Start-up Nation

CHAPTER 11 Betrayal and Opportunity

THROUGHOUT THIS BOOK, we’ve pointed to the ways the IDF’s improvisational and antihierarchical culture follows Israelis into their start-ups and has shaped Israel’s economy. This culture, when combined with the technological wizardry Israelis acquire in elite military units and from the state-run defense industry, forms a potent mixture. But there was nothing normal about the birth of Israel’s defense industry. It was unheard-of for a country so small to have its own indigenous military-industrial complex. Its origins are rooted in a dramatic, overnight betrayal by a close ally.

The best way to understand Israel’s watershed moment is through a shock to Americans that had a similar effect. During the postwar boom years, America’s global status was suddenly punctured when the Soviet Union upstaged the United States by launching the first space satellite—Sputnik 1. That the Soviets could pull ahead in the space race stunned most Americans. But in retrospect, it was a boon for the U.S. economy.

Innovation economist John Kao says that Sputnik “was a wake-up call, and America answered it. We revised school curricula to emphasize the teaching of science and math. We passed the $900 million National Defense Education Act (about $6 billion in today’s dollars), providing scholarships, student loans, and scientific equipment for schools.”[176] NASA and the Apollo program were created, as was a powerful new Pentagon agency dedicated to galvanizing the civilian R&D community.

A little over a decade later, Neil Armstrong stepped onto the moon. The Apollo program and the Pentagon’s related defense investments spurred a generation of new discoveries that were ultimately commercialized, with a transformative impact on the economy. This concerted research and development campaign gave birth to entirely new business sectors within avionics and telecommunications, as well as the Internet itself, and became a legacy of America’s response to Sputnik.

Israel had its own Sputnik moment, ten years after America’s. On the eve of the 1967 Six-Day War, Charles de Gaulle taught Israel an invaluable lesson about the price of dependence.

De Gaulle, a founder of France’s Fifth Republic, had been in and out of senior military and government positions since World War II and served as president from 1959 to 1969. After Israel’s independence, de Gaulle had forged an alliance with the Jewish state and nurtured what Israeli leaders believed to be a deep personal friendship. The alliance included a French supply of critical military equipment and fighter aircraft, and even a secret agreement to cooperate in the development of nuclear weapons.[177]

Like many small states, Israel preferred to buy large weapon systems from other countries, rather than devote the tremendous resources needed to produce them. But in May 1950, the United States, Britain, and France jointly issued the Tripartite Declaration to limit arms sales to the Middle East.

With no ready supply from abroad, Israel had already begun its arms industry with underground bullet and gun factories. One factory was literally hidden underground, beneath a kibbutz laundry; the machines were kept running to mask the banging noise from below. This factory, built with war-surplus tools smuggled from the United States, was producing hundreds of machine guns daily by 1948. Makeshift factories were supplemented by scattershot gunrunning across the globe. David Ben-Gurion had sent emissaries abroad to collect weapons as far back as the 1930s. In 1936, for example, Yehuda Arazi managed to stuff rifles into a steam boiler headed from Poland to the port of Haifa. In 1948, he posed as an ambassador from Nicaragua to negotiate the purchase of five old French mounted guns.

The Israelis got by on these banana republic schemes until 1955, when the Soviet Union, via Czechoslovakia, ignored the leaky Tripartite Declaration and made a massive $250 million arms sale to Egypt. In response, de Gaulle took the other side. In April 1956, he began to transfer large quantities of modern arms to Israel. The tiny state finally had a reliable and first-rate national arms supplier.

After Egypt nationalized the Suez Canal in 1956, the relationship only deepened. France relied on the Suez for sea transport from the region to Europe. The IDF helped guarantee French access to the Suez, and France in return showered Israel with more arms. The supply only grew as the French and the Israelis colluded on more and more operations. De Gaulle’s spy agency enlisted Israel’s help in undermining anti-French resistance in Algeria, one of France’s colonial strongholds. In 1960, France promised to supply Israel with two hundred AMX-13 tanks and seventy-two Mystère fighter jets over the next ten years.[178]

But on June 2, 1967, three days before Israel was to launch a preemptive attack against Egypt and Syria, de Gaulle cut Israel off cold. “France will not give its approval to—and still less, support—the first nation to use weapons,” he told his cabinet.[179]

But there was more to de Gaulle’s decision than trying to defuse a Middle East war. New circumstances called for new French alliances. By 1967, France had withdrawn from Algeria. With his long and bitter North African war behind him, de Gaulle’s priority was now rapprochement with the Arab world. It was no longer in France’s interest to side with Israel. “Gaullist France does not have friends, only interests,” the French weekly Le Nouvel Observateur remarked at the time.[180]

De Gaulle’s successor, Georges Pompidou, continued the new policy after his own election in 1969. The two hundred AMX tanks France had originally committed to Israel were to be rerouted to Libya, and France even sent fifty Mirage jet fighters Israel had already paid for to Syria, one of Israel’s fiercest enemies.

The Israelis quickly pursued stopgap measures. Israeli Air Force founder Al Schwimmer personally recruited a sympathetic Swiss engineer to give him the blueprints to the Mirage engine, so Israel could copy the French fighter. Israel also returned to its pre-state smuggling exploits. In one mission in 1969, five Israeli-manned gunboats battled twenty-foot waves on a three-thousand-mile race from France to Israel; these naval vessels, worth millions of dollars, had been promised to Israel before the new embargo. As Time magazine colorfully described it in 1970: “Not since Bismarck has there been such a sea hunt. . . . At various points, [the Israelis] were tracked by French reconnaissance planes, an R.A.F. Canberra from Malta, Soviet tankers, the radar forests of the U.S. Sixth Fleet, television cameramen and even Italian fishermen.”[181]

These shenanigans, however, could not compensate for the hard truth: the Middle East arms race was accelerating just at the moment that Israel had lost its most indispensable arms and aircraft supplier. The 1967 French embargo put Israel in an extremely vulnerable position.

Prior to the 1967 war, the United States had already begun to sell weapons systems to Israel, starting with the transfer of Hawk surface-to-air missiles by the Kennedy administration in 1962. Jerusalem’s first choice, then, was for the United States to take France’s place as Israel’s main arms supplier. But the French betrayal had built a consensus in Israel that it could no longer rely so heavily on foreign arms suppliers. Israel decided that it must move quickly to produce major weapons systems, such as tanks and fighter aircraft, even though no other small country had successfully done so.

This drive for independence produced the Merkava tank, first released in 1978 and now in its fourth generation. It also led to the Nesher—Israel’s version of the Mirage aircraft—and then to the Kfir, first flown in 1973.[182]

The most ambitious project of all, however, was to produce the Lavi fighter jet, using American-made engines. The program was jointly funded by Israel and the United States. The Lavi was designed not only to replace the Kfir but to become one of the top-line fighters in the world.

The Lavi went into full-scale development in 1982; on the last day of 1986, the first plane took its inaugural test flight. But in August 1987, after billions of dollars had been spent to build five planes, mounting pressure in both Israel and the United States led to the program’s cancellation, first by the U.S. Congress and then by a 12–11 vote in the Israeli cabinet.

Many years later, the project and its cancellation still remain controversial: some people believe that it was an impossibly ambitious boondoggle from the beginning, while others claim that it was a great opportunity missed. In a 1991 article in Flight International magazine, published during Operation Desert Storm, an editor wrote about his experience flying the Lavi back in 1989: “Now when the coalition forces fight in the Gulf they miss the aircraft they really need. It’s a real shame that I had to fly the world’s best fighter knowing it would never get into service.”[183]

Even though the program was canceled, the Lavi’s development had significant military reverberations. First, the Israelis had made an important psychological breakthrough: they had demonstrated to themselves, their allies, and their adversaries that they were not dependent on anyone else to provide one of the most basic elements for national survival—an advanced fighter aircraft program. Second, in 1988 Israel joined a club of only about a dozen nations that had launched satellites into space—an achievement that would have been unlikely without the technological know-how accumulated during the Lavi’s development. And third, although the Lavi was canceled, the billions invested in the program brought Israel to a new level in avionic systems and, in some ways, helped jump-start the high-tech boom to come. When the program shut down, its fifteen hundred engineers were suddenly out of jobs. Some of them left the country, but most did not, resulting in a large infusion of engineering talent from the military industries into the private sector. The tremendous technological talent that had been concentrated on one aircraft was suddenly unleashed into the economy.[184]

Yossi Gross, one of the Lavi’s engineers, was born in Israel. His mother, who’d survived Auschwitz, emigrated from Europe after the Holocaust. As a student in Israel, Gross trained in aeronautical engineering at the Technion and then worked at Israel Aircraft Industries (IAI) for seven years.

