Fragile stability probably best describes how visiting Wharton finance professor Zvi Eckstein sees the world. From Cairo’s Tahrir Square to Wall Street and beyond, the former deputy governor of the Bank of Israel recently shared his thoughts with Knowledge at Wharton about the world’s economic and social hot spots. As 2011 draws to a close, the impact on youth is considerable in his home country, Israel, as well as other nations. In this interview — conducted shortly before the eurozone’s sovereign debt crisis took yet another turn for the worse due to sinking investor confidence in Italy — Eckstein talked about what’s in the cards for the EU. While no easy solutions exist to many regional and global struggles, he offers a few rays of hope.

Below is an edited transcript of the conversation.

Israel Knowledge at Wharton: Let’s start by speaking about something that Israel’s finance minister, Yuval Steinitz, recently said. He thinks Israel’s economy this year is going to do quite well but he’s worried about 2012, mainly because of Europe. What is your view of Europe’s sovereign debt crisis and how it could affect Israel’s economy?

Zvi Eckstein: Israel’s economy has been doing very well. Growth this year is expected to be 4.8%, 4.9%, maybe even 5%. Unemployment went down to 5.6% [in August from 6.1% in January]. Inflation expectations are about 2%. So the economy in a macro sense is doing well. And exports have been growing [as] well. The key threat to the economy is that demand for Israeli products abroad goes down.

Europe is about one-third of our exports. The slowdown expected in Europe is going to be quite severe, and we have seen the ECB [European Central Bank] reducing interest rates. The U.S. and Europe account for more than 70% of Israel’s total exports. The key risk is Israeli gross exports going down 4% or 5%. That would mean the economy may grow next year in the 3.5% range … and 3.5% may actually cause a little rise in unemployment.

Knowledge at Wharton: Since we were talking about Europe and the ECB, what do you think Europe’s central bankers could have done differently?

Eckstein: It’s not only the central bankers. Europe with the euro has 17 countries … [but it] has not really generated central government decision-making [about what happens if the agreement among eurozone members about national debt-to-GDP ratios is not adhered to].

What we have seen is Europe tackling a big sovereign debt problem — Greece, in particular, but more threatening potentially are problems with Italy and Spain. Greece’s problem has been known to people analyzing data since at least early 2010, if not before. The public markets reacted already in May 2010. The main problem is what was done a few weeks ago should have been done a year ago. That’s mainly the one important decision they made to separate the European banking stability problem from Greece’s potential debt default. That certainly reduced tensions in that the markets are less sensitive to the Greece problem mainly since the end of October 2011 because all the big banks in Europe will recapitalize to 9% with a haircut of 50% or more on Greek debt and even potentially a haircut on other debts. That’s provided some stability in the banking sector. But the rest of Europe is still untouched.

Knowledge at Wharton: What do you think is in the cards for Italy and Spain?

Eckstein: In Italy, the main problem is that political stability, or instability, inside generates uncertainty about the debt-to-GDP ratio. Italy’s economy has not been doing great, to say the least, really very slow growth, even negative growth. Debt is 115% of GDP. The deficit is not terribly high, but really to get back to a reasonable debt-to-GDP level, to 60%, sometime in the foreseeable future, Italy should take important steps to revive the economy and reduce their current deficit.

To do that, they probably need a more decisive government than they have now. [Editor’s note: This interview was recorded before Prime Minister Silvio Berlusconi, was replaced by Mario Monti in November.] As long as they don’t, we will see the markets reacting and spreads increasing. The Germans have to finance this debt on 6% interest rates. That is going to be very complicated and generate increasing debt. If Italian debt, which is US$1 trillion so far, gets into the area of CDS [credit default swap] risk that we might consider much below A, Europe is in great trouble and the rest of the world is in great trouble.

Knowledge at Wharton: And Spain?

Eckstein: The feeling is that in Spain, things are more stable. It is more manageable. The Spanish economy is doing badly. Unemployment is extremely high. But it seems that the change in the political structure there will generate a path back to normality. Also, the level of debt they started with is much lower. Overall, the prospect of it becoming unstable is much lower and the past Spanish governments have behaved very responsibly in controlling fiscal budget and banking regulation policies, [so that there’s confidence that the problem with] local banks that generated too much household debt would be fixed. Spain will most likely [return to] a stable [economy by] European standards very soon this year.

Knowledge at Wharton: In looking at the persistent problems in the U.S. economy, how do you expect that to affect Israeli firms?

