Peace Economics, Peace Science and Public Policy

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Peace Economics, Peace Science and Public Policy Volume 14, Issue 1

2008

Article 1

An Economic Development Road Map for Promoting Israeli-Palestinian Cooperation Miki Malul∗

Yuri Mansury†

Tad Hara‡

Sidney Saltzman∗∗



Department of Public Policy and Administration, Ben Gurion University, [email protected] † KDI School of Public Policy and Management, [email protected] ‡ Rosen College of Hospitality Management & Dick Pope Sr. Institute of Tourism Studies, University of Central Florida, [email protected] ∗∗ Cornell University, [email protected] c Copyright 2008 The Berkeley Electronic Press. All rights reserved.

An Economic Development Road Map for Promoting Israeli-Palestinian Cooperation∗ Miki Malul, Yuri Mansury, Tad Hara, and Sidney Saltzman

Abstract In this paper we propose an interregional framework as a policy tool for identifying sectors that can stimulate Palestinian economic development while recognizing the reality of the IsraeliPalestinian economic interdependencies. Specifically, this paper emphasizes the potential role of bi-national trade channels to promote Israeli-Palestinian cooperation. To that end, we apply an interregional input-output model to 14 sectors of the Palestinian and Israeli economies and their trading relationships. We then investigate the impact of an exogenous foreign injection under alternative trade scenarios. The results suggest that foreign aid injections to the Banking and Construction sectors in Palestine make the highest impact on Palestinian output. On the other hand, if the primary objective is to promote employment, then injections should be concentrated on the Community, Social, Personal and Household Services sectors. KEYWORDS: Middle East, cooperation, economics, input-output



We thank Walter Isard of Cornell University for making it possible for us to do research on this problem and for his encouragement.

Malul et al.: An Economic Development Road Map

Introduction At least since the early 1990s, there have been intermittent but persistent and often intense efforts to provide a political framework for resolving the IsraeliPalestinian conflict.1 The most relevant of these efforts is being made by a group of four nations/institutions identified as the “Quartet” (the European Union, Russia, the United Nations and the United States). The U.S. developed and, along with the rest of the Quartet, is promoting the Road Map for Peace in the Middle East, originally proposed in 2002, which calls for Israel and the Palestinian Authority to negotiate an economic and political settlement. It was hoped that this would ultimately lead to a permanently secure and peaceful region following the establishment of a Palestinian state. This Road Map envisions a three-phase process, which is summarized as follows, to achieve this goal: “Phase 1: Ending Terror and Violence, Normalizing Palestinian Life and Building Palestinian Institutions….; Phase II: Transition: An Independent Palestinian State is Created with Provisional Borders and Attributes of Sovereignty….; Phase III: Permanent Status Agreement and End of Israeli-Palestinian Conflict…” A complementary road map that focuses on the economic aspect was introduced in January 2004 by the “Aix Group,” which includes Israeli and Palestinian academics, economists and officials, as well as members of international institutions such as the European Union, the World Bank and the International Monetary Fund. Their deliberations subsequently resulted in the January 2004 publication of the “Economic Road Map: An Israeli-Palestinian Perspective on Permanent Status,” which specifies certain trade and macroeconomic relations between the two parties as a model for development of the third and final phase of the “Road Map for Peace.” The motivation for the preparation of the Economic Road Map (Aix Group, 2004, p. 2) was the desire “…to bring together Israeli and Palestinian perspectives on economic questions related to future permanent arrangements between the two sides and to create a forum for discussing and analyzing different scenarios and propositions …(and)…focusing on developing an “Economic Road Map” as a complement to the political process started by the “Road Map”…supported by the Quartet…” The Economic Road Map (hereafter, ERM) covers a variety of topics, including institutional and procedural recommendations concerning interregional trade, human capital and labor mobility, and fiscal issues, as well as the bi1

We note that earlier attempts as articulated in the "Oslo Declaration of Principles" in 1992 failed due to the escalation of violence in 2000. Published by The Berkeley Electronic Press, 2008

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national flows of money, capital, and direct investments. The ERM acknowledges, however, that additional “road maps” are required to develop effective plans that will help “…promote independence in defining economic objectives and strategies, growth in both economies, the pursuit of policies that acknowledge economic interdependencies, and the convergence of Palestinian living standards with those of Israel.” (ERM, p.13) To achieve these goals, it is necessary to understand not only the underlying structure of the Israeli and Palestinian economies separately but also the extent of their economic interdependencies. This paper emphasizes the role of foreign aid as the key driver of economic development and employment in the Palestinian Authority, as well as the impetus of bi-national trade between Israel and Palestine. According to Bar-El and Malul (2008), the injection of financial aid into the Palestinian economy by the international community is primarily driven by the externalities that aidfinanced activities generate. Externalities are the indirect benefits of financial aid, which can be broken down into two types: the first corresponds to the well-known indirect economic benefits generated through the multiplier effects, which are the main focus of this paper. The second are socio-political externalities that include benefits not necessarily measurable in monetary terms, such as regional stability, the easing of social tensions, and the diminution of international conflicts (Bouillon 2004, Forman et al. 2000, Isard 2004, and Weede 2004). This study examines the employment impact of financial aid that has been found to be highly correlated with the second type of externalities. For example, Saleh (2004) found a significant positive correlation between the Palestinian unemployment rate and the number of suicide bombings, as well as total attacks. Amid a severe economic contraction brought about by the protracted regional conflict, Palestine remains the largest foreign-aid recipient in the world today, receiving nearly US$ 300 of aid per capita in 2004. At a conference held in France in December 2007, a total of 87 countries and international organizations pledged $7.4 billion in aid to the Palestinians. This is the most ambitious fundraising effort in more than a decade aimed to help Palestinians create a viable, peaceful and secure state of their own. In this paper we seek ways to optimally allocate that aid in order to boost output and employment in Palestine. We believe that such a tremendous injection of liquidity not only could boost economic activities in Palestine, but through bi-national trade channels could also impact the Israeli economy and thus generate positive spillover externalities. Specifically, an aid injection will likely stimulate local production in Palestine, which in turn leads to an increase in imports from Israel due to the nonsubstitutable nature of foreign input. Note that during their struggle for independence, citizens of the weaker economy often view increasing imports as a threat to their local nascent

