The Disappointing Consequences of an Incomplete Agreement

At present, the Oslo peace process is far removed from the high expectations held in September 1993, among other things with regard to its economic dimension. According to the "old" view of economic development in the Palestinian economy as perceived by those involved in formulating economic policy in 1993/94, the economic aspect of Israel-Palestine relations was a necessary ingredient of the peace process. The preamble to the economic agreement between Israel and the PLO (known as "the Protocol"), signed in April 1994 in Paris, states:
The two parties view the economic domain as one of the cornerstones in their mutual relations with a view to enhance their interest in the achievement of a just, lasting and comprehensive peace.
In more practical terms, the economic regime defined in the Protocol sought to address the following needs: employment for Palestinian laborers; economic growth to bring about a rise in standards of living and create opportunities for personal growth; and developing a public sector that would supply public goods (including infrastructure), while creating a sound tax-collection system.
The Protocol, which in effect has established the de jure regime since 1994-95, was generally believed to meet these goals. This regime can best be characterized as one that assumed the continued economic integration between the Palestinian and Israeli economies, which had prevailed since the early 1970s, with the addition of a new Palestinian Authority capable of implementing public policy. Thus, the economic regime assumed (almost) free movement of goods and labor between Israel and the Palestinian economy, the creation of a Palestinian public sector and the emergence of a revitalized private sector. The view held by the signatories was that - with international aid - the Protocol laid the foundation for sustainable growth of the Palestinian economy. By now it has become abundantly clear that real-life events were in sharp contrast with this vision (see World Bank and MAS, 1997; Zavadjil et al. [IMF], 1997).

Unbalanced Development

Since the 1970s, the Palestinian economy has depended to a large degree on the Israeli economy for employment, and has not fully developed its productive capacity, especially the production of tradable goods in the manufacturing sector. As explained below, the dependency of the Palestinian economy has changed form since 1993, but it remains the determining factor in the post-Oslo period.
The weaknesses, difficulties and strengths that have characterized the performance of the Palestinian economy since 1967 have been described and analyzed in an important World Bank study (1993). The Palestinians' economic performance was determined in large measure by its interactions with the more advanced Israeli economy. It was Israel - as military occupier - that shaped the links between the two economies and determined overall economic policy. These links between the two economies, combined with the economic policies of the Israeli government, resulted in a distorted structure of employment and trade in the Palestinian economy.
A large segment of the Palestinian labor force found employment in the Israeli economy, at wages higher than possible at home. While the remittances of these workers increased aggregate demand in the Palestinian economy, thereby raising standards of living and domestic production, the rise in living standards was not fully matched by a growth of productive capacity of tradable goods in the Palestinian economy, which continued to depend on employment in Israel.1
Several factors contributed to the continuation of this unbalanced development, especially in the manufacturing sector, between 1967 and 1994. One such factor was the difficulty encountered in exporting to Israel, due to administrative, marketing and other constraints. The rises in the standard of living in the West Bank and Gaza were thus associated with a merchandise trade deficit, while employment of Palestinians in Israel provided most of the funds necessary to cover the deficit in the balance of payments. Another factor was the lack of financial intermediation: the non-existence of a banking system between 1967 and 1981, and its weakness later on. The considerable savings of the population were therefore channeled into investment in housing rather than directed to productive capital. Other factors were the complex legal system, administrative obstacles to investment, and the general political uncertainty.
The economic Protocol of 1994 sought to correct the flaws of previous arrangements while maintaining the free movement of goods and labor between the two economies within the framework of a customs union. Import taxes were to be collected by Israel on behalf of the Palestinian National Authority (PNA), with a view to enabling the latter a period of grace in which to set up an independent fiscal system. Employment of Palestinian workers in Israel was to continue, whereas the creation of the PNA was to have created a badly needed public sector. Foreign investment, stimulated by the new climate of peace, and the improved infrastructure financed by donations from abroad, were expected to boost economic growth. The creation of a Palestinian Monetary Authority (PMA) was designed to improve financial intermediation.