Eckstein: There are two aspects. About 30% of Israeli exports go to the U.S. However, we are really exporting a lot to the high-tech sector. So far, the high-tech sector has not suffered tremendously in the U.S. Therefore, the demand still is going well. When we look at growth indices in the high-tech sector in the U.S., they’re still keeping up. That’s where there is growth in the U.S.

It [doesn’t mean] big growth of jobs, and therefore the U.S. economy doesn’t really get a huge gain from this. But the Israeli economy does. We see new generations of iPods, iPhones and Androids, and all the different products, and the Israeli high-tech sector is a key aspect [for them]. Overall, the Fed only [expecting] the U.S. economy to get back to normal in the second half of 2013 is going to have some effect on the Israeli economy, but probably not tremendously.

Knowledge at Wharton: As you’ve just said, both Europe and the U.S. are slowing down. Do you think that a possible solution for Israel could be greater economic cooperation with Palestine and the other Middle Eastern economies?

Eckstein: In fact, what has been going on in Israel is that as the U.S. and European economies began growing more slowly since 2007 and even before, we have seen an export shift to the Far East. Israeli exports are very high tech if you do any comparison with other countries in terms of the combination of products we are exporting. We export software, machinery, pharmaceuticals and other high-tech things, which is about 50% of our exports or even more. Exporting those goods to the Middle East doesn’t seem to [present] an opportunity for Israel. And we know that most trade among developed countries is with other developed countries.

Knowledge at Wharton: What then can be done to increase greater economic collaboration in the Middle East?

Eckstein: The key to collaboration and economic development for Middle Eastern countries is stability, peace and competition policies…. The main drawback of most Middle Eastern countries — and that includes the West Bank and Gaza, and maybe even Jordan, Syria, Lebanon and Egypt — is really economic stability, political stability and economic competitiveness, and the opening up of the countries to imports and exports and getting competitive advantages growing as has been the [case] in most Far Eastern countries, which came from very low per capita incomes to grow.

Stability in the West Bank [in terms of] law and order, property rights [and so on has an impact on] trade within the West Bank. One of the main problems … is the segmentation of this area and the inability to move freely and quickly between the different cities. What we see is the importance of, first, having an internal economy working and blooming. The second part is to let them use their comparative advantage in some products and get them exported. The economy is small and they can export to Israel, but what they can do is really develop large [amounts of] exports and not necessarily only to Israel.

Knowledge at Wharton: As you know, the political balance in the region has shifted quite a bit because of the Arab Spring. Do you think the political shifts in the Middle East will enhance the possibility of greater joint economic development with Israel and the region, or could it hurt the situation, and why?

Eckstein: First, the Spring that we see in Tahrir Square in Cairo, the calls for justice and social freedom and democracy are … moving to anyone who has been living in the Middle East and seeing Israel as the only model of what I would say is a modern democracy. Just the possibility of having democracy, a pure democracy in the style close to what we see in the developed world in Egypt, Tunisia [or] Libya would [offer] great hope for the people there.

How this democracy will shape into economic policies is a huge question. What we need first of all is stability — political stability, security stability and macroeconomic stability. We need budget policy stability and monetary policy stability. Those are necessary conditions but they are not enough without promoting competition and using the comparative advantage of a country in world trade, and integrating it into a global economy. It’s hard for an economy to start growing. What we see in India [and] China, what we have seen in Singapore, Hong Kong, Taiwan, Korea and Japan many years ago, is really [what] I mentioned — stability, consistent macroeconomic policy and promotion of competition.

I hope these countries learn the lesson [and] listen to the IMF’s advice. Then they will grow. The relationship with Israel is one aspect of that. I would say with Israel, the key is to establish a stable political environment and geopolitical situation.

A good example is the gas pipeline going from Egypt to Jordan and Israel. It provides a lot of benefit to the Egyptians. They provide us and Jordan with great gas very cheaply. They make a lot of money out of it. But if they cannot control the viability and stability of this product, it’s very hard to see co-operation in other things.

I can give you one more example. Israel in the south is a desert. The area between Israel and Egypt is a desert. Egypt has had a huge amount of water from the Nile for several thousand years. It’s unthinkable in the geopolitical situation today [that the use of] this water [has been allowed to] to really bloom. People think of bringing water as far away as Turkey. Why not bring water from the El-Arish Delta, which is just on the border? Why not bring it into Israel and Jordan, where we pay a huge amount for water, maybe twice as much as what it would cost to transport it?

But it is the history and the geopolitics and the threat of, “Why are you taking my water?” rather than thinking about the benefit it can bring people on two sides of the border. That’s something we have to really go through. If they would be able to do it politically, it would be a huge gain.

