Capital Deepening and Brilliance of Startup Nation: What Growth Theory Tells Us
Israel’s economy contracted by 3.5 per cent in the second quarter of 2025 as the Iran conflict shuttered businesses and cratered exports. By early 2026, the country had raised $6 billion in a three-tranche international bond offering — its first global issuance since the Gaza ceasefire — with pricing spreads narrowing close to pre-war levels. An economy that collapses and then snaps back with that velocity is revealing something about the deep structure of its growth model — something that the most powerful tools in economic theory can help us understand.
The tools I have in mind belong, in significant part, to a single Australian family. I first encountered them as an undergraduate, studying the Swan diagram in macroeconomics — that elegant framework for integrating internal and external balance that has shaped the thinking of generations of economists. Years later, my first academic appointment, at the age of twenty-five, took me to the Australian National University — Trevor Swan’s institution — where his name was still invoked on a regular basis in the staff tea lounge, not as history but as a living standard of intellectual seriousness. Trevor Winchester Swan — the foundation Professor of Economics at ANU and widely regarded as the greatest economic theorist Australia ever produced — published “Economic Growth and Capital Accumulation” in the Economic Record in 1956. Arriving simultaneously with Robert Solow’s parallel contribution at MIT, it established the Solow–Swan model: the foundational architecture of modern growth theory.
The Swan legacy branched — and flourished. Trevor’s son, Peter Swan AO, Emeritus Professor of Finance at the University of New South Wales, has sustained his father’s intellectual contribution across a distinguished career in corporate finance, market microstructure, and asset pricing. I had the pleasure of working with Peter at UNSW, and what struck me then — as it strikes me now — is the continuity of intellectual ambition: the same instinct for rigorous abstraction applied to real-world problems that defined Trevor’s work is unmistakable in Peter’s. His two-volume Palgrave collection on Trevor Swan’s work, published in 2023, is a landmark act of scholarly stewardship. Trevor’s daughter, Barbara Spencer, Professor Emeritus at the University of British Columbia’s Sauder School of Business and a Research Associate of the National Bureau of Economic Research, has forged her own formidable path. With over 12,000 Google Scholar citations and a past presidency of the Canadian Economics Association, Barbara is best known for the Brander–Spencer model of strategic trade policy — demonstrating how government subsidies to firms competing in oligopolistic export markets can shift profits from foreign to domestic producers. She also co-authored, with Robert Dimand, the definitive NBER study of her father’s contribution to the neoclassical growth model. In my view, Barbara’s contribution to economics makes her every bit as deserving of an Officer of the Order of Australia as her brother. And the lineage continues: Peter’s son Antony is also an economist, carrying the Swan tradition into a third generation
[https://research.unsw.edu.au/people/emeritus-professor-peter-lawrence-swan/publications]
There is a further connection here that borders on the uncanny. Trevor Swan worked alongside Colin Clark, the British-Australian economist who pioneered the use of gross national product as the basis for studying national economies — the two were jointly awarded the inaugural Distinguished Fellow honours of the Economic Society of Australia in 1987. Colin Clark’s nephew, through his sister Margaret, is Geoffrey Hinton — the 2024 Nobel laureate in Physics, the “Godfather of AI,” and the scientist whose work on neural networks has done more than any other individual’s to create the artificial intelligence revolution now reshaping the global economy. Hinton — whose middle name is Everest, after his relative Sir George Everest, the Surveyor General of India after whom the mountain is named — is the great-great-grandson of George Boole, the logician whose Boolean algebra became the mathematical foundation of modern computing. From Boolean logic to deep learning, from national income accounting to neoclassical growth theory — the intellectual lineage connecting Boole, Clark, Swan, and Hinton traces the entire arc from computational logic to the AI-driven economy that Israel now leads.
Capital Deepening in the Classical Mould
Israel’s first four decades track the Solow–Swan model with almost textbook fidelity. The young state absorbed massive immigration waves — doubling its population in three years — while channelling foreign capital (German reparations, US aid, Diaspora bonds) into infrastructure, agriculture, and defence. Growth was rapid but extensive. By the 1970s and 1980s, the diminishing returns that Swan’s model predicts were unmistakable — high inflation, slowing productivity, and growing dependence on external transfers. Swan’s insight was that simply adding capital to a growing labour force cannot sustain per-capita income growth. What matters is the “technical progress” residual. For Israel in this period, that residual was modest.