In the Middle East, economic considerations tend to play second fiddle to politics, and the Protocol was no exception. By and large, the economic arrangements set out in the Protocol reflect Israel's demand that no borders - economic or otherwise - should be deliberated during the interim stage of negotiations. The only trade regime that can meet such a condition is a customs union.2 The agreement reached was not the result of an economic analysis of alternative trade arrangements, but rather the result of politicians' decisions to put off (perhaps even avoid altogether) the need to agree on the demarcation of borders. In view of the ensuing political developments - violence between Israelis and Palestinians, difficulties in the negotiations and then a new Israeli government with a different agenda - parts of the Protocol were not implemented and a series of border closures interrupted the free movement of goods and labor. The resultant crisis in the Palestinian economy calls for an urgent re-evaluation of these arrangements. Moreover, a better understanding of the reasons for the failure may help the parties avoid another round of disappointments.

The Paris Protocol

The Protocol on Economic Relations between the Government of the State of Israel and the PLO, Representing the Palestinian People (or "the Protocol") was hammered out in Paris in the interval between the Declaration of Principles (DOP) in September 1993 and the agreement on its implementation in the Gaza Strip and Jericho (Oslo I) in May 1994. The Protocol's title itself deserves close attention; an effort was obviously made to present it as being drawn up between two equal partners, in spite of the fact that one party was a state and the other an organization. The preamble to the Protocol did not only stress the importance of the economic dimension as the quotation on p. 128 of this article states, but also that:
The two parties view the economic domain as one of their mutual relations with a view to enhance their interest in the achievement of a just, lasting and comprehensive peace. Both parties shall cooperate in this field in order to establish a sound economic base for these relations, which will be governed in various economic spheres by the principles of mutual respect of each other's economic interests reciprocity, equity and fairness.
This protocol lays the groundwork for strengthening the economic base of the Palestinian side and for exercising its right of economic decision-making in accordance with its own development plan and priorities. The two parties recognize each other's economic ties with other markets and the need to create a better economic environment for their peoples and individuals (Protocol, 1994, p. 1).
Thus, the Protocol accepts the fact of two parties living in the same territory, which might sometimes have different interests and priorities. These sides were to be represented by two separate decision-making bodies.
The issue of an appropriate regime became a bone of contention in the Paris talks. The negotiators knew that economic issues were subordinate to political ones. For months the two delegations to the economic negotiations, headed respectively by Palestinian Economics Minister Ahmad Qrei' (Abu 'Ala) and Israeli Finance Minister Avraham Shohat, exchanged drafts while waiting for the politicians to arrive at their decisions. Some Palestinians preferred a free trade agreement (FTA), which would have necessitated delineating borders between their economy and Israel. The Israelis, on the other hand, had firm instructions from Prime Minister Rabin (based on the recommendations of a preparatory professional counseling economic committee headed by Professor H. Ben-Shahar3) to reject the notion of any borders being drawn between the two economies. The reasons for these different positions were both political and economic: the Palestinians sought to acquire as many attributes of sovereignty as possible, whereas the Israelis wanted to defer as many decisions as possible to the negotiations over the Palestinian territories' final status. The Palestinians aspired to set their own priorities, without Israeli interference, including the formulation of a new Palestinian trade policy, which would reflect their own best interests; the Israelis tried to convince the Palestinians that a more protectionist policy would reduce the Palestinians' chances of building a prosperous economy, and proposed to continue the existing de facto customs union, which, of course, did not require the creation of trade borders between the two economies.
Once the political leaders reached an agreement on the implementation of the DOP in the Gaza Strip and Jericho, the discussions on economic matters were concluded. The final stage of the negotiations was tense. Apparently, although no official records were published, the Israelis, in a reversal of the previous stance, now proposed the creation of an FTA, not a customs union. This new offer, which was more in line with the Palestinian proposals, was actually a bargaining chip, because it included the stipulation that under an FTA the flow of labor would not be as free as under a customs union. The Palestinians were on the horns of a dilemma - the new proposal underlined the real trade-off between conducting an independent trade policy and dependence on work in Israel. It also brought to the forefront the possible contradiction between political sovereignty and economic prosperity. The Palestinians opted for the customs union package.4
The negotiators on either side were fully aware that Israel's trade policy might be amended from time to time: "Israel may from time to time introduce changes [in its trade policy]... provided that changes in standard requirements will not constitute a non-tariff barrier...." This reservation was probably introduced because of the non-tariff barriers (NTB) used by Israel in the past to protect domestic producers. The only additional restriction on Israel was its obligation to give the PNA prior notice of any changes (Article III, Paragraph 10). Thus, the customs union continued to reflect Israeli policy and was not a bilaterally coordinated trade policy as is the case with many other customs unions in the world.
