Technology companies and global investors are beating a path to Israel and finding unique combinations of audacity, creativity, and drive everywhere they look. Which may explain why, in addition to boasting the highest density of start-ups in the world (a total of 3,850 start-ups, one for every 1,844 Israelis), more Israeli companies are listed on the NASDAQ exchange than all companies from the entire European continent.

And it’s not just the New York stock exchanges that have been drawn to Israel, but also the most critical and fungible measure of technological promise: venture capital.

In 2008, per capita venture capital investments in Israel were 2.5 times greater than in the United States, more than 30 times greater than in Europe, 80 times greater than in China, and 350 times greater than in India. Comparing absolute numbers, Israel—a country of just 7.1 million people—attracted close to $2 billion in venture capital, as much as flowed to the United Kingdom’s 61 million citizens or to the 145 million people living in Germany and France combined. And Israel is the only country to experience a meaningful increase in venture capital from 2007 to 2008.

After the United States, Israel has more companies listed on the NASDAQ than any other country in the world, including India, China, Korea, Singapore, and Ireland, as figure I.2 shows. And, as figure I.3 makes clear, Israel is the world leader in the percentage of the economy that is spent on research and development.

Israel’s economy has also grown faster than the average for the developed economies of the world in most years since 1995.

Even the wars Israel has repeatedly fought have not slowed the country down. During the six years following 2000, Israel was hit not just by the bursting of the global tech bubble but by the most intense period of terrorist attacks in its history and by the second Lebanon war. Yet Israel’s share of the global venture capital market did not drop—it doubled, from 15 percent to 31 percent. And the Tel Aviv stock exchange was higher on the last day of the Lebanon war than on the first, as it was after the three-week military -operation in the Gaza Strip in 2009.

The Israeli economic story becomes even more curious when one considers the nation’s dire state just a little over a half century ago. At the time, the fledgling Jewish state simultaneously faced two seemingly insurmountable challenges: fighting an existential war for independence and absorbing masses of refugees from postwar Europe and the surrounding Arab countries.

Israel’s population doubled in the first two years of its existence. Over the next seven years, the country grew by another third. Two out of three Israelis were new arrivals. Right off the boat, many refugees were given a gun they had no idea how to use and sent to fight. Some of those who had survived Nazi concentration camps fell in battle even before their names could be recorded. Proportionately, more Israelis died in the war for Israel’s establishment than Americans in both world wars combined.

Those who survived had to struggle to thrive in a stagnant economy. “Everything was rationed,” complained one new arrival. “We had coupon books, one egg a week, long lines.” The average standard of living for Israelis was comparable to that of Americans in the 1800s. How, then, did this “start-up” state not only survive but morph from a besieged backwater to a high-tech powerhouse that has achieved fiftyfold economic growth in sixty years? How did a community of penniless refugees transform a land that Mark Twain described as a “desolate country . . . a silent, mournful expanse,” into one of the most dynamic entrepreneurial economies in the world?

The fact that this question has been treated only in piecemeal fashion is unbelievable to Israeli political economist Gidi Grinstein: “Look, we doubled our economic situation relative to America while multiplying our population fivefold and fighting three wars. This is totally unmatched in the economic history of the world.” And, he told us, the Israeli entrepreneur continues to perform in unimaginable ways.

While the Holy Land has for centuries attracted pilgrims, lately it has been flooded by seekers of a different sort. Google’s CEO and chairman, Eric Schmidt, told us that the United States is the number one place in the world for entrepreneurs, but “after the U.S., Israel is the best.” Microsoft’s Steve Ballmer has called Microsoft “an Israeli company as much as an American company” because of the size and centrality of its Israeli teams. Warren Buffett, the apostle of risk aversion, broke his decades-long record of not buying any foreign company with the purchase of an Israeli company—for $4.5 billion—just as Israel began to fight the 2006 Lebanon war.

It is impossible for major technology companies to ignore Israel, and most haven’t; almost half of the world’s top technology companies have bought start-ups or opened research and development centers in Israel. Cisco alone has acquired nine Israeli companies and is looking to buy more.

“In two days in Israel, I saw more opportunities than in a year in the rest of the world,” said Paul Smith, senior vice president of Philips Medical. Gary Shainberg, British Telecom’s VP for technology and innovation, told us, “There are more new innovative ideas, as opposed to recycled ideas—or old ideas repackaged in a new box—coming out of Israel than there are out in [Silicon] Valley now. And it doesn’t slow during global economic down-turns.”

Though Israel’s technology story is becoming more widely known, those exposed to it for the first time are invariably baffled. As an NBC Universal vice president sent to scout for Israeli digital media companies wondered, “Why is all this happening in Israel? I’ve never seen so much chaos and so much innovation all in one tiny place.”

That is the mystery this book aims to solve. Why Israel and not elsewhere?

One explanation is that adversity, like necessity, breeds inventiveness. Other small and threatened countries, such as South Korea, Singapore, and Taiwan, can also boast growth records that are as impressive as Israel’s. But none of them have produced an entrepreneurial culture—not to mention an array of start-ups—that compares with Israel’s.

Some people conjecture that there is something specifically Jewish at work. The notion that Jews are “smart” has become deeply embedded in the Western psyche. We saw this ourselves; when we told people we were writing a book about why Israel is so innovative, many reacted by saying, “It’s simple—Jews are smart, so it’s no surprise that Israel is innovative.” But pinning Israel’s success on a stereotype obscures more than it reveals.

