Economic development in Palestine and beyond

Successful economic development in Palestine will require an adequate theory of development, industrial policy, and institutional reforms

This week the Palestine Economic Policy Research Institute (MAS) has published a comprehensive study on Palestinian economic development. In this report, co-authored by my colleagues Heiner Flassbeck, Michael Paetz, and I, we explore possible solutions as to how Palestine could sustainably finance its deficits. In the coming month Jared Kushner, the US President’s son-in-law and senior advisor, is set to announce the details of the US Peace Plan for the Israeli-Palestinian conflict. Given that the Peace Plan is expected to include a large economic component to solve the conflict, it will be interesting to see to what extent it addresses the fundamental problems we identified in our research.

Our results suggest, succinctly, that under current conditions of excessive imbalances in the external sector (trade and current account), any issuance of debt securities requires fixing these imbalances first, for which, in turn, strategic public intervention is critical. This finding may come as a surprise to most policymakers, as orthodox economic theory suggests that the most efficient ways for countries to develop is through market led (as opposed to state led) policies. Historical evidence demonstrates that none of the advanced countries followed this path in their own development, yet the idea of ‘the market’ as the most efficient development tool is still widespread. Based on this belief, Western institutions wreaked havoc in developing countries during the 1980s and 1990s, and continue to do so (although some institutions, notably the IMF, show significant progress in learning from past experiences).

One of the main problems of neoclassical economic theory is that it does not have a proper theory of development, other than the Solow model (which is not a theory, but only a model coming with highly problematic and partially even outright invalid assumptions). Economic development research and advice, however, must rely on a dynamic theory of development, and address structural issues of politics, power, and financial markets. When dealing with a case such as Palestine, these questions become all the more important. It is a state that is divided and fragmented in its territory, whose authorities have only limited policy space, and whose productive structure is suffocated by Israeli occupation. The key document governing Palestinian economic relations is the Paris Protocol (PP), signed in 1995 as an interim agreement. It covers almost all facets of economic affairs and de facto formalised a customs union between the advanced economy of Israel and her developing neighbour Palestine. Under this institutional arrangement, Israel sets the terms in accordance with its own strategic and domestic imperatives, as well as its obligations and rights under the World Trade Organization and the  TRIPS agreement. The result for Palestine is an excessive dependence on Israel, which poses a major roadblock towards a two-state solution. Reducing this dependence must be a critical part of any peace deal to guarantee long-run prosperity and stability in the region.

Currently, the outdated structure of the PP combined with the occupation pose severe strains on the Palestinian economy. These stem from high fiscal leakages to the Israeli Treasury (in 2011, the Palestinian National Authority (PNA) was deprived of at least USD 310 million, which was equivalent of 3.6 per cent of GDP or 18 per cent of total tax revenues), a lack of access to critical resources such as fertile land and water (which remain largely behind the separation barrier), highly restricted movement of goods and people due to at least 540 physical obstacles (e.g. checkpoints, road gates, barriers etc.) in the West Bank alone, cumbersome administrative procedures for Palestinian firms to trade, and a tariff structure that is inadequate for a developing country. Without fundamental reform of the PP, it is hard to see how the Palestinian economy can develop and reduce its economic dependence on Israel.

At the moment, Palestine has requested that the PP should be revised, but Israel has yet to respond. Critical changes to current policy agreements must include giving the PNA more breathing space to conduct industrial policy, developing more transparent and efficient mechanism for imports and exports clearing, and setting up a procedure to ensure that the PNA is not deprived of legitimate trade revenues.   

At this point, however, Palestinian authorities must also confront a much bigger question: what is the role of the state in development? As mentioned above, many economists are still likely to suggest that getting the state out of the way is the best option. “Stabilise, privatise, liberalise” was the one-size-fits-all mantra preached by both governmental and financial institutions in  Washington in the 1980s and early 1990s and these principles were forced upon many developing countries across the world with devastating results. Yet, there are signs that economists from what used to be ultra-orthodox institutions have begun to attribute an important and active role for the state. Such analyses strikingly resemble the concept of the “enabling state” that was introduced by the United Nations Conference on Trade and Development (UNCTAD) during the 2008 Accra conference. They emphasise the importance of coordinated and strategic economic policies and interventions to “enable” markets to function in favour of genuine development. Yet, despite the historical evidence for the necessity of the visible hand of the state, many economists feel uncomfortable with that idea.  My co-author Heiner Flassbeck reported that during his last visit to Palestine, several policymakers were “amazed” by his analysis which stressed the importance of interventionist policies.

Notwithstanding the limited policy space that the PNA has, we argue in our report that strategic intervention and investments in productive capacities are a sine qua non condition for stabilising the external sector, which is in turn a prerequisite for returning to capital markets or beginning to issue a Palestinian currency. At the moment, there are three currencies in circulation in the Palestinian economy: the US Dollar, the Jordanian Dinar, and the Israeli Shekel. Further issuance of debt denominated in a foreign currency, if employed excessively, is likely to lead to highly volatile interest rates. On the other hand, the consequences of introducing a national currency would include exchange rates volatility, imported inflation, and, due to a weak productive basis, potentially an even larger trade deficit .

Without a prior revitalisation of the productive base, it will be hard to break the vicious cycle of decades of ongoing dependence on Israel (and foreign capital more broadly), continuous deficits, and the concomitant erosion of productive capacities. Given the tight budgetary constraints, we recommend that the Palestinian authorities intensify their search for grants and donations, and use these funds for productive investments, rather than public consumption (which has been, together with private consumption, the main driver of GDP growth since 1994). The ultimate objective must be to build up a proper industrial and manufacturing base that could serve as the foundation for future productivity gains.

This objective does not only apply to Palestine, but to developing economies at large. Thus, next to an appropriate theory and industrial policy, there is a third component to consider: the role of the international economic order. Over the past few decades, the G7 states have institutionalised a system that poses severe constraints for developing countries. The bargaining power of the global south as a collective block has been consistently weakened since the 1960s and 1970s, as demands for a more inclusive and equitable institutional order within the framework of NIEO and an appropriate regulation of transnational corporations (TNCs) were subdued by the G7 and its institutions. From the 1980s onwards, the implementation of structural adjustment programmes, the liberalisation of financial and product markets, and an institutionalisation of a regime of intellectual property rights (IPRs) that had nothing to do with free trade but prevented developing countries from catching up, left a legacy and an economic environment which still cripples many developing economies today.

The extant dependence on commodity prices makes a lot of developing countries vulnerable to price shocks and external debt, whilst IPRs and financial markets (for example, via carry trades and other forms of speculation) continue to suppress development. Rectifying the injustices and the systemic and institutional barriers for development – alongside ‘greening’ the process of industrialisation – remain the greatest challenges for this century. Given the disruptive potential of climate change, mass migration, and the persistence of abject poverty, all of which are direct consequences of hyperglobalisation, policymakers, academics, and the global community must not wait to take decisive action. As for the case of Palestine, large-scale investments in Gaza and the West Bank, which will be part of the Peace Plan, appear to be a step in the right direction. Without an appropriate development theory and a supportive institutional environment, however, this will not suffice.

Macroeconomic Structure, Financial Markets, and the Financing of Government Activity: Lessons for Palestine by Heiner Flassbeck, Patrick Kaczmarczyk and Michael Paetz was published by the Palestine Economic Policy Research Institute on March 11th 2019. The report is available to download here.