In Article IV the two sides agreed to create a Palestinian Monetary Authority to solve the problems of financial intermediation. The PMA was to have all the powers vested in a central bank vis-à-vis the banking system, but not the power to issue an independent Palestinian currency, which was deemed an out-and-out symbol of independence. There were now two legal tenders in the Palestinian economy: the Jordanian dinar and the Israeli shekel.
The Protocol also lays the fiscal foundations for a public sector. Article III relates to the PNA's powers to levy import taxes, and Paragraph 15 of this Article sets the mechanism for revenue clearance:
The clearance of revenues from all import taxes and levies, between Israel and the Palestinian Authority, will be based on the principle of the place of final destination. The revenue clearance will be effected within six working days from the day of collection of the said taxes and levies.
Articles V and VI empower the PNA to levy direct and indirect taxes. A detailed mechanism for clearance of VAT revenues is constructed. Other powers of the PNA are also mentioned in the Protocol, such as the power to pursue an autonomous industrial policy (Article IX), but they are largely derived from the general powers vested in the PNA according to the political agreements reached and from the fact that the PNA was the governing body in the zones designated as "A" and "B5". Article VII of the Protocol deals with labor. Its first paragraph states:
Both sides will attempt to maintain the normality of movement of labor between them, subject to each side's right to determine from time to time the extent and conditions of the labor movement into its area.
Interestingly enough, all the other paragraphs in this article deal exclusively with the transfer to the PNA of contributions made by permit-bearing Palestinian workers to the Israeli National Insurance and medical insurance systems.6
Thus, the Protocol suggests a consistent strategy to achieve the economic vision, i.e., the development of the Palestinian economy. Full employment should have prevailed thanks to the investments of the public and private sectors within the Palestinian economy and the continuation of labor movement to Israel. Intermediation was to have been facilitated by the emerging banking system under the guidance of the PMA. The public sector should have been strengthened and an efficient tax system created. Funds set up in donor countries should have helped in financing the necessary infrastructure. Free trade with Israel was supposed to enhance growth.
This strategy, however, failed to bear the desired fruit. As we shall see below, the expectations that Palestinian employment in Israel would reach pre-1993 levels, and that trade would be relatively free of obstructions, did not materialize. Although the Protocol does not provide explicit figures about the flow of labor from the Palestinian economy to Israel, the implicit figures are 70,000-100,000 Palestinian workers annually.7
Moreover, as the Protocol makes abundantly clear, interruptions in the free flow of labor were to be transitory and brief, and imposed only under exceptional circumstances. While the parties did reach agreement on the free movement of labor and trade, political and military reality dictated a different process.

Economic Performance, 1994-1997

The economic Protocol became the de jure regime in May 1994 in those parts of Gaza and the Jericho area that were handed over to the PNA. Towards the end of 1995, the Protocol's jurisdiction was extended to other populated areas in the West Bank as they came under the control of the PNA (Areas A and B in the Oslo II agreement; see footnote 5). The data for 1993-97 suggest that living standards in the Palestinian economy declined steeply; according to the IMF and World Bank estimates, measures for standard of living - such as gross national product (GNP) per capita and consumption per capita - decreased by 15-30 percent in real terms in this period (Zavadjil et al. [IMF] 1997; World Bank and MAS, 1997).
The major economic cause of this poor performance was the fact that, since 1993, employment of Palestinian workers in the Israeli economy has declined sharply. Whereas in the 1970s and 1980s the share of Palestinian workers who found employment in the Israeli economy out of the total Palestinian employed persons exceeded 30 percent, this ratio has declined steadily since 1993. In 1996, only 7 percent of all Palestinian employed persons worked in Israel. Consequently, the gross domestic product (GDP) share of "factor income from abroad" in the PNA economy - composed mainly of remittances of Palestinians employed in Israel - dropped from about one-third to less than 6 percent. This unanticipated structural change in the links between the Palestinian and Israeli economies led to a severe economic crisis: effective demand in the Palestinian economy declined and unemployment increased to around 34 percent in the West Bank and the Gaza area in 1996.
