves. Prices were already lower by 10 percent in 1931, and by 16 percent in 1932–34, compared to the peak price years of 1926–29. Though further planting was halted by 1936, the cumulative expansion of the area of groves, which peaked in 1939 (Table 3), meant that by the outbreak of the war, about 77 percent of the irrigated area held by the Jewish sector was in citrus groves. These were almost exclusively located along the central coastal plain where access to groundwater was easy and the soil composition was optimal for this crop.

The expansion of mixed farming was linked with the resettlement plan from the very beginning. From the 1920s onward, it was the declared strategy of the Jewish Agency's Settlement Department, the successor to the Zionist Organization's Palestine office, which had been directing settlement operations since 1908. Mixed farming was designed first of all to offer a European standard of living to the settlers. Its viability, with its output of dairy products, poultry, vegetables, deciduous fruit and grapes, was dependent on the rapid expansion of domestic urban markets. Owing to shorter growing periods these products were definitely less capital intensive than the citrus industry, yet nevertheless required substantial capital investment per unit of labor. To assure year-round production and a steady flow to markets, irrigation facilities were required.

The settlement drive of the 1930s and the 1940s thus entailed a major extension of irrigation facilities. Though some settlers who decided to move into farming, mainly immigrants from Germany who began arriving in the mid-1930s, could provide a significant portion of the cost of setting up their settlements, the funds for capital investment for most of the mixed farming settlements were provided by Zionist institutions from contributions collected all over the globe, and by the banking system. The bank credits were guaranteed by the Settlement Department.

The mixed farming resettlement strategy took its first steps in the 1920s. Toward the end of that decade, in 1929, the irrigated area used for mixed farming was 12,000 metric dunams, about 25 percent of the irrigated area at the disposal of Jewish farming entities. This was expanded by 25 percent through 1935–36, but the area of citrus groves grew by 240 percent in the same period, which reduced the share of irrigated land devoted to mixed farming to only ten percent of the total. At this point, the citrus plantations in the Jewish sector – though not in its Arab counterpart – stopped producing commercially for almost two decades. Yet the expansion of mixed farming, and correspondingly the irrigated area devoted to it, expanded rapidly. By 1939 the area of irrigated land used for mixed farming was almost three times greater than in 1935, and thus close to a quarter of the total at the disposal of Jewish agriculture. By 1947, in the wake of the major resettlement effort, supported by the conversion of 10–15 percent of the citrus area to vegetable and fodder growing, irrigated land used for mixed farming was greater by 150 percent than in 1939. Almost 50 percent of the total irrigated area was by that time devoted to mixed farming. The rest was in citrus groves, the intense cultivation of which was revived late in 1945 in response to the postwar revival of European markets.

In the long run, the viability of the settlements' pursuit of mixed farming depended on the availability and expansion of markets for their produce. Output grew by about six times in the 1920s and 1930s, at an average annual rate of about 11 percent from 1922 to 1939. This, however, was a significantly lower growth rate than that of the output of the Jewish citrus industry, which depended exclusively on export markets; citrus production grew by 21 times during the same period. It was, of course, the rapid growth of the Jewish urban population and its rapidly rising per capita income that provided the expanding domestic markets for food products. The importance of these markets is underlined by the data for the war and postwar periods. The rate of growth of the Jewish population declined, though the population and its per capita income kept growing significantly. But the war provided a new group of customers – British and other Allied military personnel; effectively all the markets under the canopy of the Allied Middle East Supply Center. The war also eliminated competition from foreign food imports to Palestine's domestic markets. These prospering markets absorbed the output of the mixed farming sector, which during the six years of war grew by two times at an average annual rate of more than 12 percent. It was this development that assured the viability of the rural settlements and allowed the settlers a reasonable standard of living. The settlements constituted an economically viable Jewish presence everywhere in Palestine north of Beersheba, the whole settled part of mandatory Palestine.

The Economic and Political Rationale of the Irrigation Drive

The expansion of domestic food markets was the crucial element in the success of the mixed farming strategy. The conception of that strategy, however, as the pioneers of the Second Aliyah (1903–14) arrived in Palestine, was linked to the idea of avodah ivrit. The pursuit of that agenda from the very start by the Zionist Organization's Palestine Office (founded April 1908) and its successor from the 1920s on, the Settlement Department of the Zionist Authority (from 1929 the Jewish Agency), was based on this consideration, along with the need to assure the long-term economic viability of the rural settlements. This entailed the establishment of farming communities able to provide year-round full employment and income sufficient for a near-European standard of living. Multi-branch mixed farming, which required irrigated land, met these needs.

By the 1930s price considerations led to an even greater emphasis on investment in irrigation. Palestine's population was about 700,000 in 1920, about 1 million in 1931 and 1.5 million by 1939, and the population growth led inevitably to rising land prices. In Palestine this fact had a special twist, because the dominant feature of the land business was the acquisition of land by Jews from Arab sellers. The continuing purchase of land that increased Jewish land holdings from a minuscule fraction to six percent of Palestine's total land area – 12 percent of the northern, non-arid, part of the country – raised average land prices threefold between the early 1920s and the middle 1930s. The rapidly rising seller's market in the 1920s and early 1930s suggested that the substitution of water for land area, that is, a widespread extension of irrigation, was a highly rational business proposition for the buyers. This was noted succinctly by Arthur Ruppin, the grand resettlement operator, in a review of his 25 years with the Zionist Organization in Palestine: "The more water the settler has, the less land he needs."

Political considerations as well offered support for this development in the resettlement strategy. The acquisition of land by Jews was used as a major propaganda device by the Arab leadership to generate pressure on the British government to withdraw from its commitment, embodied in the League of Nations Mandate, which incorporated the language of the Balfour Declaration, to support "the establishment in Palestine of a national home for the Jewish people." The Arabs finally prevailed on this score: the 1939 White Paper restricted the rights of the Jews to acquire land in most of Palestine's territory. A rapid extension of irrigation was an obvious response suggested by the economic and political conditions. Though expansion of the area under citrus cultivation stopped in 1936, Jewish settlement efforts in the last decade of the Mandate still focused on the extension of irrigation to accommodate the expansion of mixed farming. Between 1935 and 1947, irrigated land cultivated by the mixed farming sector grew sevenfold, and in the twilight of the Mandate period was almost similar in size to that under citrus, and, as noted above, a significant amount of citrus-growing land was converted during the war years to vegetable and fodder production (Table 3).

Schemes to allow major extensions of irrigation, thus increasing the absorption capacity of Palestine for Jewish immigration, were at the top of the Zionist agenda in the late 1930s and 1940s. The technical issues involved extracting ground-water through wells and pumping and distributing it from small rivers and springs located mostly in the north of the country. The significant increase in the irrigated area of Palestine in the Mandatory period to about 400,000 dunams by 1945 was achieved mostly on an ad hoc basis by local private enterprise and the Jewish Agency's Settlement Department. By the mid-1930s, though, the Settlement Department initiated an irrigation project in the Jezreel Valley involving, for the first time, several settlements. In 1936 it founded the Mekorot Water Company to build that project and run the system. That firm and its control of Israel's water system became a fact of public life after 1948.

Yet intensive study of the water problem by local "watermen" and invited foreign experts from the United States, involving a comprehensive vision of the system as a whole, began only during the war period. One of these experts – w.c.*Lowdermilk, an American soil conservationist – presented in 1945 a conceptual outline for a comprehensive national water grid drawing water from the Jordan in the north of the country and linking it with underground reservoirs in the center, to irrigate the arid and empty Negev in the south, comprising about 50 percent of the area of Palestine. This grand design, which presumed the creation of an integrated national water supply system, fired the imagination of the Zionist leadership, but was anathema to the Arab leadership, and inevitably beyond the horizon of practical politics of the British administration. It had to wait for the emergence of Israel as an independent state for its implementation.

The Unique Socioeconomic Structure of the Jewish Farm Sector.

The convincing performance of the farm sector, measured in terms of production, productivity, and income, is suggested by the much more rapid rise of output and product than of employment: product per farm employee increased by two times in the decade ending in 1931, and by 1945 was four times higher than in 1922. The growth of product by two times between 1939 and 1945 was especially impressive, since it occurred at a time when the citrus industry had disappeared effectively from the product side of the equation during the war. Furthermore, it was achieved with a 19 percent lower labor input (Tables 7 and 8). It reflected the success of the mixed farming component of Jewish agriculture, which responded to the pull of the markets.

The kibbutz and the moshav, the collective and cooperative settlements that emerged in 1921, dominated this sector. The founders of the two movements were imbued with Socialist Zionist notions already in the air among second Aliyah immigrants in the pre-World War i period. They were reinforced by the new immigrants of the Third Aliyah (1919–23), who carried the message of the postwar western European social democratic movement. These immigrants joined with the veterans of the Second Aliyah in building the Tiberias-Ẓemaḥ road, the first public works project of the nascent Mandatory government in 1920. In the labor camps set up along the route, they organized groups of pioneers who approached the Zionist authorities with a proposal to found farm settlements that would implement Zionist ideas of national land and self-labor. The latter condition meant, of course, the implementation of the Zionist avodah ivrit principle, since it excluded by definition the employment of hired (Arab) labor. The self-government feature of these settlements, which they proposed as well, meant that they would be managing the economic activities of the settlements on their own account.

These principles were fully consistent with the notions adopted by the Zionist movement before the war: the ownership of land by the Jewish National Fund, the movement's land purchase and ownership corporation (established in 1901), and the principle of avodah ivrit. The socialist principles of the proposed settlements – the self-labor rule and the collective or cooperative principles of running the settlements adopted by the kibbutz and moshav movements – were inconsistent neither with the Zionist message nor with its strategy of resettlement. Indeed, they were fully in line with the latter.

The two movements did differ on a crucial feature of the organization of the settlements, the management of production, and thus correspondingly on the principle of income distribution. The moshav adopted the family model, which meant that the basic social cell, the family, would control its own production and benefit from the income. It would, however, strictly adhere to cooperative marketing of output and cooperative purchase of consumer goods and supplies and equipment required for production, a policy entailing cooperative ownership of major farm machinery. Mutual help in the case of calamities was enshrined in the operating rule of these producer and consumer cooperatives. The initial endowment of land and of capital funds to each family was of course to be equal.

The kibbutz model, in contrast, was a collective. As a collective entity the kibbutz was conceived as operating as a unitary multi-branch firm, with full collective command of the labor and equipment at its disposal, and most income distributed in kind on the basic principle of equality. This initially involved the severance of the direct link between a member's contribution to production and his real income. Among the leadership of the Zionist movement, business-minded opponents of this kind of organization argued that this feature of the kibbutz would have a negative effect on effort, and thus on the efficiency of production, which would soon destroy that utopian project. In spite of the heated debate on the subject, particularly in the 1920s, the political leadership of the Zionist movement stuck to the policy it adopted in the early 1920s to rely on the kibbutz movement, inspired indeed by socialist principles, as the battering ram of the resettlement effort. They claimed that only time would prove whether the opponents or the supporters of that social experiment were right. In 1946 Martin Buber, a professor of sociology at the Hebrew University and a veteran Zionist leader from Germany, described the maturing movement at that time as an "experiment which has not failed."

In more than one sense, the socioeconomic experiment involving the two movements, which survived a very difficult initial period in the 1920s, proved to be a roaring success toward the end of the Mandate period. By that time, roughly from the mid-1930s on, the two movements were an integral component of the Zionist consensus. This shows in their expansion in geographical and demographic terms and in the growth of their production, productivity, and real income, especially during World War ii. Only 12 kibbutzim and two moshavim, effectively all post-World War i founded, were on the map in 1922, with a total population not much beyond 1,000. By 1931, there were 30 kibbutzim and 10 moshavim, with a population of close to 3,000 and 2,000 respectively. Ten years later, in 1942, there were 90 moshavim and 86 kibbutzim with almost equal populations totaling 51,000, or about ten percent of the Jewish population. By 1945 kibbutzim and moshavim, distributed throughout the country, numbered 101 and 96 respectively, with a total population in both of about 65–70,000, or some 12 percent of the Jewish population (see Table 3a).

The temporary eclipse of the citrus industry during the war, which led to the abandonment of about 20 percent of the plantation area and its conversion to mixed farming, dramatically affected employment in that sub-branch. This correspondingly reduced the contribution to employment and to farm product of the private farm settlements, which included almost all the pre-World War i moshavot and most of the moshavot founded in the 1920s and early 1930s, which specialized in citrus growing. farm employment figures for 1945 indicate accordingly that during the war years farm employment declined in absolute terms: about 13 percent of the employed persons in the Jewish economy as a whole were engaged in farming activity (Table 7). Only about one-third of these had been employed in the farming activity of the moshavot, with the traditional private enterprise-employee relationship, i.e., wage labor. Two thirds of farm employment – about 8.5 percent of total employment in the Jewish economy, in that period – was engaged in the socialist-inspired and -run settlements (Table 3a). This means that the increase in farm output and product – by two times, or an average annual rate of 12 percent in the six years of the war through 1945 – was to a significant extent due to the performance of these entities. The major increase in relative labor productivity in farming, by more than 80 percent (Table 8) in the decade from 1935 to 1945, can be ascribed to a considerable extent to these settlements, run on the basis of collective and cooperative principles.

This outstanding performance during the war years was shared by the private mixed farming enterprises active in the moshavot, most of which were located in the central coastal area. Their activities during the war met the market's rapidly rising demand for vegetables, dairy products, poultry, deciduous fruit, and grapes, and were evident in the conversion of 20 percent of the land under citrus cultivation to mixed farming. The relative decline of farm employment in the private-enterprise settlements reflects, on the one hand, the temporary eclipse of the labor-intensive citrus industry in which they specialized between the World Wars, and on the other, more importantly, the process of urbanization (including the establishment of manufacturing enterprises) that had been occurring in the older settlements since the early 1930s. This process gathered momentum in the second half of that decade and remained strong through 1947. At least five of the pre-World War i agricultural settlements had populations of 1,000 by the outbreak of World War ii. Several more were approaching 5,000 and more by that time. This meant that though farming activity was not completely eliminated in these moshavot, manufacturing and services became more and more the focus of their economic activity. Thus Netanyah, located on the central coastal plain, became from 1940 on the center of the transported diamond industry (see below, The Rise of the Manufacturing Industry, 1936–1947). The urbanization process of these settlements was after a longish period formally recognized by the Mandatory government, which granted them municipal status. The gap between the ratio of population in these "individualist" private-enterprise settlements, which was 50 percent of Jewish farm population in 1942, and that of their employment of Jewish farm labor, which was only 30 percent, is explicable in these terms.

The Histadrut and the Economics of the Yishuv

The two socialist-inspired settlement movements – the kibbutz and the moshav (see above, The Unique Socioeconomic Structure of the Jewish Farm Sector) – were components of the economy operating under the canopy of the *Histadrut, the General Federation of Hebrew Workers of Ereẓ-Israel, established in 1920. In contrast to the traditional European labor federation model, the Histadrut was not conceived as an assemblage, or congress, of trade unions, in which individual workers belong not to the federation but to the member unions, with the federation as an umbrella organization. Histadrut membership was personal; its members belonged to it directly, and in the case of married couples each adult of the family was a member, even if one of them was not part of the labor force. Unions operating in specific industries such as construction, office work, etc., were indeed established, but these were run as subsidiaries of the parent organization.

The adjective "general" in its name was designed to highlight its all-embracing structure, indicating its function as a direct representative of the interests of all workers in town and country, in private enterprises, in the public sector, and in self-employment (the last taken to include membership in the kibbutzim and moshavim). But "general" also represented much more than that; the Histadrut was conceived to embrace not only the traditional functions of unions as representatives of workers in the struggle over wages and work conditions, but those of a quasi-state institution providing social welfare services such as medical and unemployment insurance.

Furthermore, it was also, as a quasi-state institution, to serve as the promoter and owner of an enterprise sector: the establishment of the Workers' Bank in 1921 and a building and public works contracting firm were among the first, but not the only, such enterprises founded by the Histadrut at that time, as the Third Aliyah was reaching Palestine. The Zionist authorities provided some of the equity finance required to set up these two firms. the contracting firm was known as *Solel Boneh ("Road Construction and Building"); its mission was to take on contracts in these areas, offering employment and training in building skills to new immigrants particularly. The building boom of the Fourth Aliyah, starting in 1924, was a major lift to Solel Boneh, which by that time had acquired standing both in the construction and road building industries and with suppliers and banks.

Yet at the height of the crisis of 1926, in the wake of the Fourth Aliyah downturn that began in 1926, Solel Boneh had to declare bankruptcy. This required financial support from the Zionist authorities' meager and declining cash flow. These funds were destined to offer not only (very low) unemployment benefits, but also cash payments to settle a fraction of Solel Boneh's debts. The conservative credit policy of Bank Hapoalim, withstanding the pressure from the Histadrut leadership to increase credit facilities to the collapsing company, allowed it to outlive the major economic crisis of 1926–28. This saved the honor of the labor movement, which by that time was subject to bitter criticism from the supporters of private enterprise among the Zionist leaders. The collapse of Solel Boneh, which led to the tapping of the meager financial resources of the movement, provided a new stimulant to their approach.

At that juncture it led to a redirection of the Histadrut business sector toward cooperative enterprises, in the services in particular. The cooperative bus firms that emerged in the late 1920s and the late 1940s by 1947 dominated the public transportation market after their amalgamation into three major firms. These firms represented one of the dimensions of business activity emerging at that time under the aegis of the Histadrut.

As the rising tide of immigration of the Fifth Aliyah entered Palestine, the building boom of the early 1930s led to the revival of Solel Boneh as a contracting firm in the building trade. Its management had absorbed the lessons of the late-1920s collapse and the firm thus survived robustly the downturn of the late 1930s, acquiring experience and capacity that was put at once into well-paid service as the demands of the war economy grew from 1940 on. The liquidity of the banking system and the very low interest rates prevailing in the Sterling bloc (see below, The Monetary and Financial System) offered liberal credit to Solel Boneh's rapidly increasing project portfolio. From 1941 on these included major building projects ordered by the British military all over the Middle East, including Iran. It was in these years that Solel Boneh emerged as the leading contracting firm in Palestine and vicinity. It soon moved into manufacturing, acquiring from private entrepreneurs in the early 1940s profitable firms such as Nesher, the cement monopoly; Palestine's only glass producer, Finizia; and the Vulcan iron casting firm, all of them located in the Haifa Bay area, the center of Palestine's heavy industry. The broad scope of Solel Boneh's manufacturing interests soon led to the establishment of a manufacturing subsidiary corporation, Koor. For four decades after Independence, the Koor conglomerate dominated manufacturing in Israel, as did Solel Boneh the building industry until its second collapse in the mid-1980s.

Through the mid-1930s the focus of the Histadrut as a union was the avodah ivrit agenda, the struggle for the exclusive right of Jewish workers for employment in the Jewish sector of Palestine's economy. Indeed, the ventures of Histadrut into the urban business sector, through both the direct ownership of Solel Boneh, and the promotion of cooperative ventures, some in manufacturing, had the same goal as its rural enterprises, the kibbutzim and moshavim: to provide exclusive employment openings in the Jewish economy to Jewish workers. This does not mean that the Histadrut was not engaged in the traditional business of a workers union, the struggle for employment and better work conditions and wages. Its employment mission was carried out by establishing a system of labor exchanges under its canopy. The unemployment problem and the wage issue finally rose to the top of the agenda in the second half of the 1930s, as the Arab strike and uprising severely eroded the direct links between the two national sectors, eliminating almost completely avodah ivrit as a relevant issue. From then on the Histadrut, which had started out with 4,500 members in 1921, had 28,000 in 1930, and by 1939 some 100,000, put an increasing focus on typical trade union issues. During the high inflation, full-employment war years, the maintenance of real wages surfaced inevitably as a major issue. The pressure of the Histadrut led initially, in 1940, to a countrywide agreement with the Jewish Manufacturing Association on a uniform cost-of-living allowance, and eventually to the setting up of a Mandatory government committee on wages, on which the Histadrut was represented. Its recommendation to adopt a technique of automatic periodic cost-of-living adjustments (colas) was implemented in 1942.

Government sponsorship of the cola agreement between the Histadrut and the Manufacturing Association was the first step on the long winding road of price linkages that led ultimately to comprehensive indexation and prevailed for the ensuing five decades in Mandate Palestine and in Israel. It gave the Histadrut major leverage on the operations of the economy in the long run. In more than one sense it represented the political power with which it was endowed by its membership: in 1947, 27 years after its establishment, its membership comprised around 66 percent of the labor force. Its operations as a trade union, as the umbrella of the kibbutzim and moshavim, and its control of major holding companies in the building trade and in manufacturing, with the main sick fund and other welfare state services subject to its control and guidance, made it to a significant extent the executive organ of the Zionist movement in its endeavor to establish a Jewish polity in Palestine.

The Monetary and Financial System

The introduction by the British army in 1918 of the Egyptian pound as the legal tender of Palestine, replacing the confusing mix of monetary units used in the last years of the Ottoman rule, was undoubtedly the first and most significant reform implemented by the Mandatory power. The Egyptian pound, issued by a Currency Board controlled by the British government, was of course a full-blooded fiat of the British pound sterling. Its circulation in Palestine, and that of its replacement (in 1927), the Palestine pound, issued by the newly established Palestine Currency Board, meant effectively that it was sterling that provided the lifeblood of the monetary and financial system of the country for the three decades of British rule through 1948.

The modus operandi of the Currency Board was simple. It set the official rate of exchange of the Palestine pound with sterling at 1:1, and was ready to sell Palestine pounds for the presented value of the sterling, or to purchase Palestine pounds, at that effective rate. There was accordingly a free market in sterling for the Palestine currency, which meant that Palestine was on a sterling base throughout the three decades through February 1948. Sterling, and therefore the Palestine pound, was on the gold standard between 1925 and 1931, hence on a fixed exchange rate with the dollar and other major currencies, and on a flexible exchange rate regime with these currencies as sterling went off gold in 1931.

The rules also meant that the government of Palestine could not borrow from the Currency Board, which prevented it from inflating the currency. (It could borrow in the British capital market, but this option was only marginally used – the Mandatory government had on the whole a balanced budget.) The inflationary option was of course open to the British government, since it could use sterling to buy Palestine pounds for its use, and its budget, authorized by the U.K. Parliament, could involve deficit financing. That option was never used, however, during the two decades before the outbreak of the war in 1939. This meant that the money supply – the number of Palestine pounds in circulation – was, during that time, demand-determined. It was set by the cumulative requirements of private households and commercial firms and other enterprises – in other words ultimately by the "needs of trade." There was no inflation of the currency in the two decades between the wars, and the Palestine pound was regarded justifiably as a stable and highly reliable currency.

The banking system provided another component, which in developed and rapidly developing countries is an important part of the (m1), defined as the sum of currency at the disposal of the (non-banking) public and current account deposits in the banking system. In the mid-1920s even the Jewish banking sector deposit data indicate that banks were not yet a significant factor in the financial system. The Arab banking sector was in its infancy throughout the Mandatory period. The share of deposits in Arab banks in the total for Palestine in 1938 was only two percent; it grew to seven percent by the end of the war in 1946. For those same dates the share of deposits in Jewish banks was 76 and 79 percent of the total, respectively. Foreign banks, dominated by the Palestine branches of two major banking institutions, the Ottoman Bank and Barclays, held 22 percent of total deposits in 1938. This ratio declined to only 14 percent in 1946.

The dominance of Jewish banking in terms of outstanding credit was even more significant. By 1936, the Anglo-Palestine Bank had a greater credit portfolio than all the branches of foreign banks. In 1946 the credit allocated by it was three times greater than the total of all other foreign banks. The contribution of Arab banks to outstanding bank credit was five percent at most; this means that the commercial bank credit market was ruled by the Jewish banking sector. In the 1940s it accommodated 85 percent of outstanding credit (Table 10).

The story of the financial sector of Palestine is therefore the story of the Jewish banking sector. This story begins with the Anglo-Palestine Bank, set up in 1903 by the World Zionist Organization, which owned its voting shares. By 1920, at the advent of the Mandatory period, it was one of the five banking institutions operating in the country. A decade later, in 1931, the banking system already had 75 institutions, more than half of them cooperative credit associations, set up exclusively in the Jewish sector and of minuscule size even in aggregate terms. Only two of the 75 were Arab banks. Somewhat fewer than 10 of these institutions were branches of foreign banks proper, and these were dominated by major banking institutions – Barclays and the Ottoman banks. The rapid rise in the number of banking institutions in the 1920s, and the surge in the number of banks and cooperative credit associations to 134 by 1936 took place almost entirely in the Jewish sector of the economy.

The rapid expansion of the financial sector with its increase in the number of banking institutions was the result of developments in the larger economy. The very high growth rate that accompanied the absorption of the Fifth Aliyah into the Palestine economy – 170 percent in terms of the Jewish national product during the four-year period 1931–35 – of course affected the financial sector. The corresponding increase of debt held by the Anglo-Palestine Bank grew by almost 160 percent, and the more than fourfold increase in its deposits reflected the very rapid growth of the real economy (Tables 5 and 10). These figures represent only the rapidly rising volume of business in one of the approximately 130 banking institutions operating in Palestine at this date. However, with the financial flagship of the Zionist movement holding more than one-third of the deposits and an even greater proportion of the outstanding debt held by banking institutions in the country in 1936, this statistic undoubtedly offers a reasonable approximation of developments in the financial sector as a whole.

The proliferation of banking institutions in this period was not due only to the outstanding growth rate of the real economy. It reflected also the huge capital imports belonging to the immigrants, particularly from Germany and central Europe: the tide of private capital imports peaked in 1935 at a level four times higher than in 1931, and more than two times higher than the previous peak of 1925, which was linked to the arrival of the Fourth Aliyah, mainly from Poland. Indeed, the 1935 capital inflow was the all-time high of the private and total Jewish capital inflow during the three decades of the Mandatory period (Table 11). And this inflow accompanied a significant group of immigrants whose expertise was in the field of banking. The natural inclination of these immigrants was to use their own capital to open a bank in the new country. In view of the effective absence of banking legislation – until 1936 there were hardly any legal requirements, such as a government license or minimum equity requirements – they could simply proceed to do so if they chose. Only a small number of the more than 50 new banks that opened between 1931 and 1936 belonged to these immigrants with expertise and capital of their own; several were quite successful and became household names in the Jewish community. But many soon went out of business, as the 1940 entry in Table 10 indicates.

The 1936 and 1937 banking legislation, which required of banking institutions a government license, minimum capital stock, regular publication of financial statements, personal probity on the part of directors, and which established a government bank supervision department, soon led to the elimination of the more flimsy institutions. But the main reason for the disappearance of a significant number of banks by 1940 – about one-quarter of their number in 1936 – were economic and related to political developments on a world scale rather than specific developments in Palestine's economy.

The immediate causes of the closing of most of these institutions were three runs on the banks – late in 1935 and in the summers of 1938 and 1939. The first run was in response to the Ethiopian crisis, the second reflected the uncertainty related to the Munich crisis that led to the disintegration of Czechoslovakia and Hitler's dominance of Europe, and the third was caused by the Polish crisis immediately preceding the outbreak of the war on September 1, 1939. On the whole, however, the Jewish banking sector survived these three crises very well, even though Palestine had no central bank to act as a lender of last resort. After the second run in 1938, the Palestine government adamantly refused to offer any help, even though a third run was anticipated, and indeed soon occurred as the Danzig crisis gathered momentum. What the Jewish banking community asked the government to do was just to offer a guarantee to the three major foreign banks operating in Palestine – the Jewish Anglo-Palestine Bank, Barclays bank, which was the agent of the Palestine Currency Board and had been earning a hefty income in that capacity, and the Ottoman Bank. This guarantee was to be implemented if and when these banks were called on to rediscount financial assets submitted by other local banks in the case of a run in response to another war scare.

The Jewish banking system survived that run, as it did the two previous, due, among other things, to the special discount facility offered by the Anglo-Palestine Bank, even though it had no government guarantee. The willingness and ability of the apb to act as lender of last resort was, of course, due to its status as the oldest and most important financial institution of the Jewish economy and its function as the umbrella for the Jewish business and financial sector for more than three decades. Its total assets at the end of the 1920s were four times greater than the total value of the assets of the next five largest Jewish banks, and its deposits in 1936 were somewhat larger than the total deposits of all domestic (Jewish and Arab) banks; by 1940 that ratio was even higher.

