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In areas like biopharmaceuticals, telecom, and software, Israel ranks second only to the United States in technological innovation.

The most precious resource in the world economy is human genius, which we may define as the ability to devise significant inventions that enhance survival and prosperity. At any one time, genius is embodied in just a few score thousand people, a creative minority that accounts for most human accomplishment and wealth. Cities and nations rise and thrive when they welcome entrepreneurial and technical genius; when they overtax, criminalize, or ostracize it, they wither.

During the twentieth century, an astounding proportion of geniuses have been Jewish, and the fate of nations from Russia westward has largely reflected how they have treated their Jews. When Jews lived in Vienna and Budapest early in the century, these cities of the Hapsburg Empire were world centers of intellectual activity and economic growth; then the Nazis came to power, the Jews fled or were killed, and growth and culture disappeared with them. When Jews came to New York and Los Angeles, those cities towered over the global economy and culture. When Jews escaped Europe for Los Alamos and, more recently, for Silicon Valley, the world’s economy and military balance shifted decisively. Thus many nations have faced a crucial moral test: Will they admire, reward, and emulate a minority that has achieved towering accomplishments? Or will they writhe in resentment and plot its destruction?

The test has assumed a global face today, when a large proportion of the world’s genius resides in Israel. Israel has very recently become a center of innovation, second in absolute achievement only to the United States, and on a per-capita basis dwarfing the contributions of all other nations, America included. How Israel is treated by the rest of the world thus represents a crucial test for civilization. Will we pass it?

My interest in Israeli innovation began in 1998, when I invited an Israeli physicist named David Medved to speak at the Gilder/Forbes Telecosm conference. Medved described the promise of “free-space optics”—what most of us call “light”—for high-end communications among corporate buildings and campuses. He also spoke of air force experiments in Israel that used the still-higher frequencies and shorter waves of ultraviolet light for battlefield communications. Some of the most important explorations of electromagnetic technology, I realized, were happening in Israel.

Nearly a decade later, Medved introduced me to his son Jonathan, a pioneering Israeli venture capitalist. In his offices high over Jerusalem, the younger Medved told me the startling tale of Israel’s rapid rise to worldwide preeminence in high technology. I had long known that Israel held laboratories and design centers for American microchip companies. I knew that, in a real sense, much American technology could reasonably bear the label israel inside. I was familiar with a few prominent Israeli start-ups, such as the electric-car company launched by Wired cover boy Shai Agassi, which boldly bypassed the entire auto industry in redesigning the automobile from scratch, and Gavriel Iddan’s company Given Imaging, with its digestible camera in a capsule for endoscopies and colonoscopies.

But what I learned in Jerusalem was that Israel was not only a site for research and outsourcing and the occasional conceptual coup, but the emerging world leader, outside the United States, in launching new companies and technologies. This tiny embattled country, smaller than most American states, is outperforming European and Asian Goliaths ten to 100 times larger. In a watershed moment for the country, Israel in 2007 passed Canada as the home of the most foreign companies on the technology-heavy NASDAQ index; it is now launching far more high-tech companies per year than any country in Europe.

To take one example among many, Israel is a prime source not only of free-space optics but also of another form of hidden light: ultra-wideband technology. This technology features wireless transmissions that are not, like cell-phone signals, millions of hertz wide at relatively high power, but billions of hertz wide—gigahertz—at power too low to be detected by ordinary antennas. The technology is typically used for mundane purposes, such as connecting personal computers and televisions wirelessly. But a firm called Camero, in Netanya, Israel, has invented an ingenious ultra-wideband device that enables counterterrorist fighters and police to see through walls and identify armed men and other threats within. An easily portable box about the size and weight of a laptop computer, Camero’s Xaver 400 could suffuse an urban battlefield with hidden light that would penetrate walls and bunkers and be detectable only by its users. Such inventions are changing the balance of power in urban guerrilla warfare, to the advantage of the civilized and the dismay of the barbarians.

As I investigated companies like Camero, it became clear to me that Israel had achieved an economic miracle that was important to the United States and to the world. As late as the mid-1980s, Israel was a basket case, with inflation rates spiking from 400 percent to nearly 1,000 percent by early 1985. As recently as 1990, Israel was a relatively insignificant technology force, aside from a few military and agricultural initiatives. Yet in little more than a decade, the country has become an engine of global technology progress. Still more important, Israel’s technology leadership has made it a vital ally of the United States against a global movement of jihadist terror. How did it make such an astonishing leap?