The main cause of this structural change in the composition of employment in the West Bank and Gaza was the new Israeli policy governing the flow of labor from the Palestinian areas to Israel. Whereas in the 1970s and 1980s there were only minor barriers to such labor movements, the situation began changing in the 1990s. First, after the 1991 Gulf War, Israel changed its policy from admitting anyone except those who were explicitly barred, to a requirement that every Palestinian seeking work in Israel be equipped with a work permit. Enforcement of this new rule became increasingly strict. In addition, since 1993, as a result of a series of suicide bombings, Israel has introduced a "closure policy": roadblocks were set up on major transport arteries, denying entry into Israel from the Palestinian areas. Closures were declared for different lengths of time and were imposed on various categories of workers, according to sex, age, marital status, etc. As long as a closure was in effect, all existing permits were suspended.
Israeli entrepreneurs, especially in those sectors most likely to be severely disrupted by the absence of Palestinian workers (such as construction and agriculture), opposed the closures. In part as a result of the pressure exerted by these employers, most closures were lifted after a few days. As the decision to persist with the closure policy was at odds with the Israeli government's policy vis-à-vis these sectors, the government decided to issue permits allowing foreign laborers to work in the above-mentioned two labor-dependent sectors: in March 1994, less than 10,000 permits were issued; by December 1996, the number was more than 100,000. At the same time, the number of illegal foreign laborers, i.e., those who worked without permits, which was very low in 1994, rose dramatically. Conservative estimates place the total number of foreign laborers in Israel at over 200,000, of which only about half hold permits (Bank of Israel, 1996).
The frequent closures led to a decline in the number of Palestinian laborers working in Israel and opened the market to foreign laborers (notably from Romania and Thailand). Closures could now continue indefinitely, without incurring protests from Israeli employers, as was the case before 1995. Note, however, that the substitution of foreign workers for Palestinians is far from perfect: some foreign workers (e.g., Thai women) are employed as household help, whereas Arab women were not. Furthermore, it is known that Israeli employers in construction prefer experienced Palestinian workers to the East European alternative.
The closure policy also had a deleterious impact on trade between the West Bank and Gaza, on the one hand, and Israel, on the other. According to World Bank estimates, imports to the Palestinian economy were cut by around 25 percent and exports by almost half between 1992 and 1995. In part, this decline was a consequence of the reduction in the export of labor services, as explained previously (see footnote 1); in part, it was the result of the border closures. The impact on the Palestinian economy was devastating, since local employment depended on materials imported from Israel and the export markets were either in Israel or had to be accessed via Israel.
Two mitigating economic factors worked to ease the deteriorating situation in the Palestinian economy: the growing public sector and sizable international aid. The public sector had been under Israeli control since 1967, and levels of public consumption and investment were relatively low. The economic Protocol of 1994 placed the public sector under the control of the PNA. The number of public sector employees rose from 40,000 at the end of 1994 to 75,000 at the end of 1996, partly as a result of the expansion of control to additional areas in the West Bank, partly due to the increase in the police force (from 14,000 in 1994 to 34,000 in 1996), and partly reflecting the increase in the number of civilian employees from 25,000 to 41,000 (World Bank and MAS, 1997). The wage bill rose to around $400 million annually (about 13 percent of GDP). Public investment, however, remained at a disappointingly low pre-1994 level of about 5 percent of GDP. Thus, although public expenditures did compensate in some measure for the decline in disposable income, they did not stimulate long-term growth, being directed in the main to current expenditures.
The performance of the Palestinian public sector - and, more specifically, that of the newly created PNA - points to some errors, too. There has been a tendency to adopt restrictive trade arrangements that resulted in excessive monopolization; some elements have succumbed to the temptation to exploit public capacities for personal benefits. On the whole, though, most observers believe that the performance of the Palestinian economy was no worse than the relevant comparable international standards would expect, and was certainly not the cause of the troubles the economy faced.
Private investments, which could create more new jobs, remained below the expected levels, although the commercial banking system was developing apace under the supervision of the recently established PMA. The banks did not use the rapidly expanding savings deposits with them to extend credit to entrepreneurs in the risky business environment, and preferred to direct them to more attractive opportunities abroad. Part of the reason for this was the ill-defined property rights, which resulted in difficulties when arranging for adequate collateral.