Gross, a test-flight engineer at IAI, began in the design department. When he came up with a new idea for the landing gear, he was told by his supervisors to not bother them with innovations but to simply copy the American F-16. “I was working in a large company with twenty-three thousand employees, where you can’t be creative,” he recalled.[185]

Shortly before the Lavi’s cancellation, Gross decided to leave not only IAI but the whole aeronautics field. “In aerospace, you can’t be an entrepreneur,” he explained. “The government owns the industry, and the projects are huge. But I learned a lot of technical things there that helped me immensely later on.”

This former flight engineer went on to found seventeen start-ups and develop over three hundred patents. So, in a sense, Yossi Gross should thank France. Charles de Gaulle hardly intended to help jump-start the Israeli technology scene. Yet by convincing Israelis that they could not rely on foreign weapons systems, de Gaulle’s decision made a pivotal contribution to Israel’s economy. The major increase in military R&D that followed France’s boycott of Israel gave a generation of Israeli engineers remarkable experience. But it would not have catalyzed Israel’s start-up hothouse if it had not been combined with something else: a profound interdisciplinary approach and a willingness to try anything, no matter how destabilizing to societal norms.

CHAPTER 12 From Nose Cones to Geysers

DOUG WOOD IS A NEW AND UNLIKELY RECRUIT to Israel. With his calm and reflective demeanor, he stands out among his more brash Israeli colleagues. He was hired from Hollywood to do something that’s never before been tried in Jerusalem: Wood is the director of the first feature-length animated movie to be produced by Animation Lab, the start-up founded by Israeli venture capitalist Erel Margalit.

Wood worked as vice president of feature animation development and production at Turner, Warner Brothers, and Universal. When Margalit asked him to relocate to Jerusalem to create an animated feature, Wood said he would first have to see if Jerusalem had a real creative community. After spending some time in Jerusalem at Bezalel—Israel’s leading academy of art and design—he was convinced. “I met with the faculty there. I met with some TV writers and [author] Meir Shalev, and some other big storytellers,” he told us. “They were as good if not better than the people you would meet at the world’s top arts schools.”

But he also identified something different about Israel. “There’s a multitask mentality here. We’ve consulted with a lot of the Israeli technical people and they come up with innovative ways to improve our pipeline and do things more directly. And then there was this time I was working on a creative project with an art graduate from Bezalel. He looked the part—long hair, an earring, in shorts and flip-flops. Suddenly a technological problem erupted. I was ready to call the techies in to fix it. But the Bezalel student dropped his graphic work and began solving the problem like he was a trained engineer. I asked him where he learned to do this. It turns out he was also a fighter pilot in the air force. This art student? A fighter pilot? It’s like all these worlds come colliding here—or collaborating—depending how you look at it.”[186]

It’s not surprising that multitasking, like many other advantages Israeli technologists seem to have, is fostered by the IDF. Fighter pilot Yuval Dotan told us that there is a distinct bias against specialization in the Israeli military. “If most air forces are designed like a Formula One race car, the Israeli Air Force is a beat-up jeep with a lot of tools in it. On a closed track, the Formula One’s going to win,” Dotan said. But, he noted, in the IAF, “you’re going off-road from day one. . . . The race car is just not going to work in our environment.”[187]

The difference between the Formula One and the jeep strategies is not just about numbers; each produces divergent tactics and modes of thinking. This can be seen in the different “strike packages” that each air force constructs for its missions. For most Western air forces, a strike package is built from a series of waves of aircraft whose end goal is to deliver bombs on targets.

The United States typically uses four waves of specialized aircraft to accomplish a specific component of the mission: for example, a combat air patrol, designed to clear a corridor of enemy aircraft; a second wave that knocks out any enemy antiaircraft systems that are firing missiles; a third wave of electronic warfare aircraft, tankers for refueling, and radar aircraft to provide a complete battle picture; and, finally, the strikers themselves—planes with bombs. These are guarded by close air-support fighters “to make sure nothing happens,” Dotan explained.

“It’s overwhelming and it’s very well coordinated,” Dotan said of the U.S. system. “It’s very challenging logistically. You’ve got to meet the tanker at the right place. You’ve got to rendezvous with the electronic warfare—if one guy’s off by a few seconds, it all falls apart. The IAF could not pull off a system like this even if it had the resources; it would just be a big mess. We’re not disciplined enough.”

In the Israeli system, almost every aircraft is a jack-of-all-trades. “You don’t go into combat without air-to-air missiles, no matter what the mission is,” said Dotan. “You could be going to hit a target in southern Lebanon, with zero chance of meeting another aircraft, and if you do, the home base is two minutes’ flying time away and someone else can come and help you. Still, there’s no such thing as going into hostile territory without air-to-air missiles.”

Similarly, nearly every aircraft in the IAF has its own onboard electronic warfare system. Unlike the U.S. Air Force, the IAF does not send up a special formation to defeat enemy radars. “You do it yourself,” Dotan noted. “It’s not as effective, but it’s a hell of a lot more flexible.” Finally, in a typical Israeli strike package, about 90 percent of the aircraft are carrying bombs and are assigned targets. In a U.S. strike package, only the strikers in the final wave are carrying bombs.

In the Israeli system, each pilot learns not only his own target but also other targets in separate formations. “If an aircraft gets hit, for example, and two aircraft split off to go after a downed pilot or to engage in air-to-air combat . . . the other pilots have to take over those targets,” Dotan explained. “You’re expected to do that—it’s actually a normal outcome. About half the time you’re hitting somebody else’s target.”

The differences in the two countries’ systems are most obvious when Israelis and Americans fly together in joint exercises. Dotan was surprised to find, in one such exercise, that American pilots were given a “dance card” that diagrammed the maneuvers the pilot was supposed to use in the fight. “We see that and say, What the hell is that? How many times do you know what the other guy is going to do?” For Dotan, who now is an investor, the American system seems “like going into a trading day saying, ‘Whatever the market does, I’m buying.’ ”

The multitasking mentality produces an environment in which job titles—and the compartmentalization that goes along with them—don’t mean much. This is something that Doug Wood noticed in making the transition from Hollywood to Jerusalem: “This is great because conventional Hollywood studios say you need a ‘projection major’ and you need a ‘production coordinator’ or you need a ‘layout head.’ But in Israel the titles are kind of arbitrary, really, because they are interchangeable in some ways and people do work on more than one thing.

“For example,” he told us, “we have a guy who is in the CG team, the computer-generated-image team, but he also works on clay 3-D models of the characters. And then we’re doing a sequence, and he came up with a funny line for the end of this thirty-second sequence that we’re producing. And I actually liked the line so much I rewrote the script and put it in there. So the CG guy crossed the disciplinary walls and ventured into modeling and into scriptwriting.”

The term in the United States for this kind of crossover is a mashup. And the term itself has been rapidly morphing and acquiring new meanings. Originally referring to the merging of two or more songs into one, it has also come to designate digital and video combinations, as well as a Web application that meshes data from other sites—such as HousingMaps.com, which graphically displays craigslist rentals postings on Google Maps. An even more powerful mashup, in our view, is when innovation is born from the combination of radically different technologies and disciplines.

The companies where mashups are most common in Israel are in the medical-device and biotech sectors, where you find wind tunnel engineers and doctors collaborating on a credit card–sized device that may make injections obsolete. Or you find a company (home to beta cells, fiber optics, and algae from Yellowstone National Park) that has created an implantable artificial pancreas to treat diabetes. And then there’s a start-up that’s built around a pill that can transmit images from inside your intestines using optics technology taken from a missile’s nose cone.

Gavriel Iddan used to be a rocket scientist for Rafael, a company that is one of the principal weapons developers for the IDF. He specialized in the sophisticated electro-optical devices that allow missiles to “see” their target. Rockets might not be the first place one would look for medical technology, but Iddan had a novel idea: he would adapt the newest miniaturization technology used in missiles to develop a camera within a pill that could transmit pictures from inside the human body.

Many people told him it would be impossible to cram a camera, a transmitter, and light and energy sources into a pill that anyone could swallow. Iddan persisted, at one point going to the supermarket to buy chickens so he could test whether the prototype pill could transmit through animal tissues. He started a business around these pill cameras, or PillCams, and named his company Given Imaging.

In 2001, Given Imaging became the first company in the world to go public on Wall Street after the 9/11 attacks. By 2004, six years after its founding, Given Imaging had sold 100,000 PillCams. In early 2007, the company hit the 500,000 PillCams mark, and by the end of 2007 it had sold almost 700,000.

Today, the latest generation of PillCams painlessly transmit eighteen photographs per second, for hours, from deep within the intestines of a patient. The video produced can be viewed by a doctor in real time, in the same room or across the globe. The market remains large and has attracted major competitors; the camera giant Olympus now makes its own camera in a pill. That other companies would get into the act is not surprising, since ailments of the gastrointestinal tract are responsible for more than thirty million visits to doctors’ offices in the United States alone.