Its managing director, the grand old man of the Jewish financial community, E.Z. Hofien, could venture into such stormy seas due to a highly conservative credit policy modeled on the traditional pattern of the British banking system. Even though the World Zionist Organization owned the controlling shares of the bank, its management had the freedom to pursue traditional banking policy, which requires the maintenance of high liquidity ratios and protection of the institution's solvency. This allowed apb to plunge into the cold water of the second half of the 1930s to sustain the liquidity of deserving Jewish banks, a move which could be regarded as noblesse oblige. The attitude of the apb management was also affected by the fact that the strain in the financial markets on the eve of the war also reflected the general downturn of economic activity since 1936, involving rising unemployment.

The banking legislation initiated in 1936 shrank significantly the number of banking institutions. Those eliminated, however, were almost exclusively small and ephemeral; those that remained constituted a robust and profitable system. The prosperous economy of the war years bringing a flood of liquidity, high profits for businesses, and rapidly rising real incomes sustained the profitability of the banking system. This applied of course to apb whose share of the business grew to almost 50 percent of the total deposits in the entire banking system of Palestine and to about one-third of the commercial credit (Table 10). This gap between the bank's share of deposits and its share of credit indicates a huge increase in its portfolio of financial investments. The currency controls imposed at the outbreak of the war meant that the excess liquidity was channeled exclusively into British government gilt-edged bonds, turning apb effectively into a trustee of what was soon identified as the Jewish economy's ownership of Palestine's sterling balances. The low two percent interest rate of the war years, a highly inflationary context, meant that the profitability of this investment portfolio was quite low. It provided, however, a large pool of potential liquidity for the bank, which sustained the viability of the state of Israel at a crucial time as it emerged from the 1948 War of Independence.

The Balance of Payments and Jewish Capital Imports

structural features of palestine's balance of payments in the interwar decades and the war period

The outstanding performance of the Jewish sector of the economy during the Mandatory period – its net national product grew by 10 times between 1922 and 1939, and by almost 25 times in the 25 years between 1922 and the end of the Mandatory period (Table 5) – would have been inconceivable without a rapid expansion of the investment flow. The expansion of capital stock by 11 times through 1939 and 15 times for the 25 years ending in 1947 (Table 4) indicate that though the rates of investment over time were subject to significant cyclical variation, this was indeed the case (Table 4). But these huge rates of investment, which through 1936 involved ratios of 35 percent or higher of the net national product of the Jewish economy (and even at the bottom of the cycle in 1939 were still 17 percent of nnp), were not, indeed could not have been, financed by domestic savings. They were inevitably financed predominantly by capital imports associated with the waves of immigration.

Balance-of-payment data offer insight into this phenomenon and on the composition of Palestine's foreign trade and capital flows during the Mandate. These data, however, reflect the economy as a whole and thus also the Arab and government of Palestine sectors, which also grew and maintained flows of investment that expanded capital stocks. These are shown in Table 4, and indicate that net capital stock of the Arab economy grew by 2.5 times through the 25 years ending in 1947, at an average annual rate of 3.8 percent. Investment in infrastructure by the government expanded at a more rapid pace – 7.4 times during the same period, less than half the rate of Jewish capital stock. Yet by and large the government investments were financed by taxation: Palestine government capital imports were very small indeed and constituted only a small fraction of the financing of the country's infrastructure (Table 12).

The Arab economy undoubtedly financed its investment from domestic savings and, to a significant extent, from the substantial sums received from the sale of land to Jewish private entrepreneurs and to the Jewish National Fund.

Unilateral transfers, displayed in the balance-of-payments data (Table 12), reflect accordingly almost entirely Jewish sector inflows. The capital account credit figures also refer almost entirely to the Jewish sector. The flows of the government of Palestine and Palestine Currency Board appear on the debit side of the capital account. These are quite similar in volume to the credit figures in column 6 in the unilateral transfers section, which refers to inflows from non-Jewish sources. These figures indicate that the government of Palestine's contributions to the inflow of resources during the Mandatory period was negligible.

The balance-of-payment figures underline the major difference between the periods (prewar through 1939; war and aftermath, 1940–47) in Palestine's external economic relations. Palestine's current account dominated by trade flows was in substantial deficit in terms of the economic aggregate figures in the interwar years. The import flow was huge, about 45 percent of Palestine's gdp (Gross Domestic Product), while its exports were only about 13 percent. This means that the P£111 million deficit on the current account for that entire period amounted to about 32 percent, almost a third, of Palestine's gdp, a world record. The inflow of Jewish immigrants' funds on capital account, plus the flow of contributions of the Zionist and other Jewish organizations all over the world, effectively provided the funds required to pay for the huge net imports in the interwar period. Similarly, private Jewish firms and immigrants effectively provided the total inflow of funds on capital account, P£26 million in the interwar period. A major portion of this was the capital transferred under the *Haavara Agreement, which between 1933 and 1938 allowed the transfer of Jewish immigrants' private capital from Germany only in the form of goods, which were subsequently sold and therefore reconverted into capital.

These funds allowed the banking system, dominated by the Anglo-Palestine Bank, to invest its excess financial resources in London, to accumulate sterling reserves to sustain their liquidity and offer coverage for their rising current account deposits. A fraction of these funds also provided the required cover for the expansion of the monetary base – reflecting the rapid income-driven increase in the demand for currency. This feature can be inferred from the Currency Board debit balance for 1922–39 of £9 million in the capital account section of Table 12.

The structure of the balance of payments for the 1940–47 period, the years of the war and its immediate aftermath, was an altogether different story. The net current account of the country in the 1940–47 period, minus P£4 million, indicated that the huge deficit in Palestine's current account disappeared altogether, due mainly to the huge expansion of its export business. These "exports" were mainly goods and services provided to the British and allied armies in Palestine and the Middle East. The unilateral transfers account – about 87 percent of its total of P£86 million was from Jewish sources – contributed a major inflow of funds. Yet though the average yearly inflow of these funds, in nominal terms, was approximately two times greater than it had been in the interwar period, its real value, owing to major wartime inflation, was significantly smaller. The major difference was the reduction of such transfers (leading to the collapse of the nominal value, and thus even more the real value, of immigrants' funds (column 4)) reflecting of course the reduction of immigration and the abject poverty of most of those refugees who did arrive. Even so, this positive inflow financed almost entirely the major deficit on Palestine's capital account, which effectively meant an accumulation of sterling balances – a nominal debt of the U.K. government to banks, firms, and households holding currency balances. The P£10 million debit in place of the P£26 million positive private sector capital account figure from the interwar period (Table 12) actually represented investments in British funds – presumably gilt-edged bonds – by Palestine's banking system, businesses, and households. This was the only avenue open to them in view of the currency controls imposed at the outbreak of the war. It can be inferred that most of these funds originated in the Jewish sector, given the dominance of the real Jewish economy by that time in terms of gnp per capita (Table 5), and even more so its dominance of the small capital market of Palestine in those days.

The huge cumulative debit of the banking system in the balance-of-payments account in that period reflects of course the wartime inflationary developments and represents the acquisitions of sterling reserves by the banks to back their inflated current account debits. The same feature is exhibited by the huge debit flow of the Palestine Currency Board, representing its purchase of sterling-denominated gilt-edged bonds, the backing for the (inflated) increase of currency required by the public. These two outflows of nominal finance created the so-called "sterling balances" of Palestine – a nominal debt of the United Kingdom. When Palestine's sterling balances were finally released, as they were between 1949 and 1951 according to agreements between the United Kingdom and Israel, the ownership of these balances by predominantly Jewish economic entities – households, commercial business firms, and the banking system – was finally established.

jewish capital imports and growth

This survey of the structure of Palestine's balance of payments identifies the major contributions of unilateral transfers and capital imports to the workings of Palestine's economy during the three decades of the Mandate. These two major inflows of resources were indeed directed to the Jewish sector, providing it with the means for an all-out investment effort generating very rapid growth. Yet the benefit of this was inevitably transmitted to the Arab sector too, directly and indirectly, and to the cash flow of the Mandatory government, which gained from the rising income-induced expansion of tax revenue. The outstanding average annual growth rate of the domestic product of the economy of Palestine as a whole, which was about 9 percent (Table 5) for the 25-year period through 1947, is an obvious case in point.

The overall contribution of capital imports to the fabulous growth rate of the Jewish economy (an annual average of close to 14 percent during the Mandate period) is underlined by the investment and capital import figures presented in Table 11. The high investment-national product ratios are the evidence: the close to 40 percent ratios in the figures for the 1920s, and the roughly 35 percent in the 1930s – the latter reflects the leap by 3.5 times of national product in that decade – could not have been sustained from domestic savings for two consecutive decades. Investment ratios in the 1940s were lower (though not low in comparison with the ratio of Arab investment in Palestine or with conventional peacetime ratios in the major economies). These much lower ratios were due to wartime government controls imposed on investment, in housing in particular. The effect of the abolition of controls after the war shows clearly in the 23 percent investment ratio of 1947.

Investment ratios even on the order of those of the 1930s could not have been sustained by domestic savings rates. Investment rates beyond 20 percent of national product are not sustainable for such long periods even in rich economies. The capital import figures, dominated by the transfer of funds by the private sector, offers an explanation for the extraordinary investment ratios displayed in the figures for the interwar period. The capital import ratio series of Table 11 show that the inflows of these foreign resources were year-in and year-out in the 40–50 percent ratio. The very high ratios of the 1920s do not indicate higher inflows in absolute terms; the capital inflows of the 1930s were on the whole greater. The ratios of the 1920s are high because of the low absolute value of net national product in that decade.

In other words, the inflow of these funds provided full financial backing to the investment effort of the Jewish sector, and even a substantial surplus that could be used for other purposes. Yet since the net investment figures in Table 11 represent net fixed reproducible capital in 1936 prices, a major component of investment in the Jewish economy is not included: the cost of land purchased from Arab owners. These purchases were indeed an investment from the point of view of the Jewish sector, but not from that of Palestine's economy as a whole. Thus, a fraction of the difference between the approximately P£66 million inflow of Jewish capital imports in the 1930s and the approximately P£45 million in investments accounted for in the investment series of fixed reproducible capital stock, was the cost of the acquisition of land. For the whole 25-year period for which data are available the size of the gap between the total Jewish capital import and investments was greater – close to P£50 million, in 1936 prices, about 37 percent of the total capital inflow (Table 11).

The second component for which this P£50 million difference provided backing was monetary liquidity – primarily the acquisition of Palestine pounds currency balances. The total net debit figure of the Palestine Currency Board in the capital account section of Table 12 indicates that these were P£44 million (Table 12). Yet the Arab sector, too, held a fraction of these balances. The figures thus exaggerate the investment of the Jewish economy in the accumulation of a currency balance – which probably was not much more than half of the P£44 million total, and perhaps even less than that. The cumulative building up of inventories was of course another form of investment not recorded in the fixed reproducible capital stock data. It had been absorbing a fraction of the extra resources provided by the capital imports.

The debit entry of the banking system in the balance-of-payments record (Table 12), which reflects the acquisition of its secondary liquid reserves in London accumulated during these decades, was a foreign financial investment that provided the backing for the customer deposits in Palestine's banks. These funds were part of the monetary liquidity of the economy. In this case as well, and owing to the substantial size of British banks, the P£54 million cumulative debit items for banks in the capital account data in Table 12 do not represent a financial investment of the Jewish banking system only. A significant fraction of that figure represents an investment of the foreign banks, and a much smaller one of the Arab banks. Nevertheless, it explains a sizable fraction of the gap between the P£130 million Jewish capital imports and the fixed reproducible investment in the Jewish economy.

These data underline the strategic function of capital imports in the growth of the Jewish economy and that of Palestine as a whole during the Mandatory period. The huge inflow of Jewish capital imports provided the necessary backing for the investment flow that was crucial for generating the 14 percent average annual growth rates of the Jewish economy, and the corresponding nine percent rates for Palestine's economy as a whole. Furthermore, even the much lower investment rate of the Arab economy, which grew at an annual rate of 6.5 percent, would not have been realized but for the funds provided by the Jewish capital imports used to purchase Arab-owned land.

It was thus the total Jewish capital imports that had spurred the Palestine economy to the production potential it had arrived at on the eve of the war. And it was this material potential and the human capital element, dramatically increased by the immigrants, that made it feasible for Palestine to serve as the locus of the Middle east supply system set up by the British and allied forces during the war. It provided in more than one sense the infrastructure of the Middle East war effort.

Money, Prices, and War Finance

monetary and price developments in the interwar decades

A survey of the data suggests that the history of money, prices, and rates of economic activity for the three decades of the Mandate can best be understood as falling into two subperiods: the two interwar decades, and the years of World War ii and its immediate aftermath, 1940–47.

Even though the 1920s and 1930s were on average decades of very rapid growth, they were also years of declining prices in the first of the two decades, and of stable prices in the second (Table 13). This was the case even though in the second half of the 1920s, for which only currency-in-circulation data are available, the monetary expansion was quite robust: significantly beyond 12 percent, as the only available indicator, the currency expansion rate of about 20 percent between 1927 and 1929, suggests. The growth rate of the money supply (Table 13) in the 1930s at an average annual rate of about 17 percent, with prices hardly budging until the outbreak of the war, indicates that stable prices were the rule. This was the case even though in the full-employment economy of the early 1930s real growth accelerated immensely. It declined somewhat after 1935, yet the average annual ndp growth rate was still close to nine percent for the decade ending in 1939 (Table 5).

The high growth rates of the money supply – about 17 percent annually for the 1927–39 period (16 percent in the 1930s, based on more reliable data) – did not generate price inflation because they were demand-determined: the increased supply of money provided the liquidity required by the very rapidly growing economy (nine percent in the 1930s, somewhat higher than in the 1920s). The major monetarization process to which the Arab economy was subject during that period, as more and more of its production was transmitted to the market, also contributed significantly to the increase in demand for money, inevitably in the form of currency rather than current account deposits.

Thus, with an effective free-trade regime maintained by the Mandatory government, prices were on the whole determined by world markets. Prices were declining significantly in the sterling and sterling-linked economies in the 1920s; in Palestine they stabilized after the floating and depreciation of sterling in 1931, and in the wake of the worldwide economic crisis and deflation of the early 1930s. Even in the full-employment environment between 1928 and 1935, prices hardly budged. The supply of money was accordingly a dependent variable, expansion of which was determined by the growth of the economy and the monetarization process. Its expansion was a response to these rather than a proactive move by government intended to affect the level of prices.

british war finance and the inflation of palestine's monetary aggregates

World War ii, however, created an altogether different trade and monetary regime. From September 1939 on it severed lines of communication with Europe and North America and later with Southeast Asia. Shipping space restrictions reduced transport to and from the western and southern hemispheres too, before being interrupted almost completely when Japan entered the war in December 1941. This meant that imports to Palestine were soon reduced to a trickle. Exports – primarily, of course, citrus – also shrank to almost nothing with the closure of European markets.

These war-imposed developments eliminated at once the severe competition from imports to which domestic, almost entirely Jewish, manufacturers and mixed farm producers had been subject in the interwar years. It also meant that Palestine's prices were no longer determined by world markets. It was the rapidly expanding aggregate demand that, from the outbreak of World War ii through the end of the Mandate, not only set quantities (as it had before the war), but also determined the level of prices in Palestine's economy, a variable it could hardly have affected earlier.

The factor on which the trend of aggregate demand during the war years depended was, of course, British (and later Allied) military demand. Purchases for military purposes shot up from about three percent of Palestine's gross domestic product in 1937–38 to 22 percent in 1940, a year at the end of which Palestine's economy was operating at close to full employment. The peak of military demand in terms of Palestine's economic capacity was reached in 1941 at 38 percent of gdp. The military still absorbed about 16 percent of gdp in 1945, although military operations were focused from 1943 on southern and western Europe and not the Middle East.

The huge demand generated initially by the need to supply an army of several hundred thousand soldiers located in the Middle East command, which stretched from Iraq to the western border of Egypt, had to be financed. The source of that finance was primarily the United Kingdom budget. The payment instrument was, of course, Palestine pounds, which the U.K. treasury purchased from the Palestine Currency Board by submitting sterling – strictly according to the Board's operating rule. Formally, this procedure involved a deficit in the U.K. budget and not that of the government of Palestine, which on the whole maintained a balanced budget. In any case, it could not "borrow" from the Palestine Currency Board – that is, the Board could not print money.

This constraint did not apply, however, to the U.K. government, which could borrow sterling from its central bank, the Bank of England, and convert it into Palestine pounds to pay for the goods and services its military purchased in its mandatory dependency. The British government did not make use of this tactic during the interwar decades, neither in Palestine nor in other colonies or countries subject to its control, but that inevitably changed during the war. In theory, recipients of Palestine pounds had a claim on U.K. resources, since the Palestine pound was convertible into sterling. In practice this was impossible, owing to wartime currency controls. The only alternative, used by the Palestine Currency Board and the Palestine banks, was to acquire gilt-edged (non-price indexed) bonds, which represented a U.K. debt. These were the so-called "sterling balances" accumulated during the war. Palestine's sterling balances accumulated during the war, like those of other members of the sterling bloc, were frozen immediately at the end of the war. This prevented their use by creditors in Palestine to pay for imports of goods and services from Britain in the postwar period, unless released by the British Treasury.

surging war inflation, 1940–1947

This borrowing by the British government to finance bulging aggregate demand, leading by 1941 to overemployment in Palestine's economy (Table 7), was inflationary by definition. The inflationary effect shows clearly in the monetary series of Table 13. The currency data, which does not represent the whole money supply, but is available from 1927 onward, offers the first evidence of monetary inflation, one of the most significant features of the war years. In the 12 years between 1927 and 1939, currency circulation increased by approximately 5.8 times, at an average annual rate of 15.7 percent. It expanded at 26 percent annually during the seven years ending with 1946, and at an annual rate of 34 percent during the six years of the war. Reliable money supply figures are available only from 1931 on, but these tell the same story: money supply grew by an average annual rate of 34 percent in the six war years through 1945 and at a rate close to 28 percent in the seven years of war and its immediate aftermath through 1946 (Table 13). The annual rate of expansion of the money supply (m1) in the 1930s was roughly 17 percent.

With the monetarization process in the Arab sector close to completion and the gap between the expansion of the money supply on one hand and the growth of national product and income on the other at 10 percent, major inflation was inevitable. It began in 1940; the 1941 price index indicates an annual average rate of price inflation of 22 percent during these two war years. In 1945, after six years of war, the average annual price inflation was lower, but still more than 15 percent. And even though it was significantly reduced in 1946 and 1947, as the data for the Jewish markets in Table 13 indicate, the average annual inflation rate of 15 percent for the 1940–47 period had an inevitable effect on the workings of the economy, particularly on inflationary expectations, inherited by Israel in 1948.

Manufacturing and the Transformation of the Economic Structure, 1937–1947

Inflation was indeed an important feature of the war period and its immediate aftermath. It was not, however, the only significant process with long-term implications. The real economy of the Jewish sector underwent a significant change in structure during the war years, a process that had already begun to emerge in the second half of the 1930s.

the 1936–1940 recession

Economic processes during the war actually had their origins in the prewar period, and were of course affected by the context in which they began to evolve. A main feature of that context was a significant recession that started in 1936, whose impact was felt primarily by the Jewish economy. The 1936 domestic national product had fallen by six percent from the very high peak of 1935 (which had risen by about 13 percent from 1934). It further eroded somewhat through 1939 to the 1934 level. The trough of the cycle was reached in 1938. Yet in spite of the downturn, total employment in the Jewish economy increased every year through 1939; only employment in the construction industry declined (Table 7). This means that the depression was mainly an income depression, explicable by a significant negative development: the drastic fall of the prices of Palestine's main export, citrus: these were down by 30 percent by 1939. With citrus exports accounting for about 10 percent of the Jewish gdp, the price collapse had an unavoidable effect on incomes, although citrus production was in 1939 more than two times its level in 1935.

The other main source of weakness during the prewar period was the building industry, in the wake of the end of the immense building boom of 1932–35. The net product of that industry in 1939 was about only 20 percent of its 1935 peak (Table 8). Thus, while employment in the citrus industry was at least maintained through the summer 1939, employment in the building industry declined almost at once and was clearly a drag on the labor market by 1936. The unemployment rates in Table 7 show a rise in the Jewish labor market from a negligible figure in 1935 to 4.3 percent in 1938 and 1939. In comparative terms, with unemployment rates of those years in the nine-to-ten percent range in Britain and other western European countries, and at even higher rates in the United States, a rate of 4.3 percent was seemingly quite reasonable. such a retrospective reading of the situation applies particularly to the Jewish community, which continued to absorb immigrants at rates not much below the average of the wave of 1932–35. Indeed immigration in 1939 surged again, to 31,000.

This, however, was not the view of contemporaries, as the political annals of the period indicate. The situation in 1936–40 was perceived as a major crisis. The struggle to get hired for "a day's work," as the Hebrew idiom of those years had it, particularly in the Tel Aviv conurbation which "grew on yeast" in the 1930s, was bitter indeed. However, by late 1940, and particularly from 1941, the employment problem disappeared for almost an entire decade.

The weak labor market, which shows in the unemployment figures, can be seen in the wage series too. Real wages declined by almost 13 percent between 1935 and 1939, not only because of low demand, but also because of the continuous growth of the labor force (and the population as a whole), which in part reflected the continuing flow of immigration. Declining income, in terms of per capita product, was even more severe: Jewish per capita product declined by 17 percent during the same period.

the rise of the manufacturing industry, 1936–1947

The strains in the economy in the second half of the 1930s did not prevent the significant reordering of economic priorities. It was the rise of manufacturing industry that generated a major change in the structure of the production sector. This shows clearly in terms of that sector's employment and contribution to net product during that period, which accelerated during the war. It had grown only somewhat more rapidly in terms of employment and production than agriculture in the first half of the 1930s. In 1935 Jewish manufacturing employment was 80 percent of that of agriculture. By 1939, the figures were even; in spite of the slowdown, employment in manufacturing had grown by 35 percent between 1935 and 1939. By 1945 it employed 72,000, almost twice as much as in 1939 and more than twice the number employed at that time by agriculture (Table 7).

The product figures reveal a similar development. Though the rising trend of manufacturing product (value added) did slow down between 1935 and 1939, it still kept growing. Due to the downturn in the citrus markets (though not in the markets for mixed farming products), the product of agriculture as a whole was down by 26 percent (Table 8). During the war years the net product of manufacturing expanded by an annual average of almost 18 percent even though net investment slowed down. By 1945 it was the dominant sector of the Jewish economy, generating one-third of its net national product and responsible for 31 percent of its total employment, three times more than agriculture. The 1935–45 (or –47) decade accordingly saw a major restructuring of the Jewish economy. Though Zionist ideology and policy still insisted on the priority of agriculture, developments in the economy were attracting Zionist attention to manufacturing.

The surge of growth in manufacturing product was possible because of the existence of excess capacity in the wake of the major investment flow in the second half of the 1930s, which was accelerated by the highly significant contribution of the flow of private capital imports in the form of German equipment and machinery (the only form allowed to Jewish immigrants from Germany). The huge increase in military procurement provided the demand; procurement increased from about three percent of national product in 1938 to 22 percent of gdp in 1940. The peak in absolute terms and relative to nnp was reached in 1941, at 38 percent of national product. Military procurement then declined, although it was still a major component of aggregate demand, as the theater of war moved away from the Middle East. Yet that decline in the last two years of the war, to below 17 percent of gdp, did not reduce manufacturing product. Production continued to grow though 1945 and stayed almost at this peak through 1947 owing to two new demand factors that appeared during the war (Table 8).

One of these was the demand for substitutes for the producer and consumer goods that Palestine had been importing before the war, especially those from Europe. The nascent manufacturing sector in the metals and machinery, electrical equipment, textile, and clothing industries could hardly compete without tariff protections against cheap prewar imports from established industries in developed countries (which maintained their own protective tariffs), and Palestine was not allowed to join the British Imperial Preference System instituted in 1931. The second new source of demand was the economies of the Middle East, in countries where the British (later Allied) Mid-East Procurement Center in Cairo operated, and which, like Palestine, were cut off from their traditional import linkages.

The impact of the expansion of manufacturing activity during the war years is underlined by the data on the growth of electricity use by manufacturing; use grew by almost three times between 1939 and 1946. The Iraqi pipeline transporting crude oil to Haifa, the Haifa refinery that opened in 1939, and finally the heavy prewar investment in generation and transmission capacity made by the Jewish Palestine Electric Corporation (using German equipment imported under the Haavara Agreement) allowed this rapid expansion of electricity generation during the war years. The direct pipeline link from the Iraqi oilfields and the capacity of the Haifa refinery allowed Palestine to avoid energy rationing, a prevalent feature of war economies.

All types of manufacturing activity increased during the war, in response to strong domestic and foreign demand generated by rapidly rising income in Palestine and other Middle East countries. Yet three industries in particular benefited most from the vigorous expansion of these markets. One of these was the diamond industry, which "made Aliyah" – that is, it "immigrated" to Palestine in response to the outbreak of war in Europe. The others – metals and machinery, and electrical and optical equipment – benefited from the war effort, which generated specific demand for their output.

Diamond polishing in Palestine started from scratch in 1939, and by 1943 offered employment to almost eight percent of workers employed in manufacturing in the Jewish economy. In the interwar period this industry had been mainly located in its traditional centers, Belgium and the Netherlands, manned predominantly by Jewish workers and entrepreneurs. Its raw material supply came mainly from South Africa and its primary market was the United States. The two last features, and the fact that Palestine, like South Africa, belonged to the sterling bloc, were highly beneficial to the British economy, which in the war was very short of dollar export revenue. British interest coincided in this case with both the interest of the Jewish operators in that industry in fleeing Nazi-occupied Europe and the Zionist effort to foster immigration to Palestine. It was inconsistent with the major effort, fostered by the British Foreign Office and implemented by the Mandatory government, to restrict Jewish immigration to Palestine. The diamond industry case was from the point of view of the British the exception that proved its (policy) rule.

The relatively simple machinery required for diamond processing and polishing, which could be produced in Palestine, facilitated the forced and rapid transfer of the industry. In more than one sense it involved mainly the transfer of expertise – i.e., human capital at the disposal of the Jewish immigrants. The rapid expansion of output, which provided the entire supply of industrial diamonds for the Middle East, and exported 80 percent of its product, mainly to the jewelry business in the United States, required extensive training of locals. This was soon successfully accomplished. Though its comparative contribution to manufacturing employment declined significantly after the war, the diamond industry survived in Palestine even as the traditional centers of the industry in Belgium and the Netherlands were revived after the war. Israel became one of the major centers of that industry, in trading and polishing, in the second half of the 20^th century.

The second industry that expanded vigorously during the war was metal and machinery. It was converted to war production, supplying, among other things, almost all the antitank mines and spare parts for vehicles and ships required in the Middle East. The third, a related precision instruments and optics industry, was a by-product of this development and initially produced exclusively for military requirements. This complex of industries soon provided, in the immediate aftermath of the war, the foundation of what was initially the illegal small-arms industry of the Haganah, and after independence provided the basis for Israel's defense industry. A chemical industry based on the Dead Sea Potash Works, established in the early 1930s, and the beginning of a pharmaceutical industry also emerged in the late 1930s. In the last years of the war they employed about 10 percent of the labor force in manufacturing.

Neither of these industrial complexes, which took shape by the late 1930s and emerged as highly significant components of the Jewish economy's manufacturing capacity, could have emerged without a substantial group of highly trained and experienced workers. In the 1930s this was provided mainly by the stream of immigrants from Germany and Central Europe, which included a significant share, 15 percent, of university graduates: engineers, medical doctors, chemists, etc. These immigrants initially faced severe absorption problems; it was hard for them to find work in their fields of expertise. The outbreak of the war soon resolved their employment problems. The demand for their know-how grew immensely as communications and trade links with Europe and America were disrupted and the British and Allied military supply system in the Middle East had to rely more and more on domestic resources. They were soon reinforced by Hebrew University of Jerusalem and Haifa Technion (the Israel Institute of Technology) graduates, who began moving into the market for highly trained labor.