The financing of new public expenditures tells an important story. Revenues came partly from local tax and non-tax collections, partly from "revenue clearances" with Israel, as agreed in the Protocol, and partly from "foreign financing" (i.e., international aid). In 1996, over 60 percent of non-foreign revenues originated in "revenue clearances" with Israel, and less than 40 percent from tax and non-tax revenues, with the former covering 42 percent of total public expenditures and the latter covering 26 percent. The remainder was covered by "foreign finances," which provided around 34 percent of total public expenditures (about $300 million in 1996). There were periods in which Israel delayed the transfer of taxes it owed the PNA as a means of political pressure. As a result, the emerging Palestinian structure substituted dependence on employment in Israel with dependence on revenue clearances with Israel and on international aid.
The willingness of the international community to support the transition in the Palestinian economy was outstanding. Pledges for the period 1993-98 totaled around $3.7 billion, of which $2.3 billion were promised in late 1993. Actual disbursements in 1994-1997, as reported by international agencies, came to about $1,960 million, or about 40 percent of one year's GNP. The hope in October 1993, immediately after Oslo I, when the donor countries undertook to provide aid, was that the Palestinian economy would undergo a smooth process of restructuring. However, the target of sustainable growth has not been reached so far. Instead, important segments of foreign aid were channeled to a series of emergency, ad hoc programs, most of them carried out by the public sector.
In summary, only part of the Protocol was implemented: in zones A and B, a public sector was set up and the PMA was established. However, the articles related to the Palestinians' relations with Israel and the rest of the world were not fully implemented. Consequently, the plan for economic development envisioned in the Protocol did not materialize.

Structural Weaknesses of the Protocol

The story told so far is disappointing. In spite of the two parties' declarations concerning the importance of economic development to the peace process, the results were less than satisfactory. An analysis of the failure invites different interpretations. One widespread explanation, offered by some Israelis, blames the violent terrorist attacks for the collapse of the "1993 vision." According to this line of argument, the architects of the Paris Protocol erroneously assumed that the transition from war to peace would proceed in a non-violent fashion. It did not. Indeed, as mentioned before, it was the Rabin government, the initiator of the Oslo process, that replaced Palestinian workers with foreign workers. Hence, the Palestinian economy's poor performance must be ascribed to the violent opposition to the peace process.
Many Palestinians, as well as other observers, seem to favor another line of thought. They view the closures as a political measure, used as collective punishment following terrorist attacks, that are not instrumental to Israel's security. According to this view, economic relations cannot be disentangled from the political process, and the closures are a means of subjugation.
Both explanations contain some elements of truth. We will see below that the Israeli government withheld taxes it owed the PNA - a classic example of the use of economic means to create political pressure. But beyond this simplistic, down-to-earth explanation lies another, more subtle reason having to do with the design of the Protocol, which is an indirect result of the uneven balance of power between the two parties. This structural imbalance between a well-established state with a thriving economy and a big, modern army, on the one hand, and an autonomy making its first steps to national sovereignty, on the other, was reflected in the power-sharing of the Protocol itself, giving more power to Israel than to the PNA. In contrast, in many agreements on extensive economic cooperation, such as the European Union, the mechanisms of regulation are designed so as to give smaller countries more weight than their relative economic power, and even veto powers in some cases.
Our purpose in this section is to explain how the design of the Protocol was partly responsible for the undesirable outcome, using a newly developed area in economic theory - incomplete contracts - to analyze the Paris agreements.
The economic agreement between Israel and the PLO, like all complex agreements on economic cooperation between the two political entities, is inherently incomplete:8 It is impossible to specify all possible contingencies. Parties to agreements are usually aware of this fact, and hence the re-negotiation of certain issues and part of the contract is unavoidable. To arrive at a satisfactory outcome in a process of re-negotiation, power must be shared between the two parties. Economists refer to such contracts as "incomplete" contracts.9 Hart describes such a contract between himself and a building contractor. Instead of trying to pre-specify all the obligations of both parties under all possible contingencies (a tedious, expensive and fundamentally futile proposition), they agreed on a payment scheme commensurate with the work's progress, which left each party with sufficient latitude and control, thus making re-negotiation efficient. In contrast, a payment scheme whereby the entire settlement is made in advance is not a good incomplete contract, since it cedes too much control to the contractor. Incomplete economic contracts, like similar political contracts, are those that lack an efficient enforcement mechanism. In the former case, the courts are unable to provide remedies owing to information problems. In the case at hand, of course, there are no courts.