The story of Given Imaging is not just one of technology transfer from the military to the civilian sectors, or of an entrepreneur emerging from a major defense technology company. It is an example of a technology mashup, of someone combining not only the disparate fields of missiles and medicine but integrating a staggering array of technologies—from optics, to electronics, to batteries, to wireless data transmission, to software, in order to help doctors analyze what they are seeing. These types of mashups are the holy grail of technological innovation. In fact, a recent study by Tel Aviv University revealed that patents originating from Israel are distinguished globally for citing the highest number and most diverse set of precedent patents.[188]

One such mashup, a company that has bridged the divide between the military and medicine, is Compugen, whose three founders—president Eli Mintz, chief technology officer Simchon Faigler, and software chief Amir Natan—met in the IDF’s elite Talpiot program. Another Talpiot alumnus at Compugen, Lior Ma’ayan, said that twenty-five of the sixty mathematicians in the company joined through their network of army contacts.

In the IDF, Mintz created algorithms for sifting through reams of intelligence data to find the nuggets that have been so critical to Israel’s successes in hunting terrorist networks. When his wife, a geneticist, described the problems they had in sifting through enormous collections of genetic data, Mintz thought he might have a better way to do it.

Mintz and his partners were about to revolutionize the process of genetic sequencing. Merck bought Compugen’s first sequencer in 1994, a year after the start-up was founded and long before the human genome had been successfully mapped. But this was just the beginning. In 2005, Compugen transformed its business model and moved into the drug discovery and development arena, and did so using techniques different from those that dominate the pharmaceutical industry.

Combining mathematics, biology, computer science, and organic chemistry, Compugen has been pioneering what it calls “predictive” drug development. Rather than testing thousands of compounds, hoping to hit upon something that “works,” Compugen’s strategy is to begin at the genetic level and develop drugs based on how genes express themselves through the production of proteins.

A major aspect of Compugen’s approach is its unusual combination of “dry” (theoretical) and “wet” (biological) labs. “Imagine working with Big Pharma overseas or in another part of the country,” Alon Amit, Compugen’s VP for technology, explained. “The back and forth that you can expect is a lot slower than if you have the biologists and mathematicians literally on the same floor discussing what to test, how to test, and inform the models.”[189]

Though Israel’s largest company, Teva, is in pharmaceuticals, as are Compugen and a number of new Israeli companies, the more crowded field for Israeli start-ups is that of medical devices, many of them related to drug delivery. This field seems to nicely fit the Israeli penchant for multidisciplinary thinking, as well as Israelis’ characteristic lack of patience—since drugs take so long to develop.

One such mashup-based company is Aespironics, which has developed an inhaler the size and shape of a credit card that includes a breath-powered wind turbine. The problem with many inhalers is that they are tricky and expensive to manufacture. A way must be found to release the drug effectively through a wire mesh. In addition, this process must be timed perfectly with the breath of the patient to maximize and regulate the drug’s absorption in the lungs.

Aespironics seems to have solved all these problems at once. Inside the “credit card” is a fanlike propeller that is powered by the flow of air when the patient inhales from the edge of the card. As the propeller turns, it brushes against a mesh with the drug on it, thereby knocking the drug off the mesh and into the air flow in a measured manner. Since the propeller works only when the user inhales, it automatically propels the drug into the patient’s lungs.

Putting this together required an unorthodox combination of engineering skills. In addition to experts on inhalers, Aespironics’ team includes Dan Adler, whose specialty is designing gas turbines and jet engines. He was a professor at the Technion and at the U.S. Naval Graduate School and a consultant to such companies as General Dynamics, Pratt & Whitney, and McDonnell Douglas.

Mixing missiles and pills, jets and inhalers may seem strange enough, but the true mashup champion may be Yossi Gross. Born in Israel and trained in aeronautical engineering at the Technion, Gross worked at Israel Aircraft Industries for seven years before leaving to pursue more entrepreneurial endeavors.

Ruti Alon of Pitango Venture Capital, which has invested in six of Gross’s seventeen start-ups, argues that his multidisciplinary approach is the key to his success. “He has training in aeronautical engineering and electronics. He also knows a lot about physics, flow, and hemodynamics, and these things can be very helpful when thinking about devices that need to be implanted in the human body.” Plus, Alon reminded, “he knows a lot of doctors.”[190]

Some of Gross’s companies combine such wildly diverse technologies that they border on science fiction. Beta-O₂, for example, is a start-up working on an implantable “bioreactor” to replace the defective pancreas in diabetes patients. Diabetics suffer from a disorder that causes their beta cells to cease producing insulin. Transplanted beta cells could do the trick, but even if the body didn’t reject them, they cannot survive without a supply of oxygen.

Gross’s solution was to create a self-contained micro-environment that includes oxygen-producing algae from the geysers of Yellowstone Park. Since the algae need light to survive, a fiber-optic light source is included in the pacemaker-sized device. The beta cells consume oxygen and produce carbon dioxide; the algae does just the opposite, creating a self-contained miniature ecosystem. The whole bioreactor is designed to be implanted under the skin in a fifteen-minute outpatient procedure and replaced once a year.

Combining geothermal algae, fiber optics, and beta cells to treat diabetes is typical of Gross’s cross-technology approach. Another of his start-ups, TransPharma Medical, combines two different innovations: using radio frequency (RF) pulses to create temporary microchannels through the skin, and the first powder patch ever developed. “It’s a small device,” Gross explains, “like a cell phone, that you apply to the skin for one second. It creates RF cell ablation, hundreds of microchannels in the skin. Then we apply on top a powder patch, not a regular patch. Most patches out there are gel- or adhesive-based. We print the drug on the patch, and it’s dry. When we apply the patch to the skin, the interstitial fluid comes out slowly from the microchannels and pulls the lyophilized [freeze-dried] powder from the patch under the skin.”

Gross claims that this device solves one of the most intractable problems of drug delivery: how to get large molecules, such as proteins, through the outer layer of the skin without an injection. The first products will deliver human growth hormone and a drug for osteoporosis; patches to deliver insulin and other drugs, hormones, and molecules—most of them currently delivered by injections—are in the works.

The Israeli penchant for technological mashups is more than a curiosity; it is a cultural mark that lies at the heart of what makes Israel so innovative. It is a product of the multidisciplinary backgrounds that Israelis often obtain by combining their military and civilian experiences. But it is also a way of thinking that produces particularly creative solutions and potentially opens up new industries and “disruptive” advances in technology. It is a form of free thinking that is hard to imagine in less free or more culturally rigid societies, including some that superficially seem to be on the cutting edge of commercial development.

CHAPTER 13 The Sheikh’s Dilemma

EREL MARGALIT’S BACKGROUND would not normally predict a future in venture capital. He was born on a kibbutz, fought in Lebanon in 1982 as an IDF soldier, studied math and philosophy at the Hebrew University of Jerusalem, and then pursued a doctorate in philosophy at Columbia University. He wrote his dissertation on the attributes of historical leaders—he thinks of them as “entrepreneurial leaders”—who profoundly affected the development of their nations or even civilizations (he profiled Winston Churchill and David Ben-Gurion, among others, as exemplars).

Along the way, he went to work for Teddy Kollek, the mayor of Jerusalem from 1965 to 1993. Shortly before Kollek was defeated in the 1993 municipal election, Margalit pitched an idea to help encourage start-ups in Jerusalem, which, then as now, was struggling to keep young people from leaving for nearby Tel Aviv, Israel’s vibrant business capital. With Kollek gone, Margalit decided to implement his plan himself, but in the private sector. He called his new venture capital fund Jerusalem Venture Partners (JVP). It was seed-funded with capital from the Yozma program.

Since he founded JVP, in 1994, Margalit has raised hundreds of millions of dollars from France Telecom SA, Germany’s Infineon Technologies AG, as well as Reuters, Boeing, Columbia University, MIT, and the Singapore government, to name a few sources. He has backed dozens of companies, many of which have held public offerings (IPOs) or been sold to international players, producing windfall returns. JVP was behind PowerDsine, Fundtech, and Jacada, all currently listed on the NASDAQ. One of its big hits was Chromatis Networks, an optical networking company, which was sold to Lucent for $4.5 billion.

In 2007, Forbes ranked Margalit sixty-ninth on its Midas List of “the world’s best venture capitalists.” He is among three Israelis on this top one hundred list, which is populated mostly by Americans.

But Margalit’s contribution to Israel goes beyond business. He is investing huge sums of his personal fortune—and entrepreneurial know-how—to revitalize Jerusalem’s arts scene. He launched the Maabada, the Jerusalem Performing Arts Lab, which is leading in the exploration of the link between technology and art, and is colocating artists and technologists side by side in a way not done anywhere else in the world.

Next door to the nonprofit theater he founded, which was built in an abandoned warehouse, Margalit has converted a printing house into the headquarters for a burgeoning animation company, Animation Lab, which aims to compete with Pixar and others in the production of full-length animated films.