The rising incomes across the board generated, inevitably, increasing demand for consumer goods such as food and textiles. In the prosperous years of the war and its aftermath these grew, too, in terms of employment and production. However, the growth was at significantly lower rates than in producer goods. Expansion of demand was felt in the Arab manufacturing sector too. Between 1939 and 1945 its employment grew at an average annual rate of six percent and its product by about eight percent, although this was less than half the corresponding annual growth rates of the Jewish sector. Furthermore, while Jewish manufacturing was undergoing a major structural change, Arab manufacturing expanded along traditional consumption goods lines.

Although the citrus industry was in the doldrums, the Arab labor force benefited from the conditions of overemployment of the war years and moved into the openings in its own manufacturing sector, military building projects in particular. This reduced significantly its direct linkage with the Jewish economy, which in 1935 had been employing a meaningful share of Arab labor in citriculture and construction. These years thus saw the beginning of the end of the one-way labor market links between the two distinct economic sectors that had begun with the Arab uprising of 1936.

War Prosperity, Inflation, and the Short-Term Peace Reconversion

In terms of the unemployment rate, which rose to 5.7 percent in 1940, the first year of the war seemingly belongs to the period of the economic slowdown. But with employment in the Jewish economy expanding by almost six percent in that year, the labor market had been improving considerably. The rise of the unemployment rate was due mainly to the almost eight percent increase in the size of the labor force, reflecting, with a lag, the surge of Aliyah in 1939. By 1941 unemployment disappeared from the economic scene for the next seven years.

With unemployment at less than three percent in 1941, and close to zero in the six succeeding years through 1947, the labor market showed the exploding economic prosperity of these years. The relief on the employment front reflected primarily the booming war-induced domestic aggregate demand described above. It was also due to the substantial voluntary recruitment into the British army: the 27,000 Jewish volunteers serving in the Jewish brigade and other Jewish units were about 11 percent of the labor force in 1945. The most interesting feature of the postwar labor market shows in the unemployment data of 1946 and 1947; in these two years, though all the Jewish soldiers had been released from service and rejoined the labor market, and there had been 41,000 new immigrants, the unemployment rates were 0.2 and 0.3 percent in 1946 and 1947 respectively (Table 7). The markets, including the labor market, evidently operated in boom conditions at that time, which were also years of all-out struggle with the British government for "free Aliyah" as well as the illegal immigration drive carried out by the Zionist Organization. These struggles were supported emotionally, politically, and financially by the remaining Jewish communities all over the globe.

Prices, wages, and incomes responded to the war boom immediately. Prices rose at once – by the end of 1940 these were already 20 percent higher than in 1939, and by 1941 they were 49 percent higher than on the eve of the war. Nominal wages also rose, though initially at lower rates: almost seven percent in 1940 and about 14 percent in 1941. Thanks to price inflation, these figures actually represented a highly significant reduction of real wages, as can be seen in the real wage figures in Table 6. If initially, in the still weak labor market of 1940, workers and the population at large were subject to a temporary "money illusion" by the booming labor market, the severe erosion of real wages from 1941 led to a corrective arrangement: an official committee representing labor, industrial employees, and the Palestine government recommended in 1942 that wages be linked to the cost of living, with periodic adjustments to match changes in the cost-of-living index. This recommendation was immediately adopted, initiating the era of price indexation, which turned out to be a major institutional device affecting the workings of the Palestine, and later Israeli, economy for almost six decades to come.

Its immediate effect was an effective upward adjustment of real wages. By 1943 these were approximately back to the level of 1939, but now in the context of overemployment, thus reflecting a major increase in income of the entire labor force. It was increasing productivity that sustained that pattern and allowed real wages to climb further. By the end of the war these were 40 percent higher than at the previous (accidental) peak of 1935. The net domestic product per employee figures in Table 6 exhibit the rising average product of labor and indicate a robust 40 percent rise in labor productivity by 1945 from 1939. These figures explain the factors supporting the highly significant performance of the Jewish economy in terms of real wages during the six years of the war.

The economics of the last two years of the Mandate period were of special significance, particularly in the political context of that period. These were years of confrontation with the British government, which stuck to the policy articulated in the 1939 White Paper, abandoning some of Britain's commitments under the 1922 League of Nations Mandate. Yet these two years of confrontation, which involved clashes with the British army and navy, mainly related to the Zionist-organized illegal immigration of Jewish refugees, were years of roaring prosperity in Palestine, and correspondingly also of declining inflation. Price inflation was down to an average of three to four percent, and national product grew at an average annual rate of 12.5 percent. Correspondingly, per capita product in the Jewish sector grew at a somewhat higher rate due to a lower rate of population increase (Table 5). This performance, reflecting a significant increase of labor productivity in the Jewish economy, was expressed in an outstanding leap of real wages by a 9.4 percent average annual rate.

These highly beneficial developments in terms of price inflation, production, and corresponding income growth and thus overall economic welfare were due to an exogenous postwar factor that supported the maintenance of high aggregate demand yet generated downward pressure on prices. This was, of course, the reopening of communications and transport links with Europe and across the Atlantic and the Indian Ocean, allowing both the revival of citrus production and export and reopening Palestine to a flow of imports. The citrus exports – at a lower level of production than before the war, owing to the conversion to other uses of about 20 percent of the prewar growing area – offered a significant net contribution to exports representing a meaningful increase of net national product, in 1947 in particular. The imports were sufficient to generate downward pressure on domestic price levels.

The postwar high domestic aggregate demand, even though military procurements had been cut drastically, was primarily due to the instantaneous revival of the building industry. After six years in which building for civilian purposes was legally prohibited, and a full decade of a depressed Jewish building industry, the Jewish population – 20 percent larger in 1945 than in 1939 – was eager for an expansion of living space. The much higher per capita incomes and especially the accumulated savings from the war years provided the financing for a major building boom. The war-inherited inflationary expectations were of course also relevant, and suggested to many households the wisdom of an immediate move into the housing market. The building industry revival offered a substitute market for the cement and stone industries just as military procurements were disappearing. Its upturn of activity, and its traditional role in Palestine as the leading branch in the business cycle, provided the stimulus for a major revival of domestic demand. That logic applied similarly to the Arab building sector, which also rebounded sharply in the immediate aftermath of the war. The employment data of Table 7, which indicates a twofold increase in employment in construction in the Jewish sector and an increase of more than four times in the Arab sector, underlines this retrospective reading of events.

These prosperous economic conditions contributed undoubtedly to the morale and steadfastness of the Jewish population in the political struggle with the British between 1945 and 1948 for unrestricted immigration and the establishment of a Jewish state. Thus successful economic performance at this last stage of the Mandate offered the Jewish community a material base for the crucial stage of that effort.

in the state of israel

The Israeli War of Independence, set off by an Arab attack on a Jewish bus on November 30, 1947, in response to the United Nations decision on the Palestine partition plan the previous day, followed by violence against Jews and Jewish property in Jerusalem and all over the country, raged on and off in 1948 between temporary un-imposed armistices. March 10, 1949, the date when Israel Defense Force units reached Eilat, on the shore of the Red Sea, marked the end of the war.

The four armistice agreements of 1949 – the last signed with Syria in July, following earlier agreements with Egypt, Lebanon, and Jordan in February, March, and April respectively – constituted a crucial geographical and demographic watershed for the emerging Jewish state. These agreements defined the armistice lines, known as the "Green Line," – effectively, an international border – with the four neighboring Arab states. These gave effective political control to Israel over 20,770 square kilometers of the 27,009 sq km area of Mandatory Palestine – about 77 percent of its total area.

The immediate demographic impact of the war, confirmed in practice by the armistice agreements, was also highly significant. A major share of the Arab population – about 500–550,000 – that had been living in the area on the Israeli side of the 1949 Armistice lines escaped during the hostilities to areas behind the lines of the Arab forces. Those refugees who lived in the north, in Haifa and Galilee, went – temporarily, as they believed – to Lebanon and Syria. Those in the central and southern part of Palestine crossed into the Jordanian-held areas later known as the West Bank and the Egyptian-held territory soon known as the Gaza Strip. This meant that at the end of the hostilities only about 150,000 Arabs and 15,000 Druze remained within the Green Line.

On the other hand, from May 15, 1948, onward, the Zionist demand for "free Aliyah" could at last be realized. Thus, from May 15 to the end of 1948, about 100,000 immigrants arrived in Israel. A similar number arrived in the following two quarters through mid-1949 – the total for that whole year amounting to some 240,000. This meant that the Jewish population, which was almost 650,000 at the declaration of Independence, grew to almost 900,000 within one year (Table 14).

These two factors, geography and demography, inevitably determined the economic agenda of the nascent state.

Free Aliyah and Demographics, 1948–2005

the five waves of immigration

The drastic transformation of the demographic structure within that single year was an expression of the initial stage of the first wave of mass immigration, which arrived between May 15, 1948 and the end of 1951. It represented the "free Aliyah" policy adopted by the government, for which the Zionist movement had been struggling for three generations.

Its implementation at that rapid pace also reflected the availability of candidates for immediate immigration to the emerging Jewish state. First there were the approximately 100,000 illegal immigrants whom the British had deported to Cyprus between 1945 and May 1948, and held in detention camps there. Another reservoir of potential immigrants was the population of European Jewish refugees still living in displaced persons camps run by the Allied Military Government in Germany in 1948, three years after the end of World War ii. Almost all of the 200,000 immigrants to Israel through the end of 1949 from Europe (and America) shared this experience. Though the flow from Europe continued (at a significantly lower rate), the focus of the effort in 1950 shifted to Yemen and in 1951 to Iraq. Almost all of these two ancient Jewish communities, comprising 70–80,000 and over 100,000 respectively, with roots going back to the era of the Talmud and the Mishna, went to Israel in 1950 and 1951.

That first wave of mass immigration of 1948–51, which involved a gross immigration flow of almost 700,000 (more than the Jewish population at the time of independence) subsided in 1952. This was not accidental. Though the emptying of Jewish refugee camps all over Europe and the almost complete

transfer of the Jewish communities of Iraq and Yemen were highly successful, the major slowdown in 1952 reflected a deliberate, though not officially stated, policy of the Israeli government to shelve temporarily its efforts to encourage, organize, and finance immigration. This was due to the immense strain imposed on the nascent economy of Israel by the first post-independence immigration wave. The all-time high rate of 180 immigrants per 1,000 residents during the 44-month period from May 1948 to December 1951 (Table 15) offers a quantitative indication of that strain.

The absorption organization for new immigrants run by the Jewish Agency almost collapsed under the weight of the numbers; its capacity to provide shelter, food, and medical services (mainly in abandoned British army camps) was pushed to the limit. With its foreign currency reserves drying up, and a major balance of payments current account deficit, the government's ability to provide housing and assure medium-term absorption of the newcomers into the labor force was overwhelmed; the major problem was the need for employment. The economics of absorption thus suggested the absolute necessity of a temporary lull in the inflow. The average yearly number of arrivals, which was 196,000 during that first post-independence wave and which was never repeated in the ensuing five decades, underlines the economic strain to which the system was subjected (Table 15).

The second wave of immigration, after a three-year lull in which the average annual inflow was only 17,000, started in 1955 and ran through 1957. It involved an average annual rate of 55,000. As did the first, it required the allocation of resources for the immigrants' initial absorption and integration, but it imposed an altogether smaller strain on the emerging, still fragile, economic system. This is suggested by the figure of 33 immigrants per thousand residents during this period; for the whole of the decade after the end of the post-independence wave of immigration, from 1952 to 1960, it was only 18 per thousand residents. This was less than one-tenth the size of the first wave (Table 15).

The timing of this second wave was set almost exclusively by the political conditions and considerations of the regimes ruling the countries of origin of these immigrants. Primarily they were Tunisia, Algeria, and Morocco in North Africa (1955–56) and Poland (1956–57) in Eastern Europe. The Algerian war, which by that time was peaking, created the incentive for the Jewish community to emigrate. Covert consent of the governments of Morocco and Tunisia, which were by that time independent states, made emigration organized by the Jewish Agency feasible. In Algeria, at that time still under the control of France, the operations of an Aliyah organization were of course legal. In Poland, a post-Stalinist upheaval bringing a change of the leadership of the ruling Communist party, using overtly antisemitic media propaganda, induced most of the remnants of the Jewish community to take the option the authorities opened of immigration to Israel. By the mid-1950s, after almost a decade of independence, a convincing economic performance, and a much more stable inflow of unilateral receipts from abroad, allowing a formidable current account deficit, the policy of encouraging emigration to Israel and using every political loophole abroad to facilitate it was again given top priority by the government.

The third wave of Aliyah of the early 1960s through 1965, averaging again somewhat more than 50,000 immigrants annually, was also dominated by political upheavals in North Africa, and the covert consent of the Moroccan government to the operation of a Jewish aliyah organization offering Jews facilities and expenses to move, semi-legally, to Israel. The fourth, post-Six-Day War wave of immigration, with an average inflow of 45,000 through 1974, was undoubtedly generated by the identification of Jewish communities worldwide with Israel and its victory against all odds. This burst of identification and enthusiasm included even Soviet Jewry, which for almost five decades was perceived by Zionists as a "lost tribe." With Zionism an anathema to the Communist regime, and the universal ban on foreign travel for Soviet citizens, Jewish immigration to Palestine had been virtually stopped since around 1920. Due largely to foreign pressure, the conservative Brezhnev regime allowed an exception to the universal foreign travel ban and even more so on emigration. This was made only for Jews applying to immigrate to Israel. The application procedure and the secret criteria on the basis of which applications were granted or rejected imposed considerable danger on the applicants. Yet many Jews did take the risk. This resulted in an inflow of about 30,000 immigrants annually from the Soviet Union in the early 1970s (1971–74 approximately) before the policy changed and reduced permits to a trickle.

In the post-Yom Kippur War period through the mid-1980s, the so-called "lost decade" ("lost" economically), immigration reached record lows (see below, The Evolution of the Jewish Demographic Structure). The annual average was 18,000 for the 15-year period ending in the late 1980s. The rate of inflow was only four per 1,000 residents (Table 15), which means that for that rather long period aliyah had only a minor impact, if any, on the economy. Net immigration was even lower. Emigration was quite small from the 1980s on, but it usually increased during economic slowdowns such as this.

The revival of sustained economic activity began sometime around 1987–88, in the wake of the 1985 stabilization policy (see below), but only gained real momentum from 1990 onwards, as the unexpected mass immigration following the relaxation of the Soviet Union's emigration policies after 1988 began to flow into Israel, from December of that year onward. Within its first 43 months through the mid-1993, over half a million immigrants arrived – not many fewer than the 690,000 who arrived in the first post-independence wave of mass immigration of 1948–51. Though the annual average of immigrants was lower, about 130,000 compared to 200,000 for the first wave, and considerably lower per Israeli resident, 38 compared to 180, an inflow of more than 500,000 immigrants into a country with a population of about 4.5 million, and a Jewish community of 3.7 million, did of course have a significant and immediate economic impact. In the short run it first affected, inevitably, aggregate demand. In the longer run, it made a major contribution to the national product. The very large influx of immigrants of the early 1990s was not sustained throughout the decade. From 1993 to 2000, it ranged from 60–70,000; in the ensuing period through 2005 it was about 30,000. Yet in the closing of the decade of the 20^th century and through 2005, about 1.15 million immigrants came to Israel, which by the end of 2005 had a population of about seven million, with a Jewish (and Jewish-affiliated) community of some 5.5 million.

the emigration (yeridah) effect

These immigration figures and the total immigration data of Table 15, which indicate the total number of immigrants between 1948 and 2003 was close to 3 million, are of course gross figures. Net immigration was inevitably lower; Israel, as is any country absorbing significant immigration, is subject to emigration too. Its incidence among new immigrants is, as elsewhere, higher than that among the longer-established population.

Owing to Israel's inability to agree on a legal definition of "emigrants," the statistics on emigration (in Hebrew parlance yeridah, a semiderogatory expression) are rough estimates. The best estimate of emigration in the 1990s, the era of the second mass immigration, was about seven percent of the total number of newcomers. Since the option of returning to the country of origin or moving to another destination was severely limited in the late 1940s and through the 1950s, the emigration rate during the first mass immigration was clearly lower. Between the late 1960s through the 1980s, immigration rates were much lower and options to emigrate were rapidly increasing. These rates, which of course include the emigration of older immigrants and native Israelis as well, were undoubtedly higher than the seven percent of the 1990s. This applied particularly to periods of economic slowdown, for example the second half of the 1980s. All in all the available consensus estimate of emigration from 1948 through 2003 puts it at about 450–500,000. This means that the average emigration rate was about 15 percent of the total immigration inflow (Sicron 2004).

the pattern of demographic balance

The impact of aliyah on the demographic balance, a highly sensitive issue from the very beginning of Zionism in the last quarter of the 19^th century through the early 21^st century and beyond, is indicated in the population data in Table 14. Israel's total population increased 7.7 times in the 55 years between the end of 1948 through 2003, at an average annual rate of 3.8 percent, and Jewish population grew at the same rate. The latter rate was 3.9 percent, based on the rough mid-1948 estimate of the Jewish population.

These were evidently very high population growth rates. An inevitable highly significant economic implication of these very high growth rates was scarcity of land, for the population as a whole and for the Jewish population in particular. The settlements established beyond the Green Line since 1967 do not make a meaningful difference on this account. Yet in spite of the dire predictions of British experts in the early 1930s about the depressant implication of growing land scarcity, which would erode the living standards of the Palestinian Arab population in particular, the living standards of the Arab community of Israel, about one million by 2003, had improved by an order of magnitude even though the land area at the disposal of Israeli Arabs had not grown since 1949. This holds, of course, for the Jewish population too, though Israel, with an area of only about 80 percent of Mandatory Palestine, had by 2004 a population of about 7 million, compared to one million in 1930 when these predictions were made. Indeed Arab population in Israel alone was in 2003 some 20 percent larger than the Arab population of Mandatory Palestine in 1931 (Tables 1 and 14). This of course underlines the fact that land is only one of the relevant factors of production, even in the case of the farming industry.

The demographic balance, which in the seven decades of the pre-state Zionist resettlement effort was a crucial political issue, was at the turn of the 21^st century still a highly sensitive subject. Its quantitative dimensions are displayed in Table 14, in terms of the ratio of Jews to the total of Israel's population. The figure for the end of 1948, which represents the initial universal population registration implemented on November 11 of that year (before the end of the war) indicates an 82.1 percent ratio of Jewish population to the total, which at that date was less than one million. The first mass immigration changed that ratio; it peaked at about 89 percent toward the mid-1960s, when Israel's population was 2.5 million.

However, the much lower immigration rates even during the peaks of subsequent immigration waves through 1989 did not overcome the major fertility gap between the Arab (majority Muslim) population and the Jewish population. Jewish total birth rates, which were 3.56 children in the 1950s, declined over the decades to 2.73 in 2001–05. Even the recent low rates are indeed very high compared to those elsewhere in the industrial world, even those of the 1950s, and particularly at the turn of the millennium, when in some industrialized countries birth rates had collapsed to a figure below 1.0. However, Jewish birth rates paled in comparison to the total birth rate of the Israeli Muslim Arabs which were a record even in the Arab world of the 1950s and remained so around the year 2000. (They were as high as 9.23 in the 1960s.) They then declined considerably to 4.5 in 2003. The birth rates of the small Christian Arab communities were for several decades considerably lower than those of the Jewish community.

With such comparative birth rates, the low aliyah influxes of the late 1950s through the late 1980s could not overcome the declining trend of the ratio of Jewish population to the total. By 1988, before the arrival of the next, unexpected mass immigration, the Jewish population's share of the total declined to 81.7 percent. That next mass immigration, and the reduction of the Muslim-Jewish birth rate gap from 5.84 in the 1960s to 2.05 in the 1990s and to less than 2 by 2003, halted the decline. The Jewish share of the total population hovered in the 81 percent range from 1990 to 2003.

the evolution of the jewish demographic structure

The demographic structure of the Jewish community, which in the Mandatory period was dominated by immigrants from European countries, was subject to a significant change during the nearly six decades of the state of Israel's history. This had a direct long-run bearing on the productivity and on the quality of its labor force

According to the rough classifications of immigrants by previous continent of residence, in the successive waves of immigration from 1948 through 1967, about 50 percent of the immigrants were from Asia and Africa through 1960 and close to 60 percent in the 1961–67 period (the Asia-Africa category refers effectively to immigrants from Arabic-speaking countries stretching from Yemen to Iraq and through North Africa). That pattern changed from the 1970s on, since almost all Jewish communities in those countries had by that time already left, mostly to Israel, while the Communist regimes of Eastern Europe, including the Soviet Union, liberalized emigration rules for Jews who wanted to move to Israel. The collapse of the Soviet Union in the early 1990s changed the rules of the game altogether, an opportunity seized by most members of the Jewish community, generating the 1990–2000 mass immigration that brought over a million new immigrants to Israel. Immigrants in the European-American category were accordingly about 59 percent of the 1968–89 "low immigration" period, and close to 94 percent of the immigration avalanche in the 1990s and later. The overall average of European-American immigrants from 1948 through 2003 was about 70 percent of the total, including about 7.5 percent from the Americas, North and South.

The evolution of the social and cultural mosaic of Israel's Jewish community was of course affected by the rapidly growing number of its native-born members; they were 35 percent in 1948 and about 64 percent in 2003. Second generation native Israelis were somewhat less than seven percent in 1948, and more than 30 percent by 2003. What complicates the sociological features even more, and thus the economic implications of the evolving communal structure of the Jewish population, is of course the prevailing widespread inter-marriages between members of distinct Jewish communities. This has been loosening significantly the traditional cohesion of these communities, which, separated by history and geography, have found themselves together in Israel. A process of integration into a cohesive entity was of course a high priority for Zionism – the so-called "melting pot," in Zionist parlance. That process has gained considerable momentum, as the rising rate of intermarriage indicates. It was quite high by the 1990s – about 33 percent of marriages.

The immediate implication of the changing mosaic of the intermixed Jewish communal structure had an obvious effect on its comparatively high birth rate. It indeed was lower than that of the Arab Muslim population, which still has Third World features in this sphere. Yet Jewish total birth rates in the range of 2.66–2.73, as they were in the 2000–04 period, are sky-high compared to the comparable rates characteristic of the industrialized world. They were even higher (in the 3.0–3.56 range) from the 1950s through the 1970s. These rates would have been lower if most of the Oriental Jewish community had not immigrated to Israel since 1948. The available data indicates that immigrants from Asia, and particularly from North Africa, had significantly higher birth rates than those of immigrants from Europe and native Israelis. The opposite is true of the immigrants from the Soviet Union in the 1990s; the birth rate among that group was significantly less than two.

Total birth rates were also affected by religious observance. The Orthodox and "traditional" section of the Jewish community had, and has, higher birth rates than the secular group. The behavior of the latter is more in line with that of the industrialized societies of the West. It was, however, still higher by a meaningful margin than that prevalent in the industrialized countries through 2004. The higher birth rates of Oriental Jews reflect the much higher ratio of Orthodox and traditional observant Jews in that community. Nevertheless, though still higher than that of the European-American section of the Jewish community, an interesting phenomenon over time was the pattern of their obvious and consistently declining birth rates toward the relatively stable overall norm maintained in the late 1990s and into the first decade of the new century. This is evidently another manifestation of the melting pot process which has developed within the Jewish community over almost six decades.

aliyah and human capital

Human capital, the accumulation of which is of major significance in the process of economic growth, was another subject affected by the waves of immigration. The pre-state level of that factor was quite adequate, comparable to that of the highly industrialized countries of Western and Central Europe. It was undoubtedly significantly improved by the pre-state Fifth Aliyah of 1932–39, which included a relatively high number of university personnel, medical doctors, architects, and engineers, and made a major contribution towards the emergence of the industrial society of the Jewish community of Palestine. Among other things it enabled the Jewish community to make a crucial contribution to the 1939–45 war effort.

The major mass immigration of the late 1940s and early 1950s could not improve matters on that score. Even maintenance of the previous average level was a problem in view of the composition of the newcomers. The European immigrants who came to Israel were Holocaust survivors, and most of them were young people for whom school attendance had merely been a dream for those years. The immigrants from the Arab countries, about one half of the total, came from what in those decades were Third World environments, which could hardly provide a meaningful preparation for life in an industrial society.

It was thus not an accident that the very first law adopted by the Knesset was the law mandating nine years of compulsory education from kindergarten through elementary school. This assured the continuation of the effectively universal primary education system that the Jewish community had maintained in the Mandate period. The government also immediately channeled major resources into secondary schools and higher education. By the early 1960s secondary education was already universal. The two academic institutions established in the early 1920s, the Hebrew University of Jerusalem and the Technion – Israel Institute of Technology, together had only about 1,600 students in the shortened 1948–49 academic year, which started in April 1949 after the cessation of hostilities. By 1960 the number of students totaled 10,000 at these institutions and Tel Aviv University, which had also opened by that time. The number of university students was close to 40,000 by the outbreak of the Yom Kippur War in 1973, when seven universities were operating, and 125,000 by 2003. In that year there were also some 68,000 students enrolled in first- and second-degree programs in the academic colleges.

The effort to increase training, know-how, and experience during these years was mainly domestic, financed by the public sector. It was supported by significant direct contributions from Jews in the Diaspora, who financed mainly the infrastructure of the rapidly expanding and growing number of institutions of higher education. Furthermore, the immigrants of the 1970s and 1980s were better educated and had mostly come from modern industrial societies. But with aliyah low for about 15 years after the Yom Kippur War – the number of immigrants per resident was down to around four per resident (Table 15) – the impact of the better-educated new arrivals could not make a major difference on the stock of human capital. It improved with the rapidly increasing flow of graduates from universities and other institutions of higher education.

This changed as the mass immigration of the 1990s began arriving in Israel. The relatively high number of scientists and experienced engineers, and the impressive array of teachers, nurses, and other trained professionals arriving in that decade (mostly from the former Soviet Union), were reminiscent of the composition of the Fifth Aliyah. Furthermore, elementary and high school-age immigrants arriving with their parents also had a strong educational background.

Most significant was the very size of that immigration, which added more than 20 percent to the size of the population within somewhat more than a decade. Thus, on top of its contributions to the highly sensitive demographic balance of the state at the turn of the century, it undoubtedly increased significantly the stock of human capital – one of the array of factors of production, and a vital component of the labor force. The expected long-run benefit of this feature could not be fully expressed within the short period of just over a decade. Its expected impact in the longer run is obvious.

The Resettlement Saga of the State Years, 1948–2005

The dominating challenges for the leadership of the nascent state in its first decade were its control of population entry into Israel, which involved highly significant though not absolute control of the aliyah flows surveyed above, and its control of the land. Most of this latter was uncultivated state land, but it included a significant area hitherto cultivated by the rural Arab population of about 350–380,000, who left their homes during the 14 months of active hostilities between November 1947 and January 1949, and sought refuge in the Jordanian-held sector of Palestine, in Lebanon and Syria, and in the Gaza Strip, occupied by Egypt. These refugees also left housing, most of which was of very poor standards compared to that prevalent in industrialized countries. The 150–200,000 refugees from urban areas – Jaffa, Haifa's Arab neighborhoods, the mainly Arab southwestern sections of Jerusalem, and several much smaller urbanized centers, also left empty housing. A highly significant portion of this housing was used for new Jewish immigrants.

aliyah and makeshift housing

Of the roughly 200,000 immigrants who arrived within the first year of independence, and the approximately 700,000 in the ensuing 43 months through 1951, only a small number had relatives or others who could help them find housing and offer them support as they began their absorption into Israeli society. Groups organized by the kibbutz movement or the Youth Aliyah Organization would direct some to specific kibbutzim prepared to take them in, but most had no alternative but to rely on makeshift arrangements made by the official absorption organization run by the Jewish Agency. During the first 43 months of the mass immigration phase this organization directed new arrivals to the recently emptied housing in Arab towns and Arab neighborhoods of mixed towns (Jerusalem, Haifa, Safed, and Tiberias). These urban locations offered some basic infrastructure in addition to housing. Other newcomers were sent to Jewish urban centers, which could offer infrastructure, but initially only very limited housing. This process required the virtually overnight erection of campuses of temporary housing – tents and corrugated sheet metal huts for thousands. Former British army camps located in or near these towns, Haifa and Jerusalem in particular, were also used for this purpose. These were the so-called ma'abarot, a new Hebrew term invented to specify the transitional nature of these arrangements: temporary neighborhoods for new immigrants.

the expansion of jewish presence: settlements, numbers, location, and structure

The figures shown in Table 16 indicate that by 1952, four years after independence, population in Jewish rural settlements was already about 250,000 – almost 100,000 more than in 1947. Allowing for natural growth, rural settlements therefore had absorbed 70–75,000 of the new immigrants – about ten percent of immigrants who had arrived during the period of what could be described as the genesis of the Jewish state. This process involved the creation of 277 new settlements during the four years after May 1948.