With the history of twentieth-century science and technology largely a saga of Jewish accomplishment, it might seem to have been foreordained that after World War II, the rising Jewish nation would emerge as a scientific and technological leader. Yet for all the talk of deserts in bloom, the miracle did not occur quickly. For many decades after Israel achieved independence in 1948, the Jews assembled there generated few significant companies or technologies, no significant financial institutions to fund them, and little important science. Accomplishments made in American states like California, New York, and even New Jersey exceeded those of Israeli enterprise, and Jews outside Israel far outperformed Jews in Israel.

In the country’s early years, its research activities were mostly public, devoted to defense, and paltry by any standard. As late as 1965, the ratio of research-and-development spending in Israel to its gross domestic product was under 1 percent, nearly the lowest in the entire Organisation for Economic Co-operation and Development, behind only Italy. Just one-tenth of 1 percent of Israel’s employees were engineers, putting it far behind the United States and even Sweden. Michael Porter’s definitive 1990 tome The Competitive Advantage of Nations mentioned Israel only once.

All this despite the presence of the Technion, one of the world’s supreme institutions of practical science and the chief contribution of Israel’s founders to its eventual preeminence in technology. Located atop a hill overlooking Haifa, the institute sprawls over its spectacular site with a massive maze of concrete institutional architecture as formidable as MIT’s: labs, auditoriums, nuclear facilities, giant telescopes, and research monoliths, mostly named for American Jewish tycoons. But nearly 80 years passed after the Technion’s opening in 1924, with Jews around the world forging the science of the age in an intellectual efflorescence unparalleled in human history, without any exceptional contributions from Israel.

How to explain this lassitude? For much of Israel’s short history, the country has been a reactionary force, upholding a philosophy of victimization and socialist redistribution that could only impede its progress. In 1957, a team of American economic consultants found that Israel’s “high labor costs . . . reflected the high degree of job security . . . [and] the absence of adequate incentive to or rewards for superior efficiency or performance.” This was partly a result, they added, of “virtually complete protection from foreign competition.” Two years later, A. J. Meyer of the Harvard Center for Middle Eastern Studies noted “uncertainty in the minds of many [Israeli] industrial producers that theirs is the ‘good’ occupation or that society really gives them credit—financially and in status—for their efforts.” He also cited “welfare state concepts [that] often dictate that incompetent workers stay on payrolls.”

Many of Israel’s Jews, as the writer Midge Decter described them, “were coming into the country armed with their socialism and their ideologies of labor and a Jewish return to the soil.” Imagine it: urban socialists trying to reclaim their past glory and save themselves in a hostile world by returning to the soil in a desert! They created communal experiments—kibbutzim—and put intellectuals to work with hoes and shovels, for all the world like a voluntary version of Chairman Mao’s Cultural Revolution. In a truly menacing démarche of ideological madness, they attempted to abolish the family and private property.

Panicked, moreover, by the Jewish caricatures and stereotypes wielded by their enemies, they resolved to become mendicant nebbishes—touring the centers of Western money and industry with tin cups in hand—rather than bankers and financiers. They assigned close to a third of the economy to the ownership of Histadrut, a socialist workers’ organization prone to threatening nationwide strikes. Under Histadrut pressure, they instituted minimum wages that stifled employment and propelled inflation. Then they imposed more controls on wages, prices, and rents, making everything scarce.

In a general enthusiasm for public ownership of the means of production and finance, the government through the 1990s owned four major banks, 200 corporations, and much of the land. Israel’s taxes rose to a confiscatory 56 percent of total earnings, close to the highest in the world, stifling even those private initiatives that managed to pass through the country’s sieves of socialism. Erecting barriers of bureaucracy, sentiment, and culture, Israeli leaders balked the entrepreneurs and inventors who gathered there, creating a country inhospitable to Jewish genius.

Far more welcoming of Jewish and Israeli talent in those days were American companies, particularly Intel. It was an Israeli engineer, Dov Frohman, who invented electrically programmable read-only memory (EPROM), a chip-based permanent memory that could retain a personal computer’s core programming even when the power was off. EPROM would contribute some 80 percent of Intel’s profits over the next decade and sustain the company’s growth to become the world’s leading semiconductor company. (With the help of a company called Xicor, started by Israeli Raffi Klein, EPROM soon evolved into the flash memories that today dominate the industry. Today, flash memories are a forte of the Israeli microchip industry and lie behind many American miracles of miniaturization, from so-called thumb drives to Apple’s newer iPods to Hewlett-Packard’s Mini netbooks.)