Jerusalem might seem like the last place to build a world-class movie studio. As a center for the three monotheist religions, the ancient city of Jerusalem is about as different from Hollywood as one could imagine. Filmmaking is not an Israeli specialty, though Israeli movies have recently been prominently featured in international film festivals. Further complicating matters is the fact that the Israeli arts scene is centered in secular Tel Aviv, rather than Jerusalem, known more for holy sites, tourists, and government offices. But Margalit’s vision for creating companies, jobs, industries, and creative outlets was specifically a vision for Jerusalem.

This cultural commitment can be central to the success of economic clusters, of which Israel’s high-tech industry is a case in point. A cluster, as described by the author of the concept, Harvard Business School professor Michael Porter, is a unique model for economic development because it’s based on “geographic concentrations” of interconnected institutions—businesses, government agencies, universities—in a specific field.[191] Clusters produce exponential growth for their communities because people living and working within the cluster are in some way connected to each other.

An example, according to Porter, is northern California’s “wine cluster,” which is populated by hundreds of wineries and thousands of independent grape growers. There are also suppliers of grape stock, manufacturers of irrigation and harvesting equipment, producers of barrels, and designers of bottle labels, not to mention an entire local media industry, with winery advertising firms and wine trade publications. The University of California at Davis, also near this area, has a world-renowned viticulture and oenology program. The Wine Institute is just south, in San Francisco, and the California legislature, in nearby Sacramento, has special committees dealing with the wine industry. Similar community structures exist around the world: in Italy’s fashion cluster, Boston’s biotech cluster, Hollywood’s movie cluster, New York City’s Wall Street cluster, and northern California’s technology cluster.

Porter argues that an intense concentration of people working in and talking about the same industry provides companies with better access to employees, suppliers, and specialized information. A cluster does not exist only in the workplace; it is part of the fabric of daily life, involving interaction among peers at the local coffee shop, when picking up kids from school, and at church. Community connections become industry connections, and vice versa.

As Porter says, “the social glue” that binds a cluster together also facilitates access to critical information. A cluster, he notes, must be built around “personal relationships, face-to-face contact, a sense of common interest, and ‘insider’ status.” This sounds just like what Yossi Vardi described: in Israel “everybody knows everybody, and there is a very high degree of transparency.”

Margalit would point out that Israel has just the right mix of conditions to produce a cluster of this kind—and that’s rare. After all, attempts to create clusters don’t always succeed. Take, for example, Dubai. Searching for a Dubai equivalent of Erel Margalit, one thinks of Mohammed Al Gergawi. Al Gergawi is the chairman and chief executive of Dubai Holding, one of the larger businesses owned by Sheikh Mohammed bin Rashid Al Maktoum, the ruler of Dubai (and also the prime minister and defense minister of the United Arab Emirates). For all intents and purposes, Sheikh Mohammed is the chairman of “Dubai Inc.” There is no distinction between Dubai’s public finances and the sheikh’s private wealth.

Al Gergawi’s leap to prominence came in 1997 when he went to meet Sheikh Mohammed in the majlis, a forum for average citizens to come to see the sheikh—think of it as the Arab world’s version of a town hall meeting, only far less interactive. During the visit, Sheikh Mohammed pointed out Al Gergawi and declared, “I know you and you’ll go far.”[192]

It turns out that Al Gergawi, then a midlevel government bureaucrat, had been identified months earlier by one of Sheikh Mohammed’s “mystery shoppers,” whose job it is to scour the kingdom for potential business leaders. Soon after the majlis meeting, Al Gergawi was put on an accelerated path to management of one of the sheikh’s three major companies. Others within Dubai’s government told us that Al Gergawi was selected because he was regarded as a competent technocrat—he could execute extremely well but would not challenge the ruler’s vision.

Dubai’s economic system is based largely on patronage, which has kept the local citizens pliant (only 15 percent of Dubai’s 1.4 million residents are actually Emirati citizens). Like Singapore, it is an extremely orderly society, and there are no outlets for protest—even peaceful ones—against the government. Many of the founders of Dubai’s first human rights organization are also employed by the government and are dependent on Sheikh Mohammed’s largesse.

Freedom of speech is constitutionally “guaranteed,” but it does not cover criticism of the government or anything deemed offensive to Islam. When it comes to government transparency, especially as it relates to the economy, the trend is moving in the wrong direction. A new media law makes tarnishing the UAE’s reputation or economy a crime punishable by fines of up to 1 million dirhams (approximately $270,000). The government maintains a list of banned Web sites; the ban is enforced by state censorship of the Internet (users do not dial directly into the Web but go through a proxy server monitored by the state telecom monopoly). In compliance with the Arab League boycott, neither visitors nor residents can call Israel from landlines or cell phones—the 972 country code is blocked.

Sheikh Mohammed recently decreed that his twenty-five-year-old son, Sheikh Hamdan, would be crown prince; a younger son and a brother were named as his two deputies. There is no path for an Emirati equivalent of Erel Margalit to play a senior leadership role in government or run for office. Mohammed Al Gergawi himself is one of only 210,000 Emiratis in the entire country, and only people from this limited pool are eligible to serve in senior government positions or in leadership roles in the sheikh’s businesses.

Other than its official leadership circles, Dubai is open to outsiders for business and has a centuries-old history as a trade hub for everything from pearls to textiles. Sheikh Mohammed’s great-grandfather declared his city-state a tax-free port in the early part of the twentieth century. He wanted to attract Iranian and Indian merchants.

In the 1970s, Sheikh Mohammed’s father, Rashid bin Saeed Al Maktoum, ordered the dredging of the Dubai Creek and built one of the planet’s largest man-made harbors at Jebel Ali, twenty-two miles southwest of Dubai. By 1979, the Jebel Ali Port had become the Middle East’s largest port and, according to some experts, ranked alongside the Great Wall of China and the Hoover Dam as the only three man-made constructions that can be seen from space. Jebel Ali is now the world’s third-most-important reexport center (after Hong Kong and Singapore).

For Rashid, this liberal trade outlook was based on the reality that Dubai’s economic wellspring would eventually dry up. With only .5 percent of the oil and gas reserves of neighboring Abu Dhabi, and an even tinier fraction of Saudi Arabia’s, Dubai’s reserves could run out as soon as 2010. As Sheikh Rashid once famously said, “My grandfather rode a camel, my father rode a camel, I drive a Mercedes, my son drives a Land Rover, his son will drive a Land Rover, but his son will ride a camel.”

In addition to creating a world-class port, Sheikh Rashid also established the Middle East’s first free-trade zone, which allowed foreigners to repatriate 100 percent of their capital and profits and allowed 100 percent foreign ownership of properties and businesses. This sidestepped the requirement in the UAE and much of the Arab world that all companies be majority-owned by a local national.

The royal family’s next generation—led by Sheikh Mohammed—took the free-zone model even further, with the creation of business parks dedicated to specific industrial sectors. The first of these was Dubai Internet City (DIC), designed with the help of Arthur Andersen and McKinsey & Company.

DIC provided an ideal base for any technology company doing business in the Middle East, the Indian subcontinent, Africa, or the former Soviet republics—collectively a potential market of 1.8 billion people with a total GDP of $1.6 trillion. In no time 180 companies signed up as tenants, including Microsoft, Oracle, HP, IBM, Compaq, Dell, Siemens, Canon, Logica, and Sony Ericsson.

In one sense, DIC was a remarkable success: by 2006, one-quarter of the world’s top five hundred companies had a presence in Dubai. Dubai then tried to replicate that success story, founding Dubai Healthcare City, Dubai Biotechnology and Research Park, Dubai Industrial City, Dubai Knowledge Village, Dubai Studio City, and Dubai Media City (where Reuters, CNN, Sony, Bertelsmann, CNBC, MBC, Arabian Radio Network, and other media companies all have a major presence).

DIC’s director of marketing, Wadi Ahmed, a British citizen of Arab origin, explains, “We have made Porter’s [cluster] theory a reality. If you bring all the companies from the same segment together . . . opportunities materialize. It’s real-life networking. It is bringing the integrator together with the software developers. Our cluster includes six hundred companies working within two kilometers of each other. . . . Silicon Valley has some similarities but it is an area, not a single managed entity.”[193]

It is true that Dubai had at first posted impressive growth rates and that it turned itself into an important commercial hub in a short time. But there was never any comparability between the number of start-ups in Israel and in Dubai, or the amount of venture capital Dubai has been able to attract compared to Israel, not to mention the number of new inventions and patents. So what makes Israel and Dubai different in this way?