In terms of the number of settlements established, the period from May 1948 through the end of 1952 compares to the 70 years of Zionist resettlement starting with the foundation of Petaḥ Tikvah in 1878, a period within which 308 rural settlements were created. During the war, Arabs destroyed nine in locations outside the Green Line.

Though effectively part of the process of providing housing to new immigrants, this all-out effort was focused on the traditional Zionist objective – extending the Jewish presence everywhere in Ereẓ Israel. This was inhibited by British policy, which over the three decades of the Mandate first slowed the resettlement effort and after the 1939 White Paper attempted to stop it altogether.

The Armistice agreements signed between February and July 1949 meant not only the end of the Mandatory legal restriction on the acquisition of land by Jews, but also led to the transfer of Crown land, which effectively included the entire area of the Negev – about half the area of the state – to the ownership of the state of Israel. On top of that, the state took effective possession of land owned and cultivated by the Arab refugees from the rural areas, including a substantial portion of the Arab citrus groves in the coastal plain, all of which, except for the Gaza Strip, was inside the Green Line. These areas, most of which were used for dry farming of field crops, including other fruit groves, were taken under the management of the so-called Custodian of Absentee Property, serving ostensibly as the legal representative of the original property owners. These areas, too, were immediately available for cultivation at no immediate cost to the resettlement authorities, comparable to Crown land. The state of Israel thus acknowledged implicitly the titles of the original Arab owners of this land, as well as of the urban real estate which was similarly placed under the management of the Custodian of Absentee Property. Conceivably the value of these properties would eventually be negotiated at a future peace conference.

This implicit capital commitment to the absentee owners involved of course no immediate payment for the use of these properties. Nor was any cost involved for the use of cultivable state (formerly Crown) land not previously used for farming. Thus in contrast to the pre-state situation in which a major portion of Jewish capital imports had to be allocated for the purchase of land, this cost item was wiped out (although there was an ostensible conceptual commitment to payment in the future). This meant that whatever resources were immediately available for the resettlement effort could be devoted to capital investment, which among other things involved land improvement and the extension of irrigation – major inputs in agricultural production.

The high priority given to the major resettlement effort that was launched in 1948, while the war was still going on, was underlined by the establishment of 37 settlements between May 15 and the end of that year. These were more than ten percent of the number of settlements established during the previous 70 years. The urgency of this move derived from the belief that the borders of the state could be assured only by the Jewish spade.

Though reflecting the traditional priority given by the Zionist movement to agriculture, economic considerations at the time supported such a policy, not only in Israel, but everywhere. The post-World War ii environment, which still involved at that time rationing and price controls (over consumer goods and food in particular), in all western European countries, led to the universal rise of state agricultural policy across Europe (still in force six decades later in the European Union). In Israel, with mass immigration the dominant feature in the 1945–51 period, and the young state's foreign currency reserves at low levels, universal rationing and price controls were also the rule. Promotion of farm production was in these circumstances evidently of the highest economic priority, and fully in line with developments elsewhere.

Finally, the direction of a substantial group of the new immigrants to rural resettlement allowed controlled provision to them not only of housing in the new settlements, but also of an allocation of capital investment in the form of land,

farm equipment, and circulating capital, and an immediate opening to productive employment. The integration of all these elements into effective new production units providing adequate real income of course required guidance – on-the-spot instruction for the newcomers, who were not only new immigrants, but also new to agriculture. This service was provided to settlements of new immigrants by a small group of veteran farmers operating as coaches, who volunteered to stay temporarily in the new settlements.

This stage of the resettlement saga, which nearly doubled the number of rural settlements within four years, began only late in 1949. But by the end of 1948 there were the 37 new settlements – 27 kibbutzim and ten moshavim. these had been founded by groups of veterans – graduates of the local youth movements, second-generation members of the settlement movement – who had been serving in the army and had been released from active service during the period within which the last three major campaigns of the war were still being fought, suggesting the sense of urgency with which the state viewed the establishment of these settlements. The supply of this kind of settler, however – young, Mandatory Palestine-educated, graduates of the Jewish school system and youth movements – was limited. Thus, of the roughly 80 kibbutzim added to the 138 already existing in 1947, 67 were already operating by the end of 1949, and only 16 new ones were added in the succeeding three years.

This situation prevailed among the moshavim also. Only a handful of the 67 cooperative settlements established in 1949 were manned by veteran youth; the others were populated by new immigrants, most of whom were not ready to attempt a collective form of life (nor had they an inkling of how to do so). This applies even more to the approximately 70 moshavim established in 1950. Thus, of the over 150 newly established cooperative settlements dotting the map of Israel by the end of 1952, most were comprised of new, post-War of Independence immigrants (Table 16). The new immigrants' share of the total number of Jewish settlements was significantly lower, perhaps 140 of the approximately 540 (excluding the institutional and communal localities) on the ground by the end of 1952. They already made up more than 25 percent of the Jewish rural population, however, which within these four stormy years grew by almost 100,000 to 250,000.

This was not the end of the resettlement saga, which established new settlements all over, with a focus on border areas. It involved the opening of a major new development in the arid, and effectively empty, half of the state – the northern part of the Negev near Beersheba, which was intended to become a major urban center. Another focus of resettlement activity was the Jerusalem corridor, where less than a handful of Jewish settlements existed during the Mandate. The attempted Arab siege of Jerusalem through July 1948, facilitated by the absence of Jewish settlements along the road to the city, was the backdrop of the decision to grant priority to the establishment of settlements in this area at the very beginning of the resettlement campaign through 1952.

The resettlement process, which also involved the establishment of several towns, continued through the coming decades as well. Yet the figures on rural settlements from 1952 on indicate a highly significant reduction in the rate of creation of new rural settlements from 1953 to 1961; their number increased 13 percent to 708 (Table 16), but this has to be compared to the 100 percent increase in the number of settlements within the first four years of the new state. The curve in the trend declined significantly after 1960 and effectively flattened from the late 1980s onward.

Between the census years 1961 and 1971 Jewish rural populations even declined. This development, however, was not due to net migration from the settlements; it reflected rather the growth of the older and larger settlements, which in terms of population and economic activity had been transformed into urban localities and acquired the legal status of towns. Hence the reduction in the number of moshavot (the "individual enterprise" settlements) to only 44 by 1972 (Table 16). From then on, through the following three decades the curve of rural settlements turned upward again, as did rural population, which kept growing at an average annual rate of two percent.

The 1970s signified a major turning point in the resettlement strategy. The target, increasing the number of Jewish settlements, did not change at all. In the almost four decades between the Six-Day War and 2004, the traditional establishment of settlements in the Negev and Galilee, the Golan Heights (captured in 1967 and annexed to Israel), the lower Jordan Valley and Judea and Samaria (the West Bank) was still going on. In many of these new establishments production activity would focus on agriculture. This shows in the growth of the number of kibbutzim, moshavim, and moshavot (Table 16) through 1995, which did stop in the following decade. Yet total rural population still kept growing significantly in the following eight years at an average annual rate of 1.6 percent, due to the emergence of a new type of rural settlement, the "communal settlement." This type of settlement, which emerged in the 1970s both within the Green Line and in the West Bank, was not conceived as an agricultural production entity. Placed within at most an hour's driving distance from a major urban center, this type of settlement was designed as a bedroom community, whose residents would work in the nearby urban center. Some business ventures – high-tech or semi-high-tech industrial activities predominating – were established in some of these communities. And of course the option of working from home, at least part-time, was in the age of the personal computer undoubtedly quite prevalent. The social and economic character of these communal settlements were governed by the rules of their legal form of organization as a nonprofit association. This feature allowed the community to exercise control over the choice of candidates for membership. The location and small size of the communities, with hundreds of units at most, sustained their rural features.

The emergence of this novel type of community in the second half of the 1970s gathered momentum in the coming decades; 103 out of a net addition of 224 rural settlements through 2003, almost one half, were communities of this type. These also accounted for the surge in the rural population from its low point in early 1972. A parallel feature of these developments was the effect of emigration from the existing cooperative settlements, reflecting among other things the increase in mechanization and labor-saving technology. Veteran settlers had been selling their patrimonies to newcomers of the communal village type, and the second generation of settlers, who had had the benefit of Israel's higher education system, joined in and though staying in the villages went into high-tech or other business ventures unrelated to farming.

The emerging pattern of rural settlement in the closing decades of the 20^th century and in the first decade of the 21^st has thus severed the more than 100-year (since 1869) association of the Zionist movement with agricultural ventures. This was indicated in the farm employment figures: in 2003–04, it was about 30 percent lower than its all-time high in 1960, and 15 percent lower than in 1970. Agricultural product, though, was higher by more than five and three times respectively (Table 17).

the performance of agriculture

The identification of resettlement and agriculture, the policy pursued during the first decade of independence, had been closely linked in Zionist ideology and in practice. In that first decade in particular, this link was also fully consistent with the needs of the markets: the domestic market for fresh food and the foreign market for Israel's major export item in those days, citrus fruits. Universal rationing and price controls on food meant that from the very first day of independence, the domestic markets for food, fueled by the immense requirements of arriving immigrants in the first wave of mass immigration, were sellers' markets, with supply lagging behind increasing demand. This applied to British and continental markets for Israeli citrus in that decade too.

The expansion of farm output required, of course, corresponding growth in inputs – cultivable land, irrigation, capital stock, labor, and know-how. Cultivable land was not a constraining element in the first decade, and particularly in the first years after independence. This was can be seen in the expansion of the cultivated area of Jewish settlements by more than two times between 1948 and 1952 (Table 16). The 1952 figure includes 300,000 dunams in the Negev, about ten percent of the cultivated area, used for farming. Irrigated areas expanded by approximately the same ratio.

Farm output depended on the contribution of the Arab sector, thus on the amount of land at its disposal, but not exclusively. By 1948–49 and in the 1950s, when the Arab population lived predominantly in rural villages, cultivated land at its disposal was 21 percent of the total. By 1952, due to an agreed border adjustment implemented late in 1949 that added to Israel a group of villages in the fertile eastern section of the Sharon plain, that area grew substantially by about 74 percent. Its relative share in the total declined somewhat later, yet it was still 14 percent of the total area cultivated by Jewish farmers in 2003. The irrigated area at the disposal of Arab farmers, though, was initially minuscule – only about two percent of that at the disposal of Jewish farmers. By 2003 it was only five percent of that total. The Arab land input was accordingly most meaningful in production by dry farming techniques.

The major increase of output and product required a corresponding increase in the water supply to agriculture, which was implemented in that period. Water usage in farming approximately doubled during the short period between 1949 and 1952. A rough estimate for farm employment suggests that it increased by more than land and water usage. In any case the more reliable estimate for expansion of employment in farming for the 1950–52 period is quite consistent with the former figure. Though no estimate for the capital stock in agriculture in the period of the Mandate is available, the 32 percent increase in gross stock within two years (Table 17) speaks for itself. A proxy for that highly significant factor of production in Jewish sector farming – the number of tractors used, which grew almost fourfold between 1948 and 1950 – underlines the massive increase of capital stock which occurred in that brief period. Correspondingly, the capital-labor ratio in Jewish farming rose considerably.

The rapid expansion of these inputs focused initially on mixed farming and thus soon relieved the shortages on the domestic fresh food market. The rapid growth of production shown in the output and net product figures for 1950–52 (Table 17) relieved the shortages in the domestic markets by 1954–55. Even though Israel was again involved in a war, the 1956 Suez-Sinai campaign, rationing disappeared altogether from the system by the second half of the 1950s. Indeed, toward 1960, surpluses appeared in some farm products. the massive increase in farm output at an average annual rate of 13 percent for the decade of the 1960s was also due to the renewed focus on the foreign market for citrus, which shows by the more than twofold increase in the planted area of citrus compared to 1952. This reflected the very high priority given to exports, and to the state of the European markets, which in the 1950s offered generous, and for most of the 1960s adequate, rates of return on capital invested in what had been since the Mandatory period the traditional export of Palestine.

By the 1970s, however, Israel's domestic food market, like the European markets, was subject to pressure from Third World agricultural exports. Its expansion rate in that decade declined to only about five percent. From the 1980s onwards the expansion of demand declined further to two to three percent, similar to the growth rate of the population. This development squeezed rewards in agriculture to labor and capital, as is suggested by, among other things, the lower rate of growth of net product than of output.

irrigation and its natural constraint

Farming industry patterns of return were also affected by costs. This is highlighted by the peak in water usage in farming in the 1970s, and the corresponding peak in irrigated and total cultivated land a decade later. All this after a massive increase of both cultivated and irrigated land by almost threefold and sevenfold respectively during the four decades through the mid-1980s. Water usage in farming grew almost fivefold between 1949 and the mid-1970s after almost three decades of rapid expansion.

Water usage was of course limited effectively by natural constraint; Israel's water extraction from the flow of renewable fresh water sources peaked in the late 1970s. Thus, the growth of population and of water use by manufacturing forced the national water system to impose a reduction of the fresh water quota for agriculture. Seawater desalination was an option by that time, but at a very high cost that precluded its use for farm production (see below).

The great expansion of water usage and of irrigated areas in the Jewish farm sector, and also in the Arab sector – total usage went up fivefold between 1949 and 1973 – was supported by highly subsidized water prices. The growing shortage of water led among other things to the creation of sewage water treatment projects. Ultimately, however, despite the subsidies and the political clout of the Jewish farming community the price of water for farming was raised over time; since the 1970s, by about two and a half times, which in turn has affected farming costs and particularly the costs of water-intensive products – with citrus groves a striking example.

Another feature which in the longer run has affected farming costs was the rapidly rising cost of labor, reflecting the rising pattern of real wages, in the wake of rising labor productivity in competing branches; farming could not lag far behind. Wages increased by 44 percent in the 1950s, and by 1970 were twice as high as they had been in 1950 (Table 19). The citrus industry, for instance, which is both labor- and water-intensive, was therefore subjected to a significant squeeze on profitability from 1972 onward.

One way to reduce the impact of rising costs was to change the composition of the branch mix in farming. Thus in the early 1960s kibbutzim phased out vegetable growing due to its high labor intensity. Another device, which the collective

settlement movement attempted to avoid, was to employ "available cheap labor." This option came about after the 1967 Six-Day War in particular, which opened the Israeli unskilled labor market to Palestinian workers from the Gaza Strip and the West Bank. In the wake of the political developments of the late 1980s, security considerations reduced the employment of these workers – the farming and building industries were allowed to hire foreign contract labor from Southeast Asia, China, and Eastern Europe as substitutes.

The drastic reduction of the size of the citrus industry – the area under citrus cultivation was cut by 50 percent during the closing quarter of the 20^th century (Table 16) – is a clear expression of the process of branch mix restructuring in Israeli agriculture at the aggregate plane. It was clearly propelled by the rising costs of labor and water, and accelerated by the rapid urbanization of the coastal plain, the historical location of citrus plantations since early in the century. Yet the comparison of the rate of decline of land under citrus, and the output of that branch (Tables 16 and 17) between 1970 and 2000, shows that output declined much less than area. This indicates, of course, substantial rising productivity.

This was indeed typical of agriculture as a whole, which also adopted the strategies of employment of cheap foreign labor and elimination of labor- and water-intensive crops. Mechanization of all stages of production from field and orchard through packing and transportation to markets was also adopted by all branches of agriculture. These strategies were supported by close linkage to the extensive agricultural counseling service run by the Ministry of Agriculture, which spread knowledge about new plant varieties and cultivation techniques developed by its agricultural experimentation stations.

An outstanding example is the major increase in the efficiency of water use, initiated in the late 1960s and spread rapidly in the following decades. This involved the transformation of irrigation technique from sprinkler technology, which first appeared in the 1930s, to drip technology based on plastic pipes below the surface of the soil, which more recently is computer-rather than human-controlled. The latter development allows timing the irrigation for nighttime, which reduces evaporation, thus saving water per unit of output. The water-saving features of the Israeli farming industry show already in the first stage of development of Israeli farming in the quarter-century between 1948 and 1973, when farm product increased almost tenfold while water usage increased only fivefold. This was the era of sprinkler irrigation technology which, in the citrus industry in particular, replaced the previous primitive flooding technique.

Yet the major accomplishment in that area occurred in the following three decades through 2003, when farm output and net product kept growing, though at a much lower rate than previously, while water usage declined. Output and net product increased by 2.4 and 2.3 times respectively between 1973 and 2003 while water usage was over 20 percent lower. This reflected the fact that 60 percent of the irrigated area had installed computerized water-saving drip technology over that period. The natural supply constraint (see above) reflected in declining water quotas (vigorously criticized by farmers) and a 150 percent increase in the (still subsidized) price of water for farming pushed the farming community to move in that direction. The same was true of the rise of the cost of labor, since the new irrigation technology also allows for significant labor savings.

the changing status of agriculture

The pattern of rising farm output and net product suggests an outstanding performance; in the somewhat more than five decades through 2004, net product grew at an average annual rate of 6.9 percent. This average obscures the significant changes which had transformed the farming industry, nor does it reveal the major change it had undergone over time in its status in terms of economic aggregates: its comparative demands upon the available economic resources and its contribution to national product and exports.

The changes in the pattern of farm output and net product over time, however, suggest insights about some of these features. The leap suggested by the product figures of 1950 compared to those of 1949 reflect the return to normal economic activity – the end of hostilities and the major release of manpower from the army after the signing of the armistice agreements in 1949. Yet the output figures for 1955, which indicate that total farm production had approximately doubled, and even more the data for 1960, showing that agricultural output was close to four times greater than it had been a decade before, means that by then Israel's farm industry had overcome the extreme scarcity of fresh food of the first years of independence. Driven by the still reasonably good European export markets for citrus, the expansion of the major export industry of the Mandate era was given high priority. Its reconstruction proceeded at a rapid pace; the area of citrus orchards peaked by the early 1970s at a level 3.5 times higher than in 1947. Correspondingly, citrus output was more than six times higher in 1973 and exports about five times higher than in 1950.

Yet though farm output and net product grew rapidly, they did not maintain the outstandingly high growth rate of the economy as a whole during the 1950s. From then through the first years of the 21^st century growth rates of farm output and product declined to two to three percent annually, much lower than national product growth rates. This is a clear indicator of a structural change, underlining the transformation of farm production to meet the requirements of the domestic market. Moreover, the demand of foreign markets for citrus exports, which remained stable approximately through the 1970s, declined from the 1980s; by 1990 they were only about 50 percent of what they had been in 1980, and following the downward pressure of prices, exports, and thus total output, collapsed from 1990 on (Table 17).

Overall agricultural exports did not, however, decline along with those of citrus. These were still somewhat higher in absolute value terms in 2003 than in 1980 and previous decades. This was due to a change in the composition of farm exports. New products, flowers in particular, whose export to Europe was made feasible by air transportation from the early 1970s on, made the difference. These grew fortyfold through 2003. Though still growing in absolute terms, farm export growth lagged substantially in comparison to manufacturing exports, which grew tenfold from the early 1970s. This just underlines the growing domestic orientation of the farm industry in the closing decades of the 20^th century.

The rapid erosion of the status of agriculture is demonstrated in terms of its relative contribution to employment and domestic product, shown in Table 27. In the 1950s and early 1960s agriculture offered employment to about 17 percent of the total work force. That figure was down to under nine percent by the 1970s, followed by a rapidly declining trend in the following decades to just two percent or so at the turn of the century. The trend was even stronger and more rapid in the Jewish sector labor force. The Jewish farm industry employed an ever-growing number of Palestinian workers after 1967; after the outbreak of the Palestinian Intifada (uprising, literally "shaking off") in 1987, their number declined, but they were replaced by a substantial influx of workers recruited from Southeast Asia.

The domestic product figures follow a similar trend. Farm output and domestic product grew throughout the 50-year period. Product was eight times greater after about 25 years in 1973, and 18 times greater in 2003. Yet the economy as a whole expanded at a more rapid pace. Agriculture held the line in the 1950s – its net product in 1960 was still close to 13 percent of the total, as it was in 1950; yet it declined to seven percent of the aggregate net product by 1970, followed by a rapid decline to about 1.5–2 percent 30 years later, in the first decade of the 21^st century.

These data offer the best insight on the background of the change in strategy of the resettlement effort begun in the 1970s and accelerated in the 1980s. While still adhering to the resettlement goal of setting up rural Jewish settlements all over, the strategy employed to achieve this objective was changed. Resettlement, which for about a hundred years was closely linked with its historical twin, agricultural production, was diverted elsewhere. New rural settlements were designed exclusively around alternative production branches; manufacturing and later high-tech service centers served as their production infrastructure. The emergence of the automobile as a cheap, universal method of transportation made this change feasible. in response to demand, making use of their varied geographical locations, more and more older settlements also followed this pattern, in order to offer alternative employment for the younger generation.

the arab rural economy

The product and net output figures of Table 17, and thus the industrial breakdown of employment and national product, refer to the Israeli economy as a whole, the Arab sector's contribution included. This applies also to the variable inputs of Table 17, gross capital stock, tractors, and water usage. Only specific data for inputs – cultivated and irrigated land – and implied figures for employment over time suggested by the rural population data are available. The absolute level of the output and product figures described above represent accordingly the contribution of the Arab sector inputs to farm product. Yet relationships between input and output studied with reference to the Jewish sector refer to the linkage between changes in inputs over time and the corresponding changes in outputs for this sector too. And the changes were quite similar in the two sectors. Both were subjected to a process of urbanization and correspondingly to a reallocation of labor from farm employment to other branches, and both increased substantially the area under irrigation. The latter expanded indeed by a much higher factor than the irrigated area of Jewish agriculture; the rates of expansion were about twelvefold and sixfold for the Arab and Jewish sectors respectively between 1948–49 and 2003 (Table 16). The area under irrigation in the Arab sector was, indeed, initially negligible. This indicates that the Arab rural sector, which emerged after the armistice agreement with Jordan of March 1949, had effectively no citrus plantations from the time of independence.

The dramatic increase in land cultivated by Arab farmers in Israel, by more than 70 percent as suggested by the difference between the figures of 1952 and 1948–49, occurred in the 1949–50 season. It reflected the agreement in the armistice on the Green Line, which transferred the so-called "little triangle" in the eastern coastal plain to Israeli territory. Otherwise, the pattern of the increase over time in the cultivated area is similar to the pattern followed by the Jewish sector, and it also began to decline in the late 1970s, a process that accelerated in the 1980s.

This is demonstrated by the abrupt decline of the number of rural localities and of the rural population due to the rapid growth that transformed rural localities – initially de facto, later de jure – into urban localities. It also involved a transition of a major share of the Arab labor force into non-farm activities: the building industry, manufacturing, and services, involving the erosion and finally the elimination of almost the last vestiges of rural self-sufficiency and the transition to farm production for the market. The rapid rise of irrigated areas, from a negligible two percent of the total area cultivated by Arabs in the early 1950s, to about 17 percent (Table 16) is an obvious example of this transition. The structural change the Arab farm sector had undergone was highlighted by the specialization of the Arab sector in the cultivation of several crops, strawberries and vegetables, which are cash crops par excellence. This process, which involved integration into the market system of an industrializing society, and a major improvement in educational standards involving universal compulsory elementary school education, and from the 1970s also secondary education, inevitably had far-reaching implications; it was expressed by a major rise in Arab rural living standards.

A Generation of Rapid Growth, 1948–1973

Though punctuated by two wars and periods of economic strain, the first 25 years of Israeli independence were the heyday of economic growth. Rapid growth was indeed produced by all industrial economies in those decades. The Western European economic system in particular, emerging from the catastrophe of World War ii, grew at very high rates in the first two decades following the war. Yet the nine percent growth rate of gdp for the close to two decades ending at the outbreak of the Yom Kippur War in October 1973, for which the data on economic aggregates is more reliable, puts Israel at the top of the world's growth league in this era (its performance was even better for the period 1950–73); effectively, for the whole of the 25-year period from the May 1948 Declaration of Independence through the Yom Kippur surprise. The figures for the longer period, in which growth rates were even higher, imply an annual average growth rate of ten percent, made feasible by a more than sixfold expansion of investment (Table 18). The per capita figures for gdp, affected by the very rapid growth of population, indicate much lower expansion factors. gdp per capita grew about 3.5 times compared to that of 1950. This allowed an increase of living standards, in terms of per capita private consumption expenditure, by approximately three times between 1950 and 1973 (Table 18), an average annual increase of over six percent.

Yet that growth was not a smooth process. The tremendous strains imposed on the economy at the very early stages of independence are underlined by the ratio of resources available for domestic use to gnp in 1950; resources allocated to private consumption expenditures, public sector consumption, and gross investment for the economy at large were 31 percent higher than national product. The difference between these two figures was provided by the import surplus, representing the major deficit on the current account of balance of payments. This enormous deficit had to be financed somehow. From 1949 through 1951, this meant the complete running down of Israel's meager international reserves; the country was scraping the bottom of the barrel by the end of 1951.

The major improvement here, showing in the much lower ratio of resources to gnp in 1954 (1.11), was implemented by a major change in economic policy, labeled the New Economic Policy of 1952 (see below, The New Economic Policy (nep), 1952–1954). The persistent reduction of Israel's dependence on a net inflow of real resources to sustain the level of welfare of the Israeli polity is visible through the 1967 Six-Day War and its immediate aftermath. From that point on the tide turned, and by 1973, in the wake of the Yom Kippur War, the dependence of the economy on foreign resources to maintain its level of welfare in terms of consumption and investment expenditure increased again: it leapt to 19 percent of gnp from significantly below ten percent, where it had been hovering since 1955 (Table 18).

In the early 1970s Israel's economy was generating a national product seven to eight times higher than in the early 1950s, maintained by a population of more than three million compared to the 1.4 million of the early 1950s. This turnabout had a major impact on the economy and on society in the following decade through 1985, known later as the so-called "lost decade."

struggle in the first stage, 1948–1954

The major strain imposed on the economy by the first stage of the struggle to absorb the postwar mass immigration shows in terms of the aggregates: consumption expenditures, private and public, grew approximately at the same rate of growth as national product between 1950 and 1954. The rate of expansion of resources at the disposal of the economy – the growth of which was significantly lower than the growth of national product, depending as it did on the size of the import surplus that could be financed – imposed accordingly a constraint on the level of investment. Since mass immigration was still at its height in 1951 consumption expenditure, both private and public, kept growing through 1954, though at a reduced rate. Investment thus had to decline; it was lower by 15 percent in 1953 and by five percent in 1954 than in 1950 (Table 18).

But investment was the crucial ingredient that not only provided the resources to increase rapidly the stock of housing, a vital necessity when the Jewish population more than doubled between May 1948 and the end of 1951, and kept growing at a slower rate through 1954. More than half the new immigrants were at that time still living in abandoned British army camps and corrugated iron sheds put up at the outskirts of urban areas. Investment in the capital stock of production branches to achieve rapid increases in employment and housing was a high-priority requisite for the absorption process. The 11 percent unemployment rate of 1950 and the 9.2 percent rate of 1954 are a capsule expression of the two main issues of that time, housing and employment (Table 19).