After leaving Intel in 1974 for a charitable sojourn teaching electrical engineering in Ghana, Frohman returned to Israel to establish an Intel design center in Haifa. This laboratory soon conceived the so-called 8088 microprocessor, which was incorporated into the first IBM personal computer. In 1979, also in Haifa, Frohman supervised the development of Intel’s first mathematical floating-point coprocessor, a critical element in most subsequent personal computers and workstations.

As a guest in the country, albeit an imposing one, Intel could tap the genius of Jews while bypassing the rules, tolls, and taxes that frustrated Israeli companies. Following the Haifa design center, Frohman wanted Intel Israel to establish a semiconductor “fab,” or factory, in Jerusalem, together with the necessary chemical and engineering support services. After a battle with Intel executive Andrew Grove—himself a Hungarian Jew who became a legendary figure in Silicon Valley—over the costs of training Israelis to run the fab, Frohman managed to enlist $60 million in subsidies from the Israeli government and led the project to completion in three and a half years. By the late 1980s, the Jerusalem fab, Intel’s first outside the United States, was producing some 75 percent of the global output of Intel’s flagship 386 microprocessor and was gearing up to produce the 486 as well. Frohman later persuaded Grove to open production plants in Kiryat Gat in the Negev, Israel’s desert. Meanwhile, from Intel’s Israeli design centers—by now, there were several—emerged several generations of the Pentium microprocessor, as well as the Centrino low-power processor that integrated Wi-Fi wireless capabilities into portable PCs.

For all the achievements of Israelis working for Intel and other foreign firms, Israel’s native technology sector languished. Redemption came in unexpected forms. One was an infusion of genius: nearly a million immigrants, chiefly from the Soviet Union, whom Israel absorbed in the late 1980s and the 1990s. Impelled by constant harassment from the U.S. government—including Senator Henry “Scoop” Jackson’s emancipation amendment, which for a decade was attached to any American legislation of interest to the USSR—the Soviet government finally agreed to a frontal lobotomy of its economy. Under Gorbachev, it released the bulk of the Soviet Jews, who had continued, despite constant oppression, to supply many of the technical skills that kept the USSR afloat as a superpower.

The influx of Soviet Jews into Israel represented a 25 percent population increase in ten years, a tsunami of new arrivals that would be equivalent to the entire population of France being accepted into the United States. Largely barred in the USSR from owning land or businesses, many of these Jews had honed their minds into keen instruments of algorithmic science, engineering, and mathematics. Most had wanted to come to America but were diverted to Israel by an agreement between Israel and the United States. Few knew Hebrew or saw a need for it. At best, they were ambivalent Zionists. But many were ferociously smart, fervently anti-Communist, and disdainful of their new country’s bizarre commitment to a socialist ethos that punished achievement.

At the same time as the flood of Soviet immigrants, a smaller but seminal wave of Americans arrived in Israel from such companies as IBM and Bell Laboratories, with a knowledge of Silicon Valley and an interest in opportunities in Israel. Capping off and funding these catalytic outsiders was a generation of eminent American retirees who arrived in Israel with billions of dollars of available capital, petawatts of imperious brainpower, a practiced disdain for bureaucratic pettifogs, and Olympian confidence in their own judgment and capabilities.

Mix the leadership of these dynamic capitalists with a million restive and insurgent Soviets, and the reaction was economically incandescent. Throw in natural leadership from the irrepressible Natan Sharansky, who had faced down confinement in the Gulag and formed a new conservative political party in Israel to mobilize his Russian compatriots, and the impact reverberated through the social and political order as well. Such an influx could not be clamped or channeled, tapered or intimidated into the existing economic framework, and, as Israeli financier Tal Keinan remarks of the Russian newcomers, “they could not all work for Intel.” Today, immigrants from the former Soviet Union constitute fully half of Israel’s high-tech workers.

Despite the dramatic progress of the 1990s, at the dawn of this century, Israel still lacked a financial sector capable of propelling the nation into the globally dominant role it stands poised to fill today. To get there would take one more great reform.

The successful allocation of capital, like the launch of a new technology, is an elegant expression of the capitalist law that mind rules and matter serves. Jews throughout history have excelled in this most intellectual of capitalist endeavors. And yet Israel until recently had virtually no investment houses, deep capital markets, or venture capital. With performance fees barred, hedge funds were essentially illegal. “All my Jewish friends were making their money at Goldman Sachs, while Israel’s finance was dominated by a heavily subsidized labor union,” remembers Keinan. “The Zionist Rothschilds dominated European banking, but the only significant Rothschild presence in Israel was a winery.”