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industries, and as a sign of subordination to foreign interests. Such views rely on one-sided arguments however, and fail to consider the secondary (and higherorder) feedback effects benefiting the home country through trade channels: increasing imports enhance production in the trading partner, which in turn requires additional inputs from the home country. Thus, understanding the impact of foreign aid injection requires a simultaneous view of the two economies allowing cross-border feedbacks to be fully endogenized. The role of bi-national trade channels in this area must be given serious consideration because of its largely-unexplored potential to promote IsraeliPalestinian cooperation. In turn, a change in the level of cooperation itself can have a powerful impact on the extent of cross-border trade. For example, an “optimistic” outcome towards a peaceful resolution (i.e., higher level of cooperation) can conceivably be reflected in greater freedom of movement of people and goods across the borders. On the other hand, a “pessimistic” scenario may unfold following an escalation in armed conflict (i.e., lower level of cooperation), which will likely lead to significant tightening of border controls. In this paper, we propose a two-region framework as a policy tool for identifying sectors that can stimulate economic development in Palestine, while recognizing the reality of the Israeli-Palestinian economic interdependencies. We employ an interregional input-output framework to investigate 14 production sectors in the two economies and their trading relationships. 2 Using this framework, we examine how sectoral production responds to changing trade scenarios. Moreover, we examine its impact on the labor market and sectoral employment in Palestine. The interdependencies in terms of magnitudes and flows within and between these sectors of the two economies are identified, and we dicuss their policy implications. The remainder of this paper proceeds as follows: The next section briefly reviews the literature, while section 3 provides a short summary of the methodologies and data used in this analysis. Section 4 presents the results of the analysis, and finally section 5 offers a brief summary of the paper, discussing its strengths and limitations, policy implications, and areas for further research. Review of the Literature There is an established body of literature that examines the relationship between trade and economic performance. To facilitate a comparison with the experiences 2

The analyses discussed in this paper are based on data from the late 1990s. Although the political situation in the Middle East has changed very significantly since then, we believe the insights revealed in our analyses are still of interest today, and can provide a useful framework for additional analyses using more recent data

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of other countries, we concentrate on studies that examine the link between trade and national income levels. Thus, for example, we leave out the important contribution of the endogenous growth models [see, e.g., Romer (1986) and Lucas (1988); Rivera-Batiz and Romer (1991) advance a model of economic integration and endogenous growth], which have triggered a new wave of empirical studies that examine the impact of trade on income growth [e.g., Levine and Renelt (1992); Edwards' (1993) survey of the literature]. This is because growth – the permanent rate of change in the income level – is an inter-temporal process that can only be treated appropriately within a dynamic model. In contrast, our interregional input-output (I-O) framework captures the short- to medium-term impact of trade on income level, short enough that both prices and economic structure can be assumed to be stable but, though sufficient time can be allowed for the multiplier impact to be fully realized, certainly not long enough for the growth trajectory to change. We start with the classical comparative-advantage framework of David Ricardo (1817), who claims that bilateral trade is always advantageous even if one nation is, in absolute terms, more efficient in the production of all goods.3 Krugman and Obstfeld (2003) provide an excellent textbook treatment of this framework that focuses on differences in resource endowments as the basis for trade. In contrast, modern trade theories propose that even if countries have similar endowments, a country can still benefit from trade if economies of scale can be realized by specializing in a certain range of products (see the collection of articles in Grossman, 1992). Both classical and modern trade theories conclude that assuming constant terms of trade and in the absence of market failures, the opening of the trade borders is expected to free up resources allowing countries to specialize in certain products, which in turn expands their production possibility frontiers, hence raising the output levels of all countries. We stress here that theoretical works rarely consider the role of inter-industry linkages. Among the few that do, Deardorff (1979) introduces intermediate goods into the standard HeckscherOhlin model. He then establishes the expected pattern of specialization following the relaxation of border controls. Deardorff is not explicit, however, on the impact of lesser trade impediments on total output when I-O relationships exist in production. The empirical works in this area of research can be broken down into two broad categories, namely (1) those that apply multi-country regression techniques to pooled data from a large set of countries, and (2) single-country studies employing either computable general equilibrium models or time series 3

We are aware that the Ricardian framework is constructed to examine the trade impact on national income, whereas our I-O framework quantifies the impact on total output while holding the value added constant.

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econometrics. The majority of these studies found a positive effect of trade on income. For example, using the instrumental variable technique, Frankel and Romer (1999) found a quantitatively large and robust positive effect on income. In particular, the authors found that in their sample of 150 countries, on average a one-percent increase in the trade-to-GDP ratio increases per capita income by about two percent. Of particular relevance to our study here is the impact of trade when economies are either at different development stages (i.e., developing vs. developed) or of unequal sizes as measured by the dollar values of output. In this regard, recent studies found that trade between poor and rich countries leads to the promotion of economic prosperity mainly in poor countries, and therefore is likely to mitigate the rising inequality between participating nations (Lindert and Williamson 2001, Dollar and Kraay 2002). Similarly, Ghose (2004) analyzed the trend in global inequality during 1981-1997 and found that developing countries achieved significantly faster economic growth than the advanced industrialized countries so that actually the apparent increase of income inequality among countries conceals a process of convergence. For example, though a small number of developing countries achieved significantly faster economic growth than the advanced industrialized countries, they account for a majority of the world population. Thus, global inequality in fact declined even though the inter-country income inequality increased. That is, if one calculates the global inequality level (using, for example, the Gini index) for individual countries (without consideration of their size), then one will find the trend of growing inequality. However, if instead one calculates the global population-weighted inequality, then according to Ghose the trend is reversed and instead becomes one of decreasing inequality. In the context of the link between free trade and multilateral cooperation, Weede (2004) reviews studies in this area that employ quantitative methods. He concluded that bilateral trade reduces the risk of war between pairs of nations because war is likely to disrupt trade, which means that the higher the level of trade in a pair of nations, the greater the costs of trade disruption when war breaks out. More specifically, an increase in the scope of trade between Israel and the Palestine can decrease political tensions by reducing the growing economic gap between the two economies. As we showed in Mansury et al. (2005), the Palestine economy could enjoy greater a benefit from every additional dollar of foreign aid injected into the economy under the free trade scenario. We conclude that as far as we know, the literature has been largely silent on the impact of cross-border trade in the presence of inter-industry (I-O) linkages when the economies involved are at different stages of development.