Drill down a bit into what is going on in Dubai’s Internet City, for example, and the answer begins to emerge. In DIC you will not find any R&D or new innovation-based companies. Dubai opened its doors to innovative global companies, and many have come. But they have come to spread innovations made elsewhere to a particular regional market. Dubai, therefore, has not created any thriving innovative clusters; rather, it has built large, successful service hubs. So when Mohammed Al Gergawi was handpicked by Sheikh Mohammed to help catalyze Dubai’s economic miracle, the job was to grow and manage this exciting, but not necessarily innovation-generating, venture.

In Israel the story is different. Margalit is one of tens of thousands of serial entrepreneurs. No one picked him; he picked himself. All of his success came from creating innovative companies and hooking into a global venture and tech ecosystem that is constantly searching for new products and markets. And while the physical infrastructure that facilitated this process in Israel may have been inferior to Dubai’s, the cultural infrastructure has proved to be vastly richer soil on which to cultivate innovation.

Attracting new members to a cluster by offering a less expensive way to do business might be sufficient to create a cluster, but not to sustain it. If price is a cluster’s only competitive edge, some other country will always come along to do it more cheaply. The other qualitative elements—such as tight-knit communities whose members are committed to living and working and raising families in the cluster—are what contribute to sustainable growth. Crucially, a cluster’s sense of shared commitment and destiny, which transcends day-to-day business rivalries, is not easy to manufacture.

The obstacles for Dubai, in this sense, are profound. Foreign nationals—European and Persian Gulf business adventurers or South Asian and Arab temporary laborers—are there to make money, period. Once they’ve done so, they have typically returned home or moved on to their next adventure. They have a transactional relationship with Dubai; they are not part of a tight-knit community, and they are not collectively laying roots or building anything new. They evaluate their standing and accomplishments vis-à-vis the communities in their home countries, not those in Dubai. Their emotional commitment and sense of rootedness lie elsewhere. This, we believe, is a fundamental obstacle to a fully functioning cluster, and it may also be an impediment to cultivating a high-growth entrepreneurial economy.

“If there is an Internet bubble in Israel, then Yossi Vardi is the bubble.”[194] So says Google cofounder Sergey Brin, referring to Vardi’s role in helping to rebuild Israel’s Internet sector from the ashes of the global technology market crash of 2000. Vardi’s name has become synonymous with the world of Israeli Internet start-ups. He is best known for ICQ, the Internet chat program founded by his son Arik Vardi and three pals when they were in their early twenties. Isaac Applbaum of The Westly Group says that ICQ—once the world’s most popular chat program—was one of a handful of companies that “transformed technology forever,” along with Netscape, Google, Apple, Microsoft, and Intel.

ICQ (a play on “I seek you”) was introduced in November 1996, with seed funding from Vardi. It was the first program to allow Windows users to communicate with one another live. America Online (AOL) invented its own chat program, called Instant Messenger (AIM), at about the same time, but at first AOL’s program was available only to its subscribers.

The Israeli program spread much faster than AOL’s. By June 1997, close to half a year after ICQ’s launch—when only 22 percent of American homes had Internet access—ICQ had over a million users. In six months the number of users had jumped to 5 million, and ten months later to 20 million. By the end of 1999, ICQ had a total of 50 million registered users, making it the largest international online service. ICQ became the most downloaded program in the history of CNET.com, with 230 million downloads.

Back in mid-1998, when ICQ hit about 12 million users, AOL bought the start-up for what at the time was the largest amount paid for an Israeli tech company: $407 million. (They wisely insisted on taking all cash instead of stock.)

Though Israel was already well into its high-tech swing by then, the ICQ sale was a national phenomenon. It inspired many more Israelis to become entrepreneurs. The founders, after all, were a group of young hippies. Exhibiting the common Israeli response to all forms of success, many figured, If these guys did it, I can do it better. Further, the sale was a source of national pride, like winning a gold medal in the world’s technology Olympics. One local headline declared that Israel had become an Internet “superpower.”[195]

Vardi invests in Internet start-ups because he believes in them. But his dogged focus on the Internet when almost everyone else was in either classic “Israeli” sectors, such as communications and security, or hot new areas, like cleantech and biotech, is not attributable just to profit calculation. For one, Israel is his cluster, and he is conscious of his status as an “insider” in this community—a community that he wants to succeed. And with that commitment, he is also conscious of his role in sustaining this sector through a dry spell. Investing with a personal as well as a national purpose has been called “profitable patriotism,” and has been getting renewed attention of late.

More than a century ago, prominent banker J. P. Morgan almost single-handedly stabilized the U.S. economy during the Panic of 1907. At a time when there was no Federal Reserve, “Morgan was not only committing some of his own money but also organizing the entire financial community to join in the rescue,” said Ron Chernow, a business historian and biographer.[196]

When the crisis of 2008 hit, Warren Buffett seemed to play a similar role, pumping $8 billion into Goldman Sachs and General Electric over just two weeks. As the panic deepened, Buffett knew that his decision to make massive investments might signal to the market that he, America’s most respected investor, was not waiting for shares to plunge further and believed that the economy was not going to collapse.

Vardi’s interventions are not on nearly as large a scale, of course, but even so, he has had an impact on the mix of Israeli start-ups by playing a leadership role in keeping the Internet segment of the pie afloat. His mere presence and steadfastness in a sector that everyone was writing off helped turn it around.

At the 2008 TechCrunch, an influential conference that singled out the fifty-one most promising start-ups in the world, seven of them were Israeli, and many of those had raised capital from Yossi Vardi. TechCrunch founder Michael Arrington is a strong supporter of Vardi’s: “You [Israel] should build a statue of Yossi Vardi in Tel Aviv,” he says.[197]

In the best-selling book Built to Last, business guru James Collins identifies several enduring business successes that all have one thing in common: a core purpose articulated in one or two sentences. “Core purpose,” Collins writes, “is the organization’s fundamental reason for being. [It] reflects the importance people attach to the company’s work . . . beyond just making money.” He lists fifteen examples of core purpose statements. All of them are by companies—including Wal-Mart, McKinsey, Disney, and Sony—with one exception: Israel. Collins describes Israel’s core purpose as “to provide a secure place on Earth for the Jewish people.” Building Israel’s economy and participating in its cluster—which are interchangeable—and pitching it to the most far-flung places in the world are what in part motivates Israel’s “profitable patriots.”[198] As historian Barbara Tuchman observed before Israel’s tech boom, “With all its problems, Israel has one commanding advantage: a sense of purpose. Israelis may not have affluence . . . or the quiet life. But they have what affluence tends to smother: a motive.”[199]

The absence of motive is a problem in a number of the states of the Gulf Cooperation Council (GCC), which is composed of the UAE, Saudi Arabia, Bahrain, Kuwait, Qatar, and Oman. In the case of Dubai, one of the emirates in the UAE, most of the entrepreneurs that come from elsewhere are motivated by profit—which is important—but they are not also motivated by building the fabric of community in Dubai. And as we have seen in examining Michael Porter’s cluster theory, a profit motive alone will get a national economy only so far. When economic times are difficult, as has been the case in Dubai since late 2008, or security becomes dicey, those not committed to building a home, a community, and a state are often the first to flee.

In the other GCC economies, the problem is somewhat different. In our travels throughout the Arabian Peninsula, we have seen firsthand how Saudi nationals—young and old—are proud of the economic and infrastructural modernization of their economy. Many Saudis have a tribal lineage that traces back centuries, and building an advanced economy that is recognized globally is a matter of tribal and national pride.

But all of these economies also face challenges that can stifle any potential for progress.

A number of business and government leaders throughout the Arab world have turned their attention to stimulating a high-growth entrepreneurial economy, and some have been quietly studying Israel. “How else are we going to create eighty million jobs in the next decade?” Riad al-Allawi asked us. Al-Allawi is a successful Jordanian entrepreneur who has done business all over the region. Eighty million is the number we kept hearing from experts during our travels to Arab capitals.

The Arab economies of North Africa (Egypt, Algeria, Morocco, and Tunisia), the Middle East (Lebanon, Syria, Palestine, Iraq, and Jordan), and the Persian Gulf (Saudi Arabia, the UAE, Qatar, Bahrain, Kuwait, and Oman) comprise approximately 225 million people, just over 3 percent of the world’s population. And the total GDP of the Arab economies in 2007 was $1.3 trillion—almost two-fifths the size of China’s economy. But wealth distribution varies widely: there are oil-rich economies with tiny populations (such as Qatar, with 1 million people and a per capita GDP of $73,100) and oil-poor economies with large, dense populations (such as Egypt, with 77 million people but a per capita GDP of just $1,700). Generalizations about development strategies for the region are risky since the sizes, structures, and natural resources of the Arab economies vary widely.