The consumption expenditures for 1954, which show that average per capita private consumption was 26 percent higher than at the peak immigration year of 1950, indicates a significant improvement on this score. This shows similarly in terms of housing stock, which increased by two times within these four years, and in terms of the unemployment rate, still towering at 9.2 percent, but already two percentage points lower than in 1950, even though the labor force had increased by 35 percent in that short period.

toward the full employment threshold and beyond

It took more than a decade, through the four peaceful post-Suez (1956) years to 1960 before the expansion of employment caught up with population growth. An unemployment rate of 4.6 percent for 1960 put the economy on the threshold of full employment, the dominating economic feature of all the industrialized economies of these decades. This was achieved even though the labor force of 1960 was 20 percent greater than that of 1954, in the wake of a significant increase of aliyah from 1955 onward. The rapid expansion of the labor force and employment was still at a significantly lower rate than the accumulation of capital stock. Capital stock – the stock of the production branches plus infrastructure (roads, electricity, etc.) – which had expanded by almost four times between 1950 and 1954, had accumulated at a very rapid pace of about 12 percent annually between 1954 and 1960. The capital-labor ratio, which grew by 42 percent between 1950 and 1954, expanded accordingly by another 60 percent in the ensuing six years through 1960 (Table 19). The rapidly rising total factor productivity (tfp), which was more than 50 percent higher in 1960 than a decade before, led to a somewhat lower yet still highly significant increase of real wages and contributed to the expansion of national product over and above the rates of growth of capital and labor.

The growth of national product by close to three times in the 1950–60 decade, and by 73 percent in the six years from 1954 to 1960, and a corresponding though slower growth of per capita gdp, allowed a significant improvement in living standards. Per capita household consumption expenditures in 1960 averaged more than 60 percent higher than in 1950, and were about 30 percent higher than in 1954. Housing standards, too, were in much better shape. With a housing supply greater by 3.7 times in 1960 than in 1950, and by 80 percent than in 1954, dwelling space per capita did not only increase at a higher rate than total population, it outpaced the growth of the Jewish population, which grew by 59 percent in that period.

These two indicators, the highly significant improvement of housing standards and the increase in per capita consumption expenditures dominated by nonhousing components, are a clear expression of a promising performance. An obvious indicator of what had been going on in the field of housing was the almost complete elimination of the ma'barot, the immigrant housing camps that had sprouted all over during the 1950s. This followed the provision of housing – austere, but permanent, newly built or renovated – for all newcomers.

growth and growth pains: wadi salib

These figures are averages, however, and do not indicate the rising inequality in Jewish society, with a dividing line running effectively between "oldtime" settlers, specifically 1948 settlers, and new immigrants. This rift came into the open in the July 1959 riots in Wadi Salib, a dilapidated downtown Haifa neighborhood with rundown housing that had been a poor Arab neighborhood, a slum, in Mandatory times. The residents were immigrants from the Maghreb, the Arab countries of North Africa. The outburst had, therefore, an ethnic component reflecting the immigrants' sense of being discriminated against by the European Zionist establishment. Yet it had undoubtedly a solid economic cause: these people faced poor employment and economic opportunities, while the new immigrants from European countries were already being absorbed quickly into society. The outbreak of these riots was a complete surprise to the community at large and to the political establishment in particular. In their wake the Israeli political agenda was reset, with priority given to economic development and especially more even income distribution, with a focus on the large Jewish immigrant community from Arab North Africa.

Yet, in spite of this worrisome incident at the turn of the 1950s, the 1960s, effectively through the Yom Kippur surprise of October 1973, were a period of robust economic growth and rapidly rising living standards. The decade was punctuated by the policy-designed slowdown of 1966–67 (see below, The Mid-1965-to-Mid-1967 Slowdown), clearly displayed in the 10.4 percent unemployment rate of 1967 (Table 19) and rapidly fading away in the aftermath of the June 1967 war. The growth process in that decade-plus period had finally transformed the branch structure of the economy (Table 27) and generated economic benefits all over. Private consumption expenditures per capita were more than 30 percent higher in 1965 than in 1960; by 1973 they were 71 percent higher, having grown at an annual average of more than five percent during what had been labeled the "seven good years" between the Six-Day War and the outbreak of the Yom Kippur War. Though evidently not evenly distributed among the various population strata, an expansion rate of private per capita consumption expenditures at these huge annual rates could not but filter down to the lowest income groups. Public consumption expenditures for welfare state benefits – education, health, social security – had a similar effect.

The increase of living standards over time was evidently constrained by the corresponding trends of national product and the import surplus, the sum of which had been determining the level of resources available for spending on investment. One of the most important developments from the mid-1950s through most of the 1960s was the meaningful reduction of the contribution of import surplus. This meant a reduction of dependence on foreign real resources to sustain the level of spending on consumption and investment in the domestic economy, and thus sustain welfare levels. By 1960 the ratio of resources to domestic product, which was as high as 1.31 in 1950, was down to 1.06 in 1960, and effectively stayed at that level through 1967. This suggests that the allocation of resources for consumption and investment in the Israeli economy of the 1960s required a real boost from abroad of only six percent, compared to the 31 percent required for that purpose in 1950, over and above the resources generated by domestic production. And this six percent excess over gdp of real resources had a reliable foreign financial backing through this period from the contribution of Jewish communities abroad, U.S. foreign aid, and German reparations (which ended in 1966), as well as Germany's personal restitution payments to individual Israeli residents, the flow of which even increased later on.

the "seven good years" and the mortgage on the future

The impact of growth on rising welfare shows in a rapid rise of per capita private consumption expenditure in the 1960s, particularly during the "seven good years" between the Six-Day War and the Yom Kippur surprise attack against Israel. This was a period of full employment, and from 1970 on, overemployment – in more than one sense, years of exploding prosperity. The 11 years of relative peace along the borders between 1956 and 1967, allowing rather stable defense expenditures in terms of a rapidly rising gnp (Table 20), led to a significant improvement in public sector finances; this was expressed in the closing years of the 1950s by a major reduction in government deficit. Current expenditure on income account flows (excluding capital account operations) even had a slight surplus. Between 1960 and 1965, there was even into substantial surplus (Table 23).

This feature is underlined by the gross savings ratios of the economy at large presented in Table 20. These represent an estimate of the total of private sector and government savings. Thus from 1960 through 1965 domestic savings provided three-quarters of the resources required for investment, compared to one-quarter in the early 1950s, and somewhat more than half in the second half of the 1950s. The balance of the resources required for the major increase of investment during this period was provided by the import surplus, the ratio of which to gnp was comparatively low. Furthermore, this vital component of the total resources at the disposal of the economy had by that time sound backing, even though by the mid-1960s U.S. economic aid was terminated after Israel

was officially classified as a "highly successful graduate" of its aid program; German reparations too, which flowed into the coffers of the government, came to their planned end. Slowly rising levels of United Jewish Appeal funds, and personal restitution payments to Israeli residents, which grew for several decades, provided most of the funds required to pay for the import surplus of those years.

Though robust growth and rapidly rising living standards made feasible by an avalanche of investment starting from a cyclical trough in 1967 were maintained through the "seven good years" between the two wars, the financial infrastructure of investment was subjected to a severe shock in the wake of the Six-Day War and succeeding war of Attrition (1968–70). It was rocketing defense expenditures that made the difference:

they leapt from 8.5 percent of gnp in 1965 to 17 percent in 1967 (and from eight to 16 percent in terms of resources; see Tables 18 and 20), and much more in absolute terms. By 1970 these were about 24 percent of gdp. Through boosting aggregate demand and growth this imposed a major burden on the budget, and on the balance of payments, which was subjected to an avalanche of defense imports. The balanced government budget between 1957 and 1966 was by 1967, and even more so by 1970 and later, a lost cause. The deteriorating fiscal situation shows clearly in terms of government consumption expenditures, which by 1967 were almost 50 percent higher than in 1967, and by September 1973 were again higher by almost 60 percent, in real terms, than the 1967 budget, which had to cover expenditures of the Six-Day War.

The inevitable spurt in the budget deficit eroded Israel's savings rate; it was cut in half at once from 20 percent of gnp in 1965 to nine percent in 1967, declining further to six percent of gnp by 1973. The increasing rate of investment, which despite these fiscal pressures was maintained between the wars, required accordingly a substitute for the flow of domestic savings: a rapidly increasing import surplus, which was indeed achieved. But it had to be financed by borrowing abroad. in view of the huge resources required, Israel had no option but to approach the U.S. government, which indeed was forthcoming; its aid, however, was in credits, thus increasing the state's foreign debt substantially (Table 22). An increased flow of donations from Jewish communities in the Diaspora as well as funding on capital account by means of the purchase of State of Israel Bonds and direct investment in Israeli business were the other options pursued in these circumstances.

The booming economy of the almost seven interwar years, involving overfull employment between 1970 and (October) 1973, rode on a rapidly increasing total national debt. Net debt was 47 percent of national product in 1966 and rose rapidly in 1973 to 75 percent of gnp, which had in that time almost doubled. National debt in absolute (real) terms had accordingly nearly tripled. Correspondingly, the foreign debt, a component of the total national debt, rose by somewhat more than three times in nominal dollar terms (Table 23). This ominous development would figure as a major constraint on the economy in the forthcoming decade (1974–85) later referred to as the "lost decade."

the role of inputs: labor, capital stock, and productivity

The growth performance, within the first 25 years of statehood, was set by the rate of expansion of primary inputs at the aggregate plane: the labor force and employment, the accumulation of human and real capital stock, and their interaction subject to improving entrepreneurship. Finally, public sector attitudes and policy had a major impact on the economy as a whole, particularly in the first decade, when comprehensive controls, including through the 1952 universal rationing, were still the order of the day. Currency control, though more relaxed than in the first decade, was still the practice by 1973 and continued for more than another decade.

The free aliyah policy inevitably had a major impact on the expansion of the labor force. Between 1950 and 1970 population and the labor force grew effectively at the same rate (Tables 19 and 14). Yet the size of a labor force suggests only its potential as a factor of production. Its effective contribution to the growth of output and national product depends on the state of employment, and also on its quality – a highly educated and trained labor force makes an obvious difference, in industrialized economies in particular. The pre-state Jewish population had a comparatively high education standard, quite comparable to that of industrialized Central and Western Europe and North America. About one third of the labor force had high education qualifications. This proportion declined during the 1950s. In 1947 the median number of years of schooling of immigrant males in the age range of 14+ was 9.9 years; it was down to 7.3 by 1954. The efforts put into education from the very beginning – the first law passed by the Knesset early in 1949 was the Compulsory Education Law – showed results in the statistics after a decade. By 1960 the median figure of years of schooling of the same age group of males was part of the way back toward the higher standard: it was 8.2 years. The effort to improve the qualifications of the labor force was implemented at all stages – primary, secondary, and higher education. Two higher education institutions, the Hebrew University of Jerusalem and the Technion-Israel Institute of Technology in Haifa, had fewer than 2,000 students in 1949–50, and awarded 193 degrees that year. By 1959–60 Israel already had four university-level institutions, with 9,300 students; 1,237 degrees were awarded in that academic year. By 1974–75, there were seven institutions of higher education with 52,000 students, and 8,800 degrees were awarded. By that time, Israel had certainly overcome the decline in the average qualification of its labor force that occurred in the 1950s, in the wake of mass immigration.

Employment opportunities, however, were the most significant immediate constraint on the potential contribution of the labor force to production. Employment through 1954 grew at a rate higher than the growth of the labor force; this reduced the unemployment rate, dominated by the new immigrant group, to 9.2 percent from the very high 11.2 percent in 1950. The struggle to absorb newcomers into productive activity was one of the main priorities of that decade. By its end, that effort was on the threshold of success, as the 4.6 percent unemployment rate of 1960 suggests. The threshold was finally crossed at the very beginning of the 1960s. The 3.6 percent unemployment rate of 1965 is a clear indicator of the prosperous years of the first half of that decade. The engineered slowdown of 1966–67 (see below, The mid-1965-tomid-1967 Slowdown) generated a significant reversal to 10.4 percent. The slowdown was short-lived, however, interrupted by the outbreak of the Six-Day War. By 1968 the system was already back to full employment levels. Indeed, the 15 percent increase in employment, two times higher than the growth of the Israeli labor force by that time, could not have been implemented without the appearance of a new economic factor: Palestinian workers from the occupied territories. Employers eagerly hired them at a time of overfull employment, which was the state of the labor market and the highly prosperous economy between 1970 and October 1973.

The hiring of Palestinian workers from the West Bank and Gaza Strip reflected the preference of individual employers, in agriculture and the building trades in particular. The tightening labor markets in the closing years of the 1960s, and the much lower wage rates at which these workers could be hired, were incentives. But policy considerations of the government, supported by public opinion, were also in favor of the practice. Employment in the Israeli economy was undoubtedly beneficial to the unskilled and semiskilled laborers who dominated the labor force from the territories. Wages offered by the Israeli employers, though low in Israeli terms, were undoubtedly much higher than the alternatives in the West Bank and Gaza Strip. The response to the demands of the Israeli market was therefore rapid and highly significant in quantitative terms. By 1973, six years after the opening of the border allowing free movement across the lines, close to one-third (31.5 percent) of the total employment of residents from the territories was in Israeli enterprises and municipalities. These workers' comparatively high earnings raised substantially the living standard of the lower income strata of the territories' population in absolute terms, and undoubtedly also in relative terms compared to that of the middle class.

Yet, though Israeli employment of Palestinian workers was soon a major share of employment for the territories, it was only 5.6 percent of total employment in the Israeli economy at that time. The immediate short-run effect on the workings of the economy was accordingly considered beneficial by the political establishment. Political considerations clearly suggested that this "natural" business driven development was highly beneficial politically, as an effective instrument serving peace and stability in the short run, and rapprochement in the long run. The long-run effects of the employment of these workers at the lowest unskilled and semiskilled levels, particularly in the building trades and agriculture, on the wages and employment of low-skilled Israeli labor in the same industries, was not considered, or at least was not considered highly relevant. In the long run, however, it had a major impact on relative wages in the Israeli economy: it reduced the wages of low-skilled workers. This led to a biased income distribution, increasing the spread between the lowest tenth percentile of wage earners and those in the higher brackets. It soon induced an outflow of Israeli workers from these jobs, in the building trades and agriculture especially.

The performance of the economy in these 25 years, during which the growth rate of the economy was on average ten percent a year, was of course conditioned by the increase of the real reproducible capital stock of the production branches. This increase over time is displayed in the "Other" Capital Stock figures of Table 20. In the 23 years through 1973 it grew at an annual average of 11.5 percent. The growth rate was even greater at the very beginning; it was close to 19 percent in the 1950–54 interval, and in the 10 percent range in the following two decades though 1973.

These very high growth rates were achieved by an all-out investment effort, made feasible mainly by government control of the real resources acquired abroad – the import surplus – and the highly significant share of that inflow in the total of the resources at the disposal of the economy. Investment in the early years of the Israeli economy was accordingly very high: it absorbed between one-third and one-quarter of the total resources, which of course implies much higher ratios to national product (Tables 19–20). In spite of the major strain of mass immigration in these years, investment in infrastructure was a very high priority. Thus, the major water projects of 1950–54 – the such as the Yarkon Project providing water to the Negev and Jerusalem – absorbed ten percent of total investment (including housing) in 1950–54, which was close to three percent of gnp.

These very high investment rates in the production branches soon generated rates of expansion of capital stock significantly over and above the high growth rates of the labor force and of employment. The rising capital-labor ratio figures of Table 19 offer insight into the long-run implications of this process on productivity and on the pattern of real wages. The corresponding productivity figures (Total Factor Productivity, tfp), which represent a weighted average of the productivity curve over time, attributed to the two factor inputs – capital and labor – suggest that in the 1950–55 period, factor productivity increased by 25 percent. This means that national product increased by 25 percent more than can be attributed to the expansion of the weighted average of these two factors of production. In the five-year period preceding the war through 1973, the rate of increase of productivity was lower, in the 20 percent range per period. Yet the per capita gdp growth, which was close to 3.5 times during that 24-year period from 1950 to 1973, would not have been realized but for the increase of weighted factor productivity by approximately 2.5 times during the same interval.

The obvious economic implication of rising factor productivity is a feasible increase of the rewards – real wages – as well. This process shows clearly in the real wage figures for that period, covering the span of a generation. The rise of real wages by 2.2 times during the 1950–73 period, an average annual rate of close to seven percent, could not have been achieved without the rising capital-labor ratios, by a factor of five, and the simultaneous rising factor productivity, which implies rising average labor productivity too. The real wage pattern displays accordingly a highly important feature of the growth process: the real wages that rose rapidly even in periods of high unemployment such as 1950–55 and 1966–67 (Table 20) served as a vehicle to spread the benefits of growth widely – hired workers were increasingly a dominant group of income recipients.

On the other hand, the productivity and wage rate figures display and explain another interesting feature: between 1950 and 1955, when productivity rose more rapidly than it did for the next 18 years, wages, at least through 1954, increased more than total factor productivity. This means that no reward was left to the other factor of production – capital and those who provided it, in those years effectively the government. In 1955, a year of transition (see above, The Histadrut and the Economics of the Yishuv), things improved only marginally in that regard. Yet even in this year of recovery, unemployment was still high – 7.4 percent of the labor force, an improvement compared to the 11 percent of the early 1950s. the benefit of the very rapidly rising wages went, of course, only to the employed section of the population, which by that time included a substantial component of post-1948 immigrants. The ranks of the unemployed, however, were dominated by post-1948 immigrants, and they obviously did not benefit from the wage increase. With unemployment still about seven percent in 1957 the inevitable social tension and resentment among the immigrants in the second half of the 1950s clearly prepared the way for the 1959 Wadi Salib riots (see above, Growth and Growth Pains: Wadi Salib), even though unemployment was down to 5.5 percent in that year.

A similar feature, a significantly higher increase of real wages (owing to the success of the Histadrut Labor Federation in pushing them up) than total factor productivity, is visible in the data for 1965 through 1967, with a corresponding leap of unemployment after about six years of nearly full employment (Table 19). The slowdown of these two years, mid-1965 to mid-1967, was due, among other things, to the same feature – the rise in real wages, over and above the rise in labor productivity.

Nevertheless, the rapidly rising employment and corresponding rise of real wages linked to rising factor productivity allowed a major improvement in the welfare of a widening segment of society. This effect may be attributed to, among other factors, the rapid increase of "other" capital stock (the stock of the production branches) as well as to the increased stock of housing, which had undoubtedly a major effect on the welfare of society. The high priority the government gave to housing, which required a major fraction of investment resources, can be seen in the capital stock figures for the period. In the first years through 1955 the stock of housing grew at a higher rate than that of the production branches. This relationship reversed in the late 1950s. Yet even the 1970 and 1975 figures in Table 19 indicate that investment in housing did not lag far behind investment in infrastructure and the production branches.

There was, however, another silent, unmeasured factor that contributed to the pattern of rising national product, and thus of measured productivity improvement in terms of tfp: the accumulation of so-called "human capital," a term that surfaced in the growth literature of the 1960s. Basically, human capital is know-how, expertise, skill, acquired through education in schools, universities, training institutions, and on-the-job training (the last, though, usually also requires some previous formal training or education).

Accumulating human capital involves costs, and in industrial societies these can be heavy in view of the length of the learning process. Secondary school graduates spend 12 to 13 years studying, and those with a higher education close to two decades. These costs are measurable, but measurement of the stock of human capital offers conceptual and technical difficulties. A technique to overcome these problems, involves the use of proxy indicators, such as years of schooling of the labor force, and/or the quantitative expansion of the population of students. For the first decade through 1960, the number of students is the only available measure. From then on, better data on years of schooling and median years of schooling are available.

Thus, in the school year 1959–60, the number of students in the Jewish school system from kindergarten to university was 4.2 times greater than in 1950, and the number of students in universities 4.7 times greater. The much smaller Arab education system grew by almost the same factor. Yet Arab students at universities were at that time still a very small number. In the same period 20.1 percent of the Jewish population had 0–4 years of schooling, a similar number had 5–8 years of schooling, and only 9.9 percent of the Jewish labor force had post-secondary or higher education. The median figure for years of schooling was 8.4 years. The significance of these figures, which suggest a much higher stock of human capital even at this stage, can be seen by a comparison to the data on the Arab population. Its median was 1.2 years of schooling in 1961, with 63.4 percent in the 0–4 years bracket.

Within one decade, by 1970, the standard of education of the post-15-year-old group – effectively the whole labor force – had improved considerably. The more drastic change occurred in the Arab population. The median years of schooling of the Jewish population rose to 9.3 years, and 11.8 percent of the labor force had a post-secondary or university education, while almost 40 percent had secondary education. Correspondingly, the median years of schooling of the Arab population rose to five years and 13 percent had 9–10 years of schooling. By 1975, the median years of schooling were 10.3 and 6.5 years for the Jewish and Arab communities respectively.

These figures suggest a drastic change in the stock of knowledge of the labor force. It was already visible clearly by 1960, and supports the proposition that the rapid accumulation of human capital was a significant factor explaining rapid productivity enhancement, and thus growth of product per capita, and rising welfare.

The Balance-of-Payments Constraint

The outstanding performance of the economy in the long run, involving a 5.5 percent annual rate of increase of private per capita consumption expenditure for a generation, meant that by 1973 this expenditure was 2.5 times higher than in 1950. This is also true of public sector expenditure, which had to finance a heavy burden of defense and welfare-state spending. It required very high rates of investment, and thus a diversion of available resources to the buildup of capital stock: infrastructure, housing, and the equipment and structures used by the production branches.

This effort is demonstrated by the investment figures displayed in Table 20, which show the value of the annual flows of investment in terms of resources and gdp. Investment was above 40 percent of national product through 1951; it declined to what was still a very high percentage of gdp in 1952, and after 1954 settled to still comparatively high rates of 25 and 20 percent for the following decades. These very high rates of investment were not and could not have been financed by domestic production, as indicated by the corresponding rates of saving, which were in 1950 11 percent of gdp, and thus provided resources for only one-quarter of real capital formation in that year. The contribution of domestic savings improved later; by the mid-1950s savings contributed about one half the resources channeled into investment, and in the first half of the 1960s the contribution of savings rose further, to about 75 percent of investment. Yet this trend, which pulled the economy toward "economic independence" (the declared objective of the economic agenda of those years), turned abruptly downwards toward the 50 percent range in the prosperous years of 1967–73, which was, however, a period of combat and exploding defense spending.

The balance of resources required for these very heavy investment expenditures were provided by the huge import surplus. With its exports of goods and services less than 20 percent of its imports between 1948 and 1951 (Table 21), Israel was down to the last dollar of its foreign currency reserves. By that time the government was desperate to raise cash to pay for a tanker of crude oil to fuel the economy's electricity generation capacity. The balance of payments was clearly the dominant constraint on the activities of the system. Things improved on the foreign currency front thanks to the New Economic Policy (see below, The New Economic Policy (nep), 1952–1954). By 1955 exports covered one third of the cost of imports of goods and services plus net foreign interest payments, which were significant due to the rising foreign debt that had been accumulating since 1949. In 1960 and through the mid-1970s, the much greater and robust economy improved its balance-of-payments current account. Exports in that period financed imports plus interest payments within a range of 45–55 percent of that total. However, even a 50 percent gap here, particularly in an economy which by 1973 generated a national product eight times greater than that of 1950, meant that the foreign payments balance was still of major relevance. It had indeed been the Achilles' heel of the system during the entire 25-year period since 1948. To finance year in and year out such unusually high foreign debt, quite out of line with those prevailing in older industrialized economies, was therefore always at the top of the economic, and thus the political, agenda. Its seriousness was underlined by the contemporary political discussion over the (quite popular) notion of economic independence.

Table 21, Foreign Trade and Balance of Payments, and Table 22, focusing on unilateral transfers and the capital account of the balance of payments, offer insight into the strategy by which successive Israeli governments attempted to maintain simultaneously high rates of investment and private and public sector consumption expenditures requiring resources significantly greater than those generated by domestic production. The thrust of their economic policy required mobilization and control of large balances of foreign finance. It depended on a major and reliable inflow of unilateral receipts, which do not create foreign debt, and from late 1949 on, long-term foreign credits, which do accumulate foreign debt. The dominant share of debt during these 25 years was credits to the government or to public sector utilities, such as the nationalized electricity utility being a case in point. The low credit rating and tight exchange controls prevailing through the early 1970s and later precluded significant private venture capital imports.

Unilateral receipts, which consisted originally only of contributions from Jewish communities abroad, were supplemented from 1952 through 1965 by U.S. government grants, and from 1953 through 1965 by West German reparations. From 1954 on German restitution payments to Israeli citizens, which increased in volume through the turn of the 21^st century, were another component of unilateral payments.

The annual totals of these flows of unilateral transfers, which grew persistently over time in real terms, were clearly the mainstay of foreign finance, which made the comparatively large, and sometimes very large, input surplus feasible. Their ratio to the deficit on trade and services plus net foreign interest payments was about 55 percent through 1955. This declined later, but on the whole was still in the 40–45 percent range through 1975 (Table 21).

The balance of the funds required to even out foreign payments consisted of long-term capital imports, which in the 25 years through 1973 were predominantly on government accounts. The first attempt to obtain long-term foreign credits was confined to the U.S. In 1949, the U.S. government-owned Export-Import Bank approved two major loans of $135 million to the Israeli government. These loans were to finance purchases of American products, equipment, and raw materials for the Israeli economy. the immediate contribution of these funds to the capital stock and production facilities of the economy is suggested by the fourfold increase in the number of tractors used in Israeli farming within one year from 1949 to 1950 (Table 17). These funds were used across the board – to purchase equipment for public transportation and for manufacturing industry too.

The second avenue of entrance into the capital market was the setting up of the State of Israel Bonds organization in the U.S. This was later expanded to other industrialized countries in which substantial Jewish communities were living. Since these bonds carried similar rates of return to those of U.S. government bonds of the same term, their sales, which for years was more or less confined to members of the Jewish community, were effectively promoted as quasi-donations. By the early 1960s, after the buildup of foreign currency reserves from virtually zero in 1951, Israel's improved credit rating initiated an inflow of short- and medium-term Jewish capital from other countries, in Latin America in particular, involving government guarantees and denominated in U.S. dollars. These funds were mainly used to increase substantially the foreign currency reserves, thus improving Israel's credit significantly in the post–Six-Day War period (Table 21).

The Table 22 figures showing the sources of unilateral transfers and the sum of transfers and capital imports offer an insight into the considerations leading to a policy that relied on a huge import surplus to sustain a major investment effort during these 25 years. Note first that transfers through 1970 grew threefold in real dollar terms, while gdp grew almost sevenfold. In 1973, transfers significantly outpaced the growth of gdp. This year, similar to 1967, was indeed an exception that proved the rule: in these two years, which were years of full-scale war, transfers grew by almost 80 percent and 100 percent respectively compared to the preceding years. It was the generosity of the Jewish communities abroad that made the difference owing to the special circumstances of these two years.

These exceptions help to identify the assumption underlying the policy. This was that Israel could rely in the long run on the generosity of the Jewish communities of the world to provide a substantial flow of donations through the United Jewish Appeal. And indeed, a stable, slowly rising flow of financial resources have been put at the disposal of Israel's public sector entities. In the 1950s and through the mid-1960s there were two other stable and quantitatively predictable sources of unilateral transfers: U.S. government foreign aid, of which Israel was a recipient through 1965, and German reparations payments, whose annual level was determined in the 1951 Reparations Agreement. Another source of unilateral finance was German restitution payments to individual Israeli citizens. By the mid-1950s these were still small, but toward the late 1950s and even more in the 1960s and later these rose to a significant flow. Finally, there were the funds of immigrants, linked to the waves of immigration. These were negligible in the age of the first, poverty-stricken mass immigration of the early 1950s and through the mid-1960s, but rose in the later decades.