The Protocol itself recognizes the possible need for re-negotiation, and provides a framework designed specifically for that purpose - a Joint Economic Committee - whose task is "to follow up the implementation of this Protocol and to decide on problems related to it that may arise from time to time." Consider now a contingency not mentioned in the Protocol: a security risk due to suicide terrorist attacks. The Protocol does not specify the reaction of the parties to such an event, stating only that:
Both sides will attempt to maintain the normality of movement of labor between them, subject to each side's right to determine from time to time the extent and conditions of the labor movement into its area.
A possible interpretation of this passage is that Israel is entitled to halt labor movements (say, in cases of terrorist attacks), but not to disrupt the "normality" of labor movement for extended periods. A re-negotiation of the terms of labor movements under the new political circumstances was therefore quite sensible, but due to the imbalance in power and control, it did not materialize. Although the frequent closures changed the basic assumptions concerning economic development in the Palestinian economy, the issue of border closure was not brought before the Joint Economic Committee. Had the Palestinians possessed the economic means with which to retaliate to the closures, Israel might have followed a different course. For example, if there had been customs borders between Israel and the Palestinian economy, the PNA might have imposed a quota on entering Israeli goods, thereby creating political pressure within Israel that might have lifted the closures. Instead, a Palestinian grass-roots movement boycotted Israeli goods, especially in the electronics industry, in the hope that Israeli exporters would lobby their government.10
Another important case was Israel's decision, in the summer of 1997, to delay the transfer of tax clearance it owed to the PNA, following a wave of terrorist attacks. This measure was prima facie a clear violation of the Paris agreements. Had the Palestinians possessed economic retaliatory power (for example, funds that were to be passed on to Israelis), the Israeli government would probably not have chosen to pursue this policy.
An analysis of the reasons for Israel's excessive economic power under the Protocol, and methods to reduce it and create a more balanced structure, may contribute to improved Palestinian economic performance in the future. Following are the main sources of Israeli economic power that stemmed from the Protocol and some proposals to create a more balanced structure:
• The customs union places all external economic borders under Israeli control. The result is that import taxes accrue first to the Israeli Finance Ministry, which transfers a share to the Palestinian Treasury (for commodities destined for the Palestinian economy). Allowing the Palestinians to collect import taxes at ports of entry to their economy, at the same rates as those imposed in Israel, would improve their financial independence. Of course, the necessary bilateral compensation and clearance schemes would have to be put in place. Such a regime is called a "non-discriminatory" trade arrangement. Since about 60 percent of the income of the PNA in 1997 - excluding funds from external sources such as transfers from donor countries - came from revenue clearance with Israel, the proposed change would contribute to a more balanced power structure, without damaging the principles of the customs union.
• Palestinian trade passes through Israeli (sea or air) ports, across internal borders between Israel and the Gaza area or the West Bank, or through border-crossings (controlled by Israel) connecting the Palestinian area with Jordan and Egypt. Independent Palestinian access to the outside world could be brought about by setting up an independent sea or air port in Gaza, subject to Israeli security arrangements.
• Labor movements are another cause of the unbalanced power structure. One-third of the Palestinian labor force was employed in Israel before 1994. Due to the closure policy and the relatively new phenomenon of foreign (non-Palestinian) labor, their number dropped to less than 10 percent. An agreed procedure to guarantee free passage to Palestinian workers with security clearance may help reverse the decline in labor flows and reduce its volatility. In the longer run, the creation of domestic employment will reduce Palestinian dependency on employment in Israel.
• Since 1967, Israel has been responsible for the infrastructure of the Palestinian economy, including energy, telecommunication (especially international calls), etc. Greater diversification in supply will reduce overall Palestinian dependency in this sphere.
It is clear from the foregoing analysis that measures must be taken to reduce the imbalance in economic power sharing. We believe it is possible to isolate at least part of the economic sphere from other aspects of the conflict, provided both sides deem it profitable to do so. If the Protocol and the resulting economic environment are modified wisely, economic cooperation will benefit both sides.