In the mid-1980s, Yitzhak Shamir’s Likud government, with Benjamin “Bibi” Netanyahu as its United Nations ambassador, did cut taxes—increasing the rewards of work and investment by some 30 percent, dramatically boosting economic growth, and reducing inflation. As prime minister in the 1990s, Netanyahu also ushered in dramatic deregulation, along with tax cuts that brought in floods of new revenue. Further spurring local entrepreneurs was the Yozma program in 1993, which waived double taxation on foreign venture-capital investments in Israel and put up a matching fund of $100 million from the government. Demand for the money became so intense that the government hiked the amount and doubled the matching-funds requirement. Nevertheless, throughout the 1990s, most of the money powering Israel’s technological ascent came from the Israeli government or from American technology companies. As the millennium dawned, Israel had failed to create a financial-services industry or to wrest control of much of Israel’s capital from the hands of Histadrut.

The force driving the Israelis decisively out of their socialist slough into the modern world of finance was once again the ingenuity of Netanyahu. As finance minister, Netanyahu used the financial crisis of 2003 and 2004, precipitated by the latest campaign of Palestinian terror, as a lever to transform Israel’s economy from a largely socialized domain dependent on foreign finance into one of the world’s most open and flourishing financial systems. In the process, he created what occasional advisor Keinan today calls “the greatest opportunity in our lifetimes.”

An Israeli supply-sider, Netanyahu faced the adamant opposition of Histadrut and its allies in the Knesset. To overcome the hostility to finance capitalism that had long hobbled the Israeli economy, Netanyahu enlisted vital help from President George W. Bush and his treasury secretary, John Snow. Netanyahu sought a sovereign loan guarantee that would give Israeli bonds the full faith and credit of the United States Treasury, so that despite intifadas and other perils, Israel could issue bonds on the same terms as the world’s leading economy. Not wanting the U.S. to appear a patsy, Snow refused to do the deal without a significant quid pro quo, stipulating that Netanyahu secure from the Knesset a series of major financial reforms.

First, Histadrut, which dominates the pension system in Israel, had to give up its direct line to the Israeli treasury, which had guaranteed it an inflation-adjusted 6 percent annual yield. This special arrangement would be phased out over a period of 20 years. Starting immediately with the first 5 percent of its holdings, Histadrut would need to begin finding other ways to invest its $300 million per month of cash flow. Somehow a financial industry would have to arise in Israel to handle this huge trove of funds. A second briar-patch reform demanded by Snow was the immediate privatization of Israel’s state-owned industries, reducing the government’s stake in these companies from an average of 60 percent ownership to minority ownerships of about 20 percent. Among the privatized ventures were oil refineries, nearly all the banks, the Bezeq telephone monopoly, and the national airline, El Al. The third key reform was the emancipation of the financial-services industry, complete with legalization of investment banks, international private equity funds, and performance fees for hedge funds. Eliminated were double taxes not merely on investments in Israel but also on international investment activities by Israelis. The Netanyahu-Snow agenda went into effect on January 1, 2005.

In under 25 years—starting from those first modest tax reforms of the mid-1980s—Israel has accomplished the most overwhelming transformation in the history of economics, from a nondescript laggard in the industrial world to a luminous first. Today, on a per-capita basis, Israel far leads the world in research and technological creativity. Between 1991 and 2000, even before the big reform of 2005, Israel’s annual venture-capital outlays, nearly all private, rose nearly 60-fold, from $58 million to $3.3 billion; companies launched by Israeli venture funds rose from 100 to 800; and Israel’s information-technology revenues rose from $1.6 billion to $12.5 billion. By 1999, Israel ranked second only to the United States in invested private-equity capital as a share of GDP. And it led the world in the share of its growth attributable to high-tech ventures: 70 percent.

Even a year or two later—while the rest of the world slumped after the millennial telecom and dot-com crash and Israel suffered an acute recession—its venture capitalists strengthened its lead in technological enterprise. During the first five years of the twenty-first century, venture-capital outlays in Israel rivaled venture-capital outlays in all of the United States outside California, long the world’s paramount source of entrepreneurial activity in high technology.

Today, Israel’s tech supremacy is even greater. A 2008 survey of the world’s venture capitalists by Deloitte & Touche showed that in six key fields—telecom, microchips, software, biopharmaceuticals, medical devices, and clean energy—Israel ranked second only to the United States in technological innovation. Germany, ten times larger, roughly tied Israel. In 2008, Israel produced 483 venture-backed companies with just over $2 billion invested; Germany produces approximately 100 venture-backed companies annually. The rankings registered absolute performance, but adjusted for its population, Israel comes in far ahead of all other countries, including the United States.

