(FORTUNE Magazine) – With its hardwood floors, glass walls, and elegant French cuisine, Chloelys restaurant in Tel Aviv would be right at home in Santa Monica or South Beach-as would the players who frequent its tables. In one corner sits the former head of Shin Bet, Israel's FBI; at another table a lawyer-the son-in-law of former Prime Minister Yitzhak Rabin-is wooing a client; and a bigtime venture capitalist named Yossi Vardi walks around as if he owns the place. Chloelys is buzzing, but dishes like seafood-stuffed zucchini flowers only partly explain why. After a three-year slump brought on by the intifada and compounded by the bursting of the global tech bubble, Israel's economy is growing again, and its success has implications for both the U.S. and the entire Middle East.

Owner Victor Gloger says half-jokingly that things started getting better at Chloelys only when Yasir Arafat died last fall. Actually Israel started recovering before that, aided by new demand for its high-tech exports and by a series of free-market moves initiated by Finance Minister Benjamin Netanyahu. The Bush administration's decision to topple Saddam Hussein as well as the cease-fire announced in February by Israeli Prime Minister Ariel Sharon and Arafat's successor, Mahmoud Abbas, have helped, too, allowing Israel to spend 10% less on defense, reducing its budget deficit, and ultimately boosting growth. Israel is, as ever, a tense place: These days Sharon's plan to uproot thousands of Israelis from their homes in Gaza in August has Jewish extremists vowing to respond with violence-including, it is feared, attacks against Sharon himself. But the country's newfound prosperity has given even some Palestinians cause for hope.

But geopolitics isn't what's driving Israel's new boom. Economic growth couldn't have returned if the government hadn't found a way to block the suicide bombers who carried out dozens of attacks in 2002 and 2003. Thanks mostly to the controversial security barrier now snaking its way through the West Bank-a forbidding amalgam of concrete, barbed wire and deep ditches that has been condemned by the World Court and the European Union-deaths from bombings dropped from 54 last year to just 11 so far in 2005. "We are one of the few countries dealing successfully with the threat of suicide bombers," says Shlomo Maital, a Canadian-born economist and professor at Israel's Technion Institute of Management. The barrier has enraged Palestinians trapped on the other side, while reinforcing the Jewish state's pariah status in much of the world. But the sense of security ordinary Israelis now feel has enabled normal life to resume and made both tourists and foreign investors willing to come here again. "People feel better psychologically," says Gloger. "After the bombings and the invasion of the West Bank in 2002, the place was nearly empty. But business is up 35% this year."

The skills gained through reestablishing Israel's security haven't just helped merchants at home. They've been a key factor in allowing Israeli companies-from software designers to fence builders-to sell their wares throughout a terror-torn world. And that, in turn, has enabled this resource-poor country of just under seven million to prosper in the global economy.

In 2004, Israel's GDP grew by 4.2%, double Europe's growth rate. This year it's expected to rise by 3.8%, and Israeli companies are flexing their muscles worldwide. An Israeli real estate firm recently snapped up New York's Plaza hotel for more than a half-billion dollars. And last year Israeli pharma giant Teva purchased U.S. generic drugmaker Sicor for $3.4 billion. Lehman Bros. investment banker Len Rosen advised Teva on that deal, and Rosen says Lehman is aiming to have nine investment bankers based in Israel by year-end, up from five in 2002. "Last year was our best ever," says Rosen, whose team helped raise $1.7 billion in the U.S. for Israeli companies in 2004. Israel already has more companies listed on Nasdaq than any other foreign country except Canada, including six that have debuted since the beginning of 2004. Real estate is also rebounding, helped by lower mortgage rates and an influx of French Jews worried by signs of increasing anti-Semitism at home. Broker Yoav Etiel returned to Israel after 17 years in the U.S., setting up a company that caters to foreigners in the seaside town of Zichron Yaacov. "About half my business comes from abroad," he says, adding that prices for the homes he's selling are up 20% in the past year.

Like other veterans of the Israeli business scene, Lehman's Rosen makes a distinction between the current rebound and the one that followed the signing of the Oslo peace accord in 1993. "It's security that matters more than peace," says Rosen, echoing the argument that preventing terror attacks has helped the economy more than overtures to Palestinians and other Arab neighbors. "Back then people were looking for peace to provide growth. Now they're looking for security so violence doesn't curtail growth."

Security vs. peace may sound like a matter of semantics, but the debate will affect any eventual agreement with the Palestinians. Both the barrier and the planned withdrawal of Israeli settlements from the Gaza Strip are unilateral steps taken by Sharon to ensure Israel's security, replacing the negotiated peace process envisioned in Oslo. If Israel can make itself secure enough to enable the economy to grow, leaders like Netanyahu argue, a peace deal with the Palestinians becomes less urgent.