Table 22 offers an outline of the relative contributions of the major sources of unilateral transfers. In the years of mass immigration through 1951 the source of these funds was almost exclusively Jewish communities abroad; they provided 90 percent of the flow in 1950. By 1955 the West German government provided more than 40 percent of these funds, rising to 50 percent by 1960, as the personal restitution payments began. The German share was reduced to 30 percent by 1965, as the reparations commitment was phased out. U.S. aid provided close to ten percent in the 1950s and was also phased out by 1965. It came back with a bang after the Yom Kippur War. In any case, over these 25 years, world Jewry contributed year in and year out about 30–45 percent of unilateral transfers, a reliable flow of resources that sustained Israel's economic activity.

Capital imports – in practice, mainly foreign credits granted to the government of Israel or subject to government guarantee – were throughout that period another major source of funds used to finance a meaningful chunk of Israel's major import surplus. The two U.S. Export-Import Bank loans of $100 million and $35 million in 1949 were a case in point. A significant portion of U.S. economic aid in the 1950s and effectively the whole of it between 1965 and 1973 was in the form of long-term credits at low interest rates, funded by programs such as the Agricultural Surplus Program, designed to promote U.S. farm exports. Because of its volume, which increased considerably from 1970 on to support the purchase of major weapons systems by Israel, the sum of the foreign support of Israel's import surplus was made up of somewhat different elements from that of the transfers alone. In the crucial mass emigration era, U.S. government aid was 25 percent of that total, declining in the late 1950s to ten percent, and leaping to 30 percent of total transfers plus the capital imports component of Israel's balance of payments, as the War of Attrition along the Suez Canal and the Jordanian border peaked in the late 1960s and early 1970s. Yet the mainstay of the economic support was still world Jewry, though its share declined over time. It was about 64 percent of the total in the 1950s and 37 percent in 1970. Germany's relative contribution changed similarly pari passu (Table 22, section B).

The major import surplus maintained for these 25 years, which were the gestation period of the Israeli economy, was, as noted, a crucial element of the economy's transformation into a vibrant, rapidly growing system, almost fully industrialized, by around 1970. Its maintenance at high ratios in terms of the economy's aggregates depended crucially on the availability of these three finance flows, provided by world Jewry, by the U.S. government (directly and indirectly), and by the German government, year in and year out for a generation. For better or for worse, the balance of international payments served as a kind of regulator for the net inflow of foreign resources into the system. Israel's economic policy captains had of course only partial control of the size and the timing of the inflow of these resources. U.S. commitments, for instance, were annual, on the basis of its budget years; the contributions of world Jewry were for better or worse the result of the decisions of a multitude of individuals. Even the German commitments, particularly after the completion of the Reparations Agreement in 1965, were to a great extent subject to the decisions of Israeli households. It was in this sense that the balance-of-payments constraint affected behavior, at the level of the policymakers in the first instance, and by the public at large. Events in the external economic front were accordingly a key control instrument of the economy.

The Dominant Role of Fiscal Policy

The public sector had the dominant role in managing the economy because it controlled both the available resources and the instruments of policy. The public sector – that is, the "great government," defined as the government of Israel, the Jewish Agency, municipal authorities, and nonprofit institutions financed substantially by government funds – (1) was the pipeline through which most of the available foreign currency was channeled into the economy, supported by tight currency controls; (2) promoted and enabled the resettlement effort; (3) allocated resources for investment and determined the branch composition of capital formation generated by this investment; and (4) managed immigrant absorption. These functions have been outlined in previous sections. In what follows the focus is on the traditional functions of fiscal policy and measures of fiscal performance, offering a glimpse of the considerations that shaped Israeli policy, its scope and objectives, its successes and failures, and its critical turning points, over the first 25 years of statehood.

The public sector expenditure figures in Table 23 offer clear evidence on the scope of the "great government." At the very beginning, in the first three years after independence, total public sector spending was 51 percent of gnp. The highly significant reduction of its scope to 38 percent in 1952–55 is, among other things, a clear expression of a crisis situation, a crucial turning point along a bumpy road. This budgetary measure of the scope of government was reduced in the following rapid-growth decade through 1966 to about 30 percent of gnp, quite in line with the level of government expenditure in the industrial nations of Western Europe. In more than one sense, the Israeli economy was part of the post-World War ii trend among these nations in which the scope of the public sector increased with major extensions of the welfare state.

Yet the expenditures from 1967 through the seven good years until the Yom Kippur surprise attack indicate another crisis situation. Expenditures leapt first to 43 percent of gnp in 1967–69, 10 percentage points higher than in 1966. This reflects mainly a much higher defense budget, due to and in the wake of the Six-Day War. The second even higher spurt in expenditures in 1970–73 to 63 percent of gnp reflects the cost of the War of Attrition, the rebuilding of the Suez Canal defense line, and later the cost of the Yom Kippur War, attributed to 1973. Defense expenditures in that year were about 29 percent of national product (Tables 18 and 20). The 75 percent of gnp fiscal expenditures of 1974 underline the burden the defense budget had imposed on the system from 1966 onward. The political crisis had had an explosive impact on the economy. Defense expenditures of about ten percent of gnp were the rule from 1960 to 1966; they rose to 20 percent of gnp on average from 1973 through 1976.

This does not suggest, however, that the rapid rise of the scope of government, as measured by public sector expenditures, was exclusively due to the defense burden. The decades between 1954 and the Yom Kippur War were an era of a rapidly expanding welfare state. The National Insurance Institute, created in 1954, served initially as a public sector instrument of the absorption process. Compulsory payroll and self-employment contributions to the universal insurance service were initially, through the 1960s, higher than the benefits paid to the insured. Entitlements were only 1.6 percent of gnp in 1957. But these grew rapidly, as more and more programs were added to the system. By 1970 benefits paid out were 5.2 percent of gnp, and by 1974 8.7 percent, which meant that social security benefits were already more than ten percent of total budget expenditures. Adding the cost of health and elementary, secondary, and higher education, we see that by 1970 at least 35 percent of the exploding budget expenditures of the 1970s were allocated to welfare state services.

The huge scope of government expenditures in terms of the initial production capacity of the economy, and the large scope later on in the post-1954 decades, required corresponding revenue. Yet tax revenues through 1951 were minuscule compared to expenditures. To these should be added the income from unilateral transfers flowing exclusively into public sector coffers – mainly to the Jewish Agency, which was put in charge of the initial absorption of immigrants in the era of mass immigration, and of the resettlement effort. Through 1951 these unilateral receipts consisted entirely of contributions from Jewish community appeals abroad; the 6.5 percent of Israel's gnp that these appeals infused into the system at this time could be conceived as a self-imposed tax on Jews all over the world. This infusion of resources was highly significant. Yet, though adding it to the meager tax revenue of that age increased the cash flow into the public sector by 50 percent, to 19 percent of gdp on average in the three fiscal years 1949–51, the public sector still generated a huge deficit, about 31 percent of gnp (Table 23). The gap in the cash flow was covered by the classical technique adopted by governments in this predicament everywhere – printing money.

The mechanics of that process and the impact on price levels of this way of evening out the government cash flow are discussed below (see The Monetary Infrastructure and Suppressed Inflation). The relevant feature in the fiscal context suggested by the data is that the three-year average through 1955 shows a drastic reduction of the fiscal deficit to 11.5 percent of gdp. Furthermore, in the following year, the year of the Suez/Sinai Campaign, the budget deficit was down to less than four percent of gnp. In the following decade, in 1966, it was pulled effectively into the black (Table 23).

The year 1952 was a critical turning point in the realm of government finances. the new Economic Policy (nep) announced in the Knesset by Prime Minister David Ben Gurion on February 9, 1952, was based on the premise that the necessary condition for stable economic progress was to put government finances on a firm basis. This meant an immediate reduction of the current budget deficit to a reasonable level. The rapid growth of national product and the reduction of rising public sector expenditures below the rate of growth of gnp, indicated by the 38 percent ratio for 1952–55 (compared to 51 percent in 1950), made the difference.

The end of the first wave of mass immigration in 1951 helped to make this achievement more feasible. It was helped, however, by a highly significant boost on the revenue side. Note first the major relative increase of unilateral receipts, reflecting the appearance of U.S. economic aid in the form of grants starting in 1952, and German reparation payments in 1953 (Table 23). Though Israel's robust economic growth soon reduced their ratio from nine percent of gnp to 5–6 percent, these offered a stable source of revenue for more than a decade through 1965.

The further, though relatively small, reduction of the growth of public sector expenditure, which kept it within the 30 percent range through 1966, contributed to the maintenance of fiscal discipline during this period. But the real revolutionary development in the fiscal dimension of the economy occurred on the revenue side of government finances. The revenue system inherited from the Mandatory government was designed within the conceptual framework of the British colonial tradition, which, in line with the "free trade" concept, also envisioned a small government. In any case, the Mandatory model of government did not envision a government attempting to promote growth and construct a welfare state. Thus, for the first two decades of the British rule of Palestine, no comprehensive income tax was instituted.

The small ratio of tax revenues to gnp inherited from the Mandatory government reflected accordingly the absence both of the legal framework and of the experienced revenue administration required to provide significant revenues to government. These were built up during the 1950s. By 1956 the tax system collected revenues on the order of about 22 percent of gnp. By the 1960s, supported by revenue from compulsory payments to the National Insurance Institute, tax revenues amounting to 30 percent of gnp was quite comparable to those collected in the older industrial economies. In the early 1970s through 1973 tax revenues moved to very high absorption rates – 45 percent of gnp, comparable to those collected by the "high–revenue" systems of the Scandinavian countries. These rates were implemented by a major increase of compulsory National Insurance Institute payments and higher effective real income tax rates. This performance of the revenue system was a major factor in keeping tight fiscal discipline between 1955 and 1966. It thus effectively obviated the need for the government to resort to the printing press at the Central Bank.

Yet 1967 was another turning point for public sector finances: they started to move in the opposite direction. The slight 0.3 percent deficit of 1966 was caused by the severe macroeconomic slowdown, which involved a high unemployment rate. But the leap to an average annual fiscal deficit rate of 5.7 percent of gdp in the 1967–69 period was of an altogether different significance. That deficit rate was not due to failure on the revenue side; tax revenue rose considerably to 33 percent of gnp (Table 23) as a result of rapidly rising incomes and the increasing efficiency of the tax administration. The response of the Jewish communities worldwide to the 1967 Six-Day War and the subsequent War of Attrition generated a significant rise of unilateral transfers to 4.5 percent of gnp. What made the difference was rapidly mounting defense costs, which increased government expenditures by ten percentage points to 43 percent in the closing years of the 1960s.

Since the leap in government expenditures and the corresponding rise of aggregate demand were initiated at the bottom of the cycle, showing a 10 percent unemployment rate by mid-1967, the rapidly rising demand was initially absorbed by the rapid expansion of production; national product rose at an annual average of almost 14 percent in 1968 and 1969. This was facilitated by a rapid reduction of unemployment and underutilized manufacturing capacity. The inflation of expenditure thus initially pulled the wheels of the economic system forward. But toward the end of 1969, the economy was clearly on the threshold of full employment. With an unemployment rate of 4.5 percent in 1969, even though a massive inflow of Palestinian workers had already been pulled into the economy to sustain a 13 percent expansion of employment, it was at that time quite clear that by 1970 at the latest the economy would have crossed the threshold of full employment.

This eventually called for fiscal restraint, at least from 1970 on. An attempt at restraint along the revenue route was indeed implemented; owing to the significant rise of rates of social security contributions in that year, and of other tax rates, government revenue leapt from 33 to 45 percent of gnp in the 1970–73 interval. But the spurt of expenditures easily overcame the effort of restraint on the revenue side of the fiscal balance. The very high expenditure levels, averaging almost 60 percent of gnp between 1970 and September 1973 (just before the Yom Kippur War), meant that the inflationary impact of the fiscal policy could not be contained. To even out its cash flow the Treasury had no option but to use its credit facility at the Bank of Israel to print money.

The overfull employment level, underlined by the unemployment rates of 2.7 and 2.6 percent in 1972 and 1973, and the employment of a quantitatively significant group of Palestinian workers, meant that the public sector deficit of 10.3 percent of gnp from 1970 through September 1973, just before the outbreak of the war, generated heavy inflationary pressures. And indeed, this reversal, from more than a decade of tight fiscal restraint to the exploding budget deficits of the early 1970s, could not but provide the fuel for rapid inflation. This rose to double-digit rates from 1970 on. In the three prewar quarters of 1973, it was already running at an annual rate of 21 percent (Table 25).

The Monetary Infrastructure and Suppressed Inflation

the emergence of the israeli pound

One of the first demonstrations of sovereignty made after the Declaration of Independence was the replacement of the Palestine pound (P£) with an Israeli currency. The Mandatory Palestine pound served as legal tender for more than two decades through August 16, 1948, when the Israeli government concluded an agreement with the Anglo-Palestine Bank to issue the Israel pound (I£), as it was named, and confer on it the status of legal tender. The conversion rate of a Palestine pound to an Israel pound was set at 1:1. That established a de facto exchange rate for the new currency, since the nominal value of the Palestine pound was identical to that of the British pound sterling (the exchange rate between them was 1:1). This meant that the Israel pound had, initially, the same nominal exchange rate as the British pound with the U.S. dollar and other currencies.

Neither the date of issue of the Israeli currency, nor the choice of a Currency Board to execute that function, nor the decision to locate the Department of Issue within the Anglo-Palestine Bank, were matters of chance. The exchange rate set for the Israel pound was also not plucked from thin air. All these decisions had well-founded reasons. The three months' delay of the transition to a national currency was imposed by a major foreign policy constraint, set by the United Nations decision of November 29, 1947 to establish two states within the area of Mandatory Palestine, the economies of which were to be linked by a customs union and a single currency. An immediate issue of an Israeli currency would have been inconsistent with this decision.

The implementation of the new currency was accordingly delayed until almost the last minute, even though it generated strain in the markets due to shortages of currency for transactions. This was clearly demonstrated by the appearance of substitutes – municipal coupons, etc. The unilateral exclusion of Palestine from the sterling bloc in February 1948, a clearly hostile move by the British government, and the closing of the Barclays Bank offices in beleaguered Jerusalem, which had been serving as the agent of the London-based Mandatory Issue Department, technically prevented even the use of foreign exchange to acquire Palestine pound notes from March 1948 on. In any case, the closing of the Mandatory Issue Department's Agent's offices offered a political opening for a move by Israel, which could also refer to the declared refusal of the Arab side to proclaim its independent state. In view of the urgent need for circulating money, and even more to provide the government with the required liquidity for its day-to-day operations, the government decided to take the plunge.

Since the creation of a central bank was of course an impossible feat within the first three months of independence, the currency board device was the obvious option. It suggested continuity with the previous system in the provision of monetary liquidity. Furthermore, the establishment of the Israeli Issue Department within the Anglo-Palestine Bank (apb) – the largest banking institution of Mandatory Palestine and the long-standing Zionist flagship in the realm of finance, with over 40 years of experience and presence in Palestine – followed in a sense the classical British Bank Act of 1844. It established the Issue Department as a distinct legal entity, the profits and losses of which were revenue or debit charges on the government budget. According to the covenant between the government and the apb, two representatives of the government were appointed as (minority) members of the management committee of the Issue Department. In a separate letter attached to the covenant, but not published, apb agreed that with regard to two subjects – the volume of credit allocated to the government, and the setting of its rate of discount, the management of the department "could take into consideration the point of view of the government." The covenant, which granted a monopoly for issuing currency to the apb – soon to change registration from a British to an Israeli banking corporation and adopt the Hebrew name Bank Leumi le-Israel (National Bank of Israel) – was set to last three years. Though the length of that term was a bone of contention in the negotiations, the Issue Department stayed in place for more than six years within Bank Leumi, until it was moved to the Bank of Israel, which opened its gates on December 1, 1954.

Though formally similar to its predecessor, the Mandatory Issue Department, the set of assets that it could purchase in return for its issue of currency – the only liability it could create – indicates that it was an altogether different kind of "money-creating" institution. Whereas the Mandatory entity was allowed to purchase sterling only in return for issuing Palestinian currency, and hold its reserves only in gilt-edged British government securities, the Israeli institution was empowered to own a portfolio of "domestic" assets, besides foreign currency. These included short-term Treasury bills and, following the amended legislation of 1949, Land Issue bonds (long-term government debentures), and also "commercial paper."

The last option, however, was never used. The first two, which in practice amounted to the granting of credit to the government, were soon made use of by the Treasury. To reduce the risk of an inflationary impact due to the Issue Department's legal obligation to finance the cash flow of the government, the Board of Directors of apb requested a clear legal restriction on its ability to extend credit to the government. The August 1948 legislation, which made the covenant law, included accordingly the requirement of a minimum of 50 percent foreign currency reserve against the only liquid liability of the Issue Department – the outstanding nominal balance of Israeli currency. The June 1949 amendment to the original 1948 legislation, which added Land bonds – soon to surface in the money market as an asset legally similar to foreign currency – effectively neutralized the foreign currency reserve restriction, which, however, remained in the law.

The money supply figures offer the rationale for this amendment to the original legislation designed to restrict the money supply, only one year after its enactment. Currency in circulation at the end of 1948 had increased at an annual rate of more than 100 percent, and the supply of money by 70 percent, within the seven or so months of independence, including the last quarter of that year after the successful completion of the one-month trial (mid-August to mid-September) during which the population exchanged its Mandatory currency for Israel pounds. The rapid rise in monetary liquidity continued in 1949, the first full year of the new monetary regime. The outstanding balance of currency increased in that year by 60 percent and the supply of money by almost 40 percent. All in all the money supply during the three years between the end of 1948 and the end of 1951, a period of mass immigration, grew at an annual average of about 34 percent (Table 24). This meant eventually a major inflation of the money supply.

This development was triggered by the huge deficit, the average of which was 31 percent of gnp during the 43 months through the end of 1951, in spite of the highly significant inflow of unilateral transfers from the donations of Jewish communities abroad. To even out its cash flow the Treasury sold Treasury bills to the banking system, thus borrowing at an interest rate of about 2.5 percent. These rates charged by the banks were based on the commitment of the Issue Department, made upon its opening, to purchase any quantity of Treasury bills offered to it at a discount rate within the range of 1.3–1.7 percent.

These very low interest rates were quite similar to the comparable rates in the industrialized countries at the time. Such rates were the subject of dispute between managements of central banks and national treasuries, but were still prevailing in Western Europe and North America. The discount rate range set by the management of the Issue Department was therefore not out of line with what was acceptable elsewhere at that time. Yet as in the case of the exchange rate of the Palestine pound with the Israel pound, set at 1:1 in August 1948, the discount rate, though facilitating the acceptance of the new currency and thus seemingly reasonable in the very short run, created major economic problems later.

The complication that triggered these problems involving the exchange rate and the discount rate (and thus the cost of bank credit) was the difference between inflation rates in Palestine and those in Britain and the United States. the inflation rate during the war was much higher in Palestine than in Britain. In Palestine prices rose by about three times between 1939 and 1947 (Table 13). In Britain during the same period they rose by approximately 80 percent. Since British inflation was higher than American during the war and its aftermath, the gap between Palestine's rate of inflation and that of the U.S. was even greater.

The choice of 1:1 as the rate at which Palestine currency was converted into Israeli currency (and was thus the exchange rate with sterling as well) – involved therefore a highly significant overvaluation of the Israel pound in relation to sterling, and an even greater overvaluation against the U.S. dollar. This choice offered therefore an implicit subsidy to imports and penalized exports. The difference between the average annual rates of inflation between 1939 and 1947 in Palestine (about 15 percent) and Britain (about half that) meant that inflationary expectations in Israel, still involved in a shooting war in 1948 and later subject to an avalanche of mass immigration, were much higher than in the U.K. The inevitable consequence of an interest rate for bank credit lower than the inflation rate (in line with the Issue Department's discount rate) was a strong and accelerating demand for credit by businesses and households. The highly liquid banking system was able to provide credit at low rates, in view of the low discount rate set by the Issue Department for treasury bills, which allowed banks to resupply their reserves when required, at low cost. This soon created an all-out inflation of the money supply, shown by the m1 figures in Table 24.

suppressed inflation, 1948–1951

The expansion of the money supply by more than by two times between the end of 1948 and 1951, at an annual average rate of 34 percent, could not but generate a major increase in the price level, though resources grew substantially too. The estimate for the growth of resources for domestic uses during the same period put the annual average rate of increase at 15–20 percent at most. Comparison with an inflation of the quantity of money by 34 percent annually suggests severe price inflation. Yet the price data in Table 25 does not, apparently, warrant the conclusion suggested by economic theory. Indeed, the data indicate that prices even declined somewhat between 1948 and 1950, and that the significant 1951 increase reflects the worldwide Korean War inflation effect of that year, which inflicted a major cost shock on the world economy, since it raised commodity prices all over the globe. However, even this shock, which also affected Israel in 1951, meant that during the first three full years of independence since the beginning of 1949, the annual average increase in prices was apparently within the three-to-four percent range. This was quite similar to the rate of price inflation to which industrial countries were subject in that postwar period.

Yet an inspection of the price data of Table 25 suggests immediately that this very low reading of the inflationary environment in Israel at that period is facile. This is the clear message to be read in the rise of the cost of living by almost 67 percent in 1952 and a further 19 percent in 1953. The price readings for the pre-1952 years, like those in its aftermath, were official prices of a price-controlled economic system subject to tight rationing. The price controls were inherited from the Mandatory period and were inevitably extended during the 14 months of active combat through the first quarter of 1949. The immediate impact of the mass immigration on the limited resources of the economy, involving in these years a huge import surplus (Table 18), financed, among other methods,

by drawing on the last dollar of international reserves in 1951, led inevitably to the extension of the scope of rationing early in 1951. While European economies were at that time rapidly getting rid of the shackles of World War ii-era rationing, in what the Labour government of Britain described in 1951 as a "bonfire of controls," the Israeli government felt that it had no option but to make a major move in the other direction. It attempted to increase the scope and tighten the regime of supply and rationing – the name of the ministry which later became the Ministry of Trade and Industry – by extending rationing from food to clothing, involving a point coupon book issued to every resident.

The tight and tightening rationing regime supported by price controls was, however, subject to rising pressure from the government deficit of those years (see above, The Dominant Role of Fiscal Policy), which forced the government to print money to sustain its cash flow. This rapidly inflated the volume of currency in circulation – the monetary base – and on top of that allowed an expansion of bank credit, and thus a corresponding increase of the money supply. With the money supply expanding by 138 percent between 1948 and the end of 1951, and official prices rising by only 11 percent, even an annual average 20 percent increase of resources in the economy could not have withstood the immense pressure of that avalanche of money flowing into the pockets of households and businesses during this period.

The success of the price controls and rationing inherited from the British depended inevitably and crucially on the acceptance and support of public opinion, which began to erode by mid-1950. Prime Minister David Ben-Gurion thus put his prestige on the line in a radio address, and appealed to the public to avoid resorting to, and to fight the appearance of, black markets. The increased purchasing power put into the pockets of the populace later on eroded the support of public opinion and burst the price control dam, and black markets spread rapidly. When an early election was called for June 1951 to settle a sensitive dispute over education between the religious and secular segments of the population, the main issue of the campaign turned out to be rationing and price controls.

A small liberal party, advocating the virtues of a market economy and calling for the abolition of controls, succeeded in tripling its parliamentary representation, while left-wing parties lost power. The political turn of the tide, and the growing understanding in political circles, supported by the minister of finance and top Treasury officials, that controls, and the over-valuation of the Israeli currency, are "anti-production" devices, suggested the scrapping of the supply and rationing policy. This position was strongly supported by the agricultural settlements, whose memberships were predominantly supporters of the ruling Labor Party. The major resettlement effort during these three years had generated by 1951 a substantial increase of output, but price controls prevented farmers benefiting from the sellers' market still dominating the produce markets. They could do that only by selling on the black market, which they were reluctant to do, even though they did not avoid these markets altogether. With the election campaign out of the way by midsummer, a reformulation of economic policy involving a dramatic departure from the supply and rationing/suppressed inflation model was put into practice.

The New Economic Policy (NEP), 1952–1954

The alternative model – the New Economic Policy model inaugurated formally on February 9, 1952 in the prime minister's statement in the Knesset – was much more market-oriented. It was obvious that the necessary condition for reform was a reasonable fiscal stance. Budget deficits of the size allowed during the first 44 months of independence were not a viable option any more, especially in the context of a stabilization policy. Yet, the absorption of mass immigration and the resettlement drive, which required an all-out effort to provide housing and urgent infrastructure investment in water and irrigation, roads, school facilities, etc., required a flow of investment resources beyond the small capacity of the Israeli economy to provide. The population figures alone suggest the nature of this constraint. The national product of a Jewish population of about 650,000 by mid-1948 could not have provided the resources for the investment required for a Jewish population of 1.4 million in 1951. This meant that to sustain the investment flow even at the level of 1950, a substantial import surplus was essential. Foreign finance to pay for it was equally essential.

By the end of 1951 Israel's foreign currency reserves, consisting effectively of sterling balances accumulated during World War ii through 1947, which had financed partially the capital formation since 1949, were exhausted. During 1951, the Israeli government, with the full support of the Jewish leadership in the U.S., made a successful effort to set up the framework for a stable flow of foreign finance. This involved three new sources of finance, in addition to the annual contribution of United Jewish Appeal (uja) funds of $90–100 million (current) dollars, which had already been flowing for several years. The first of these was an expected flow of about $65 million annually for 12 years from the West German government under the Reparations Agreement. This agreement was concluded in 1952 after a major, soul-searching and highly divisive political dispute that split Jewish public opinion all over the globe, and led to riots in the streets of Jerusalem in January of that year as the Knesset debated the issue. The submission of a claim for reparations was finally approved by a small majority; the agreement was finally signed in September and the flow of funds started in 1953.

The success of the Jewish leadership in including Israel among the recipients of American economic aid, involving grants, long-term loans, and credits under the U.S. farm surplus program, ensured a second stable source of about 40–50 million current dollars for more than a decade from 1952 onward. Though not formally a long-term commitment, and thus needing renewed Congressional approval annually, it was nevertheless, and rightfully, conceived as a stable source of funds. The third new source for funds on the capital account was the State of Israel Bonds organization supported by the Jewish communities in the U.S. and later in Canada (and over time in other countries with sizable Jewish communities). To avoid competition with the United Jewish Appeal, which collected contributions, and to underline its character as a businesslike organization, the Israel Bonds organization was designed to sell long-term (ten-year) government of Israel debentures carrying an interest rate similar to that of U.S. government long-term debt. This rate did not compensate, of course, for the major difference between the financial risk involved in bonds of the government of Israel and that of U.S. government debentures. The sale of these bonds was accordingly based on campaigns similar to those run by the uja. The first campaign was inaugurated with a coast-to-coast appeal led personally by David Ben-Gurion in the winter months of 1951. These bonds soon provided a flow of close to $50 million annually. However, they involved the creation of long-term foreign debt to be repaid after 10 to 15 years. Yet what counted most in the formulation and implementation of the nep was immediate liquidity considerations, for which the Israel Bonds funds were on an equal footing with German reparations and U.S. government aid.

The New Economic Policy was based on the assumption that a flow of roughly 150 million (current) dollars from these three sources was assured. This meant that together with an annual inflow of about $90–100 million of U.S. funds, a cash inflow of about $200–250 million annually could be counted on for investment allocation. On the basis of this assumption, even though the German Reparations Agreement had not been finalized by that time, it was possible to nail down the basic premise of the New Economic Policy: fiscal rectitude. The program committed the government to avoid budget deficits; the regular budget would be covered by tax revenue and the substantial development budget by the flow of funds from abroad.

The monetary dimension of the program committed the government to stop immediately the sale of Land Bonds and Treasury bills to the banking system and to the Issue Department to sustain its cash flow. This meant that the government was to stop forthwith printing money to finance its expenditures, as it had been doing since August 1948.

Though the respective fiscal policy and the corresponding restrictive monetary policy were to serve as the foundation of the policy, what conquered the headlines and public opinion as nep came into the open in February 1952 was the immediate major devaluation of the Israeli currency: it was to be devalued by threefold, though that move was to be tempered initially by maintaining the previous rate of exchange for the import "essentials" (crude oil, food, and feed grains), and an intermediate rate for the import of other raw materials. That three-tier exchange rate system was eroded over time by moving more and more import items into the higher rate. When the process was finalized late in 1954, and the two lower exchange rates were eliminated, the top rate was again devalued by 80 percent. Thus, by 1955 the official exchange rate of I£1.8 to us $1.00 was higher by five times than the November 1949 rate in which Israel followed the U.K. devaluation of sterling against the dollar at the same rate of about 44 percent.