But even with all the differences, the unifying economic challenge for the Arab Muslim world is its own demographic time bomb: approximately 70 percent of the population is under twenty-five years old. Employing all of these people will require the creation of eighty million new jobs by 2020, as al-Allawi told us.[200] Meeting this goal means generating employment at twice the U.S. job growth rate during the boom decade of the 1990s. “The public sector isn’t going to create these jobs; big companies aren’t going to create these jobs,” says Fadi Ghandour, a successful Jordanian entrepreneur. “The stability and future of the region is going to depend on our teaching our young people how to go out and create companies.”[201]

But entrepreneurship has played only a negligible part in Arab world economies. Even before its economy imploded less than 4 percent of the UAE’s adult population was working in early-stage or small enterprises. So what are the barriers to an Arab “start-up nation”? The answer includes oil, limits on political liberties, the status of women, and the quality of education.

The vast majority of the region’s economic activity is driven by the production and refinement of hydrocarbons. The non-oil GDP exported by the entire Arab world—with a population of approximately 250 million people—is less than that of Finland, with a population of 5 million. Outside of oil, there are some successful multinationals, such as UAE-based Emirates Airlines, Egypt-based Orascom Telecom, and Jordan-based Aramex, a logistics support provider. (Orascom and Aramex were founded and built by savvy entrepreneurs.) Family-owned service businesses are also prominent and—in the case of countries like Egypt—textiles and agriculture, too. But the oil industry is by far the biggest contributor to the region’s GDP. The region produces almost one-third of the world’s oil and 15 percent of the world’s gas.

There is an ever-increasing growth in demand for oil, with China and India the most prominent examples of countries that need more oil. Beginning in 1998, India and China’s combined demand increased by a third in less than a decade. So however much the price of oil fluctuates, the demand is undergoing a global transformation.

But the Arab world’s oil economy has stymied high-growth entrepreneurship. Distributing oil wealth largesse to the masses has insulated governments in the Persian Gulf from pressure to reform politically and economically. Oil wealth has cemented the power of autocratic governments, which do not have to collect taxes from their citizens and therefore do not need to be terribly responsive to their complaints. As historians of the Muslim world have put it, in Arab countries “the converse of a familiar dictum is true: No representation without taxation.”[202]

The badly needed reforms that the elites regard as a threat—the right to free expression, tolerance of experimentation and failure, and access to basic government economic data—are necessary for a culture in which entrepreneurs and inventors can thrive. For precisely all the reasons that entrepreneurship helps economies grow and societies progress—it rewards merit, initiative, and results rather than status—the Persion Gulf governments have stifled it. This is what political scientist Samuel Huntington once called the “king’s dilemma”: all modernizing monarchs ultimately try to balance economic modernization with limits on liberalization, since liberalization challenges the monarch’s power. In the Arab world, British journalist Chris Davidson, author of Dubai: The Vulnerability of Success, calls this the “sheikh’s dilemma.”

With the exception of Lebanon and Iraq, there has never been a genuinely free election in any of the other twenty-two Arab League countries. After one attempt at an election in the UAE in 2006 attracted low voter turnout, a prominent member of the government remarked, “This is particularly disappointing given that all of the candidates and participants were from very good families, and were all personally approved by the UAE’s rulers.”[203]

A number of Persian Gulf Arab governments have sought to work around the “sheikh’s dilemma” by using oil wealth to modernize the hard infrastructure of their economies, while leaving the political structures virtually untouched. Income from the previous oil booms—in the 1970s—was not absorbed by the regional economies but, rather, spent on imports from the West, investments overseas, and military arms. The local economies saw little direct benefit. But since 2002, over $650 billion from this new—demand-driven—oil windfall have been reinvested in the gulf economies alone.

Alongside the cluster strategy adopted by Dubai and a number of other gulf Arab countries, much of the region’s oil revenues have gone into real estate development. The GCC real estate sector has been the fastest growing in the world. Between 2000 and 2010, an estimated 19.55 million square yards of new leasable space—new office buildings, shopping malls, hotels, industrial facilities, and housing developments—will have been added in the region, mostly in Saudi Arabia and the UAE, growing at 20 percent annually during this period. (China’s annual growth in leasable space was 15 percent.)

But as in much of the rest of the world, the Persian Gulf real estate bubble has burst. As of early 2009, residential and commercial values in Dubai, for example, have declined by 30 percent and are expected to plummet further. Home owners have actually been abandoning their homes and just leaving the country—to avoid the prospect of imprisonment for failure to pay a debt. Large-scale construction projects have been frozen.

Neither oil nor real estate nor clusters have built a high-growth entrepreneurial or innovation economy.

With the demographic time bomb ticking, the gulf’s oil-rich governments have also tried to build academic research clusters. Every technology cluster has a collection of great educational institutions. Silicon Valley famously got its start in 1939 when William Hewlett and David Packard, two Stanford University engineering graduates, pooled their funds of $538 and founded Hewlett-Packard. Their mentor was a former Stanford professor, and they set up shop in a garage in nearby Palo Alto.

But the Arab world’s cultural and social institutions, as was reported by a U.N.-sanctioned committee of Arab intellectuals, are chronically underdeveloped. The United Nations’ Arab Human Development Report, which presented the organization’s research from 2002 through 2005, found that the number of books translated annually into Arabic in all Arab countries combined was one-fifth the number translated into Greek in Greece. The number of patents registered between 1980 and 2000 from Saudi Arabia was 171; from Egypt, 77; from Kuwait, 52; from the United Arab Emirates, 32; from Syria, 20; and from Jordan, 15—compared with 7,652 from Israel. The Arab world has the highest illiteracy rates globally and one of the lowest numbers of active research scientists with frequently cited articles. In 2003, China published a list of the five hundred best universities in the world; it did not include a single mention of the more than two hundred universities in the Arab world.[204]

Recognizing the importance of universities for R&D, which is necessary for patents and innovation, Saudi Arabia is opening the King Abdullah University of Science and Technology, to create a research home for twenty thousand faculty and staff members and students. It will be the first university in Saudi Arabia to have male and female students in the same classes. Qatar and the UAE have established partnerships with iconic Western academic institutions. Qatar’s Education City houses satellite campuses for Weill Cornell Medical College, Carnegie Mellon University’s computer science and business administration programs, a Georgetown University international relations program, and a Northwestern University journalism program. Abu Dhabi—one of the seven emirates in the UAE—has established a satellite campus for New York University. The idea is that if Arab countries can attract the most innovative researchers from around the world, it will help stimulate an innovation culture locally.

But these new institutions have not made much progress. They cannot recruit a reliable stable of foreign academic talent to lay roots and make a long-term commitment to the Arab world. “It has been more about bringing education brands to the gulf than immigrating and assimilating brains,” Chris Davidson told us. “These universities are focused on national reputation building, not real innovation.”[205]

Israel’s case was different. Top-notch universities were founded well before there even was a state. Professor Chaim Weizmann, a world-renowned chemist who helped launch the field of biotechnology with his invention of a novel method of producing acetone, commented on this oddity at the inauguration of the Hebrew University of Jerusalem on July 24, 1918: “It seems at first sight paradoxical that in a land with so sparse a population, in a land where everything still remains to be done, in a land crying out for such simple things as ploughs, roads, and harbours, we should begin by creating a centre of spiritual and intellectual development.”[206]

The Hebrew University’s first board of governors included Weizmann, Israel’s first president, as well as Albert Einstein, Sigmund Freud, and Martin Buber. The Technion was founded in 1925. The Weizmann Institute of Science followed in 1934 and, in 1956, Tel Aviv University—the largest university in Israel today. Thus by the late 1950s, Israel’s population was only around the two million mark and the country already had the seeds of four world-class universities. Other major universities, such as Bar-Ilan University, University of Haifa, and Ben-Gurion University of the Negev, were founded in 1955, 1963, and 1969, respectively.

Today, Israel has eight universities and twenty-seven colleges. Four of them are in the top 150 worldwide universities and seven are in the top 100 Asia Pacific universities. None of them are satellite campuses from abroad. Israeli research institutions were also the first in the world to commercialize academic discoveries.

In 1959 the Weizmann Institute established Yeda (which means “knowledge” in Hebrew) to market its research. Yeda has since spawned thousands of successful medical technology products and companies. Between 2001 and 2004, the institute amassed one billion shekels (more than $200 million) in royalty revenues. By 2006, Yeda was ranked first in income royalties among world academic institutes.[207]

Several years after the creation of Yeda, the Hebrew University founded its own technology transfer company, called Yissum (a word for “implementation” in Hebrew). Yissum earns over $1 billion annually in sales of Hebrew University–based research and has registered 5,500 patents and 1,600 inventions. Two-thirds of its 2007 inventions were in biotechnology, a tenth were in agricultural technology, and another tenth were in computer science and engineering products. The research has been sold to Johnson & Johnson, IBM, Intel, Nestlé, Lucent Technologies, and many other multinational companies. Overall, Yissum was recently ranked twelfth—after ten American universities and one British university— in global biotech patent rankings (Tel Aviv University is ranked twenty-first).