But anything less than a lasting peace won't ease the underlying anxiety that's a part of everyday life in Israel and clear the way for long-term prosperity. Out of sight beyond the barrier is a fast-growing population of more than 3.5 million Palestinians, suffering from 30% to 40% unemployment and increasingly drawn to fundamentalist Islamic groups like Hamas, which oppose any peace deal at all. The wall may have bought Israel time and allowed the economy to rebound, but few Israelis are ready to celebrate. "What if we're wrong and this is an illusion?" wonders Yoram Oron, an Israeli venture capitalist. "It doesn't take much."

On a clear day you can see the Palestinian town of Kalkilya from the ninth-floor cafeteria in the gleaming Ra'anana headquarters of Nice Systems, a high-tech firm that is typical of the companies driving Israel's economic rebound. While Nice is thriving by selling its data-recording and analysis systems worldwide, Kalkilya is completely surrounded by the wall, with just two entrances for its 40,000 citizens to pass through. In some places, 28-foot-high gray concrete slabs cut off Kalkilya from surrounding Palestinian villages; elsewhere it's a wire and mesh affair with remote electronic sensors that automatically detect anyone trying to circumvent it.

Although the fence itself isn't visible from Nice, the political situation is never far from anyone's thoughts there, not since one of Nice's employees died in a suicide bombing at a beachfront pub in Tel Aviv in 2003. "On the one hand, it showed how vulnerable we are," says Koby Huberman, Nice's corporate vice president for business development. "On the other hand, it showed how strong we are, because we managed to get through it as one big family. This is part of being an Israeli company."

For better or worse, Nice's Israeliness is also a selling point. The police departments, brokerage firms, and government agencies that buy its products want advice from a company that's on the front line of the war on terror-and Nice is dominating its niche. All incoming calls to the Los Angeles and New York City police departments are recorded on Nice technology, as are roughly 90% of the transactions at brokerage firms worldwide. Nice also sells systems for video surveillance and audio interception to government agencies, helping them sift for both visual and audio clues to potential security threats. Nice's earnings are expected to jump 36% in 2005, to $34 million, and its shares have doubled over the past 12 months.

For other companies the link between the war on terror and the bottom line is even more direct. Security firms like ISDS have developed a profitable niche selling their strategies to overseas clients that figure if anyone can defeat terrorists, it is veterans of Mossad, Israel's intelligence service. Leo Gleser, who founded ISDS after working as an air marshal for El Al and serving in the military, is currently advising Pemex, Mexico's national oil company, on how to improve its security procedures. Magal, the Nasdaq-listed company constructing the West Bank security barrier, also provided Buckingham Palace with its security system. Israeli companies will continue to prosper in this environment, selling the know-how they've acquired the hard way. "People believe we are the only ones who have experience testing this equipment in real life," says Magal CEO Jacob Even-Ezra.

That kind of success boosted Israel's exports last year by 16%, to $23.6 billion, according to Technion's Maital. High tech accounted for nearly half those sales, and Israeli firms have been aggressive in three of the hottest high-tech niches-Wi-Fi, WiMax, and VOIP, or voice over Internet Protocol. Alvarion, based in Tel Aviv and traded on Nasdaq, makes the base stations and other hardware that create Wi-Fi and WiMax hot spots. Another Nasdaq company, AudioCodes, provides both the algorithms that allow phone conversations to travel the Net, and the chips, routers, and other hardware carriers needed to supply VOIP to callers.

Much of that cutting-edge technology has its roots in research for Israel's military and security services. Nasdaq-listed Given Imaging developed a pill-sized camera that can be safely swallowed, allowing doctors to examine the small intestine while sparing patients more uncomfortable endoscopies. The vitamin-sized camera had its origins in missiles that beam back pictures to military controllers. Information-security software players like Aladdin and Check Point draw much of their talent from elite military units, and the founders of many startups often meet while still in uniform. The execs who started M-Systems, a creator of popular key-chain-sized memory devices, met in the Israeli navy.

As long as the authorities don't consider it a security threat, veterans are free to take what they've learned in the military and apply it to civilian life. "If you leave Cisco and start a company with what you've picked up, you'll face their lawyers," says Oron, the venture capitalist. "Here, if you leave the army and start a company, you'll get government support. There are no intellectual-property issues."

The supply of science-minded young men and women coming out of the army each year, as well as from top-notch universities like Haifa's Technion, has also led American companies such as Intel, Microsoft, and HP to build sizable R&D operations in Israel. Intel's Centrino technology was developed at a Haifa design center. Along with the homegrown talent, the exodus of Jews from the former Soviet Union brought Israel a bonanza of scientists and engineers. "More engineers came from Russia than Technion has graduated since it was founded in 1924," says Maital. "They were the rocket fuel for the tech industry."

