(FORTUNE Magazine) – ISRAELIS are facing up to a new kind of war. A decade of hyperinflation has brought the country close to economic Armageddon. Now Israel is battling back. ''We don't have the luxury of watching our economy sink slowly into the mud like Britain or Belgium,'' says Daniel Doron, director of the Israel Center for Social and Economic Progress, a Tel Aviv-based think tank. ''Surrounded by enemies, Israel either prospers or dies.'' Inflation has come down from 445% in 1984 to around 19%, thanks to what the government called an emergency stabilization program that temporarily froze prices and rolled back most wages by 25%. The budget was nearly balanced in 1986, Israel's best performance in a dozen years. And in December the National Unity government, a coalition of Prime Minister Yitzhak Shamir's nationalist Likud faction and Foreign Minister Shimon Peres's left-leaning Labor party, unveiled a new reform program that has a lot in common with Reaganomics and the free-market policies now spreading across Europe. The government plans to reduce spending and cut taxes, among other things, to unleash Israel's formidable brainpower and entrepreneurial drive. Safeguarding the economy does not come as naturally to Israeli politicians as, say, defending the Golan Heights. The joke in Jerusalem is that Prime Minister Shamir is a big improvement over predecessor Menachem Begin on economics. When the subject came up in cabinet meetings, the story goes, Begin's eyes glazed over within three seconds. Shamir's eyes stay focused for six seconds. Back in the Prime Minister's office for a second time, Shamir seems to have learned that he cannot run away from the economy, boring as it may be to him. ''Restoring economic health is the raison d'etre of this government,'' he told FORTUNE. Shamir has a powerful incentive to succeed. In a unique aspect of the Unity government, Shamir, who followed the ailing Begin as Prime Minister in 1983, had to split the job with Peres after the indecisive national election the following summer. Peres served first, turning the office back to Shamir last October, though Peres stayed in the cabinet. In his two years, Peres's approval rating soared from below 45% to 73%, largely because of the drop in inflation. Polls show that more than three-quarters of Israeli voters support the stabilization program and want to see it continue. Shamir knows that if he can produce more economic miracles between now and the next general election in October 1988, he and the Likud party stand to inherit that popularity. It helps that both parties now recognize that the country's economic problems have more complex roots than the drain of outsize defense budgets. Defense spending is huge; $3.8 billion last year, or 18% of GNP, vs. 6% for the U.S. But defense should not take all the blame. The early Zionist pioneers were romantic socialists who set out to build an egalitarian society. It turned into a full-blown European-style welfare state. In Israel's open- collared, full-throated democracy, party alliances were cemented with government patronage. To attract the votes of new immigrants, politicians shoveled out the cash. Idealism faded as later arrivals clamored for what Israelis call ''the three Vs'' -- videos, villas, and Volvos. By the early 1980s rising personal incomes far outpaced productivity. In 1984 GNP growth slumped to zero from a 6% annual rate in the previous decade. Israel's powerful labor union, Histadrut, which represents more than 90% of Israeli workers, fought for and got a nationwide cost-of-living package that tied wages to the roaring inflation rate. Between 1980 and 1985, nominal wages shot up 220 times, as inflation exploded to a monthly rate of 27.5% by the summer of 1985. Business planning went out the window. ''We had no idea what the numbers were telling us,'' says Eli Hurwitz, chairman of Bank Leumi, one of Israel's largest commercial banks. National debt rose to $60 billion, almost 2 1/2 times Israel's GNP. The Bank of Israel increased the money supply by more than 600% between 1984 and 1986. With a trade deficit approaching $4 billion and ordinary Israelis abandoning the shekel in favor of the dollar, foreign currency reserves evaporated. ''I couldn't see a ray of hope,'' says Peres. ''My best friends -- some of whom are economists -- warned that it would be political suicide to try to clean up the mess.'' HE TRIED ANYWAY, and made stunning progress. The price freeze drastically slowed inflation without leading to shortages. The wage reductions gave employers breathing space and helped avoid a sharp rise in unemployment. Meanwhile, the government slashed subsidies to business from $1.1 billion to around $400 million. The cabinet quietly abandoned its old habit of voting quarterly supplementary budgets to cover shortfalls as ministry budgets were gobbled up by inflation. New legislation gives the central bank independence to resist the Treasury's pressures for monetary expansion. The success of the stabilization program owes as much to pure luck as to newfound political will. Low prices chopped Israel's oil bill from $1.25 billion in 1985 to around $600 million last year. The weaker U.S. dollar, to which the shekel is linked, helped Israel postpone until this January a currency devaluation that would have further hurt its balance of payments. The Unity government's tax cuts are aimed at the right target. Israel's tax system is one of the most burdensome in the world. By slapping some 200 new levies on goods and services to balance the budget last year, the government increased its tax take from 48% of GNP to 58%. Many Israelis supplement meager paychecks with earnings from Israel's flourishing underground economy -- and by cheating the taxman. Informal estimates of tax evasion reckon that about a fifth of all income goes unreported. Finance Minister Moshe Nissim's new tax reform proposal would simplify the tax system and reduce the top rate from 60% to 45%. ISRAEL is turning to business for some tasks the government has not been able to do very well itself. For years geological studies surmised that vast reserves of oil and natural gas lay buried deep in the Negev desert. But no major international oil company cared to drill, for fear of irritating oil- rich Arab states. Israel's only significant oil find was a 100-million- barrel field in the Sinai, which Israel returned to Egypt as part of the 1979 Camp David Accord.