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Data and Models Data In this study, we start with a 14-sector breakdown of the I-O transactions representing both the Israeli and Palestinian economies. In Mansury et al. (2005), we have described in detail our inter-regional I-O data set representing the binational economic interdependence between Israel and Palestine. Briefly, the two primary data sets used in this study are the I-O data sets for the combined West Bank and Gaza regions (i.e., “Palestine”) for 19984 and for Israel for 1995.5 These input-output data sets are broken down into fourteen sectors, namely: 1. Agriculture 2. Manufacturing 3. Electricity and Water Supply (Utilities) 4. Construction 5. Wholesale and Retail Trade (Trade) 6. Tourism/Accommodations 7. Transport, Storage and Communication

8. Banking, Insurance and Other Financial Institutions 9. Real Estate, Renting and Business Activities. 10. Public Administration 11. Education 12. Health Services and Welfare 13. Community, Social, Personal and Household Services (Other Services) 14. General Expenses

The last sector, General Expenses, is essentially a balancing account that ensures that total output is consistent with national accounts data, and has zero value in the Palestinian data set. Because the last sector does not represent a true economic activity, we shall focus on the first 13 sectors in the discussion that follows. Employment data We obtained employment data from the website of the Palestinian Central Bureau of Statistics (http://www.pcbs.org). The original data, however, decompose the labor force into five sectors only. Therefore, several additional estimates were necessary in order to render the employment data compatible with the 14-sector IO data. First, we employ the 2002 data for Palestine (see Hara, 2004) to 4

We thank Sebastien Dessus of the World Bank for the 1998 SAM data of West Bank/Gaza. See http://www.cbs.gov.il/publications/input_output/input_en.htm for the Israeli input-output data set.

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disaggregate the labor force into 24 sectors of employment. After condensing the data to render them compatible with the I-O classification system, we then compute the proportion of workers employed in each of the 13-sectors. Using this 2002 distribution, we subsequently expand the original 1998 data into 14 sectors as shown in Table 1. Table 1. Estimated sectoral breakdown of employment and employment per 1,000 US$ of sectoral output, West Bank and Gaza combined, 1998. Sector

Workers (000)

Workers per US$ 1000 of Output 0.073 0.015 0.015 0.090 0.072 0.007 0.054 0.019 0.010 0.105 0.016 0.021 0.477

Agriculture 72.253 Manufacturing 81.441 Electricity and Water Supply 4.544 Construction 125.580 Wholesale and Retail Trade 97.474 Tourism/Accommodations 1.352 Transport, Storage and Communication 24.570 Banking, Insurance and Other Financial Institutions 3.503 Real Estate, Renting and Business Activities 5.677 Public Administration 81.691 Education 4.585 Health Services and Welfare 5.034 Community, Social, Personal and Household 38.017 Services Total 546,000 Source: Authors’ calculations based on the data posted on the website of the Palestinian Central Bureau of Statistics, http://www.pcbs.org. Table 1 reveals that the largest Palestinian employer is Construction with 125,580 workers, followed by the Palestinian Authority (i.e., Public Administration) and Manufacturing. Using workers per output to describe the type of technology utilized, the right column of Table 1 indicates that the Social, Personal and Household Services sector is the most labor-intensive activity (0.477 workers per US$1,000 of output), followed by Public Administration and then Agriculture.

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The Inter-Regional Input-Output (IRIO) Model The inter-regional input-output (IRIO) model is the chosen framework in this study because its underlying assumption (i.e., free trade with minimal border controls) is closest to the ultimate goal of the ERM. We compute the IRIO multiplier matrix, Mir, using the following formula:

(1)

⎡ ⎡ I M 0 ⎤ ⎡ A II ⎢ ⎢ M ir = ⎢ ⎢⎢L M L⎥⎥ − ⎢ L ⎢ ⎢ 0 M I ⎥ ⎢ A PI ⎦ ⎣ ⎣⎣

M A IP ⎤ ⎤ ⎥⎥ M L ⎥⎥ M A PP ⎥⎦ ⎥⎦

−1 ,

where AII and APP represent, respectively, the Israeli and Palestinian domestic I-O transactions, while AIP and API, respectively, the cross-border trade flows from Israel to Palestine and the corresponding flows from Palestine to Israel. Finally, I stands for the identity matrix and 0 the matrix containing all zero elements. If we also have the sectoral breakdown of employment (see, e.g., the middle column of Table 1), then the vector of labor coefficients, L, can be computed such that each element l i ∈ L represents the number of workers required to produce US$ 1,000 worth of output i (see, e.g., the right-most column of Table 1). The impact of an economic perturbation on employment can then be computed as the product of the multiplier matrix and the vector of labor coefficients = M ir ⋅ L . The Trade Adjustment Factor Evaluating the endogenous economic impacts of changes in the trading propensity between two economies is another potentially important extension of the IRIO methodology presented in section 3.2. Let us define a parameter called the “trade adjustment factor,” TijAB = 1.0, to represent the current level of trade between two economies, A and B, where A is exporting goods from its sector i to B’s importing sector j (e.g., region A exporting its manufactured goods to B’s agricultural sector). If the political climate between A and B deteriorates and negatively impacts the overall level of trade between them, one would expect the trade adjustment factor to fall to 0 ≤ TijAB < 1 . On the other hand, if the political climate improves and positively affects trade, then one would expect the trade adjustment factor to rise, 1 < TijAB . For our specific case of Israel and Palestine, A = I (for Israel), and B = P (for Palestine). If one multiplies each element in the trading matrices AIP and API http://www.bepress.com/peps/vol14/iss1/1 DOI: 10.2202/1554-8597.1122