For starters, the idea of a unitary Jewishness—whether genetic or cultural—would seem to have little applicability to a nation that, though small, is among the most heterogeneous in the world. Israel’s tiny population is made up of some seventy different nationalities. A Jewish refugee from Iraq and one from Poland or Ethiopia did not share a language, education, culture, or history—at least not for the two previous millennia. As Irish economist David McWilliams explains, “Israel is quite the opposite of a unidimensional, Jewish country. . . .  It is a monotheistic melting pot of a diaspora that brought back with it the culture, language and customs of the four corners of the earth.”

While a common prayer book and a shared legacy of persecution count for something, it was far from clear that this disparate group could form a functioning country at all, let alone one that would excel at—of all things—teamwork and innovation.

Indeed, Israel’s secret seems to lie in something more than just the talent of individuals. There are lots of places with talented people, certainly with many times the number of engineers that Israel has to offer. Singaporean students, for example, lead the world in science and mathematics test scores. Multinationals have set up shop in places like India and Ireland, too. “But we don’t set up our mission critical work in those countries,” an American executive from eBay told us. “Google, Cisco, Microsoft, Intel, eBay . . . the list goes on. The best-kept secret is that we all live and die by the work of our Israeli teams. It’s much more than just outsourcing call centers to India or setting up IT services in Ireland. What we do in Israel is unlike what we do anywhere else in the world.”

Another commonly cited factor in Israel’s success is the country’s military and defense industry, which has produced successful spin-off companies. This is part of the answer, but it does not explain why other countries that have conscription and large militaries do not see a similar impact on their private sectors. Pointing to the military just shifts the question: What is it about the Israeli military that seems to foster entrepreneurship? And even with the influence of the military, why is it that defense, counterterrorism, and homeland security companies today represent less than 5 percent of Israel’s gross domestic product?

The answer, we contend, must be broader and deeper. It must lie in the stories of individual entrepreneurs like Shai Agassi, which are emblematic of the state itself. As we will show, it is a story not just of talent but of tenacity, of insatiable questioning of authority, of determined informality, combined with a unique attitude toward failure, teamwork, mission, risk, and cross-disciplinary creativity. Israel is replete with such stories. But Israelis themselves have been too busy building their start-ups to step back and try to stitch together how it happened and what others—governments, large companies, and start-up entrepreneurs—can learn from their experience.

It would be hard to imagine a time when understanding the story of Israel’s economic miracle could be more relevant. While the United States continues to be rated the world’s most competitive economy, there is a widespread sense that something fundamental has gone wrong.

Even before the global financial crisis that began in 2008, observers of the innovation race were sounding alarms. “India and China are a tsunami about to overwhelm us,” predicted Stanford Research Institute’s Curtis Carlson. He forecasts that America’s information technology, service, and medical-devices industries are about to be lost, costing “millions of jobs . . . like in the 1980s when the Japanese surged ahead.” The only way out, says Carlson, is “to learn the tools of innovation” and forge entirely new, knowledge-based industries in energy, biotechnology, and other science-based sectors.

“We are rapidly becoming the fat, complacent Detroit of nations,” says former Harvard Business School professor John Kao. “We are . . . milking aging cows on the verge of going dry . . . [and] losing our collective sense of purpose along with our fire, ambition, and determination to achieve.”

The economic downturn has only sharpened the focus on innovation. The financial crisis, after all, was triggered by the collapse of real estate prices, which had been inflated by reckless bank lending and cheap credit. In other words, global prosperity had rested on a speculative bubble, not on the productivity increases that economists agree are the foundation of sustainable economic growth.

According to the pioneering work of Nobel Prize winner Robert Solow, technological innovation is the ultimate source of productivity and growth. It’s the only proven way for economies to consistently get ahead—especially innovation born by start-up companies. Recent Census Bureau data show that most of the net employment gains in the United States between 1980 and 2005 came from firms younger than five years old. Without start-ups, the average annual net employment growth rate would actually have been negative. Economist Carl Schramm, president of the Kauffman Foundation, which analyzes entrepreneurial economics, told us that “for the United States to survive and continue its economic leadership in the world, we must see entrepreneurship as our central comparative advantage. Nothing else can give us the necessary leverage.”

It is true that there are many models of entrepreneurship, including microentrepreneurship (the launching of household businesses) and the establishment of small companies that fill a niche and never grow beyond it. But Israel specializes in high-growth entrepreneurship—start-ups that wind up transforming entire global industries. High-growth entrepreneurship is distinct in that it uses specialized talent—from engineers and scientists to business managers and marketers—to commercialize a radically innovative idea.

This is not to suggest that Israelis are immune from the universally high failure rate of start-ups. But Israeli culture and regulations reflect a unique attitude to failure, one that has managed to repeatedly bring failed entrepreneurs back into the system to constructively use their experience to try again, rather than leave them permanently stigmatized and marginalized.

As a recent report by the Monitor Group, a global management consulting firm, described it, “When [entrepreneurs] succeed, they revolutionize markets. When they fail, they still [keep] incumbents under constant competitive pressure and thus stimulate progress.” And the Monitor study shows that entrepreneurship is the main engine for economies to “evolve and regenerate.”

The question has become, as a BusinessWeek cover put it, “Can America Invent Its Way Back?” The magazine observed that “beneath the gloom, economists and business leaders across the political spectrum are slowly coming to an agreement: Innovation is the best—and maybe the only—way the U.S. can get out of its economic hole.”

In a world seeking the key to innovation, Israel is a natural place to look. The West needs innovation; Israel’s got it. Understanding where this entrepreneurial energy comes from, where it’s going, how to sustain it, and how other countries can learn from the quintessential start-up nation is a critical task for our times.

From the book Start-Up Nation, Copyright (c) 2009 by Dan Senor and Saul Singer. Reprinted by permission of Twelve Books/Hachette Book Group, New York, NY. All rights reserved