Knowledge at Wharton: You referred to the Tahrir Square protests. Israel during the past summer also saw a lot of protests in many cities. A lot of young people were shouting slogans against the “tycoonim” or tycoons. What do you think are some of the main economic issues that face young Israelis? What policy changes are required to deal with those situations?

Eckstein: It’s hard for me to say what the underlying mechanisms are that generate these protests. First of all, I’m not a sociologist or social psychologist. [But] I would want to point to an important issue that has also come up with Occupy Wall Street, which came later than Israel and maybe to some extent the Arab Spring. Young people want to see lights in front of them. They want to work hard and get to a better place. That has been the case, I would say, since the second half of the 20th century, for many young people in many places.

What the people on the streets of Israel, the young people were telling us, the policy makers, [was that] “We don’t see a hopeful light there. We see inequality. We see a deterioration of the services we receive. We see a lot of people below the poverty line. And we do not see ourselves living in the standard we were thinking we could in terms of houses and support we can give to our children, [such as] education and so forth.”

To some extent, there is a common view in the Occupy Wall Street movement. I would say it is a populist phenomenon historically that when things get worse and you don’t see the light, you point to the very top people … [even though] some of them probably earned their income legally, but are using [their] monopoly to maintain power. Maybe some of them were even crooks and the police caught them or did not. It’s easy to point to these people. But things are much deeper and more complicated. I think trying to blame a few people at the top of the earning scale in the last few years is not the way to think about changing the economy.

In fact when you look back in history, there were always some people at the top of the scale, and people trying to replace them. Usually, what happened is that they replaced them with other people who didn’t change the situation. What we have learned over time as economists is that policies set by governments that enable people equal access to opportunities and prevent monopolies and enhance competition are the policies that enhance growth and the light for the people at the end of the road. That’s what we try to implement in Israel, and I would say not necessarily always with great success.

Knowledge at Wharton: Let’s turn now to some questions about your research. Maybe I could start with a small question about a big issue. What role has education played in shaping Jewish history?

Eckstein: That’s a topic that Maristella Bottichini of Boconni University in Milan and I have been studying for more than 10 years. We are publishing, in mid-2012, a book, The Chosen Few: How Education Shapes Jewish History. The Jews made a big change in their religion after the selection of the Temple Mount [in Jerusalem] in 73 – 100, where boys learned to read and later to write the Torah as their core of Judaism.

When they promoted it over the years, they generated the first society of mandatory education. I think already before the turn of the millennium, almost 100% of Jewish boys knew how to read, [but] literacy in farming societies was at most 10%. That provided the Jews a big advantage economically in choosing occupations that could fit their ability to read and not only to read. Reading was the ‘infrastructure’ for a Jewish religion….

There is a mission now to interpret the Torah. The Torah itself is a law. But there is a mission to take in its details. The mission says you have to read, and this mission was interpreted by another set of laws, which is the Talmud. Rabbis have been using the Talmud for years and built on each other. That generated an infrastructure for the Jews in the Muslim empire to become traders … where they could write contracts and, if they had a disagreement about the contracts, they could assign arbitrators, which were the rabbis. And they moved their families. They were trading from India, China and all the way to Spain, England and France, already in the eighth, ninth [and] tenth centuries, way before Marco Polo in the 14th century started traveling[to Central Asia and China]. That’s basically the basis for why the Jews are called a merchant society, an urban society. They moved into being urban dwellers, earning relatively much more than most of the population around.

But in the process of moving to that, they separated themselves from the other religion, which was Christianity, which [cast itself as] the new Jews when they started and was not based on requiring people to learn and reaching a lot of people. Basically, the Jews live next to the Christians and Muslims mainly as an urban minority, which migrated on its own will to find more income, becoming merchants, money lenders, doctors, etc. They continue to be in the lead in this respect because the rest of the world only reached mandatory education in the early 20th century. That was a big advantage for the Jews when they came to the U.S. at the end of the 19th century. They all came literate. For them, going into the education system in the U.S. was kind of natural.

Education started with this change in the religious norm, and had a huge impact on the whole occupation, migration and population size of Jewish people. That’s what we find in the book and we document it year by year. Our book ends just before the Jews were expelled from Spain in 1492 to 1496. But we show that up to this period, the key reason for the Jews choosing the particular occupation they were in was mainly the comparative advantage they had because of literacy and their goal of building up this Jewish community and law, rather than [because of] restrictions — sometimes other historians and people say the Jews couldn’t own land. Most of the time, they could own land; they could be farmers. But the jobs they chose gave them much higher standards of living.