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(see Eq. 1 above) by their respective elements in TIP and TPI, then one would obtain the new adjusted level of trade between the two economies. Since these trade levels have been endogenized in the multi-regional and inter-regional models used in this paper, the new level of economic activities associated with the adjusted trade levels within both regions would be different from those associated with the initial or current level of trade. To see how the trade adjustment factor can be utilized for analyzing alternative trade scenarios, consider the following example. Suppose the outlook for peace and increased trade between Israel and Palestine improves significantly, then this could be reflected in the rise of the trade adjustment factors to Tijip = 3.0 and Tijpi = 1.5 for all i, j. That is, under an optimistic scenario diminishing conflict would increase Israeli exports to Palestine by 200%, and increase Palestinian exports to Israel by 50%. The asymmetrical increase in trade (by 200% for Tijip and by 50% for Tijpi ) can be due to, for example, future increases in foreign aid to Palestine, which leads to a higher propensity to import from Israel. We stress that although the trade adjustment factor has been defined in terms of changes in political interrelationships, a similar approach can be used in more general cases, such as measuring the economic impacts of disasters affecting trade, the imposition or elimination of tariffs, etc. Results Benchmark simulation: T = 1

Table 2 lists the multiplier impacts of a shock originating in one of the Palestinian sectors. The table reveals that the Palestinian sectors that yield the greatest economic impact depend on our criteria with respect to our regions of interests. For example, if we are concerned with the performance of the combined economies of Palestine and Israel, then the IRIO multipliers in column (1) of Table 2 suggest that Banking produces the largest multiplier impact (3.217), followed by Construction (2.438), and Electricity (2.317). Focusing only on the Palestinian economy, column (2) of Table 2 shows that again Banking (2.83) and Construction (1.968) were the top two impact generators, but here Trade (1.747) ranks third, reflecting the role of both wholesale and retail trade within the Palestinian borders. However, the entire ranking changes if instead we are concerned primarily with the spillover effects to Israel (last column of Table 2. In this case, Electricity (0.974), Manufacturing (0.713), and Tourism (0.709) transmit the largest inter-regional spillovers. For example, the Electricity sector yields a total multiplier effect of 2.317, of which 1.343 accrues solely to the

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Palestinian economy. The difference, 2.317 – 1.343 = 0.974, constitutes the interregional effect that spills over from Palestine to Israel. Thus, the total impact of Banking or Construction shock is large because the Palestinian proportion is significant: 87.99% and 80.71% of the total IRIO multipliers, respectively. By contrast, the spillover effect from Electricity and Manufacturing is large due to significant leakages to Israel: 42.05% and 35.14%, respectively.

Table 2. The IRIO multiplier impacts of a shock originating in Palestinian sectors (in descending order). Column (1) ranks the total sectoral impacts on the combined economies of Palestine and Israel, (2) the impacts on the Palestinian economy only, (3) the spillover effects to Israel. The numbers represent the magnitude of the impact in each sector. Note that for each sector of origin, (1) = (2) + (3). Palestine and Israel (1) Banking 3.217 Construction 2.438 Utilities 2.317 Tourism 2.183 Agriculture 2.065 Manufacturing 2.029 Transport 2.005 Trade 1.962 Public Admin 1.917 Health 1.879 Other Svc 1.877 Real Estate 1.243 Education 1.236 Mean 2.028 Std. Dev. 0.500 C.V. 0.247

Palestine Only (2) Spillover to Israel (3) Banking 2.830 Utilities 0.974 Construction 1.968 Manufacturing 0.713 Trade 1.747 Tourism 0.709 Public Admin 1.616 Transport 0.661 Other Svc 1.609 Agriculture 0.575 Agriculture 1.490 Construction 0.470 Tourism 1.474 Health 0.427 Health 1.452 Banking 0.386 Transport 1.343 Public Admin 0.302 Utilities 1.343 Other Svc 0.268 Manufacturing 1.316 Trade 0.215 Education 1.145 Real Estate 0.184 Real Estate 1.058 Education 0.092 Mean 0.568 Mean 0.460 Std. Dev. 0.449 Std. Dev. 0.256 C.V. 0.286 C.V. 0.557

In general, Table 2 shows that if the shock originates in one of the Palestinian sectors, then the inter-regional spillover effect to Israel is relatively significant. In contrast to that, Table 3 shows that if instead Israeli sectors are the sources of the shock, then the spillover to Palestine is, by comparison, relatively smaller. These results suggest a higher dependency of the Palestinian economy on Israel rather than the latter on the former, such that increased investments in Palestine bring about larger spillovers in the form of import leakages. For

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example, the U.S. promise6 of US$ 50 million to fund infrastructure development in Gaza would, if we assume it would be primarily in the Construction sector, have a multiplier of almost two (1.97), implying an economic impact of almost $100 million for Palestine alone with an additional spillover to Israel of almost $23.5 million. On the other hand, because the Israeli economy does not rely much on the Palestinian economy, rising final demand for Israeli products only has a relatively marginal impact on Palestinian activities.

Table 3. The IRIO multiplier impacts of a shock originating in Israeli sectors. Column (1) ranks the total impact on the combined economies of Palestine and Israel, (2) the impact on the Israeli economy only, (3) the spillover to Palestine. The numbers represent the impact magnitude. Palestine and Israel (1) Agriculture 2.119 Construction 1.876 Manufacturing 1.853 Health 1.754 Transport 1.745 Trade 1.697 Utilities 1.655 Public Admin 1.609 Other Svc 1.599 Tourism 1.559 Banking 1.447 Real Estate 1.344 Education 1.343 Mean 1.661 Std. Dev. 0.219 C.V. 0.132

Israel Only (2) Agriculture 2.053 Construction 1.861 Manufacturing 1.827 Health 1.750 Transport 1.742 Trade 1.693 Utilities 1.650 Public Admin 1.604 Other Svc 1.597 Tourism 1.552 Banking 1.446 Real Estate 1.342 Education 1.341 Mean 1.651 Std. Dev. 0.205 C.V. 0.124