What was not revealed at the official introduction of the nep, nor in the government response to the debate in the Knesset made by Eliezer Kaplan, the first minister of finance, who prepared the program, was the last item of the nep program: a 10 percent tax (formally a non-price-linked loan) on money – that is, on cash and demand deposits. The delay in implementing that important component of the program was caused by a technicality: the implementation of the tax on currency required an exchange of old for new banknotes. The new notes, carrying the new Hebrew name of the issuing bank, Bank Leumi, instead of its former name, the Anglo-Palestine Bank, were not ready for distribution. In any case, the delay was fortunate since the implementation of nep was expected, and indeed proved, to be a complicated and painful exercise.

One feature of the pain was the necessity to cut government expenditure significantly. The prime minister, who also served as minister of defense, decided to support the commitment to a balanced budget with a 20 percent cut in the defense budget. This led to the resignation of the chief of staff. A related move designed to lower expenditure was the termination of the postwar wave of mass immigration by the end of 1951. Though not actually a drastic move – it was more a passive response to the situation in the countries of origin of potential immigrants – it was still important to the success of the policy. This move was not publicized at the time. The major slowdown in the inflow of immigrants allowed accordingly a slight reduction of the absorption budget.

Yet besides the pain indicated by the rise of unemployment – in 1953 the rate rose again to 11 percent, and was still 9.4 percent in 1954 when the nep was considered an outstanding success – it was the price explosion that imposed universal pain on households. This was not accidental; on the contrary, the leap of prices (67 percent in 1952, 19 percent in 1953) was part of the disinflation policy. It was this price explosion, combined with the 10 percent tax on money finally imposed in June 1952, that reduced at one go the purchasing power of the Israel pound, and thus the real quantity of money, which had expanded tremendously under the suppressed inflation policy though 1951. Though never stated in so many words by the prime minister or the finance minister, the adoption of the nep meant the virtual abandonment of the supply and rationing policy pursued through 1951, thus allowing greater market control of the economy.

The first two years of the process was a bitter pill for the economy, and strained the tolerance of the political community and that of the beleaguered new finance minister, Levi Eshkol, who took over from the ailing Kaplan in the summer of 1952. Employment in 1953 was lower than in 1952; the rising unemployment led to a virtual freeze of gnp growth and of the volume of real resources in the economy. Prices rose steeply, as noted above. And the final adjustment of the exchange rate, to a level 80 percent higher than the top rate of February 1952, was about to be implemented through 1954. Under the open inflation of the nep this was expected to raise prices further.

Yet the economic aggregate and price data for 1954 suggest that the difficult surgery of the nep had seemingly succeeded, and the sick body of the economy was undoubtedly on the road to recovery. After almost two years of stagnation gnp shot up by about 20 percent, corresponding to the growth of employment by four percent. This reduced the unemployment rate to a still high, but significantly lower, 8.9 percent. Price inflation was down to 7.5 percent. With the government deficit of 1954–55 down to 7.5 percent of gnp it was also clear that a major fiscal improvement had been achieved (Table 23).

These results showed even more strongly in the 1955 data. With inflation down to about 5 percent and gnp starting its rapid, decade-long growth process at an annual rate of 12 percent, employment higher, and the unemployment rate at 7.4 percent, it was clear by that time that the operation had succeeded and the patient had survived. This was clearly felt among most of the population; the per capita product and private consumption expenditures were higher by 35 and about 30 percent respectively than in 1950, only five years before.

The now more regular pulse of the state also showed in what was popularly considered the measure of well-being, the rate of immigration. down to only 11,000 in 1953, it was up to 38,000 in 1955, signaling the beginning of the second wave of mass post-independence Aliyah. It lasted for a decade through 1965, and brought half a million immigrants to Israel.

The Bank of Israel (boi) and Macroeconomic Policy, 1954–1973

the creation of a central bank

The last quarter of 1954 marked not only the end of the nep, by that time already perceived as a highly successful operation. It also marked the establishment of the Bank of Israel (boi) as the state's central bank. Its incubation period was longer than expected, so the length of service of the Issue Department at the Bank Leumi, initially set for only three years, was extended to more than six years, until December 1, 1954, at which date the Bank of Israel opened for business.

The 1954 Law of the Bank of Israel was prepared by a committee that had the advice of a panel of five (Jewish) experts, who also scrutinized the final results. one member of the panel was a top executive of a major commercial bank in the U.K., another was a member of the Board of Governors of the Central Bank of Canada, and the three others included a leading academic monetary economist in the U.S., the first director of research of the International Monetary Fund, and the secretary of the United Nations Economic Affairs Committee. The law was, of course, significantly affected by the Keynesian worldview, which dominated economic thought in the immediate aftermath of World War ii. It gave the bank the classical function of central banks, making monetary policy. It provided its management with the conventional instruments of central banking, forged in the 19^th century and developed in the first decades of the 20^th.

The Bank's management was accordingly empowered to set minimum commercial bank reserve ratios, and to run a discount window. Through its discount rates it would have the ability to regulate the volume of currency in circulation and affect the volume of current account deposits, the two components that make up the money supply (m1). The Bank, as an institution of governance, worked in tandem with the Treasury, which in accordance with the traditional division of labor in industrialized economies, made fiscal policy.

Coordination of macroeconomic policy, the sum of these two elements (monetary and fiscal), has always been a problem for governments, and Israel's was no exception. The problem soon surfaced in the 1950s and 1960s, and focused on the inevitable issue – the momentum of growth versus price stability. The boi Law indeed specified the two targets the Bank was to aim at: it was "to ensure the external and domestic stability of currency" and simultaneously ensure "a high level of production, employment, national income and investment."

Price stability and growth were accordingly set on an equal footing as the targets of monetary policy. But policies pursuing these two targets cannot necessarily be compatible over time. The Treasury, representing the political community, would usually focus on full employment and growth, which are not always consistent with price stability. The inflationary experience of Israel through 1951, which forced the economy to go through the drawn-out agony of the New Economic Policy, was an obvious example, just at the time the boi commenced operations.

The task of guiding the economy along a path of virtue – growth and stable prices – was therefore considered of paramount importance by the first governor of the bank, David *Horowitz, who remained at the helm for 17 years through 1971. His freedom of action, when he believed a situation required restrictive policy such as higher interest rates and slower expansion of the money supply, was constrained by several features of the Bank of Israel Law. The most important of these was the section that allowed credit accommodation of the government by the central bank. It did involve a constraint: the volume of such an accommodation was not to exceed 20 percent "of the size of its budget." The level of such a credit was thus practically set by the decision of the Knesset's Finance Committee – a representative of the political authority, that is, the government itself. That section of the law was formulated in a "permissive" sense: the central bank was "permitted" to make an accommodation, yet not "required" to respond positively to an application for such accommodation.

The Bank of Israel's preliminary decision to change the minimum liquidity ratio required approval by the government. In practice this meant that the approval of the Ministerial Committee of Economic Affairs, of which the Bank's governor was a nonvoting member, could be delayed, partially eroded, or not forthcoming at all. Finally, the ability of the bank to have an "open market" policy, by means of which it could set its discount rate, was effectively limited owing to the shortage of financial instruments such as traded government bonds. An option to overcome this constraint was available under to a specific section of the law, but it too required government approval, which was not forthcoming for more than a decade, until 1966. The Bank's management's freedom of action to implement a restrictive monetary policy on its own volition was therefore quite limited.

Another constraint on the Bank of Israel's degree of freedom was the Ottoman-era law that put a ceiling on the legal nominal rate of interest that creditors, and thus the banking system, could charge for credit. The rate maintained through the Mandatory period was nine percent, a ceiling that was not relevant between 1920 and 1939, an era of declining, and in the late 1930s, stable, price levels. It would, however, have been an effective limit on the ability of boi to restrict monetary expansion, even in the later 1950s, when the annual average price inflation was in the four-to-five percent range.

The only weapon entirely at the disposal of the Bank of Israel's management, through 1973 and later, was the requirement stated in section 35 of the law that "at whatever date the outstanding volume of means of payment had risen by 15 percent or more over and above its volume in the last 12 months, the governor of the bank has to publish a 'Report on the Expansion of the means of Payments.'"

This reference to the governor in person, rather than to the central bank management, underlines another inherent structural weakness of Israel's central bank through its first 50 years of existence. The boi Law does not mandate the institution of a board of governors or a committee to be in charge of monetary policy. The only decision-making authority of the central bank is, under the law, the governor of the bank himself. He had a seven-member advisory committee with which he could consult, and a larger advisory council of 15 (including the seven advisory committee members) was also a component of the management structure. But these two bodies were entitled only to advise the governor. The actual decisions on monetary policy were his and his alone. Without the support of a board, the governor, when meeting with his counterparts from the government – the minister of finance and the members of the Ministerial Committee of Economic Affairs – was indeed going alone into the negotiating chamber.

the bank of israel's debut

Despite the inherently weak position of the leadership of the institution formally charged with managing the monetary dimension of the economy, the Bank of Israel's performance in the following decade through 1965 was reasonable. During this period, Israel absorbed another half million immigrants; its population grew by 52 percent, its gdp grew by almost 10 percent annually and its per capita gdp increased by an average of 5.7 percent annually (Table 18). And this was achieved at a modest annual average rate of inflation of 5.5 percent, a rate which was not altogether out of line with inflation rates in Western European industrialized countries.

The money supply figures grew at a seemingly high annual average rate of 17 percent, a rate somewhat higher than the 15 percent at which the law required the governor to issue a formal warning – the required "report on the Expansion of the Means of Payment." Yet with gdp growth at almost 10 percent annually, and an extensive monetarization process going on both in the Arab sector of the economy, whose linkage with markets accelerated in that period, and among the substantial population of immigrants who had to acquire quickly domestic means of payment, demand for money in real terms grew on average of 13–14 percent annually. Thus, money supply grew by only a few percentage points, more rapidly than demand for it. The expansion of the money supply beyond the demand for it was accordingly minor for most of those years, with some exceptions mainly towards the end of the period. This indeed reflected fiscal discipline, maintained on the whole throughout that decade, even though Israel was again engaged in a war, the Suez/Sinai Campaign, late in 1956, following increasing tensions and military activity along the borders in 1955. The budget deficit of 1956 was only four percent, and through the following decade there were small surpluses (Table 23). The cash flow on income account of the government was accordingly evened without exceptional applications for central bank credit accommodation i.e., printing money.

Indeed, during its introductory period, through about 1960, the central bank was hardly called upon to exercise monetary restraint. Furthermore, its success in persuading the Treasury and the government to raise the legal ceiling on interest rates allowed it a greater degree of freedom in the making of monetary policy. The low inflation rates of the closing years of the 1950s (in the range of three to four percent), the higher ceiling on interest of 10 to 11 percent, and the elimination of a legal requirement to consider cost-of-living data in setting interest rates, made the difference.

Yet by late 1960, the Bank called for restrictive monetary action, due to the rise of the money supply in that year at a 22 percent annual rate, generated by an unexpected significant increase in West German personal restitution payments, converted into Israeli currency. The advisory bodies of the Bank approved the governor's proposal to raise the banks' minimum legal reserve ratio, designed to restrain their capacity to expand their current account deposits. This would have restrained the expansion of the money supply. Yet government approval of this proposal was not immediately forthcoming. It was delayed by six months, and when it finally came, the ministerial committee approved a smaller increase than the Bank had proposed. Furthermore, the ministerial approval included another erosion of the proposed restriction: it increased the quota of subsidized credit that the banking system was requested to allocate to privileged borrowers in farming and manufacturing.

In more than one sense this was the pattern of the ministerial committee's actions for the next 25 years, whenever the central bank proposed to make a restrictive monetary move. The next incident came soon: the rise of inflation in 1961 at an annual rate of nine percent, compared to the three percent average annual rate in the previous three years, and the rapidly rising restitution payments, data on which was known to the boi by mid-1961, suggested the need for a further tightening of monetary policy. This was even more urgent in view of the discussion going on at that time between the Treasury and the Bank about a further significant devaluation of the currency. That move was necessitated by the cumulative rise of prices since 1954, the date of the last change in the nominal exchange rate.

This boi proposal for another raise in the liquidity ratio was also delayed, and the amount of the raise shrunken. It was implemented only a year later, in the third quarter of 1962, after the February devaluation of that year – clearly another critical juncture for the Israeli economy. The devaluation had therefore taken place in an inappropriate monetary environment. Delay in the decision-making mechanism had given the political community the ultimate power in monetary matters.

the 1962 devaluation

The decision to raise the nominal exchange rate from I£1.8 to I£3 to the dollar, made on February 9, 1962, was not the result of an immediate balance-of-payments crisis, as such a hefty change might suggest. On the contrary, since the receipts of unilateral payments alone covered 80 to 90 percent of the import surplus at that time, there was no short-term foreign payments problem. The corresponding rise of net capital imports easily covered the difference between these two flows, and even allowed a significant increase of foreign currency reserves (Table 21). In 1960, reserves were seven times greater than they were in 1954, and in 1961 alone these increased by 27 percent, while gnp grew by about ten percent, the "standard" rate for that decade. This growth performance involved, among other things, a lower contribution of the import surplus to the economy – its share was down to only six percent of gnp (Table 18) – and ample reserves, which in 1954, 1960, and 1961 were a reasonable three months' worth of imports.

The decision to make the move on the exchange rate was reached after a lengthy debate in which Minister of Finance Levi Eshkol and the governor of the Bank of Israel, supported by academic opinion, were in favor of that move, and the minister of trade and industry was adamantly against it. It reflected purely long-run considerations. It was first of all the import surplus, down indeed to six percent of gnp in 1960 (higher in absolute terms), that was the concern of Treasury officials. The rising flow of unilateral transfers, the level of which was quite close to the value of the import surplus in the early 1960s, served as a medium-run insurance policy. Its importance was enhanced by the corresponding long-term capital imports, which were also rising. Yet it was also obvious that a growing economy, wedded to rapid growth, as in the Israeli case, would require a corresponding increase of imports. Even if imports and exports grew at a similar rate, the gap between them in absolute terms would get larger, requiring expansion of foreign financing – transfer payments and/or capital imports. Yet by the turn of the 1960s the grant element of U.S. aid was already phasing out, and the total of grants and long-term credits was down. Thus, even optimists who presumed that U.S. aid, in the form of long-term credit, would continue beyond 1965, thought that it would not grow in absolute terms. The predictions on German transfers, which in 1960 provided 50 percent of the unilateral receipts (Table 22), were even worse. According to the 1952 agreement reparations would end by 1965, which meant that approximately one half the foreign currency flow from West Germany would be cut. On the assumption that individual restitution payments would continue to grow and partially compensate for the loss of reparations payments, total German transfer payments would be lower by perhaps 25–30 percent.

This reading of the situation suggested that a highly optimistic estimate of the future balance of payments would assume that the flow of transfers plus capital imports would be maintained at the approximate levels of the 1960s. Yet rapid growth required corresponding growth of imports, which would soon generate a threatening payment gap unless Israeli exports grew at a more rapid pace than imports. Devaluation of what was clearly the nominally overvalued Israeli currency was accordingly the cure prescribed by rational economic analysis.

This reasoning was supported by the relation between the nominal and effective exchange rates. The effective rate was the sum of the nominal exchange rate and the various (and differing) subsidies paid by the state to exporters of goods – citrus exporters, for instance, were paid a different, lower, subsidy for each dollar of foreign currency submitted to authorities, than, among others, exporters of manufactured goods. On the other hand, domestic producers were protected by high duties, by specific impositions over and above the nominal prices that importers had to pay for the foreign currency they required to pay for imports. These impositions were differential too and discriminated between types of product, location of plants, etc. Finally, some domestic products, textiles in particular, were protected by quotas. Thus, though the nominal exchange rate was frozen at its 1954 level, the effective exchange rate – the one that was actually in effect and generated the behavior and decisions of exporters and importers, and thus ultimately of producers and consumers in the domestic market – did change over time.

The data on the effective rate in Table 25, which represents an average of the great number of differential rates, indicates that by 1959 the effective exchange rate on imports was 44 percent higher than in 1954. In the next two years through 1961 it rose to a premium of 54 percent over and above the nominal rate set in 1954 and frozen since then. The corresponding 1961 average effective exchange rate for exports was higher by 45 percent. This nine percent gap between the effective exchange rates averages on imports and exports indicates discrimination in favor of industries selling in domestic markets over export industries. These figures reflect averages; within each of these two groupings, exports and imports, differing subsidies or impositions were assigned to specific enterprises, based on development policy. This practice generated a host of specific rates, which had accumulated haphazardly over time.

Furthermore, though by 1961 imports had the benefit of the average 54 percent higher rate of exchange and exports received a premium of 45 percent on the nominal exchange rate of foreign currency at conversion, unilateral transfers and capital imports were converted at the nominal rate. Since prices, though lagging behind the rate of increase of the effective exchange rate, were still 37 percent higher than in 1954, this meant that the real value of transfer payment funds and capital imports account was eroded by this rate, at least if the funds were converted at the official rate.

Those bearing the burden of the erosion were accordingly those who received funds on unilateral transfer and capital account. They included first of all the public sector, the government, whose real foreign receipts therefore shriveled. To maintain its level of expenditure, it thus borrowed from the central bank, from the banking system, and by issuing price- and foreign exchange-linked bonds. This option was of course not open to private sector recipients of transfers, particularly households receiving German restitution payments and immigrants who had been bringing in their own funds, nor to private sector capital imports. Any policy intended to encourage these inflows, rather than to discourage their transfer, needed to eliminate the effective confiscation of significant portions of these funds through conversion at the nominal rate of exchange. A compensating device was therefore soon invented: another "unofficial" rate of exchange, implemented by means of a complicated capital market device, which was soon applied to private capital imports too. this was added to what was called in the market vernacular of the early 1960s "the set of one thousand exchange rates."

The price and cost structure, and thus the allocation of resources, was soon adapted to the differential exchange rate, the impact of which is necessarily strong in small, comparatively open economies like Israel's. This, however, led to a growing distortion of the structure of the economy that reduced efficiency and eroded growth. The complicated set of exchange rates, which in practice involved several prices for the same item, a given unit of foreign currency, was wide open for abuse, and some of the abuses made headlines. The long-term distorting effect of the multi-exchange rate system, which had been growing over time with the additions to the sets of rates, prompted the eventually successful argument made by the academic economists: that there must be an immediate major adjustment to the nominal exchange rate and that all (or at least most) of the industry-specific and product-specific rates accumulated over time must be abolished. The two ministries responsible for quotas, import impositions, and export subsidies, the Ministry of Trade and Industry and the Ministry of Agriculture, were against the devaluation policy, and the Ministry of Finance and the Bank of Israel, supported by the academic economists, were in favor.

Given the differences between the nominal and the effective exchange rates, the 67 percent nominal rate devaluation announced in February 1962, exactly a decade after the initiation of the New Economic Policy, though seemingly very high, was not what appearances suggested. The effective exchange rate of imports in 1961 was already 154 on the 1954 100 base, and the export rate was at 145 on the same base. The cost effect in the markets of the official increase of the nominal exchange rate by 67 percent was accordingly nine percent at most. Weighted to account for import goods, the price effect could not have been more than about five to six percent even if no other factors were involved. Moreover, domestically the cost effect of the devaluation was at least partly compensated for by the elimination, or at least reduction, of some of the impositions that previously substituted for a higher formal exchange rate. Furthermore, due to the downward world market trend, dollar import prices declined by almost three percent in 1962, pushing the cost effect of the devaluation to at most two to three percentage points. On the other hand, the positive effect on exports should have been significantly greater, since the rate of nominal devaluation was about 15 percent higher than the effective export exchange rate of 1961. Thus even the elimination of some export subsidy items from the register in response to the devaluation should still have increased export profitability by some eight to ten percent.

Yet the long-term beneficial effects of the devaluation still hinged on the macroeconomic environment in its aftermath. The rapid growth process, reflecting robustly growing aggregate demand, is not friendly to the simultaneously cost- and demand-boosting effect of devaluation. With an unemployment rate of 4.6 percent in 1960, declining to 3.6 percent in 1961, in spite of a significant rising wave of immigration, the economy was clearly operating at full employment capacity. In these circumstances, a boost to exports to reduce the expansion, in absolute terms, of the imports surplus, which was the main immediate target of the devaluation, required a highly restrictive monetary policy, with higher interest rates, to reduce the demand on resources for domestic use – for investment and consumption.

This policy, however, was not forthcoming, due to the adamant refusal of the government to allow the boi to pursue it. In the short run the rate of inflation increased considerably in the wake of devaluation: following the leap of inflation to nine percent in 1961, annual rates of inflation in 1962–65 ranged from 8.2 to 9.6 percent, on the verge of double digits. This was quite out of line with Israel's experience in the second half of the 1950s, and of course with contemporary rates of inflation in industrial countries. These rates, which inevitably reflected and affected the pattern of nominal wages, rose by an annual average of 12 percent between 1960 and 1965. This process rapidly eroded the higher post-devaluation real rate of exchange as well as the feasibility of hitting the original target – the reduction of the import surplus relative to gnp.

the mid-1965–to–mid-1967 slowdown

The reckoning of performance early on in 1965 suggested that the prediction of a slower rate of increase of unilateral transfers was right (Table 12). Yet the targeted improvement of the import surplus was not achieved – it increased not only in absolute (real) dollar terms, it grew at an even higher rate than the rapidly growing domestic product, to seven percent of gnp in 1965 compared to its six percent level since 1960. This suggested that the worries about the longer-run ability of the economy to finance the deficit on the current account of the balance of payments were justified. High inflation rates in the full-employment economy persisting for the fourth year by 1965 were another feature that required a response. This situation led to the decision of the Finance Ministry, never stated officially, to attempt to slow down the economy by employing the fiscal tools at its disposal. The slowdown was to be implemented by reducing the size of the development budget used to finance the government's infrastructure investment (cheap credits for business-sector investments in production branches and cheap mortgage credits for housing). The curtailment of the flow of mortgage finance reduced the scope of immigrant and public housing projects, which led to a slowdown in the building industry – the business cycle's leading branch – by mid-1965.

The completion of several major projects made this strategy feasible with hardly any public outcry or political fuss. The completion of the National Water Carrier in 1964 led to the reduction of expenditures on the water system from about 1.2 percent of gdp in the 1960–64 period, to 0.6 percent in 1966. The completion of the Ashdod port project, the country's second deepwater port, which was absorbing a similar fraction of resources; the end of the reconstruction of the Dead Sea Potash Works; and of a major defense project that occurred at about the same time, reduced immediately and significantly the demand for labor, equipment, and raw materials, and of course financing. What the decision on the slowdown amounted to was postponing the start of work on other major projects that were indeed in the pipeline.

The effect of these measures was eventually felt in 1966; the unemployment rate of that year, before the downward pressure on the price level, rose from 3.6 to 7.4 percent. It increased further in the first prewar quarters of 1967 to 10.4 percent of the labor force. This very rapid and substantial deterioration of economic performance reduced the inflation rate early in 1967 from the almost eight percent rate of 1966 almost to zero. The major downturn of 1966 through the first quarter of 1967 was expected by the authorities. They were thus already inclined to initiate fiscal re-expansion to reduce the impact of the slowdown. The unexpected outbreak of the Six-Day War in June 1967 engendered of course an immediate reversal of the economic cycle, which soon turned vigorously upwards.

the "seven good years" and the demise of monetary control, 1967–1973

The vigorous rise of aggregate demand in the third quarter of 1967 was fed by the dramatic surge in defense expenditures. Domestic defense expenditures were 6.9 percent of a depressed gnp in 1966, higher by only one percent than in 1965. These however averaged almost 13 percent in the six-year period of 1967–72, in which national product grew by leaps and bounds: the gnp of 1972 was almost 80 percent higher than that of 1966. Thus by the outbreak of the October 1973 war, domestic defense expenditures in real terms were close to three times higher than they were before the Six-Day War. These expenditures were generating direct public sector demands for supplies and labor across the board; the size of the standing army, inclusive of reserves, grew significantly. A major fraction of the defense expenditure was channeled to defense industries, whose scope of activity and demand for resources grew astoundingly in that period. Employment in the defense manufacturing sector in 1972 was 2.5 times its size in 1966, and involved 20 percent of employment in manufacturing.

That all-out defense effort showed immediately as it surfaced in the fiscal balance, which for a decade between the Sinai Campaign of 1956 and the Six-Day War of 1967 was not running a deficit on its regular budget expenditures; for most of these years it was even in surplus. Only in 1966 did a slight deficit surface, which was in any case quite warranted economically in view of the slowdown of that year. Yet in the three years from 1967 to 1969 a highly significant deficit aver-aging 5.7 percent of gnp appeared. And in those three years and the three quarters of 1973 before the unexpected outbreak of the Yom Kippur War, the fiscal rectitude pursued since 1952 collapsed altogether. The annual average deficit of 10.3 percent of gnp is the obvious illustration.

This, however, did not result from Treasury negligence on the revenue front. On the contrary, tax revenue actually leapt from the 31 percent of gnp in 1966 to 45 percent on average for 1970–September 1973. That very high absorption rate, and its overall increase, reflected also the very rapid growth of national income. First of all, however, it was an expression of expanding tax legislation, which among other things significantly increased National Insurance Institute rates. Furthermore, the tax absorption effort also benefited at this stage from the inflationary increase of income, since income tax exemptions were not calibrated to inflation. It was also supported by a meaningful growth of unilateral transfers. These grew significantly in absolute terms: from the trough of 2.7 percent of gnp to four, even 4.5 percent of Israel's much higher gnp of the early 1970s. It reflected also the return of U.S. aid in the form of grants, paying mainly for defense imports from the U.S., and of course the major increase in donations from Jewish communities abroad.

Yet this major rise in public sector revenue could not cope with the flood of rising expenditures. This pattern was not due only to the all-out expansion of defense expenditures. It was also due to a substantial simultaneous increase of the scope of the welfare state, and of the role of the National Insurance Institute, in particular. Its canopy was significantly increased by the widening of the child allowance program and several other small programs in the early 1970s. Nevertheless, through 1972, after a hefty increase in payroll contributions in 1970, it was still paying its way – in 1965 its revenue from contributions was still 30 percent higher than the flow of its benefits. Yet by 1973 its flow of receipts was lower than the benefits, which amounted to roughly two percent of gnp. Substantial increases of expenditure in other welfare state budgetary items, such as education and health, were also implemented in those years, thus contributing to the dangerous increase in the budget deficit.

The overall expansionary fiscal policy characterizing the seven good years called evidently for a restrictive, and after 1970 highly restrictive, monetary policy. The Bank of Israel's failure to convince the minister of finance, and thus the Ministerial Committee of Economic Affairs, to restrict the monetary avalanche in the wake of the 1962 devaluation shows clearly in the interest data for that period. Instead of rising, interest rates continued to decline, even after the devaluation of 1962–65, though monetary policy in the wake of such a move in a full-employment context requires the very opposite.

The post-Six-Day War expansionary fiscal policy began late in 1967, leading to a rise in aggregate demand. A countervailing restrictive move by the central bank was again the order of the day. At this juncture, the boi was much better equipped to follow along a restrictive policy on its own volition and the timing of its management's choice. This was due to a contract signed with the Treasury in April 1966, in the altogether different very high-unemployment context of that time, with nobody expecting a war within a year. According to this document, the Treasury put at the disposal of the boi a significant quota of short-term Treasury bonds, or Makam (the Hebrew acronym for "short-term loan"). The central bank was allowed to sell or buy them in the money market at discount rates and timing determined by itself. This meant of course that the boi was handed the option, which it did not have previously in 1961–65, to run open market operations. The Treasury agreed not to use the proceeds of Makam sales deposited at the boi for its cash flow. It nevertheless still kept ultimate control of the open market operations, since boi could not sell more than the allocated quota. Thus, on the volume of sales, the Treasury still had the size of the quota as a control mechanism. In 1966 and the prewar quarters of 1967 the Treasury did not bother to control the volume of open market purchases, since these were of course expansionary monetary moves.

