Last week, Secretary of State Hillary Clinton told Israeli Prime Minister-designate Benjamin Netanyahu that the U.S. does not want to be restricted by "old formulas" when it comes to the peace process. As she works on a new approach, she may want to ask why costly diplomatic efforts have not led to Israeli-Palestinian peace but to ongoing war.

Though billions of dollars in "aid" have flowed into the Palestinian territories, there is still no Palestinian state, nor security for Israel. With no effective restrictions on this aid, Palestinian leaders used it to bolster terrorist groups and fight Israel, rather than build their society.

In order to succeed -- finally -- peace efforts need to create positive incentives. An economic peace process can create such a reality, as it has in the past until political obsessions interrupted it.
[Mideast Peace Can Start With Economic Growth] Associated Press

Following Israel's conquest of the West Bank and the Gaza strip in 1967, Gen. Moshe Dayan wisely let the Palestinians manage their economic affairs. His "open bridges" policy facilitated the free movement of goods and people, and brought prosperity to the private sector. Hundreds of thousands of Palestinians were employed in Israel for much higher wages than under Jordanian and Egyptian rule. Living standards quintupled and agriculture, manufacturing, education, health and the status of women and children rapidly improved. Arabs enjoyed freedom of movement in Israel, yet there were practically no incidents of terrorism. Israelis shopped and ate in Arab towns. Their spending provided a lion's share of a skyrocketing Palestinian GDP.

This informal peace process was resisted, however, by traditional Palestinian elites. Modernization threatened their beliefs and their privileged status. Then, in 1987, an economic recession and harsher interference by Israeli bureaucracy in Arab life ignited an intifada that was taken over and politicized by the Palestinian Liberation Organization (PLO). Yasser Arafat's PLO killed whatever economic cooperation remained.

Today, many policy makers advocate a total separation between Israel and the Palestinians. But the latter cannot develop a prosperous economy and a viable state in economic isolation. Separation will result in economic ruin, as has already happened in Gaza. Israel and the West Bank are simply too small and too geographically integrated to support two economically divided entities. The fates of Israelis and the Palestinians are economically intertwined.

Jerusalem provides a good model of economic integration. The city has a large population of Israeli Jews and Palestinian Arabs living in close proximity. The latter are ardent Muslims, and most Jews in Jerusalem do not belong to the peace camp. Yet despite strenuous efforts by Palestinian terrorist organizations to inflame the city with repeated attacks, income from tourism has been so rewarding that Jerusalemites coexist without too many problems.

Wide-scale prosperity can come to the West Bank and Gaza by providing direct aid to Palestinian families still living in refugee camps. Unlike previous failed attempts, when aid was given to a corrupt Palestinian Authority, refugee families should get cheap loans and/or grants. Infrastructure construction should be allotted by competitive bidding to small and medium-sized Palestinian firms, not to politically connected mega-contractors. And to further perpetuate economic growth, the monopolies that now strangle both the Israeli and the Palestinian economies (often the same ones) must be broken.

For centuries, civilized Europeans slaughtered one another and political solutions were unable to stop the carnage. Then the creation of a European economic community shifted political priorities and peace came to reign. A similar process can lead, again, to peaceful developments in the Middle East. With no viable alternatives it's certainly worth trying.

Mr. Doron, president of the Israel Center for Social and Economic Progress, is writing "Profits of Peace," a book about the economic peace process.