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How Industrial Policy Made the Desert Bloom

Israel seems always to be at the center of some political controversy, and this moment is plainly no different. But on the subject of economic policy, the country occupies a place of remarkably copacetic consensus, in two important respects.

First, Israel is widely renowned for its outsized role in global innovation. It leads all nations in R&D spending as a share of GDP. Its high-tech sector accounts for 10% of employment (double the typical level for a developed economy) and 43% of exports, allowing the tiny and isolated nation to maintain a healthy trade surplus. Tel Aviv is recognized frequently as one of the world’s top innovation ecosystems, supporting an unrivaled level of start-up activity.

Second, everyone agrees how a desert nation of refugees, under constant attack, accomplished this miracle: with industrial policy. The aggressive role of public investment and direction in building Israel’s innovation ecosystem is not itself surprising—indeed, that’s exactly how such ecosystems usually emerge, as Wells King has shown was the case for Silicon Valley. But that fact usually prompts angry denials from market fundamentalists committed to an economic narrative built on “creative destruction” and “permissionless innovation” with which government only interferes. For Israel, perhaps because the evidence is so irrefutable and the outcome so remarkable, reality goes largely unquestioned.   

Uri Gabai, CEO of Israel’s Start-Up Nation Policy Institute, provides a representative assessment. Dismissing explanations grounded in the nation’s “mandatory military service, the elusive Jewish entrepreneurial gene, or the famous Israeli ‘chutzpah,’” he writes, Israel’s “secret sauce” is “bold yet pragmatic innovation policies,” an emphasis on “public-private partnership,” and “a government entity with the mandate and capabilities to advance policy measures to achieve the vision.” 

Gabai’s policy institute is no socialist front. The “Start-Up Nation” network, spawned by a 2009 book of that name by Dan Senor and Saul Singer, counts among its supporters some of America’s hardest-nosed capitalists. Hedge-fund tycoon Paul Singer founded the non-profit Start-Up Nation Central and served as the policy institute’s initial co-chair. Back stateside, Singer chairs the board of the Manhattan Institute, “a leading free-market think tank” more inclined to the liturgy of tax cuts and deregulation. 

What happened in Israel? A new American Compass case study, How Industrial Policy Made the Desert Bloom, tells the story of the government-led economic strategy that even market fundamentalists can’t explain away. In the 1960s, Israel spent less on R&D than any developed nation aside from Italy; the private sector employed fewer than 900 researchers. As Erez Maggor, a fellow at the Hebrew University in Jerusalem, recounts in American Affairs, “State planners at the Ministry of Trade and Industry (MOTI) concluded that Israel’s economy was in ‘urgent need [of] rapid technological development’ and required ‘an accelerated effort in the field of industrial R&D,’ … and that ‘industrial R&D in Israel will not be able to develop fully without massive government aid.’”

What followed was an intensive and long-lasting program of public support and oversight. Israel’s Office of the Chief Scientist (OCS), formed in 1968 and fully operational in 1973, played the role of an “academic grant giving foundation,” distributing R&D funding without regard to sector to maximize investment and encourage all types of businesses to pursue technology-intensive markets. As one of the first OCS employees later explained, the goal was “to create a sort of paradigmatic change in the way businesses thought about what they are doing. … We did not really care who, what, why, when, we just wanted to create an R&D dynamic.”

OCS attached two vital stipulations to its grants, formalized in the Encouragement of Industrial Research and Development Law of 1984: First, products developed with OCS funding must be manufactured exclusively in Israel. Second, intellectual property created during such projects could not be transferred outside the nation’s borders. Such draconian measures may trigger fear of stagnation and capital flight in the minds of Americans, accustomed to devices “designed in California” but made on the Pacific’s other side. But in Israel, they worked—even attracting foreign investment. 

Texas Instruments and Motorola both came to Israel in the late 1970s and early 1980s to conduct OCS-subsidized research and then constructed advanced manufacturing facilities. In Start-Up Nation, Senor and Singer tell the story of how Intel arrived in Israel to conduct R&D, proceeded to construct its first non-U.S. fabrication plant in Jerusalem, and in the 2000s placed a company-defining, and ultimately winning, bet on a breakthrough mobile chip developed in Haifa. One of the book’s chapters is titled, “An Industrial Policy That Worked.”

Another important provision of Israel’s program required any firm receiving OCS funding to repay that funding as a royalty on future revenues, up to 150% of the initial grant. This entitled OCS staff to closely monitor activities within firms, ensuring for instance that neither intellectual property nor production were offshored. With grants disbursed piecemeal, so many firms receiving them, and harsh penalties for failure to comply with OCS terms, the government had a powerful means of keeping private-sector energies channeled toward productive ends. 

As Israel’s innovation economy expanded, its government supports did as well. OCS launched a start-up incubator in 1991 to provide inexperienced entrepreneurs with assistance and infrastructure, and a series of research consortia in 1992 among firms and academic researchers working on the same technologies. Most significantly, also in 1992, OCS launched Yozma, designed to jumpstart a domestic venture capital industry. The program deployed $80 million to create 10 new private funds, each of which had to secure additional investments from at least one foreign and one local financial institution, and $20 million to create a public fund. By 1996 the new funds had more than doubled in value and Yozma became a model for investment policy around the world. By the mid-2000s, Israel had more NASDAQ-listed companies than all of Europe combined.

The policies that propelled a small developing country to global technological leadership may not translate directly to the modern American context. But their success does offer lessons that bear directly on American policy debates, in which efforts to develop an industrial policy responsive to contemporary challenges encounter market fundamentalism’s steadfast objection that government interventions cannot work. Clearly they can. A prominent public role in funding and directing research and development, infrastructure and subsidies to help businesses launch and grow, and restrictions that keep both knowledge and production within our borders are not incompatible with rapid economic growth and technological progress. They are a proven formula for just that.

The lesson that SUNPI’s Gabai has learned is one that should resonate well with American policymakers right now: “Technology and innovation are too important to be left to tech companies.”

Oren Cass
Oren Cass is the executive director at American Compass.
Read the Case Study
How Industrial Policy Made the Desert Bloom

A case study on the public investments behind the Israeli economic miracle