Cycle of Hardship.(Israeli economy)

Moshe Basson counts himself among the lucky ones. Though his gourmet restaurant in downtown Jerusalem is nearly empty most nights and $150,000 in debt, Basson is still in business. The 52-year-old chef has owned Eucalyptus, once one of Jerusalem's most profitable upscale restaurants, for 15 years. He serves Israeli cuisine a little like a performance artist--scattering dried herbs across a dinner table, then reciting a Bible tale about the rituals of food. Before fighting with the Palestinians erupted two years ago, Basson's 20 tables were reserved almost every night, and he regularly turned away customers. But suicide bombers and plunging financial fortunes have emptied the place. Sitting under the gracefully decorated arches of his restaurant, he ticks off the names of Jerusalem establishments that have gone under--dozens in the last year alone--and carps about the government's handling of the economy. "We've sat with financial officials and suggested changes that would help the situation, but they don't listen," says Basson.

He's not alone. Ever since the latest intifada began two years ago, Israel's economy has gone into a serious slump. Economic output has been shrinking for two years. Unemployment now exceeds 10 percent, and inflation will reach 8 percent this year. The country's construction and agriculture industries have been in steady decline, but now the malaise has spread to business sectors that, not long ago, were thriving.

The intifada, which has taken an even higher toll on the Palestinian economy, is not solely to blame. "We've been hit by series of complicating factors," says Nadine Baudot-Trajtenberg, an economist with Israel's Bank Hapoalim. Tourism and regional trade have certainly been walloped by the bloody conflict with the Palestinians, which has never looked more intractable. But the large high-tech industry--which powered Israel's economy through the late '90s and accounts for an astonishing 65 percent of industrial exports--has fallen victim to a worldwide plunge in technology spending. Israelis who do have jobs complain of salary erosion due in part to a sharp weakening of the local currency. Israelis are even buying less meat, drawing cattle raisers into the cycle of hardship.

Yet while an economic issue--funds for Jewish settlements in the West Bank--was the pretext for the breakup of Israel's broad governing coalition last month, analysts say the election tentatively slated for late January will not be fought over the economy. That's because voters have always viewed security matters as paramount in Israel, and economics as a political luxury. "Candidates have tried to campaign on economic issues, but they usually don't resonate," says Hanoch Smith, a Jerusalem pollster who has advised parties on both sides of the political map.

Prime Minister Ariel Sharon's political fortunes illustrate the point. While only about 20 percent of Israelis think he's done a good job managing the economy, according to Smith, about 65 percent are satisfied with the way he's handled the security issue. And that's just where his overall approval rating stands--65 percent. Smith says some people tend not to blame the government for their financial woes because they perceive them as being caused more by external factors than anything else. Even critics of Sharon's economic policy tend to overlook it once at the ballot box. "People think about the bombings and the peace process when they cast their vote. Other things are secondary," Smith says.

In Israel, the two things--peace and prosperity--are to a degree inextricable. Many sectors of the economy, like tourism, are critically dependent on a ...