Spillover to Palestine (3) Agriculture 0.066 Manufacturing 0.026 Construction 0.015 Tourism 0.006 Utilities 0.005 Public Admin 0.005 Trade 0.004 Transport 0.003 Health 0.003 Other Svc 0.002 Real Estate 0.002 Education 0.001 Banking 0.001 Mean 0.011 Std. Dev. 0.018 C.V. 1.636

A comparison of column (1) of Table 2 and column (1) of Table 3 reveals that in general the magnitude of the IRIO multipliers are larger for shocks originating in Palestine (mean = 2.028) than that for shocks originating in Israel (mean = 1.661). For the latter, however, the impact that is retained in Israel (mean = 1.651) outweighs the Palestinian proportion that is retained in West Bank and Gaza (mean = 1.568). Once again, these summary statistics point to Palestine’s greater dependency on Israel than the reverse. We note also that there is greater 6

By President Bush to President Abbas on May 26, 2005, see the website of the U.S. State Department, http://www.state.gov/p/nea/rls/rm/46824.htm . Published by The Berkeley Electronic Press, 2008

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variability among Palestinian multipliers [standard deviation = 0.500 and coefficient of variation (C.V.) = 0.247 for the total IRIO impact] than for Israeli multipliers (standard deviation = 0.219 and C.V. = 0.132)

Employment impact, T = 1 The right column of Table 4 shows the impact of shocks originating in 13 Palestinian sectors on sectoral employment. As expected, the Social, Personal, and Household Services sector yields the highest employment impact due to its highly labor-intensive structure (see the middle column of Table 1). An interesting result is that the Banking sector, which yields the highest multiplier in dollar terms, does not greatly increase employment. In contrast, the Social, Personal, and Household Services sector that generates the highest employment multiplier, yields a relatively low multiplier in dollar terms. These results thus suggest a potential conflict between employment and output goals.

Table 4. Employment impact of an economic perturbation originating in Palestinian sectors (in number of jobs created per US$ 1,000,000 of output). Sector

Employment Impact

Agriculture Manufacturing Electricity and Water Supply Construction Wholesale and Retail Trade Tourism/Accommodations Transport, Storage and Communication Banking, Insurance and Other Financial Institutions Real Estate, Renting and Business Activities Public Administration Education Health Services and Welfare Community, Social, Personal and Household Services Mean Std. Dev. C.V.

90.532 25.443 20.205 114.760 110.890 16.907 62.914 54.918 12.571 131.811 21.091 35.386 511.782 93.016 132.493 0.702

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Varying the Trade Adjustment Coefficient (T) Changing the Trade Adjustment Coefficient, T, corresponds to switching a trade regime. T values smaller than unity represents more restricted trade between Palestine and Israel relative to the current regime; conversely T values larger than unity represent lesser border controls and therefore increased trade flows between the two economies.

Optimistic, counterfactual scenario: T = 10 This scenario corresponds to considerable relaxation of border controls (T = 10), hence is expected to significantly promote economic cooperation between Palestine and Israel. Table 5 presents the multiplier impact caused by a ten-fold increase in bi-national trade (T = 10) and simultaneously an increase in final demand in Palestine. The results [column (1) in Table 5] suggest that greater cooperation between the two economies lead to total multipliers that are generally higher (mean = 2.251), as well as lower volatility in output (standard deviation = 0.486) relative to the base run [column (1) in Table 2].

Table 5. The IRIO multiplier impact of a shock from Palestine, T = 10. Palestine and Israel (1) Agriculture 3.292 Construction 3.041 Manufacturing 2.955 Banking 2.864 Utilities 2.663 Transport 2.624 Tourism 2.579 Health Svc 2.491 Public Admin 2.324 Trade 2.300 Other Svc 2.280 Real Estate 1.849 Education 1.508 Mean 2.521 Std. Dev. 0.486 C.V. 0.193

Palestine Only (2) Construction 1.917 Banking 1.751 Trade 1.703 Agriculture 1.503 Public Admin 1.433 Other Svc 1.368 Manufacturing 1.247 Health Svc 1.210 Tourism 1.142 Education 1.111 Transport 1.105 Utilities 1.091 Real Estate 1.034 Mean 1.355 Std. Dev. 0.288 C.V. 0.213

Spillover to Israel (3) Agriculture 1.789 Manufacturing 1.708 Utilities 1.572 Transport 1.519 Tourism 1.438 Health Svc 1.281 Construction 1.124 Banking 1.112 Other Svc 0.912 Public Admin 0.892 Real Estate 0.815 Trade 0.597 Education 0.396 Mean 1.166 Std. Dev. 0.432 C.V. 0.369

Note that when border controls are sufficiently reduced, as in this case with T = 10, the portion that stays within Palestine also increases for all sectors. Published by The Berkeley Electronic Press, 2008

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This we can see by comparing column (2) of Table 5 with column (2) of Table 2. The behavior of the Palestine-only effect therefore can be represented by a Ucurve (see Figure 1). Specifically, starting from a no-trade position (T = 0), the portion that stays within Palestine initially decreases as Palestine becomes more integrated with Israel (i.e., T rises). However, if it is possible to increase T to a very high level, then the Palestine portion will start to rise.

Figure 1. The U-curve showing the relationship between the Palestine-only portion of the multiplier impact and the trade adjustment coefficient T. Origin of Shock: Palestinian Agriculture 4.5

IRIO M ultiplier Im pact

4 3.5 3 2.5 2 1.5 1 0

0

0

0.05 0.1 0.5

1

1.5

3

5

10

13

14

15

20

Trade Adjustment Coefficient (T) Total (Combined Palestine & Israel)

Palestine only

At these much higher levels of trade between the two economies, Agriculture becomes the largest generator of inter-regional impact (3.292), replacing Banking which ranks first in the base run. Interestingly, and consistent with the case of T = 0.1 (see below), Banking again exhibits an inverse relationship with the trade level. Specifically, Banking is the only sector that experiences a decrease in the magnitude of the IRIO multiplier, from 3.217 in the base run (Table 2) to 2.864. It is thus likely, we hypothesize here, that Palestinian Banking ends up being the losing sector as Palestine and Israel increase the extent of their economic cooperation.