Moving into the arena in the recessionary third quarter of 1966, the boi was initially purchasing Makams rather than selling. By the beginning of 1968 the economy was on the road to recovery. Employment was nine percent higher than in 1967, and the unemployment rate was down to 6.4 percent. The very great expansion of money in 1967 – by 26 percent pushing interest rates downward – was by that time in the sights of boi management. Its open market desk thus entered the money market vigorously on the selling side, raising the discount rate in 1969 to 6.3 percent from the lowest rate of the series, 5.8 in 1968. The abolition of the legal ceiling for the nominal interest rate in 1970 offered leeway for further restrictive moves, reflected in Table 24 in a further rise in the discount rate to 7.75 percent.

Yet this proved to be too little too late. The final attempt to restrain monetary inflation was made in 1971, when the discount rate was raised to 8.5 percent after a struggle with the Treasury, which was unhappy even with the 1970 adjustment. The interesting feature of this process in which the boi attempted to implement a restrictive monetary policy was the growing reluctance of the political community represented by the Ministerial Committee of Economic Affairs to allow it to proceed. Yet the data for two subperiods of the seven good years between the wars indicate clearly that the policy of the Ministry of Finance was a crucial mistake. In the first subperiod, embracing the three years from 1967 through 1969, when the boi was allowed to pursue a restrictive monetary policy, the money supply grew by only about 14 percent, not significantly beyond the growth of demand for liquidity generated by the 10-to-11 percent growth of gnp supported by a monetarization process. During this period, in which by 1969 the economy was operating at the threshold of full employment, and in which there was even a small devaluation against the dollar, prices rose by an annual average of only two percent. Yet as the economy clearly passed the brink of full employment and moved into a period of overfull employment – the unemployment rate was down to 3.8 percent in 1970, and was only 2.7 percent in 1972, even though Palestinian workers were already employed all over – a highly restrictive policy was evidently called for.

At this juncture, however, the boi was unable to turn the screws tighter. The inevitable result of the expanding fiscal deficits of these years, not countervailed by restrictive monetary moves, was a monetary explosion. The annual average expansion of the money supply in the 45 months between January 1970 and September 1973 was 31 percent. This explosion carried prices to an annual 11 percent inflation rate in 1970, where it hovered though 1972. In the last nine months prior to the Yom Kippur War, inflation in Israel was running at 21 percent annually. This clearly signified a major failure of macroeconomic policy. And it preceded the outbreak of the unexpected war, and thus could not be attributed to it.

The Manufacturing Drive and the Restructuring of the Economy, 1954–1973

The price explosion during the 45 months from 1970 through September 1973, with inflation rising to an even higher double-digit rate for the fourth year running, might suggest a reversion to the environment of the early 1950s; the 1973 prewar inflation rate, 21 percent, was similar to the inflation rate of 1953. Yet the economy of 1973 was altogether different, and not only because of its size. At the outbreak of the war Israel's gnp was more than seven times greater than that of 1950, and more than five times greater that that of 1954, but no less significant was the far-reaching structural change the economy had undergone during these two decades. The most outstanding feature of that change was of course the rise of manufacturing. In terms of its product, it grew to almost ten times its 1950 level, and 7.5 times its 1954 level (Table 26). This means that manufacturing product was growing at an annual average rate of more than 11 percent, outpacing the very rapid growth of gnp, which was around nine to 10 percent in that period.

By the early 1970s manufacturing was the main production branch in terms of inputs (capital stock and employment) and product. In 1970 24 percent of the total labor employed in that full-employment period, and almost 26 percent of national product, were in manufacturing (Table 27). The growth of capital stock clearly outpaced the expansion of employment in that branch, which meant a rising capital-labor ratio. This trend accelerated significantly from the 1960s through the early 1970s, when the highly capital-intensive defense industries surged dramatically.

Israeli industry of the 1950s was still in its early phase. The identification of manufacturing as the growth branch par excellence was made only later, after the 1956 Suez/Sinai Campaign, toward the end of the first decade of independence. Although traditional Zionist policy had identified the resettlement process with the establishment of agricultural settlements, by this time even its most fervent supporters were coming to accept that this had to change. A market constraint imposed by the limitations of demand for farm products (resulting in overproduction of some that had been in short supply just a few years before), and a supply constraint imposed by the natural limitations of the availability of water, both suggested that these settlements were close to the maximum employment that could offer a decent living standard. This led to a new consensus on the policy of economic development, designed to maximize the absorption of immigrants: priority shifted to the development of manufacturing industry.

This shift first appeared in the late 1950s in the program for the Lachish region, in the center of which was to be built a major urban center based on manufacturing, the new town of Kiryat Gat. It was planned as the location of a new major textile manufacturer, Polgat (an acronym formed from the name of the entrepreneur who was to build and run this entity, and the name of the town). A similar industrial hub, based on a textile combine, was to be built in the new town of Dimonah in the arid, empty eastern Negev. Three other new immigrant towns, Kiryat Shemonah in Galilee, and Sederot and Ofakim in the western Negev, were to follow the same model of manufacturing base and service center for new farm settlements, which toward the end of the 1950s had already been operating for several years.

This shift of priorities toward manufacturing shows clearly in the input and production data of Table 26, which record features of manufacturing industry, and in Table 17, which documents inputs and product in agriculture through the 1970s. Initially, farming production grew at a much higher rate than manufacturing. By 1954 manufacturing product was 25 percent greater than in 1950, while that of farming grew by 80 percent – reflecting the booming sellers' market for fresh food in the first decade of the state. But by 1962 manufacturing had drawn even with farming in terms of product growth, and from that point onwards it was always ahead.

This was due to the growth of inputs. Until approximately 1955, when Pinhas Sapir, the new minister of trade and industry, announced the industrialization drive, the expansion of employment in the two branches was similar. After a decade, by the mid-1960s, the growth of employment in manufacturing (and handicrafts) overtook by a significant measure that of agriculture. By 1970, the growth of farm employment has stopped, while manufacturing employment kept growing. This was the end of the story; agriculture, which employed a significant share of the labor force – 17.3 percent of the total in 1950 – and maintained that share through 1960, was down to only nine percent by 1970, while manufacturing employment expanded at a more rapid pace than total employment between 1950 and 1970, when almost 25 percent of total employment was in manufacturing and handicrafts.

The comparative trends of investment and thus capital stock follow a similar pattern. Both branches had had the benefit of a major investment drive, generating corresponding expansion of their capital stock. Yet by 1960 capital stock at the disposal of manufacturing was almost five times greater than a decade before, while that in farming, which also grew very rapidly, was less than three times its 1950 size.

The comparative factor productivity of manufacturing displays an interesting feature. While that for the whole business sector increased significantly between 1950 and 1955, reflecting the success of agriculture and other industries on this score, that of manufacturing declined. This was of course the period of mass immigration, during part of which the economy was under the supply and rationing regime. The price upheaval of 1952 might have distorted the complicated productivity estimates for the period, thus exaggerating the erosion of productivity in manufacturing. But by 1965, at the end of a decade of rapid growth, manufacturing drew even with the business sector as a whole in terms of productivity, and from that point on kept ahead (Table 26). Since the productivity measure for the whole business sector is heavily affected by that of manufacturing, due to its significant weight in the total, this suggests of course that its performance on that score had been much better than that of several other manufacturing sub-branches.

As is the case in any industry, manufacturing consists of a variety of types of activity. Thus any industrialization drive orchestrated by the government would require a decision about focus. The protected domestic market, short of basic manufactured consumer goods, was at this juncture the obvious priority for manufacturing activity. The obvious lines of business for development were food processing, textiles and clothing, and of course building materials, which in 1952 accounted for 17, 23, and 8 percent respectively of total employment in manufacturing. To these, metal machinery and electronic equipment, lines that had expanded rapidly during World War ii, and by 1952 accounted for 23 percent of total employment in manufacturing, might be added.

The establishment of major textile works and food processing factories was therefore at the heart of the first industrialization drive in the latter half of the 1950s. This choice reflected not only market considerations; resources were also relevant. There was a shortage of private entrepreneurs and private investment capital, as well as of managerial experience and general know-how. The low capital intensity of these industries, which meant that they offered a high number of employment openings per unit of capital investment, made them better able to accommodate the shortage of investment funds. They also required a less highly skilled labor force, so that they could more easily employ immigrants who lacked industrial experience.

Furthermore, in these two lines managerial skills and know-how were available. Two major private-enterprise textile conglomerates had been established in the Jewish community of Mandatory Palestine in the 1930s, and textiles and clothing had been primarily Jewish industries in prewar Eastern Europe (and in South America, where many Jewish entrepreneurs had fled), whence came most of the new immigrants. Thus, the effort to persuade Jewish entrepreneurs to invest in the textile industry, which also would receive government funding, was high on the agenda. It did generate a response; the Polgat conglomerate of Kiryat Gat was one example.

These traditional manufacturing activities, operating in the protected domestic market of the late 1950s and early 1960s, could not offer much potential for export penetration into the markets of major industrialized economies. Others could; by the early 1960s, Israel had a pioneering pharmaceutical industry. It had been established in the early 1930s; the academically trained and technically skilled manpower required for it was provided in that decade by immigrants from Germany and several other Central and Eastern European countries. It bloomed during the war years, when the Middle East was cut off from European and North American supplies. This situation provided it with the war-protected British military market and those of other Middle Eastern countries. Consequently, it could already hold its own in postwar foreign markets. The same was true of the chemical industry, which, after the reconstruction of the Dead Sea Potash Works, the first stage of which was completed in the late 1960s, developed rapidly.

Yet the real breakthrough of Israel's manufacturing industries into the world market occurred with the emergence of the high-tech electronics industry in the 1960s. This date is highlighted by the fact that the Central Bureau of Statistics 1960 Yearbook had no entry for electronics in its manufacturing industry tables. Yet in the Yom Kippur War, the Kfir fighter jet produced by Israel Aircraft Industries (iai), a government-owned corporation employing close to 10,000 workers, was already engaged in combat with the Egyptian and Syrian armies. The major components of this fighter jet, though not its engine, were produced by iai or its subsidiaries; its highly advanced state-of-the-art electronics were designed and produced in Israel. This aircraft symbolized the entry of Israeli manufacturing into the era of high-tech. If textiles were the focus of the first stage of the industrialization drive of the late 1950s and early 1960s, the rapidly expanding defense industries were the engine of the second stage in the late 1960s and through the early 1970s.

Employment in this industrial complex, by that time mostly owned and run by the government, grew by 4.4 times between 1960 and 1972, while that of manufacturing as a whole grew only twofold. Thus, by 1973, about 20 percent of industrial employment was offered by defense industries. Furthermore, since the capital intensity of the production of the sophisticated components of these industries was and is much higher than in other manufacturing sub-branches, the capital stock of the former necessarily expanded at an even higher relative rate. The expansion of manufacturing in the two decades from 1954 to 1973, and its conversion into the major industrial branch in terms of employment, capital stock, production, and from the 1960s onwards, exports, was to a great extent due to the performance of the defense industries.

Exports were undoubtedly a highly meaningful expression of the structural change the Israeli economy had undergone in the 25 years between the Declaration of Independence and the Yom Kippur War. In 1950 the dollar value of industrial exports (exclusive of diamonds) was only about 50 percent of the value of farm exports; by 1970 industrial exports were more than three times greater than farm exports. This, of course, underscores the major transformation of the real dimension of economic activity. In 1950 agriculture was still employing 17 percent of the labor force, compared to 21 percent in manufacturing and handicrafts, and agricultural production was almost 12 percent of net national product. That of manufacturing was 28 percent. By 1970 agriculture was down to only 8.8 percent of total employment while manufacturing employed close to 25 percent of the labor force. By that date, the contribution of agriculture to the nnp was down to 6.9 percent, while that of manufacturing was about 26 percent (Table 27). Israel's socioeconomic structure had been transformed and now exhibited the characteristics of a highly industrialized economy, in which urban manufacturing and services dominated.

economic slowdown, revival of aliyah, and the emergence of high-tech, 1974–2004

The three decades in which Israel's economy moved into its maturing stage between the early 1970s and the first years of the 21^st century through 2004 were on the whole significantly affected by war and war-generated strains. It was the Yom Kippur War and its immediate political aftermath that set the economic agenda at the beginning of that period, soon followed in the early 1980s by the 1982–84 Lebanon campaign, which involved an occupation of a significant slice of south Lebanon. The outbreak of the first Palestinian Intifada late in 1987 shifted the focus from the armies of neighboring Arab states to a struggle with Palestinian resistance, which on and off after several short pauses in the 1990s, was restarted on a full scale late in 2000.

This had of course far-reaching domestic political implications and inevitably affected the economy. Soaring defense expenditures that through the whole of the 1970s required the allocation of resources of an order of 25–30 percent of national product imposed a heavy burden on the economy at large, and also on the fiscal system, which almost collapsed under the strain.

Yet in spite of these challenges to the system and populace, the overall economic performance was seemingly reasonable. gdp was higher by more than three times in 2004 than it was in 1973, and the product of the business sector even grew

by about 3.7 times. Correspondingly, private consumption expenditure grew by almost five times in these three decades, benefiting of course from the much lower expansion rate of public sector consumption expenditure. The latter grew by only 40 percent through 2004, due to the relatively stable, in absolute terms, defense expenditures. From the early 1990s on these required, therefore, only about eight to nine percent of a significantly greater gnp. The overall growth figures could not match, of course, the average nine to 10 percent growth rate of the 1948–73 period, but they still allowed a reasonable 1.4 percent annual per capita growth rate (Table 28), even though population increased rapidly, by industrial countries' standards, at 2.5 percent annually.

There was a rapid population increase in the last decade of the 20^th century, due to mass immigration from the Soviet Union and, after 1991, its successor states, whose Jewish population had been released from the restrictions imposed by the Soviet state until 1989. About a million people arrived in this immigration (Table 15), lifting aliyah from the nadir of the 1980s and making a major change in the demographics of the Jewish population, which grew to about 5.6 million by the end of 2005 (when the total population reached almost seven million).

This growth of course affected the performance of the economy. The familiar lag in economic absorption of the immigrants had a depressant effect on per capita product, though inevitably less of one on per capita consumption. The twofold population increase in the three decades through 2003, an annual growth rate of 2.4 percent (an unusually high rate compared to other industrialized countries), offers a partial explanation of the "meager" (by its historical standards) 1.4 annual average increase in Israel's per capita gnp. It was far off the phenomenal 5.5 percent corresponding growth rate during the 25-year period ending with the Yom Kippur War (Table 18).

The comparatively very high demographic expansion also offers a partial explanation of the decline of Israel's comparative per capita product from the levels reached early in 1990, it was about 70 percent of that of the United States and about 80–85 percent of the European Union average, and declined to somewhat more than 50 percent of the U.S. and E.U. figures by 2000. For better or worse, the Israeli economy, with a population of about seven million and generating a national product more than three times its size of the early 1970s (with corresponding growth of its exports and imports) was by 2005 an entirely different enterprise than in the early 1970s. Yet though it had clearly crossed the threshold of industrialization in the interval, the progress toward that target was sloppy. The period through the mid-1980s was trying indeed, but performance and well-being improved significantly from the 1990s onwards.

The "Lost Decade": War Expenditures and Inflation, 1974–1985

the growth record

The drastic decline of the growth rate of national product in the so-called "Lost Decade" (economists' name for the interval between the Yom Kippur War in October 1973 and the start of the highly restrictive Economic Stabilization Policy on July 1, 1985) can be seen in the data of Table 28. The national product of that twelve-year period grew at a rate of 3.3–3.4 percent for total and business sector products respectively, only about one third of the very high growth rate, in the range of nine to 10 percent, over the 25-year period through 1973. Per capita gdp grew at an annual rate of only 1.2 percent, about one fifth of the performance in the previous period. The growth rate of private consumption expenditure, an indicator of current living standards, expanded at less than 50 percent of the growth rate prevailing in the 1948–73 period, the so-called formative period of the state.

This decline of growth performance in the later 1970s and 1980s was not unique to Israel. Mediocre performance, even dismal in some cases, as in Britain, was universal from the 1970s on throughout the industrialized countries, which had been driving the world economy in the postwar era. Low or flat output growth and higher rates of inflation led to the emergence of a new economic term, "stagflation," a shorthand expression for the two dominant economic phenomena of these years, stagnation and inflation. The simplistic and popular explanation for these features, which were indeed visible everywhere, attributed them to the so-called "energy crisis," which became the subject of headlines after the opec oil cartel's price hikes, the first of which was implemented on October 19, 1973, while the Yom Kippur War was still being fought. The initial quadrupling of oil prices, followed by further hikes in the 1970s through the early 1980s, at which time prices finally collapsed, undoubtedly had a significant impact on the workings of the major economies. Yet the widespread malaise of the 1970s was clearly also affected by the exhaustion of the postwar reconstruction efforts of the Western and even Eastern European economies, which had been going on from the end of World War ii until 1970.

The seeds of rapid worldwide inflation were generated by the full employment U.S. economy of the 1960s, which had been pursuing a significant war effort in Vietnam while financing a major Cold War defense budget, and simultaneously implementing President Johnson's War on Poverty programs. The so-called Vietnam inflation was a fact of life in the U.S. by 1968. Given the dominance of the U.S. economy in the world at large, this could not but generate an inflationary impact on the other industrialized and fully employed economies of that era. The sudden price explosion of crude oil, and thus of energy generally, added of course to the conflagration.

the slowdown of aliyah and the effects of sluggish investment

These developments had of course an immediate impact on the Israeli economy, which by 1970 had crossed the threshold into a full-employment environment, and from around 1971 moved into overfull employment. Yet structural factors specific to Israel, as well as short-run domestic developments, go a long way to explain the weak economic performance during that decade. The meaningful slowdown

of aliyah, which had been a major engine of growth for the 25 years through 1973, had undoubtedly a considerable effect on the growth pattern. Though specific to Israel, this factor was imposed by an external authority, the Soviet Union, through its policy on emigration: the flow of Jews from the Soviet Union, which between 1969 and 1973 reached 40–50,000 annually, was reduced to a trickle by 1974. Immigration thus plunged to an annual average of only 19,000 during the ensuing 15 years through 1988.

Thus, with the housing industry, the traditional leading sector of a rising economic cycle, in the doldrums, investment was low. Though the economy did grow, it was sluggish during the lost decade; the rate of growth declined successively year in and year out. Gross investment in 1985 was 83 percent of the level it reached in 1973. It revived in the second half of the 1980s, yet by 1989, in the wake of the 1985 Stabilization Policy, and before the surge in aliyah, it was still only at 94 percent of the 1973 levels, when gdp had been only 60 percent of what it was in 1989 (Table 28). Reflecting the dismal economic environment of the lost decade, investment in the production branches was similarly continuously lower in these years than in 1973. Its revival began only in the early 1990s, when the economy changed track (see below, The Resurrection of Growth and Restructuring).

Similarly to the reduction of the growth rate of the labor force to an annual rate of two percent during the lost decade, half what it was in 1970–73, the much lower investment rates reduced the growth rates of the capital stock of the production branches (see the figures for "other" capital stock in Table 29). The slower expansion of capital stock and of the labor force, and the state of the markets, negatively affected the productivity pattern of the economy, with an inevitable negative impact on national product. This shows in the total factor productivity data, implying lower labor productivity measurers (Table 29). tfp stopped growing altogether between 1973 and 1975, and during the lost decade grew on average at only half the rate that had prevailed in the "seven good years" between 1967 and 1973.

dismal fiscal fundamentals, 1973–1985

The strangulation of growth and the rapidly increasing inflation were due to the expansionary fiscal policy supported by a permissive monetary stance. Undoubtedly the expanding, indeed exploding, defense expenditures were the cause of fiscal expansion from 1967 on. Defense expenditures did indeed shoot up in 1967; at the end of that year these were higher by almost 80 percent than in 1966, when nobody expected an actual war. At the end of the War of Attrition along the Suez Canal in the summer 1970, defense expenditures were twice the level of 1967 in real terms. The Yom Kippur War generated a further expansion, so that at the all-time high in 1975 they reached a level never reached again through 2005; in real terms these were 55 percent higher than in 1970, thus more than five times the 1966 level in real terms.

The burden that expenditures of this magnitude imposed on the economic system is underlined by the ratios of these rising defense expenditures of domestic resources, shown in the Table 20 data which allow a comparison with defense expenditures before 1967. In one year, from 1966 to 1967, defense expenditures leapt from eight percent to 16 percent of total resources in the economy for domestic use. By 1970 defense expenditures required 21 percent of the same total. This rise reflected the 1968–70 War of Attrition and the threatening strategic environment of the Cold War, in which the Arabs had the political and military backing of the Soviet Union.

This rapid increase of defense expenditures, not only in absolute terms, but also relative to the production capacity of the economy, was subjected to another upward push by the Yom Kippur War and its aftermath; defense expenditures rose to a record high of 26 percent of resources. Since in those years resources included a substantial component of import surplus financed by unilateral transfers, including donations from world Jewry, U.S. government grants, and foreign credits, the ratios of defense requirements to production capacity, and thus to the taxing capacity of the government, offer a more meaningful picture of the tremendous burden defense imposed on the economy. The ratios of defense expenditures to domestic resources displayed in Table 30 show that these were about 21, 24, and 26 percent of Israel's gnp in 1970, 1973, and 1975 respectively. This of course means that if foreign finance had not been available, the public sector would have been required to impose taxes at these levels just to finance defense. Civilian public sector services – education, health, welfare, and roads – would accordingly have required additional taxes.

It was at this juncture, at the beginning of the 1970s, in which welfare state long-term trends and short-run political considerations imposed a further squeeze on the strained fiscal system. The social security system, which started in 1954, had been providing a net contribution to the cash flow of the government, though at declining rates, through 1972. This was due to the youth of the population, which meant that old-age benefits required a lower outflow of payments than the inflow of payroll contributions to the National Insurance Institute. Twenty years after the system began the age structure effect reduced this surplus. Furthermore, child allowances, introduced in the 1960s, were initially negligible, but substantially increased in the early 1970s, reflecting the priorities of the political community at this stage. Thus, between 1965 and 1975 the cost of old-age benefits rose by more than one percent of gnp, and the cost of child allowances grew by more than 1.5 percent of gnp. Hence, despite a major hike in payroll contributions in the early 1970s, before the war, the National Insurance Institute, which had a surplus cash flow of 0.6 percent of gnp in 1970, had a negative cash flow of two percent of gnp from 1973 onward, increasing over time.

To cope with these rapidly rising expenditures, the Treasury attempted persistently to raise tax revenues. Both rapidly rising national income and extensions of the scope of tax legislation contributed to the effort. Thus, between 1967 and 1969, tax revenues grew by 10 percentage points to 33 percent of gnp. In the almost four years before the Yom Kippur War, the rate of increase of tax revenue was significantly greater. By 1970 tax revenue was about 42 percent of gnp compared to only 31 percent in 1966, and by the outbreak of the war it rose to 44 percent (Tables 23 and 33). Furthermore, unilateral transfers, reflecting the contributions of world Jewry and U.S. defense and economic aid (which resumed in 1970 in the form of long-term loans and in 1973 as grants as well), rose very significantly (Tables 22 and 32), thus contributing to government revenue absorption. Yet the leap of absorption, defined as the sum of tax revenue, donations, and grants, was not enough, and could hardly have been large enough to countervail fully the avalanche of expenditures.

The balanced budget of the first half of the 1960s, which was initially in surplus on current account and effectively balanced in 1966, disappeared from the horizon for two decades through 1985. In 1967–69 the public sector was already running a significant deficit of 5.7 percent of national product. In 1970 the deficit run by the government was already beyond

12 percent of gnp and in the wake of the war it grew further, to its all-time high of 21 percent of product. The reduction of defense expenditures during the next decade through 1984 allowed correspondingly lower deficits, but these persisted beyond the 12–15 percent range (Tables 23 and 33). To even out the cash flow, the government resorted to the age-old device that governments have always used during periods of war and crisis – the printing press. Fully in line with the 1954 Bank of Israel Law, the central bank accommodated the cash flow requirements of the public sector, reflecting of course the dismal imbalance of fiscal fundamentals that surfaced in the wake of the Six-Day War in 1967, and began to generate rapid inflation. It was beyond 10 percent annually from 1970 onward.

The lag in the appearance of price inflation for three years in spite of deterioration of the fiscal fundamentals from 1967 onwards is quite explicable. The vigorous fiscal expansion, followed by a revival of investment in the second half of 1967 after the Six-Day War, occurred in the context of a depressed economic environment. The peak 10 percent unemployment rate of 1967 and the following two years of about 7.5 percent, and inevitably a corresponding underutilized capital stock, indicate the level of excess capacity. The significant average of budget deficits for the three years through 1969 of 5.7 percent of national product generated rising aggregate demand, which had first of all a quantity effect – it could be and was met by rapidly rising production. The price effect, which coincided with an upturn from a major depression, was accordingly very small, even though a devaluation of 17 percent against the dollar (the same rate as the British pound, also devalued that year) was implemented in November 1967.

These years were thus a period of rising product and incomes, at average rates beyond 10 percent, and of comparatively stable prices. Yet the unemployment rate of 3.8 percent in 1970 (even though immigration was rising rapidly from 1969 onward) and the influx of Palestinian workers from the territories who were rapidly increasing the domestic labor supply suggest that by that time the economy had crossed the full-employment threshold. This is highlighted by the unemployment rates in the range of two to three percent in 1972 and 1973 (Table 29), indicating that by that time the economy was already at overfull employment.

Highly restrictive fiscal measures were required, supported by a restrictive monetary policy, to avoid inflation in 1970, and even more so in the succeeding years through the outbreak of the October 1973 war. Yet neither of these policy measures were forthcoming. The budget deficit of 1970, at the very high level of 12 percent of gnp, and the average from 1971 through the nine prewar months of 1973 beyond 10 percent, more than twice its annual level in 1967–69 (Tables 23 and 33), underlines its impact on the inflationary developments which soon affected the economy and society as a whole. In view of the fiscal expansion, which was accommodated, rather than countervailed (see below, The Sterilization of Monetary Policy), the 22 percent annual inflation rate of the nine prewar months of 1973 (Table 36) was, of course, no surprise. That major prewar turn-up of inflation could not be attributed to the unexpected war, nor to the environment of foreign markets, in which inflation also was rising at the time. The most inflationary industrial economy of 1973, Britain's, was undergoing only single-digit inflation.

The immediate impact of the war, which generated a skyrocketing budget deficit of 21 percent of gnp in 1975, added of course to the conflagration (Table 33). Inflation was already running at 40 percent in that year, and in 1976. After a failed attempt to liberalize currency controls late in 1977, inflation took off at 50 percent and soon, towards the end of 1979, crossed the triple-digit mark. It finally accelerated to 400 percent in 1984.

The reduction of defense expenditures in the second half of the 1970s, after a temporary increase in 1981–82 linked to the invasion of Lebanon, made the significant reduction of the budget deficit from the 21 percent of 1975 to the 12–14 percent range of the early 1980s feasible. At such deficit levels, which inevitably required corresponding central bank credits to even out the government's cash flow, a reduction of inflation running at rates beyond 100 percent annually was of course impossible. Government effort to reduce the size of the gap involved the impositions of ever-higher tax rates. These succeeded indeed in pushing tax revenue temporarily to a record high of almost 50 percent of gnp by 1980, which supported the reduction of the deficit to the 12 percent range.

Yet real tax revenue was lower by nine percent of gnp in 1984 than it was in 1980. And this was not due to a reduction of tax rates: it reflected, rather, the dynamic effect of inflation – which by that time was beyond 100 percent annually for the fifth year – on the fiscal fundamentals. These were eroded by the so called "Tanzi Effect," which describes a feature of the behavior of taxpayers and tax transmitters (employers deducting income tax and social security contributions, businesses charging purchase taxes) in economies in which inflation runs at about three percent or more per month. Since, owing to administrative constraints, it is feasible to collect tax revenue only once a month, or at most every 15 days, taxpayers, even law-abiding taxpayers, pay only on the very last day.