Israel, a nation of immigrants, has continually been dependent on successive waves of immigration to grow its economy. It is in large part thanks to these immigrants that Israel currently has more engineers and scientists per capita than any other country and produces more scientific papers per capita than any other nation—109 per 10,000 people.[208] Jewish newcomers and their non-Jewish family members are readily granted residency, citizenship, and benefits. Israel is universally regarded as highly entrepreneurial and—like the IDF—dismissive of the strictures of hierarchy.

In the Persian Gulf, however, governments will allow residency visas for only up to three years, nothing longer—even for fellow Muslims and Arabs. There is no path to citizenship in these countries. So globally sought-after researchers have been unwilling to relocate their families in meaningful numbers and invest their careers in an institution whose host country stifles free speech, academic freedom, and government transparency and puts a time limit on residency. While five- or ten-year residency visas have been considered in several gulf Arab countries, no government has ever ultimately allowed for them.

These residency restrictions are also symptomatic of a larger obstacle to attracting academics: the few research professionals who have shown up quickly became aware of the government’s desire to keep them on the outskirts. The laws emanate from the pressure on governments to be responsive to Arab nationalism broadly, and sovereign nationalism specifically. For example, an Emirati woman who marries an expat must give up her citizenship, and their children will not be issued a UAE passport or any of the government’s welfare benefits.

One of the major challenges to a high-growth entrepreneurial culture elsewhere in the Arab world—beyond just the gulf—is that the teaching models in primary and secondary schools and even the universities are focused on rote memorization. According to Hassan Bealaway, an adviser to the Egyptian Ministry of Education, learning is more about systems, standards, and deference rather than experimentation. It is much more the Columbia model than the Apollo.

This emphasis on standardization has shaped an education policy that defines success by measuring inputs rather than outcomes. For example, according to a study produced by the Persian Gulf offices of McKinsey & Company, Arab governments have been consumed with the number of teachers and investments in infrastructure—buildings and now computers—in hopes of improving their students’ performance. But the results of the recent Trends in International Mathematics and Science Study ranked Saudi students forty-third out of forty-five (Saudi Arabia was even behind Botswana, which was forty-second).[209]

While the average student-teacher ratio in the GCC is 12 to 1—one of the world’s lowest, comparing favorably with an average of 17 to 1 in OECD countries—it has had no real positive effect. Unfortunately, international evidence suggests that low student-teacher ratios correlate poorly with strong student performance and are far less important than the quality of the teachers. But the education ministries in most Arab countries do not measure teacher performance. Inputs are easier to measure, through a methodology of standardization.

Focusing on the number of teachers has particularly harmful implications for boys in the Arab world. Many government schools are segregated by gender: boys are taught by men, girls by women. Since teaching positions have traditionally been less appealing to men, there is a shortage of teachers for boys. As a result of the smaller talent pool, boys’ schools often employ lower-quality teachers. In fact, the GCC gender gap in student performance is among the most extreme in the world.

Finally, a perhaps even larger factor in the limit on high-growth entrepreneurial economies is the role of women. Harvard University’s David Landes, author of the seminal book The Wealth and Poverty of Nations, argues that the best barometer of an economy’s growth potential lies in the legal rights and status of its women. “To deny women is to deprive a country of labor and talent . . . [and] to undermine the drive to achievement of boys and men,” he writes. Landes believes that nothing is more dilutive to drive and ambition than a sense of entitlement. Every society has elites, and a number of them were born into their upper-echelon status. But there is no more widely dispersed sense of entitlement than ingraining in the minds of half the population that they are superior, which, he argues, reduces their “need to learn and do.” This kind of distortion makes an economy inherently uncompetitive, and it is the result of the subordinated economic status of women in the Arab world.[210]

The economy of Israel and many of those in the Arab world are living laboratories for the economic theory of clusters and, more broadly, what it takes for nations to generate—or stifle—innovation. The contrast between the two models demonstrates that a simplistic view of clusters—one that maintains that a collection of institutions can be mechanically assembled and out will pop a Silicon Valley—is flawed. Moreover, it seems that a stake in the country, Tuchman’s “motive,” provides an essential glue that helps encourage entrepreneurs to build and take risks.

CHAPTER 14 Threats to the Economic Miracle

THE ISRAELI ECONOMY is still in its infancy. The start-up scene that seems so established today was born at roughly the same time as the Internet economy itself, just over a decade ago. The dawn of Israel’s tech boom coincided not only with a global surge in information technology but with the American tech-stock bubble, the jump-starting of Israel’s venture capital industry through the Yozma program, the massive wave of immigration from the former Soviet Union, and the 1993 Oslo peace accords, bringing what seemed to be the prospect of peace and stability. What if Israel’s economic miracle were simply built on a rare confluence of events and would disappear under less favorable circumstances? Even if Israel’s new economy is not just the product of happenstance, what are the real threats to Israel’s long-term economic success?

One need not speculate about what would happen if the positive factors that launched Israel’s tech boom in the late 1990s were to disappear. Most of them have.

In 2000, the tech-stock bubble burst. In 2001, the Oslo peace process crumbled, as a wave of suicide bombings in Israel’s cities temporarily wiped out the tourism industry and contributed to an economic recession. And the massive flow of immigrants from the former Soviet Union, which swelled the Jewish population of the country by one-fifth, exhausted itself by the end of the 1990s.

These negative developments happened about as rapidly and simultaneously as their positive counterparts had just a few years earlier. And yet the new state of affairs didn’t bring an end to the boom that was only about five years old. From 1996 to 2000, Israeli technology exports more than doubled, from $5.5 billion to $13 billion. When the tech bubble burst, exports dropped slightly, to a low of less than $11 billion in 2002 and 2003, but then surged again to almost $18.1 billion in 2008. In other words, Israel’s technology engine was barely slowed by the multiple hits it took between 2000 and 2004 and managed not just to recover but to exceed the 2000 boom level of exports by almost 40 percent in 2008.

A similar picture can be seen in venture capital funding. When the VC bubble burst in 2000, investments in Israel dropped dramatically. But Israel’s market share of the global VC flow increased from 15 to 30 percent over the next three years, even as the Israeli economy came under increasing stress.

Israel may not, however, fare as well in the current global economic slowdown, which, unlike that of 2000, is not limited to international tech stocks and venture capital funding but is being dramatically felt in the global banking system as well.

That said, the breakdown in international finance has infected almost every nation’s banking system, with two notable exceptions: neither Canada nor Israel has faced a single bank failure. Since Israel’s hyperinflation and banking crisis of the early 1980s—which culminated in 1985 with the trilateral intervention of the Israeli and U.S. governments and the IMF—tight restrictions have been in place. Israel’s financial institutions adhere to conservative lending policies, typically leveraged 5 to 1. U.S. banks, on the other hand—precrisis—were leveraged at 26 to 1, and some European banks at a staggering 61 to 1. There were no subprime mortgages in Israel, and a secondary mortgage market never came into existence. If anything, a shortage of financing—even before the crisis—for small businesses in Israel drove even more people into the technology sector, where taxes and regulations were more friendly and venture capital was available.

As Israeli financial analyst Eytan Avriel put it, “Israeli banks were horse-drawn carts and U.S. banks were racing cars. But those racing cars crashed badly whereas the carts traveled more slowly and stayed on course.”[211]

This is the good news for Israel. Yet while Israel’s economy was not exposed to bad lending practices or complex credit products, it may be overexposed to venture finance, which could soon be in scarce supply. Venture capital firms are funded largely by institutional investors such as pension funds, endowments, and sovereign wealth funds. These investors set aside a specific allocation for what are called alternative investments (venture capital, private equity, hedge funds), typically in the range of 3 to 5 percent of their overall portfolios. But as the dollar value of their public equity (stock market) allocations has shrunk—due in large measure to crashing markets globally—it has shrunk the absolute dollar amount available for alternative investments. The overall pie has been downsized, reducing available funds for venture capital investments.

A diminished supply of venture capital dollars could mean less “innovation finance” for Israel’s economy. Thousands of workers in Israel’s tech scene have already lost their jobs, and many tech companies have shifted to four-day workweeks to avoid further layoffs.[212] In the absence of new financing, many Israeli start-ups have been forced to close.

In addition to an overdependence on global venture capital, Israeli companies are also overdependent on export markets. Over half of Israel’s GDP comes from exports to Europe, North America, and Asia. When those economies slow down or collapse, Israeli start-ups have fewer customers. Because of the Arab boycott, Israel does not have access to most regional markets. And the domestic market is far too small to serve as a substitute.

Israeli companies will also find it harder to negotiate exits—like Given Imaging’s IPO on the NASDAQ or Fraud Sciences’ sale to PayPal—which are often the means by which Israeli entrepreneurs and investors ultimately make their money. A global slowdown will coincide with fewer IPOs and acquisitions.