Pessimistic, counterfactual scenario: T = 0.1 This scenario simulates the effects of tightening regulatory trade measures, and thus represents a setback to the promulgation of economic cooperation between Palestine and Israel. Table 6 presents the multiplier impact from one such scenario (T = 0.1), when the shock originates in Palestine. The results suggest that http://www.bepress.com/peps/vol14/iss1/1 DOI: 10.2202/1554-8597.1122

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Malul et al.: An Economic Development Road Map

more restrictive trade typically leads to decreasing total multiplier impacts for the combined economies of Israel and Palestine (mean = 1.791), as well as higher volatility in output (standard deviation = 0.516 and CV = 0.288). We note also that Banking and Construction remain the sectors that generate the greatest total impact, with IRIO multipliers of 3.230 and 2.147, respectively [column (1) of Table 6]. It therefore can be concluded that the total IRIO multipliers decline in magnitude because of the significant fall in the spillovers to Israel. Indeed, this is what we found by comparing column (3) of Table 6 with column (3) of Table 2. Tightening trade between Palestine and Israel therefore increases the portion that stays within Palestine, yet reduces the total multiplier impact of an economic stimulus by decreasing the spillovers to Israel.

Table 6. The IRIO multiplier impact of a shock from Palestine, T = 0.1. Palestine and Israel (1) Banking 3.230 Construction 2.147 Utilities 1.918 Tourism 1.868 Trade 1.836 Public Admin 1.746 Other Svc 1.729 Agriculture 1.712 Health 1.625 Transport 1.617 Manufacturing 1.584 Education 1.176 Real Estate 1.092 Mean 1.791 Std. Dev. 0.516 C.V. 0.288

Palestine Only (2) Banking 3.174 Construction 2.074 Trade 1.803 Tourism 1.752 Utilities 1.714 Public Admin 1.701 Other Svc 1.691 Agriculture 1.629 Health 1.564 Transport 1.516 Manufacturing 1.474 Education 1.163 Real Estate 1.070 Mean 1.717 Std. Dev. 0.510 C.V. 0.297

Spillover to Israel (3) Banking 0.055 Construction 0.073 Trade 0.033 Tourism 0.117 Utilities 0.204 Public Admin 0.045 Other Svc 0.039 Agriculture 0.082 Health 0.061 Transport 0.101 Manufacturing 0.110 Education 0.013 Real Estate 0.022 Mean 0.073 Std. Dev. 0.051 C.V. 0.699

IRIO multipliers and the trade regime A positive relationship between the total IRIO multipliers and the trade adjustment coefficient, T, is typical. Figure 2 and Figure 3 show such a relationship for Palestinian Agriculture and Palestinian Manufacturing, respectively. For these two sectors, the relationship is positive but non-linear with a concave-shaped curve. Published by The Berkeley Electronic Press, 2008

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Figure 2. The multipliers of the Palestinian Agriculture sector, various T values.

Total Multiplier Impact

S hock: Agriculture-Palestine 3.500 3.300 3.100 2.900 2.700 2.500 2.300 2.100 1.900 1.700 0

2

4

6

8

10

12

T (Trade Coefficient)

Figure 3. The multipliers of the Palestinian Manufacturing sector, various T values. S hock: Manufacturing-Palestine

Total Multiplier Impact

3.100 2.900 2.700 2.500 2.300 2.100 1.900 1.700 0

2

4

6

8

10

12

T (Trade Coefficient)

Very atypical is the relationship between the multipliers and trade that Banking exhibits (Figure 4). For this sector, the association is negative, and further there might be an inflection point somewhere as initially the curve exhibits a convex shape but at some point becomes concave.

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Malul et al.: An Economic Development Road Map

Figure 4. The multipliers of the Palestinian Banking sector, various T values.

Total Multiplier Impact

S hock: Banking-Palestine 3.300 3.250 3.200 3.150 3.100 3.050 3.000 2.950 2.900 2.850 2.800 0

2

4

6

8

10

12

T (Trade Coefficient)

To summarize, these results imply that the interregional interactions among activities generate higher total multipliers than the intra-regional (Palestine only) interactions, which means that as the trade scope increases, the extent of the interregional interactions will increase as well, leading to higher total multiplier impacts. An interesting result is that the impact on Palestine is the opposite in most sectors. That is to say that the Palestinian multipliers decrease as the trade scope increases, which means that Palestinian sectors lose from higher integration with Israel. However, it appears that an increase in trade scope can lead to a Pareto improvement for both economies. As one can see, an increase in trade scope leads to a gain for Israel that is higher in absolute values than the loss to Palestine. So if Israel is willing to offer a Kaldor-Hicks compensation to Palestine, then a win-win outcome can be realized. For example, if the Manufacturing sector is to be promoted (under a high level of trade with T = 10), then a prior agreement could be established such that Israel would compensate Palestine an amount of at least US$ 0.069 (which is the loss that Palestine would incur due to trade liberalization from T = 1 to T = 10). Such a compensation scheme would thus result in a Pareto superior outcome in which both parties become better off. In contrast, the Palestinian Agriculture sector behaves differently, as it generates a U-shape multiplier impact with rising trade flows T (see Figure 1), which means that Palestine could gain or lose depending on the initial level of trade. In this case a significantly higher level of trade, as we show with T = 10, could achieve a Pareto improvement even without any ex ante compensation for Published by The Berkeley Electronic Press, 2008

