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How the Start-Up Nation Could Fail

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Lucian Bebchuk and Oliver Hart explain why Israel’s proposed legal transformation would undermine not only its democracy but also its economy.

Israel’s ruling coalition is now pushing through its parliament an array of major legal changes that would greatly curtail the independence of judges and their authority to review any legislative and executive choices. There is strong resistance, both from inside Israel and from its friends and supporters abroad, and there are good reasons for this resistance.

Israel’s court system currently provides the main source of checks and balances. The country does not have a constitution, a federal system, or two houses of Parliament, and a ruling coalition’s leaders commonly control both the executive and the legislative branches. Thus, if the restructuring is adopted, the current group of party leaders will face few constraints on their power until the next election in four years. Indeed, these leaders would have the power to tilt the next election in their favor, by making the media subservient or adopting favorable election rules. They could even defer such an election altogether.

A key concern about the changes is their effect on democracy and individual rights. As in any electorate, however, many Israeli voters are keenly interested in how the changes would affect the economy. Therefore, Mr. Netanyahu and other coalition leaders have been arguing that the changes would bolster economic growth. These claims are inconsistent with the rapid decline of the Israeli currency in the weeks since the coalition unveiled its plans, and with the broad opposition to the changes among Israeli business leaders. They are also inconsistent with solid economic reasoning.

A group of 56 leading US economists, including 11 Nobel Laureates, recently issued a statement warning that the changes would be detrimental not only for democracy but also for economic well-being. It is uncommon to find agreement among the members of such a broad group of prominent economists.

Three Key Effects

We joined this statement because there is a significant body of economic research, backed by empirical evidence, about how economies benefit from a system of adequate checks and balance. One key reason is that, as work by Daron Acemoglu, James Robinson and others has shown, economic prosperity requires inclusive political institutions with a broad distribution of power. Lack of a broad distribution of power brings about increased extraction of value from some groups to others.

In the current setting in Israel, for example, eliminating constraints on the ruling coalition could be expected to increase value transfers to and preferential treatment of the ultraorthodox and settler communities represented by key coalition partners, which would be at the expense of the half of the population not so represented. Such value extraction and favoritism have been shown to bring about significant distortions and inefficiencies that hold economies back.

A second channel is that weakening the courts’ independence and authority operates to distort outcomes by facilitating political favoritism or even corruption. Instead of a level playing field, the decisions of governmental officials and judges would be tilted in favor of politically connected players. As the work of Andrei Shelifer, Robert Vishny, and others has shown, strengthening the grabbing hand of political players produces serious distortions that are detrimental to economic performance.

A third channel involves the effect that eliminating checks and balances has on foreign investors and firms. When those in power are able to change the rules of the game quickly and to favor politically connected players, foreign investors and firms become wary of investing in or dealing with local firms. Such foreign entities would be concerned about how the rules would be applied to them.

The Arguments of Coaliiton Leaders  

In support of the restructuring, coalition leaders have argued that it would benefit the economy by reducing the time that private parties currently wait to get a court judgment. But adding judges and streamlining litigation procedures (rather than by weakening the courts) would best address such delays, and no such measures were included among the many elements of the proposed changes.

In addition, coalition leaders have also argued that the changes would facilitate private contracting by making judicial outcomes more predictable. However, there is no reason to expect that subjecting judges to political control would decrease rather than increase uncertainty. Furthermore, the current rush to push through major changes introduces substantial future uncertainty even about the basic rules of the game. Indeed, the claims that the changes would facilitate transacting between private parties are inconsistent with the broad opposition to the proposed changes among Israeli business leaders.

Risks Produced by Israel’s Special Circumstances

Finally, while eliminating checks and balances would raise substantial concerns in any circumstances, several aspects of Israel’s situation make these concerns especially severe. First, Israel is an open economy with international trade that is large relative to GDP. In such circumstances, structural changes that would discourage foreign investors and business partners are especially harmful.

Second, and related, the past success of the Israeli economy has been substantially due to the large high-tech sector that the “start-up nation” has developed. Because this critical sector depends heavily on funding from foreign investors and cooperation with foreign firms, it is especially vulnerable to the effects on such investors and firms that the produced restructuring would have.

Third, because of Israel’s national security challenges, its citizens have to participate in a compulsory military service and bear large defense spending, and this has required a high degree of social solidarity. Curtailing the inclusiveness of political institutions would weaken Israel’s ability to induce continuations of such contributions from the broad range of its citizens.

Indeed, by making the distribution of power less inclusive, and paving the way for subsequent changes that would favor the interests and preferences of the ultraorthodox and settler communities, the proposed restructuring could well alienate other societal groups and increase emigration. Significant emigration, especially if it came from the large number of people employed in the high-tech sector who seem to be broadly opposed to the changes being pushed through, would undermine the Israeli economy’s ability to meet Israel’s national security challenges.

We should stress that the proposed restructuring could well be strongly opposed because of its effects on democracy and individual rights even if the restructuring were expected to be economically beneficial. But both economic theory and evidence indicate that the restructuring would undermine not only democracy and individual rights but also the economic well-being of the start-up nation.

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.

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