The Zionist movement set out to create a homeland for the Jews and largely as a result of its policies, the Jewish population of Palestine rose from about 25,000 in 1885 to 600,000 in early 1948. The demographic development of the Yishuv was matched by its economic growth: In the period 1922–1948, national income per capita rose nearly threefold, in real terms (see Appendix 2.1). This extraordinary achievement was made possible by inputs of capital as well as labor and by the very high level of human capital of the immigrants. In 1948, the Jewish population of Israel had one of the highest educational levels in the world, something that made the efficient absorption of capital possible. The successful economic development of the Yishuv was also due to the appropriateness of its economic policies. These emphasized agriculture and the result was to create the foundations needed for industrialization. British economic policies were broadly helpful or at least did not prevent the development of the Yishuv’s economy. The increase in demand from the British military in the Middle East during World War II gave industry in the Yishuv a significant boost.

The early years of the state were extremely harsh. In addition to the destruction resulting from the long war of independence, war casualties that amounted to 1 percent of the population and the arrival of huge numbers of immigrants – the raison d’être of Zionism – posed huge challenges. The country lacked the resources to integrate them: Most crucially, there were shortages of housing and employment. In macroeconomic terms, there were large budget deficits, financed by inflationary means, partly suppressed by rationing and other controls. In addition, there were large balance of payments deficits. As a result of these pressures, the government adopted very pragmatic policies that sometimes gave rise to political conflict at home. In the early 1950s, a reparations agreement was negotiated with the Federal Republic of Germany that gave Israel vitally needed foreign exchange, but it was bitterly opposed by opposition parties. The reparations agreements eased the balance of payments constraint and permitted the economy to grow. A second pragmatic policy was the decision – also in the early 1950s – to seek out entrepreneurs from abroad who were encouraged to invest in Israel. Within a framework of import substitution, industrialization was pushed forward. The government offered land, labor, and capital, as well as markets protected from foreign competition. By restricting the number of investments within any sector, the government also limited competition in the home market. This package was enough to encourage a number of vital investments in basic industries such as clothing and textiles. The aim was to increase employment and output and thus supply the local market with the basic products that it needed. By the early 1960s, the development of the economy using import substitution was beginning to weaken. Local markets were becoming saturated with noncompetitively produced goods, and consequently firms were experiencing declines in demand for their products. They needed new markets if they were to continue growing and if the economy was to generate enough new jobs to employ labor market entrants, including immigrants. Once again, pragmatism prevailed and a trade agreement was negotiated with the European Economic Community. This enabled Israel to export industrial products to the EEC with few restrictions, but the price was that Israeli markets would have to be opened to imports. In the 1970s, this agreement was significantly widened; in the 1980s, a free trade agreement was signed with the United States, and in the 1990s, Israel unilaterally reduced restrictions on imports from third-world countries with which it did not have specific trade agreements.