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Palestine. On the other hand, if the level of trade was not very high to begin with, then a reduction in trade scope could lead to a Pareto improvement for Palestine. This last result implies that if it is started from a moderate trade relationship, as in the current regime, then interactions among local (Palestine only) sectors due to a shock in Palestinian Agriculture could generate a higher total multiplier than interregional interactions. Concluding Remarks Comparing our results with those predicted by existing theoretical frameworks, to the best of our knowledge no theoretical model has shown the adverse impact of trade on the smaller region. Thus, for example, Markusen (1981) determines that if the commodity markets are only imperfectly competitive, then a more extensive bilateral trade may actually cause the larger county to suffer a loss in income. In contrast, perfect competition is a critical assumption in our model (otherwise the assumption of linear production functions cannot be justified), which could explain the contraction of the smaller Palestinian economy. Although macroeconomic approaches are both important and necessary, in and of themselves they are not sufficient to bring peace to this volatile region of the Middle East. There is a precedent and a need for also taking a more microeconomic, project-oriented approach in which groups of Israelis and Palestinians, either separately or together, could cooperate on, for example, regional economic development projects in which both sides would benefit, at least indirectly if not directly. The success of even relatively small cooperative projects at this level, in which the benefits are widely distributed, would likely encourage the implementation of even larger projects, thereby creating a constituency that would have a growing interest in further regional economic development rather than in its violent destruction. We believe that the approach outlined in our two papers provides a framework or road map for the economic evaluation of such projects that would help to maximize their economic benefits to the Palestinian and /or Israeli economies. Isard (2004) argues that history provides some encouragement to believe that this microeconomic approach can be successful, either as a part of a more comprehensive (i.e., macro-) framework as proposed above or as a stand-alone effort that can grow into a much larger cooperative process. An example of planting such seeds for cooperation which gradually spread throughout the entire conflict arena is shown in the formation of the coal and steel community in the 1950s, which cut through centuries-old conflicts between France and Germany and their respective allies. This small initial step soon led to other small cooperative steps, for example, the establishment early on of Eurotom. These and subsequent other small, yet incrementally larger, steps eventually led to the

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Malul et al.: An Economic Development Road Map

adoption of a common currency across much of Europe along with the beginnings of banking and political unions, and later with the beginning of the development of a constitution covering the union of 25 states. A more recent set of effective small cooperative efforts is slowly taking place between North and South Korea. First proposed at the 1997 Peace Science Society International Conference in Sidney, Australia, a small cooperative tourism project in the Demilitarized Zone was put forth by Cornell researchers as a modest way to begin to reduce the likelihood of conflict between these two past and potential enemies (Isard, 2004). Efforts along these lines began in 1998 when a contract to establish such a cooperative project was signed by these two adversaries. This has lead to other subsequent small cooperative steps that have significantly reduced tensions between these two nations (the current nuclear stand-off between the U.S. and North Korea notwithstanding). Even small-scale projects, however, generate economy-wide repercussions that can only be fully accounted for using a general equilibrium framework. If aggregate benefits were an important criterion for the evaluation of small-scale projects, as Bar-El (2005) recently argued, then we propose here an IRIO framework precisely to enumerate such benefits. To briefly summarize, our results suggest that if we focus on the combined economies of Israel and Palestine, then promoting the Palestinian Banking and Construction sectors is expected to generate higher aggregate incomes than promoting any other Palestinian activities. An interesting result is that the Banking sector, which yields the highest multiplier in dollars terms, does not greatly increase employment However, other services that yield a high employment multiplier yield a relatively low multiplier in dollar terms. So if the objective of the international community is to increase employment, then the injection should be concentrated on the Community, Social, Personal and Household Services sector. In addition, we found that when border controls are sufficiently reduced the portion that stays within Palestine also increases for all sectors. These results imply that interregional interactions among activities generate higher total multipliers than the intra-regional (Palestine only) interactions, which means that as the trade scope increases, the extent of the interregional interactions increase as well, leading to higher total multiplier impacts. Future extensions of this study should update the 1998 IRIO transaction flows using more recent data to better reflect the contemporary structure of both the Palestinian and Israeli economies as far as we know for 12/2007 there is no available data to update our model however we believe that new data would be published in the next years. Further, to evaluate the economy-wide impact of small-scale projects more accurately, it is necessary to disaggregate production into sufficiently smaller sectors. To do so, we can utilize the 45-sector breakdown, as in the original 1998 data for Palestine. Finally, the economic road

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Peace Economics, Peace Science and Public Policy, Vol. 14 [2008], Iss. 1, Art. 1

map for peace would be more complete if the expected losers and winners under alternative dispute resolutions can be identified. Extending the IRIO framework into a social accounting matrix (SAM) would accomplish that goal by explicitly taking into account the distribution of income among various factors of production (e.g., labor, capital, etc.) as well as among heterogeneous household groups (e.g., rural-agricultural, urban-professional, etc.). If the losing groups can be identified, then a compensation scheme can be implemented to mitigate the costs, and hence maximize the likelihood of a peaceful outcome.

Appendix Appendix Table 1. Multiplier effects for all pairs of origin-destination, for shocks originating in the Palestinian economy (based on 1998 data).