Although Finance Minister Benjamin Netanyahu is among the most hawkish of Israeli politicians, he resists attributing the economic rebound to improved security or high-tech exports. Instead, he argues that his Reaganite recipe of spending, tax, and welfare reductions, along with the privatization of state enterprises, made nearly all the difference. "Ninety percent of the growth is because of what we've done domestically," Netanyahu says, sitting in his office at Israel's Finance Ministry, tie askew after a long day listening to the debate in the Knesset about the withdrawal from Gaza. Hearing this claim, Vice Prime Minister Ehud Olmert, a rival of Netanyahu's for the leadership of the conservative Likud Party when Sharon retires, can't resist tweaking him. "Only 90%? Bibi must be feeling modest."

Indeed, in a country where chutzpah is considered a virtue, Netanyahu stands out. "I take the accusation that I'm a Reaganite or a Thatcherite with great pride," he says, standing at a whiteboard in his office and discoursing on everything from the Laffer curve to evangelical Christian tourism to Moses Maimonides, the medieval Jewish philosopher. "We've gone from being a high-tax, monopolistic, bureaucratic welfare economy to a low-tax, low-welfare, open, and competitive economy," Netanyahu says. That's a bit premature. Although the tax burden on Israel's economy has been reduced by $4.1 billion since 2003, the top marginal income tax bracket is still 49%, compared with 35% in the U.S. And while dependency on American aid is decreasing, Israel received more than $2.7 billion from the U.S. last year, much of it in the form of grants for military hardware.

But Netanyahu has had undeniable success reducing Israel's welfare rolls and shaking off the legacy of decades of socialist economic policies. Over the past two years the percentage of the population on the dole has dropped from 6.5% to a more manageable 4.3%. Those spending reductions, along with cuts in the traditionally sacred defense budget, have reduced Israel's budget deficit from 5.6% of GDP in 2003 to an expected 3% this year. Not only has that helped Israel's international credit rating, it has also cut ten-year government-bond yields from 12% in March 2003 to 7.5% now, further stimulating domestic consumption.

The final element in Netanyahu's agenda has been to sell off government-held stakes in businesses like the Israel Discount Bank, telephone company Bezek, and El Al, the national airline. Netanyahu's program was heretical in a country founded on the communal sprit of the kibbutz, but the opposition Labor Party let it pass because it supported disengagement from Gaza and other dovish steps advocated by Netanyahu's boss, Prime Minister Sharon. "The Labor Party voted for the budget holding its nose," says Maital. Now, even business leaders who can't stand Netanyahu's hawkish political policies grudgingly admit they like his free-market agenda. When Netanyahu was Prime Minister from 1996 to 1999, "he made an unbelievable number of mistakes," says Tsvi Kan-Tor, a prominent Tel Aviv lawyer. "I couldn't see myself supporting him on anything. But since he's been confining himself to the economy, he's done a tremendous job. I was wrong, and I'm happy to admit it."

While business leaders like Kan-Tor admit prosperity is returning, there is still tremendous anxiety that a renewed wave of terror will halt the recovery in its tracks. "Here, being too much of an optimist is a disease that calls for immediate hospitalization," he says. "It's not hard to be optimistic-it's impossible."

The worries are never far from the surface. Even as companies like Nice thrive, the grandchildren of the Jews who fled here before the war and of the Holocaust survivors who came after are increasingly thinking about leaving. In many cases, the descendants of immigrants from European nations are eligible for dual citizenship, and the prospect of an EU passport is appealing. Twenty-eight-year-old Liron Ziv, whose father came to Israel from Romania in the 1950s, is in the process of getting a Romanian passport. "It's always good to have a plan B," he says. Although the unemployment rate is easing, good jobs are still hard to come by outside high tech. And Ziv, who fought in Lebanon and the West Bank before working on a farming kibbutz, is tired of politics and violence. "You feel the tension," he says. He'd like to try living in Holland. "It's peaceful-there's a lot of agriculture and a good economy," Ziv says. "If the papers are ready in a few months and I don't find anything in Jerusalem, maybe I'll go."

The coming months will be crucial in determining whether young people like Ziv envision their future in Israel. In August, when Sharon's government removes the Israeli settlements in Gaza-by force, if necessary-some fear that Israel could edge toward civil war. Just as worrisome would be a return to open confrontation with the Palestinians if the pullout doesn't go smoothly. But if the peace process does move forward, it will help both Israel's neighbors and the U.S. An Israel reaping the economic rewards of peace is more likely to favor a wider accommodation with the Arabs. Since America is so closely identified with Israel in the Arab world, any easing of Israeli-Arab tensions would help the U.S. throughout the Middle East, and especially in Iraq. And over the long term, a prosperous Israel might even forge closer trade ties with key U.S. allies such as Jordan and Egypt. That's the optimistic scenario-and ordinary Israelis are all too aware of what will follow if it doesn't materialize. "You can sense the mood in the country," says Maital. "For the first time in four years people are traveling domestically without fear of terror. They're not expecting it to last forever-they're just enjoying it now."

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