The government has given a lease on a two-million-acre tract, equal to 40% of ! Israeli territory, to a private consortium called Isramco. The outfit is no Exxon. Its headquarters is a paper-strewn rabbit warren occupying half a floor of a nondescript Tel Aviv office building. But Isramco's founder, an Israeli named Joseph Elmaleh, has lined up $12 million in private money from a dozen U.S. backers, including Occidental Petroleum chief Armand Hammer. Over the past 18 months Isramco has identified eight drilling prospects. ''We may yet see the day when an Israeli becomes head of OPEC,'' jokes Elmaleh. ''I'm thinking of changing my name to 'Sheikh Joseph.' '' Israel is trying hard to boost exports and attract new investment. Tariffs on goods traded with the Common Market have been dropping, and will reach zero by the end of 1988. A trade agreement with the U.S., signed in 1985, will phase out duties on U.S.-Israeli trade over a ten-year period. The incentives appear to be working already. Murray Lender, the Connecticut ''Bagel King'' who sold his bakery to Kraft three years ago, is setting up a trading company to market Israeli food products to American supermarket chains and boost Israel's $57-million food exports to the U.S. In June, The Limited, the Columbus, Ohio-based women's clothing retailer, opened a $2-million textile factory with Israeli partners in a depressed area near the Sea of Galilee. If the factory's 160 unskilled workers can match the efficiency of The Limited's plants in Mexico and the Far East, the company says it will increase its investment to $10 million. The ultimate weapon in Israel's economic arsenal is the brainpower and entrepreneurial zeal of its work force. Israel may well have more MIT graduates per capita than any country besides the U.S. IBM, Digital Equipment, Intel, National Semiconductor, and Motorola have established computer design centers in the new industrial parks mushrooming around Jerusalem and Tel Aviv. ''In the U.S. people talk about creativity as a trait one strives to acquire,'' says Intel director of operations Dov Frohman. ''In Israel creativity is a prerequisite for survival.'' He claims his Israeli- trained engineers are second to none in coming up with innovative technical solutions.

Israelis are starting to relearn old selling skills that sustained Jews in the Diaspora. Gil Weiser, Digital Equipment's Israel-born general manager, had trouble finding skilled salespeople when he set up DEC's Israeli subsidiary in 1972. Weiser thinks Israelis disdained selling because it revived unpleasant - memories of the pushcart peddler tradition of the East European shtetls. ''When the new settlers came to Israel,'' says Weiser, ''they wanted to get their hands dirty farming for a change. Now marketing is being seen as respectable again.'' Israel is also breeding entrepreneurs who are turning out ingenious new products. Luz Industries, the world's only producer of large-scale solar energy systems, has signed 19 agreements to sell power to Southern California Edison. Luz plans to build $1 billion of solar fields in the Mojave Desert by 1992. Like many new Israeli companies, Luz handles sales and financing out of its U.S. office, in Los Angeles, and does manufacturing and R&D in Israel. Luz co-founder Arnold Goldman, a Rhode Island-born former Litton Industries engineer who settled in Jerusalem in 1977, claims that Luz can produce solar- generated electricity at a price equivalent to $18-a-barrel oil, and he aims to bring the cost down by 25% over the next five years. Israel's young start-up companies are free of unions and reward performance with bonuses and stock options. But Israeli entrepreneurs are driven by more than the lure of great personal wealth. ''They don't want three homes and a yacht,'' says Ed Mlavsky, director of the Israel-U.S. Binational Industrial Research and Development Foundation, an agency that helps Israeli companies develop ties with the U.S. ''They want to build a nation, a motive more attractive and more powerful than sheer venality.'' Boaz Misholi, an energetic 35-year-old computer engineer with a gung-ho Silicon Valley style, typifies the new spirit. In 1982 he started Efrat Future Technology, a manufacturer of a pioneering voice-activated electronic mail system. The U.S. is his biggest market. ''It's harder to do business from Israel,'' Misholi says, ''but my roots are here, and everything else is secondary.'' One statistic Israelis pay a lot of attention to is the government's annual accounting of net migration -- the difference between the number of Jews settling in Israel and the number who leave. Lately the numbers have been discouraging. Last year more left than arrived for the third time since 1980. Government experts think economic uncertainty drives people out, rather than the rigors of living at the flashpoint of Mideast tensions, and that the net outflow will continue in 1987. Will Israel prosper or perish? Emanuel Sharon, top civil servant in the Finance Ministry and an architect of the stabilization program, draws two very different scenarios for the coming year. In Sharon's hopeful view, Israel will succeed in pushing its inflation rate down to around 5% and run a surplus of goods and services of some $500 million. In his gloomy view, inflation will climb toward 40%, bringing deficits of $500 million and the threat of another run on foreign currency reserves. If the worst happens, says Sharon, ''we'll be back to square one.'' The Israelites are not out of the wilderness yet.