The Endogenous Turn — and the Strategic Trade Dimension
The transformation came in the 1990s, vindicating two theoretical traditions simultaneously. The endogenous growth models of Paul Romer and Robert Lucas argued that innovation is the product of deliberate R&D investment, with human capital accumulation generating positive externalities that raise economy-wide productivity. Meanwhile, Israel’s innovation policy embodied the Brander–Spencer logic with remarkable precision: in oligopolistic industries characterised by significant economic rents, a government can improve national welfare by subsidising domestic firms’ R&D and export capacity. This is exactly what the Israel Innovation Authority does. With annual investments exceeding $500 million in grants, incubators, and accelerators, Israel systematically subsidises early-stage R&D in sectors — cybersecurity, artificial intelligence, defence technology — where a handful of global firms compete for oligopolistic rents.
The results speak for themselves. Israel invests over five per cent of GDP in R&D — the highest in the OECD. It hosts 434 multinational R&D centres employing a third of its tech workforce. High technology contributes roughly twenty per cent of GDP and over fifty per cent of exports. And mandatory military service through elite units such as Unit 8200 functions as a state-funded human capital programme of extraordinary scale, producing the dense alumni networks and risk-tolerant culture that seed globally significant companies.
The Solow Residual, Real Options, and the Le Chatelier Principle
Israel’s tech sector essentially is the Solow residual — the total factor productivity component that the basic model treats as a black box. GDP per employee in the sector has reached NIS 730,000, with exports per employee rising in parallel. But there is a deeper structure here that growth theory alone does not capture. Israel’s R&D pipeline functions as a portfolio of real options. Each startup, each incubator grant, each military-to-civilian technology transfer is an option on future innovation — a small upfront investment that creates the right, but not the obligation, to scale if the technology proves viable. Knowledge spillovers between firms reduce the cost of exercising adjacent options, and the tight feedback loop between military training, university research, venture capital, and multinational acquisition compresses the time from option creation to exercise.
The Le Chatelier principle offers a further insight. When an external shock disturbs a system in equilibrium, the system adjusts to partially offset the disturbance. The Iran conflict was a massive exogenous shock: reservists pulled from civilian employment, international business linkages disrupted, risk premia spiking. But the system’s response was to intensify investment in cyber and security-focused AI — the very sectors where geopolitical instability generates demand. The shock produced its own partial offset. This is Le Chatelier dynamics in action, and it explains the speed of the post-conflict rebound.
When Google completed its $32 billion acquisition of Wiz — founded by Unit 8200 veterans — in March 2026, it was a single transaction that embodied everything the Swan family’s collective body of work illuminates: the returns to human capital investment (Trevor), the role of market design in channelling capital to its highest-value use (Peter), and the strategic logic of government-subsidised R&D in oligopolistic export sectors (Barbara). Add the real options lens, and Wiz was the exercise of an option that Israel’s ecosystem had been writing for two decades.
The Dual Economy: Where Theory Meets Its Limits
Yet Israel also exposes the limits of these frameworks. The OECD’s 2026 Foundations for Growth and Competitiveness report states plainly that low employment among Haredi men and Arab-Israeli women drags down overall performance, and demographic trends make this a structural crisis. In Solow–Swan terms, a growing share of the population outside the productive labour force pushes the economy below its potential steady state. In endogenous growth terms, it represents a massive failure to capture human capital externalities. In Brander–Spencer terms, the strategic subsidies benefit only the globally competitive segment. And in real options terms, the dual economy means Israel is writing options on only half its population. The other half — a demographic cohort that is growing faster — represents optionality that is never created and therefore can never be exercised.
McKinsey quantifies the stakes: integrating Arab and Haredi workers and achieving 1.2 per cent annual TFP growth would add NIS 7,000 per month to average wages by 2035. Business as usual yields half that gain.
The Swan Legacy and Israel’s Next Chapter
Trevor Swan showed that sustainable growth requires more than capital accumulation. Peter Swan demonstrated that how capital is allocated matters as much as how much is invested. Barbara Spencer proved that strategic government intervention can be welfare-enhancing in oligopolistic industries. Israel embodies this entire intellectual arc — from Solow–Swan capital deepening, through the Brander–Spencer logic of strategic innovation subsidy, to Le Chatelier dynamics and the value of a deep real options portfolio. Its dual economy problem poses the question that no branch of growth theory has adequately answered: how do you ensure that the benefits of technological progress reach the entire population?
Israel is an economy that writes brilliant options on half its human capital and leaves the other half unwritten. The Swan family, across three generations, have given us the tools to see that clearly. The question now is whether Israel’s policymakers will use them — not merely to sustain the Startup Nation, but to build the whole nation.
Robert Solow (1924–2023). American economist who won the Nobel Prize, described himself as an “old-fashioned Jewish boy from Brooklyn”.
Solow-Swan Growth Model: https://economics.mit.edu/sites/default/files/inline-files/Lectures%202%20and%203%20-%20the%20Solow%20Growth%20Model.pdf