Destination: Israeli sectors

Destination: Palestinian sectors

Origin of shocks: Palestinian sectors (1998) 1

2

3

4

5

6

7

8

9

10

11

12

13

1

1.140

0.036

0.002

0.024

0.175

0.009

0.010

0.004

0.003

0.016

0.002

0.010

0.010

2

0.242

1.192

0.056

0.768

0.139

0.269

0.203

0.097

0.014

0.276

0.065

0.285

0.166

3

0.027

0.009

1.277

0.015

0.038

0.024

0.004

0.029

0.003

0.020

0.012

0.018

0.030

4

0.002

0.003

0.003

1.090

0.008

0.006

0.001

0.007

0.001

0.050

0.033

0.053

0.023

5

0.026

0.054

0.003

0.038

1.243

0.014

0.034

0.009

0.016

0.058

0.004

0.018

0.019

6

0.000

0.001

0.000

0.001

0.008

1.004

0.001

0.038

0.001

0.040

0.003

0.004

0.015

7

0.003

0.007

0.001

0.008

0.043

0.011

1.020

0.072

0.004

0.056

0.008

0.015

0.041

8

0.001

0.004

0.000

0.011

0.016

0.105

0.037

2.410

0.004

0.016

0.002

0.005

0.015

9

0.020

0.008

0.001

0.011

0.069

0.030

0.032

0.158

1.010

0.059

0.014

0.036

0.079

10

0.000

0.000

0.000

0.000

0.001

0.000

0.000

0.000

0.000

1.004

0.000

0.001

0.199

11

0.000

0.000

0.000

0.000

0.000

0.001

0.001

0.006

0.001

0.005

1.001

0.001

0.003

12

0.028

0.001

0.000

0.001

0.004

0.000

0.000

0.000

0.000

0.000

0.000

1.002

0.001

13

0.000

0.000

0.000

0.000

0.003

0.000

0.000

0.001

0.000

0.017

0.000

0.004

1.007

1

0.228

0.028

0.008

0.018

0.037

0.013

0.008

0.003

0.001

0.009

0.002

0.008

0.006

2

0.214

0.560

0.172

0.362

0.088

0.172

0.145

0.061

0.018

0.146

0.034

0.158

0.093

3

0.038

0.015

0.618

0.014

0.023

0.028

0.007

0.016

0.002

0.013

0.007

0.013

0.017

4

0.003

0.005

0.007

0.003

0.002

0.008

0.004

0.005

0.005

0.004

0.001

0.003

0.003

5

0.013

0.016

0.015

0.010

0.007

0.013

0.015

0.004

0.002

0.006

0.001

0.008

0.005

6

0.001

0.001

0.002

0.001

0.003

0.332

0.002

0.013

0.001

0.014

0.001

0.002

0.006

7

0.018

0.022

0.032

0.016

0.022

0.025

0.387

0.038

0.005

0.029

0.005

0.015

0.023

8

0.021

0.020

0.037

0.014

0.009

0.030

0.033

0.184

0.005

0.010

0.003

0.011

0.010

9

0.025

0.036

0.060

0.025

0.020

0.068

0.042

0.049

0.139

0.024

0.006

0.023

0.027

10

0.001

0.001

0.006

0.000

0.000

0.001

0.001

0.001

0.001

0.038

0.000

0.001

0.008

11

0.000

0.000

0.001

0.000

0.000

0.000

0.001

0.000

0.000

0.001

0.027

0.000

0.000

12

0.007

0.001

0.000

0.000

0.001

0.000

0.000

0.001

0.000

0.001

0.000

0.176

0.001

13

0.001

0.002

0.003

0.001

0.001

0.009

0.003

0.001

0.002

0.003

0.001

0.002

0.066

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References Aix Group. 2004. “Economic Road Map: An Israeli-Palestinian Perspective on Permanent Status,” < http://www.aixgroup.org > Bar-El, Raphael. 2005. “Assessing Regional Cooperation Projects in the Middle East,” preliminary summary prepared for the Jan Tinbergen Peace Science Conference, Amsterdam, June 27-29, 2005. Bar-El, Raphael and Miki Malul, 2008, “The Role of External Partners,” The Economics of Peace and Security Journal , 3(1):17-24. Bouillon, Markus E. (2004). The Failure of Big Business: On the Socio-economic Reality of the Middle East Peace Process. Mediterranean Politics, 9(1), 1-28. Dollar, David, and Aart Kraay. 2002. “Spreading the Wealth,” Foreign Affairs, 81(1), 120-133. Deardorff, Alan V. 1979. “Weak Links in the Chain of Comparative Advantage.” Journal of International Economics, 9(2), 197-209. Edwards, Sebastian. 1993. “Openness, Trade Liberalization, and Growth in Developing Countries.” Journal of Economic Literature, 31(3), 1358-1393. Forman, Shepard, Stewart Patrick, and Dirk Salomons. (2000). Recovering From Conflict: Strategy for an International Response. Center on International Cooperation, New York University. Frankel, Jeffrey A. and David Romer. 1999. “Does Trade Cause Growth?” American Economic Review, 89(3), 379-399. Ghose, Ajit K. 2004. “Global Inequality and International Trade.” Cambridge Journal of Economics, 28, 229-252. Grossman, Gene M. (Editor). 1992. Imperfect Competition and International Trade. Cambridge, MA, MIT Press. Hara, Tadayuki. 2004. “Estimating the Economic Impacts of the Tourism Industrial Complex on the West Bank and Gaza: an Analysis of the Crossroads of Tourism and Terrorism along the Road Map for Peace.” Unpublished Ph.D. dissertation, School of Hotel Administration, Cornell University. Isard, Walter. 2004. “A Jordan/West Bank Development Proposal, Peace Economics,” Peace Science and Public Policy, 10, 36-55. Krugman, Paul and Maurice Obstfeld. 2003. International Economics: Theory and Policy. Boston, Addison-Wesley, 6th edition. Levine, Ross and David Renelt. 1992. “A Sensitivity Analysis of Cross-Country Growth Regressions.” American Economic Review, 82(4), 942-963. Lindert, Peter H., and Jeffrey G. Williamson. 2001. “Does Globalization Make the World More Unequal?” NBER Working Paper No. 8228. Lucas, Robert E. 1988. “On the Mechanics of Economic Development,” Journal of Monetary Economics, 22(1), 3-42.

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Mansury, Yuri, Tadayuki Hara, Miki Malul, and Sidney Saltzman. 2005. “Measuring Bi-National Economic Interdependence: An Exploration of the IsraelPalestine Case.” Mimeo, Cornell University. Markusen, James. 1981. “Trade and Gains from Trade with Imperfect Competition.” Journal of International Economics, 11, 531-551. Ricardo, David. 1817. The Principles of Political Economy and Taxation. London, J.M. Dent & Sons. Rivera-Batiz, Luis A. and Paul M. Romer. 1991. “Economic Integration and Endogenous Growth.” Quarterly Journal of Economics, 106, 531-556. Romer, Paul M. 1986. “Increasing Returns and Long-Run Growth,” Journal of Political Economy, 94(5), 1002-1037. Saleh, Basel (2004). Economic Analysis of the Palestinian Second Intifada. Ph.D. Dissertation, Kansas State University. Weede, Erich. 2004. “The Diffusion of Prosperity and Peace by Globalization,” Independent Review, 9(2),165-186.

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