ISRAEL 
HIGH-TECH & INVESTMENT REPORT

from the September 2003 issue


"Optimistic Overconfidence" vs. "the Real Thing"


As global economies wobble and international stock markets shake they continue to defy comprehension, economists are turning to Nobel winner psychologist Daniel Kahneman for his incisive insights related to psychology. The Israeli/American Princeton University professor is known for research conclusions indicating the effects of economics to quirks in human behavior. Among these is the tendency to be overconfident or avoid risk. This, asserts the Professor, may lead to investor decisions that don't always bring the best, or most logical, outcomes.

His "Prospect Theory" suggests that people's degree of pleasure depends more on their own subjective experience, than on objective reality.

Professor Kahneman was recently honored at Israel's Ben Gurion University. His lecture started us thinking as to how psychology affects Israelis' attitudes towards this country's economic prospects. How often do we hear the cantankerous sounds of people holding diametrically opposite points of view.

Recently the influential Business Week wrote: "Something is afoot in Israel's financial markets. The leading Tel Aviv stock index is up 34% so far this year. Since reaching this level it has retreated by several percentage points. After unable to raise money on the international capital markets for more than two years, the Israeli government recently attracted institutional investors to a commercial bond offering, raising $750 million".

Prof. Kahneman's reaction might likely be: "If the market starts rising, that rise in some sense expresses a better mood, but it also causes a lot of people to become more optimistic". Prof. Kahneman's Prospect theory helps explain biases of beliefs such as "optimistic overconfidence" -- whereby people believe they can do, what in fact they cannot do. When you have a situation where everybody believes they are above average, the markets are going to behave in a funny way".

Yet any high school student will tell you if asked, that the Israeli economy is likely to grow less than 1% this year.

The country's gross domestic product that droppped 3.8 percent in 2002 is headed for an additional drop. The intifada's cost to Israel's economy has been estimated by the Bank of Israel at $4 billion. Income has shrunk and the Central Bureau of Statistics reports that unemployment soared to 10.3 percent, close to the highest figure in Israel's history. So far this trend has not been reversed. The conclusion may be drawn that the Israeli public is exhibiting a strong dose of "optimistic overconfidence"

So what is to be expected for the rest 2003 and beyond? We view the future with a "a measured touch of pessimism capping our basic optimism".

The geopolitical situation that prevailed in the Middle East since Israel's inception, precluded trade between Israel and its neighbors. Furthermore, the quality and structure of Israel's industrial production made Europe and the US natural trading partners for Israel. In 2002, the US and the EU accounted for 31% and 30%, respectively, of Israel's exports and for 22% and 40% of its imports. Our guess is if the American economy picks up next year it will have a highly positive impact on Israel's high tech exports and the economy as a whole. The dependence of Israel's industrial exports on American demand should not be overlooked.

The export-driven hi-tech sectors are affected primarily by external demand, and tend to be less sensitive to geo-political events. Exports should not be affected even if the Middle East politics worsen, which is not expected.

The negative investment climate, a a product of perceived instability, resulted in a decrease in Foreign Direct Investment in 2002. FDI to Israel is still high when compared to investment in other industrial nations. Average inflows of non-EU FDI to the EU (as percentage of GDP), for example, were lower than those for Israel. 2002 figures indicate a sharper decline in FDI inflows, a trend that may be reversing, following the war against Iraq. Foreign investors are already expressing optimism in the economy. In the first five months of 2003, the securities portfolio of foreign investors in TASE-traded stocks rose to $1 billion. Foreign interest in the private equity market is also on the rise, as the second quarter of 2003 saw an increase in the participation of foreign venture capital in financing Israeli start-ups.

We do not expect the Intifada to resume though the period ahead will likely be marked by tensions and threats of a return to widespread terrorist violence. What could upset the applecart would be the enalrgement of the scope of the most recent sporadic acts of terror. The Israelis' indominable will to carry on even in the face of lethal suicide bomber attacks makes the restart of the Intifada an unprofitable policy. But the unprofitability of bad policies has never deterred the Arab world from rash actions. Israel's Finance Minister Benjamin Netanyahu, argues that one key reason smart money is heading to Israel is the government's radical program to liberalize its economy. In three months, Israel has pushed through massive reductions in state spending, including the first-ever cut in public-sector wages. Income tax rates will be cut. The planned cut in taxes is similar to that enacted by President George Bush that its intent is to put more spending money in the pockets of the citizens. Fundamentally, we do not disagree with the Finance Minister's optimism, but we worry a bit whether it includes a measure of "optimistic overconfidence".

"Israel has the greatest concentration of people capable of producing conceptual products -- value-added products -- in the world. There are only two economies that have that capacity. Ours is the most concentrated, even though it's a lot smaller than that of the U.S. I claim that everything in Israel is undervalued. A $16,000 per capita income is ridiculous for a country like Israel. It should be around $40,000". Our only concern is that the time span required for the return of prosperity be as short as possible.


Reprinted from the Israel High-Tech & Investment Report September 2003

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