And a continued deterioration of the regional security situation could also threaten Israel’s economic success. In 2006 and at the turn of 2008 to 2009, Israel fought wars against two groups trained and funded by Iran. While these wars had little effect on the Israeli economy, and Israeli companies have become adept at upholding their commitments to customers and investors regardless of security threats large and small, the next iteration of the Iranian threat could be different from anything Israel has ever experienced.

Iran, as is widely reported by international regulatory bodies and news organizations, is in pursuit of a nuclear capability. If the Iranian government establishes a nuclear-weaponization program, it could spark a nuclear arms race throughout the Arab world. This could freeze foreign investment in the region.

While much of the international focus is on the potential threat of an Iranian nuclear missile strike on Israel, the political and security leadership of Israel warns against the effect of an Iranian nuclear capability on the region even if it is never directly used. As Prime Minister Benjamin Netanyahu told us, “The first-stage Iranian goal is to terrify Israel’s most talented citizens into leaving.”[213]

Clearly, if the Iranian threat is not somehow addressed, the Israeli economy could be affected. So far, however, the presence or potential of such threats has not deterred foreign companies and venture funds from increasing their investments in Israel.

Indeed, when it comes to threats to the economy, discussion within Israel centers more on domestic factors. Maybe because Israel has inoculated itself against security threats to its economy in the past, or maybe because the prospect of a nuclear threat is too grave to ponder, Tel Aviv University economist Dan Ben-David is fixated on another threat—the “brain drain” from the faculties of Israeli universities.

To be sure, Israel is a leader in the international academic community. A global 2008 survey by Scientist magazine named two Israeli institutions—the Weizmann Institute and the Hebrew University of Jerusalem—as the top two “best places to work in academia” outside the United States.[214]

Economist Dan Ben-David pointed us to a study by two French academics that ranks nations outside the United States according to publications in top economic journals between 1971 and 2000. The United Kingdom—including the London School of Economics, Oxford, and Cambridge—came in at number two. Germany had fewer than half as many publications per faculty member as the British had. And Israel was number one. “Not five or ten percent more, but seven times more—in a league of our own,” Ben-David crowed to us. “And as good as Israel’s economists are, our computer scientists are apparently even better, relative to their field. We have two Nobel Prizes recently in economics, and one or two in chemistry.”[215]

But despite all this success, Ben-David is worried. He told us that Israel’s academic lead has lessened in recent years, and will fall further as older faculty members retire and many of the rising stars leave to teach abroad. In his own field, economics, Ben-David pointed to a study that found that of the top thousand economists in the world, as measured by citations of their work between 1990 and 2000, twenty-five were Israelis, thirteen of whom were actually based in Israel. Since that study was published, only four of these have remained in Israel full-time. And none of the twelve Israelis working abroad in 2000 have returned to Israel. In total, an estimated three thousand tenured Israeli professors have relocated to universities abroad.

Ben-David is one of those four top economists who remain in Israel. And he is sounding the alarm on Israel’s continued economic growth. From 2005 through 2008, Israel grew substantially faster than most developed countries. But there was a recession the previous few years so, Ben-David argues, “all we’ve done is return to the long-term path. We’re not in uncharted territory; we are where we should have been had we not had the recession.”

The problem, according to Ben-David, is that while the tech sector has been surging ahead and becoming more productive, the rest of the economy has not been keeping up. “It’s like an engine,” he says. “You have all the cylinders in the engine. You have all the population in the country. But we’re using fewer and fewer of the cylinders to move this machine forward.” In essence, the tech sector is financing the rest of the country, which is “not getting the tools or the conditions to work in a modern economy.”

This underutilization brings us to what we believe is the biggest threat to Israel’s continued economic growth: low participation in the economy. A little over half of Israel’s workforce contributes to the economy in a productive way, compared to a 65 percent rate in the United States. The low Israeli workforce participation rate is chiefly attributable to two minority communities: haredim, or ultra-Orthodox Jews, and Israeli Arabs.[216]

Among mainstream Israeli Jewish civilians aged twenty-five to sixty-four, to take one metric, 84 percent of men and 75 percent of women are employed. Among Arab women and haredi men, these percentages are almost flipped: 79 percent and 73 percent, respectively, are not employed.[217]

The ultra-Orthodox, or haredim, generally do not serve in the military. Indeed, to qualify for the exemption from military service, haredim have to show that they are engaged in full-time study in Jewish seminaries (yeshivot). This arrangement was created by David Ben-Gurion to obtain haredi political support at the time of Israel’s founding. But while the “yeshiva exemption” first applied to just four hundred students, it has since ballooned to tens of thousands who go to yeshiva instead of the army.

The result of this has been triply harmful to the economy. Haredim are socially isolated from the workforce because of their lack of army experience; plus, since they are not allowed to work if they want a military exemption—they have to be studying—as young adults they receive neither private-sector nor military (entrepreneurial) experience; and thus haredi society becomes increasingly dependent on government welfare payments for survival.

There are two primary reasons why Israeli Arabs have low participation rates in the economy. First, because they are not drafted into the army, they, like the haredim, are less likely to develop the entrepreneurial and improvisational skills that the IDF inculcates. Second, they also do not develop the business networks that young Israeli Jews build while serving in the military, a disparity that exacerbates an already long-standing cultural divide between the country’s Jewish and Arab communities.

Each year, thousands of Arab students graduate from Israel’s technology and engineering schools. Yet, according to Helmi Kittani and Hanoch Marmari, who codirect the Center for Jewish-Arab Economic Development, “only a few manage to find jobs which reflect their training and skills. . . . Israel’s Arab graduates need to be equipped with a crucial resource which the government cannot supply: a network of friends in the right places.”[218] And in the absence of those personal connections, Israeli Jews’ mistrust of Israeli Arabs is more likely to hold sway.

Another problem is the bias within the Israeli Arab community against women in the workplace. A 2008 study by Women Against Violence, an Israeli Arab organization, found that public opinion among local Arabs may be slowly changing, but traditional attitudes are still entrenched. In a survey, even participants who “opposed older attitudes” still agreed with the statement “Arab society is predominantly patriarchal, where men are perceived as the decision-makers and women as inferior and ideally subservient. . . . A man who treats his partner other than [according to] the acceptable norm endangers his social standing.”

Despite this paradox, Women Against Violence director Aida Touma-Suleiman said that she sees men as partners for change, including a new acceptance of women who work outside the home. “There are Arab men who are unhappy with this balance of power, and wish to improve the relations between the genders. They see it as in their interest as much as anyone else’s,” she said.[219]

Yet because of the high birth rates in both the haredi and the Arab sectors, efforts to increase workforce participation in these sectors are racing against the demographic clock. According to Israel 2028, the report issued by an official blue-ribbon commission, the haredi and Arab sectors are projected to increase from 29 percent of Israel’s total population in 2007 to 39 percent by 2028. Without dramatic changes in workforce patterns, this shift will reduce labor-force participation rates even further. “The existing trends are working in stark opposition to the desired development,” the report warns.[220]

As he was campaigning to return to the premiership, Bibi Netanyahu made getting Israel to number among the top ten largest (per capita) economies in the world a centerpiece of his agenda. An independent think tank, the Reut Institute, has been pursuing a similar campaign called Israel 15. Gidi Grinstein, the founding president of Reut, was an adviser to former prime minister and current defense minister Ehud Barak, who had been a political rival of Netanyahu’s. Yet Grinstein agrees with Netanyahu that Israel’s goal should be not just to keep up with advanced nations but to rise to rank among the top nations as measured by GDP per capita.

As Grinstein sees it, “This challenge is not a luxury, it’s a necessity.” At a minimum, Israel must grow 4 percent per capita for a decade, he believes; the current gap in living standards between Israel and other developed countries is dangerous. He says, “Our business sector is among the world’s best, and our population is rich in skills and education. At the same time, the quality of life and the quality of public services in Israel are low, and for many, emigration is an opportunity to improve their lot.”[221]

This may be overstated, since record numbers of Israeli expatriates have recently been returning from the United States and other countries, in part due to a newly enacted ten-year tax holiday on foreign income for such returnees. And, of course, other factors besides income enter into “quality of life” decisions.

But the point that Israel can, should, and must grow its economy faster is crucial. Of all the threats and challenges facing Israel, an inability to keep the economy growing is perhaps the greatest, since it involves overcoming political obstacles and giving attention to neglected problems. Israel has a rare, maybe unique, cultural and institutional foundation that generates both innovation and entrepreneurship; what it lacks are policy fixes to further amplify and spread these assets within Israeli society. Fortunately for Israel, it is probably easier to change policies than it is to change a culture, as countries like Singapore demonstrate. As the New York Times’ Thomas Friedman put it, “I would much rather have Israel’s problems, which are mostly financial, mostly about governance, and mostly about infrastructure, rather than Singapore’s problem because Singapore’s problem is culture-bound.”[222]