It is interesting to note that the measures proposed entail the creation of an economic border. If there were no political constraints, the "first best," derived from economic theory, would be to have no economic border. However, since this "first best" is not feasible, the creation of economic borders represents a "second best," which is superior to the present situation where inefficient de facto economic borders exist. The following example can illustrate the same principle: It is well-known that there are scale economies in using a sea port. Consequently, the World Bank, among others, objected to the construction of a deep-sea port in Gaza, maintaining that the Palestinians can use the nearby Israeli port (Ashdod) to reduce transportation costs. However, due to the complications caused by the closures, the use of Ashdod port is not efficient. Thus, the "second best" solution, a Gaza sea port, is a better solution than the non-feasible, theoretically "first-best" solution.
We have shown that the current imbalance of power bodes ill for future economic cooperation and, thus, changes in the Paris Protocol, similar to the ones discussed above, are unavoidable. While acknowledging the new political reality brought about by the change of government in Israel, the required modification of the Protocol should address both short-term and long-term needs of both parties. The above analysis suggests that, although the overall balance of power between Israelis and Palestinians is unequal, the economic sphere may be restructured so as to allow for present and future cooperation, bringing win-win outcomes.


The Paris Protocol was conceived under the premise that the free movement of goods and labor is an efficient organizing principle for the economic relations between Palestinians and Israelis. We have shown that the agreed framework is not functioning satisfactorily. Our analysis of this failure emphasized the problems of implementing a contract, beyond the common efficiency considerations. The free movement of goods and labor within a customs union has not materialized due to the unbalanced power structure behind the Protocol. Consequently, both the dynamics of implementation and unanticipated events, such as suicide bombings, yielded imperfect economic cooperation.
A customs union regime, which is probably the "first best" option, cannot be implemented. A revision of the Protocol will have to include the demarcation of economic borders. Although this is a "second-best" solution, it is a feasible one, unlike the "first-best" solution envisioned in the Protocol.


A free trade agreement (FTA) is an agreement between two or more sovereign bodies to allow uninterrupted trade in commodities produced in each territory. Such is the North American Free Trade Agreement (NAFTA) concluded between the US, Canada, and Mexico. This trade regime holds only for goods produced within the signatory states, which are allowed to pass freely across the internal border of the FTA. Goods produced outside the FTA have to cross external trade barriers set up by the parties, i.e., external borders. Since these trade barriers may not be the same in different external borders (e.g., customs rates on the same goods may differ for each partner), all goods have to be screened at an internal border, in order to ascertain their origin: from outside or from within the FTA.
The only trade regime that enables the abolition of internal trade borders between partners is a customs union. A customs union extends the free flow of goods beyond those produced by the FTA partners to goods produced by the "rest of the world." It does so via an agreement between the partners to apply identical barriers to trade with other ("third") parties. This obviates the need for checking the origin of goods when they pass notional internal borders.

1. This was partly due to the equilibrium in the balance of payments: the existence of an external source of income necessarily creates an offsetting import surplus (see also below, the discussion on trade).
2. See the Appendix for definitions of the terms "Customs Union" and "Free Trade Agreement."
3. See Ben-Shahar (1993); Kleiman (1994, 1995).
4. Although there is no explicit reference to a "customs union" in the Protocol, its third Article, "Import Taxes and Import Policy," translates this economic concept, with some modifications, into legal terms.
5. The zoning system defined the cities (about 3 percent of the West Bank area) as category A and most of the villages as category B (about 24 percent of the West Bank). There are 8 cities and some 190 separate B areas. Israel remained responsible for overall security in the B areas, whereas civilian affairs were the responsibility of the PNA. The remaining area, where Israel continued to be the only authority, is called C.
6. This was an important issue for the Palestinians, who felt that they were paying dues without enjoying the benefits from them.
7. The Ben-Shahar Report (1993, pp. 26-39) cites a figure of 60,000 annually. In Ben-Shahar (1995), the estimated number of Palestinians expected to continue employment in Israel in the long run is 100,000-120,000 annually.
8. One should not confuse this term, borrowed from contract theory, with the fact that the Oslo agreement was unfinished.
9. Complete contracts are those in which all contingencies are covered (a good example is fire insurance). It is interesting to note that the North American Free Trade Agreement (NAFTA) attempted to answer many contingencies. The text exceeds 1,000 pages.
10. Israeli exports to the Palestinian economy did drop steeply, mainly due to the decline of Palestinians' income in shekels.