Venture capital is the most catalytic force in the world economy. In the United States, venture-backed companies produced nearly one-fifth of GDP in 2007. At a time when American venture capital is flagging under the financial crisis, the emergence of a comparable venture scene in Israel, linked closely to Silicon Valley, is providential for both the American economy and its military defense.

This development makes Israel one of America’s most important economic allies. Israel’s creativity now pervades many of the most powerful and popular new technologies, from personal computers to iPods, from the Internet to the medical center.

Early in 2009, for example, Intel launched a massive new advertising campaign to celebrate what it described as its most important advance since its initial invention of the microprocessor chip some 40 years ago: the new Core i7 device, code-named “Nehalem,” which combined leading-edge computing power with unprecedented economy of energy use. Like many of the inventions that have made Intel the world’s leading microchip company, the Core i7 was designed in Israel.

Israelis are also leaders in arguably the most important technology arena today, particularly for military uses. This is the ability of computers using parallelism to sense, accept, and process information as quickly as modern transmission techniques—especially fiber-optics lines—can deliver it. A representative device in this effort, and a powerful symbol of Israel’s leading position in Internet technology, is the “network processor.” Just as a Pentium microchip is the microprocessor that makes most PCs work, the network processor is the device that makes the next-generation Internet work, doing the vital routing and switching at network nodes. The next-generation Internet will allow “petaflops” (1015 floating-point operations per second) of real-time computational power to be deployed to virtually any point on the earth. The network processor will let any desktop computer access data and processing power exponentially greater than that incorporated in any PC or any single corporate data center.

The next-generation Internet and its associated technologies will be both the next great machine of capitalism and the next great weapon in its defense. Only by accepting and processing sensory data as fast as or faster than the human brain registering a glimpse of a known terrorist’s face buried beneath $100,000 worth of plastic surgery will computers make the leap from glorified adding machines to indispensable allies against the forces of chaos and terror. Leading the field are companies like Eli Fruchter’s EZchip (in which I have long been an investor), launched in the late 1990s with a few dollars, no customers, and a compelling PowerPoint presentation in lieu of any actual products. In less than a decade, EZchip drove most of its rivals—firms like Intel, Motorola, and IBM—to the sidelines, and welcomed the rest, like Cisco and Juniper, to its list of major customers.

During a trip to Israel in 2008, Fruchter, Amir Eyal, and Guy Koren of EZchip took me out to dinner in Caesarea. The restaurant was on the Mediterranean beach. Above the beach stood the ruins of Roman temples and terraces, theaters and arches, all surfaced with golden sandstone and carefully refurbished and illuminated. Shops and restaurants were decorously arrayed along the beach. The rush of water on the sand, the scent of fish in the air, the glow of sunset, and the lights on the Roman stone all lent the area a magical feeling of peace and prosperity.

I thought of Gaza, under 100 miles to the south, with similar beaches and balmy weather, and similar possibilities of human advance. Could the Gazans join the Israelis to create a Riviera on their exquisite beaches, their glowing sands? To do so, they would have to leave behind a world of zero-sum chimeras and fantasies of jihadist revenge. And they would discover that their greatest ally is a man long portrayed as their most feared enemy, a man who, having led for decades the fight to liberate Israeli Jews from self-destructive socialist resentment, now offers to bring all of Palestine and perhaps all of Arabia on the same journey.

Netanyahu’s vision is an Israel that, as a global financial center, could transform the economics of the Middle East. Israel could become a Hong Kong of the desert. Just as Hong Kong ultimately reshaped the Chinese economy in its own image when Deng Xiaoping mimicked its free economy, Israel could become a force for economic liberation in the Middle East, reaching out to Palestinians and other Arabs with the blandishments of commercial opportunity. After all, it has long been Israeli enterprise that has attracted Arabs to Palestine. Between 1967, when Israel took over the West Bank and Gaza Strip, and 1987, when the first intifada erupted, those two territories were one of the fastest-growing economies on earth. GDP surged 30 percent a year for a decade, the Arab population nearly tripled, six new universities were launched, and Arab longevity jumped from 43 years to 74.

Netanyahu has long believed that the peace process as we know it is irrelevant, focused on a handful of issues that breed anger and perpetuate conflict. Meanwhile, true peace—and the promise of a decent life—lies waiting to be picked up by those Palestinians and Israelis who are willing, and now increasingly able, to invest in creation over destruction.

George Gilder is the founding director of Gilder Technology Associates, a venture capital fund, and a contributing editor of Forbes. His books have sold more than 2 million copies worldwide. The newest is The Israel Test.