Knowledge at Wharton: You have an interesting book coming out next year dealing with a wave of large-scale immigration into Israel. Could you tell us about that research and your main findings?

Eckstein: In the early 1990s when we started seeing the large wave of immigrants from the former Soviet Union to Israel, we [Sarit Cohen-Goldner of Bar Ilan University and Yoram Weiss of Tel Aviv University] established a group of researchers and collected data on the integration of the Jewish immigrants arriving from the former Soviet Union to Israel. During the decade from 1990 to 2000, about 900,000 people came and became something like 20% of the Jewish population. What we studied is how well they were integrated in the labor market.

There are several questions. One question is, do they negatively affect the locals, the natives? The natives are always afraid of immigrants. What we document is that the negative impact on natives is very minor, maybe for a year at the beginning. The main reason why is that the government provided them with a way to invest in local human capital — meaning they invested in adjusting their skills to the local market, learning the language, learning the jobs that are available in a new country, like engineering or other jobs with machines.

They integrated very quickly into the labor market. And they expanded the economy. The economy expanded because of their interest in working and learning how to work in this [country]. By allowing them to choose their occupations and the location of their studies, but also helping them to invest in local skills, made the integration into the economy very smooth and the economy grow through the entire period without a downturn.

What we learned is if you bring in immigrants, you have to worry about providing them with the resources to invest in local human capital to get them integrated into the labor market.

Knowledge at Wharton: That sounds fascinating because immigration is such a huge issue in many European countries and in the U.S. What could the rest of the world learn from the way Israel dealt with this issue?

Eckstein: You have to manage your immigration policy and cannot just think about immigration as whoever wants to come [can come and] we make a quota or something like this. What you have to think about is when you let people come in, you really want to provide them with the mechanism with which they can learn how to integrate themselves into the economy. Otherwise, they may have a negative impact, especially if you bring low-skilled people in large amounts; they really push wages down among lower skilled people. That generates inequality and that’s really devastating.

What you need to control when you get immigrants, and diversity [is that] they come with different skills. And when they come, you want to make sure they have the means to invest in the language and the skills required in the new country, because the market does not provide the resources for this investment. The government pays for much of this investment through the tax system [across] the whole country.

Knowledge at Wharton: You are a labor economist. As you know, the U.S. economy has been struggling to create jobs. If President Obama were to ask you your advice on how the U.S. can generate jobs, what would you tell him?

Eckstein: I have to study this issue to be honest. We have to really identify where the main blocks in the labor market are. The key question in labor markets is [always whether there is] too much demand or supply. We have long-term unemployed, a lot of them from construction, with a lot of experience and some with relatively high wages in the past. Now, the housing market is not really absorbing them. We have to study in detail what the main blocks are. Is it the demand side or the supply side in terms of adjusting those skills?

What we learn in the labor market is that it’s not just the demand and supply, [but also] matching the quality — you need to find the right workers for the market. Today in the U.S., it’s highly complicated because we see a real problem in the demand side. Investment, consumption, consumer and investor feeling, and the public perception of where the economy is going are not high enough to provide demand.

Another thing is that I am not sure that the workers who are [in the market] fully understand the opportunities and whether they are investing in the right skills for the job market given the change of the economy, the deleveraging and other things.

One thing I want to say is that I have not seen good, comprehensive research surveying this data … and providing a good enough solution that works for the two sides — demand and supply –and focused on the people who are unemployed and searching for work. That, I think, is missing.

Alan Krueger [an unemployment expert and Obama’s chief economist] is a good economist. He’s a labor economist. In fact, most of the advisers to the government and to the president now are labor economists and micro-economists, and I hope they do this kind of research and study the details of what’s going on.

But to summarize what we learned in academic research, it’s really the matching and the quality of matching between the workers and the firms. If I go back to my story about the immigrants, what we found is a mismatch of the qualities as something we wanted to fix. When we enabled the two sides to overcome that, it was much easier. One reason why it was easier in Israel was that the people came from the Soviet Union and were willing to work for lower wages. That generated a lot of demand from firms. I am afraid that one of the main problems now in the U.S. is that a lot of people are not willing to work for lower wages than they received in the past. It’s hard for them to do that. That has made a problem for firms. In this sense, there might be a place for some subsidies to match workers and firms. But I want to be careful before I go and provide President Obama and his advisers a “menu” [of solutions]. I’m just guessing that that could be a way to look into this problem.