Israel is facing the biggest erosion of its strategic environment since its founding. It is alienated from its longtime ally Turkey. Its archenemy Iran is suspected of developing a nuclear bomb. The two strongest states on its border — Syria and Egypt — are being convulsed by revolutions. The two weakest states on its border — Gaza and Lebanon — are controlled by Hamas and Hezbollah.

It was in this context that Prime Minister Benjamin Netanyahu went before the Knesset last Wednesday and argued that the Arab awakening was moving the Arab world “backward” and turning into an “Islamic, anti-Western, anti-liberal, anti-Israeli, undemocratic wave.” Ceding territory to the Palestinians was unwise at such a time, he said: “We can’t know who will end up with any piece of territory we give up.”

Netanyahu added: “In February, when millions of Egyptians thronged to the streets in Cairo, commentators and quite a few Israeli members of the opposition said that we’re facing a new era of liberalism and progress. They said I was trying to scare the public and was on the wrong side of history and don’t see where things are heading.” But, he told the Knesset, events had proved him correct. Netanyahu reportedly said that when he cautioned President Obama and other Western leaders against backing the uprising against Egypt’s then-president, Hosni Mubarak, he was told that he didn’t understand reality: “I ask today, who here didn’t understand reality?”

Netanyahu’s analysis of the dangers facing Israel is valid, and things could still get worse. What is wrong is Netanyahu’s diagnosis of how it happened and his prescription of what to do about it — and those blind spots could also be very dangerous for Israel.

Diagnosis: From the very start, Israeli officials have insisted that Obama helped to push Mubarak out rather than saving him. Nonsense. The Arab dictators were pushed out by their people; there was no saving them. In fact, Mubarak had three decades to gradually open up Egyptian politics and save himself. And what did he do? Last year, he held the most-rigged election in Egyptian history. His party won 209 out of 211 seats. It is amazing that the uprising didn’t happen sooner.

Israel’s fear of Islamists taking power all around it cannot be dismissed. But it is such a live possibility precisely because of the last 50 years of Arab dictatorship, in which only Islamists were allowed to organize in mosques while no independent, secular, democratic parties were allowed to develop in the political arena. This has given Muslim parties an early leg up. Arab dictators were convenient for Israel and the Islamists — but deadly for Arab development and education. Now that the lid has come off, the transition will be rocky. But, it was inevitable, and the new politics is just beginning: Islamists will now have to compete with legitimate secular parties.

Netanyahu’s prescription is to do nothing. I understand Israel not ceding territory in this uncertain period to a divided Palestinian movement. What I can’t understand is doing nothing. Israel has an Arab awakening in its own backyard in the person of Prime Minister Salam Fayyad of the Palestinian Authority. He’s been the most radical Arab leader of all. He is the first Palestinian leader to say: judge me on my performance in improving my peoples’ lives, not on my rhetoric. His focus has been on building institutions — including what Israelis admit is a security force that has helped to keep Israel peaceful — so Palestinians will be ready for a two-state solution. Instead of rewarding him, Israel has been withholding $100 million in Palestinian tax revenues that Fayyad needs — in punishment for the Palestinians pressing for a state at the U.N. — to pay the security forces that help to protect Israel. That is crazy.

Israel’s best defense is to strengthen Fayyadism — including giving Palestinian security services more areas of responsibility to increase their legitimacy and make clear that they are not the permanent custodians of Israel’s occupation. This would not only help stabilize Israel’s own backyard — and prevent another uprising that would spread like wildfire to the Arab world without the old dictators to hold it back — but would lay the foundation for a two-state solution and for better relations with the Arab peoples. Remember, those Arab peoples are going to have a lot more say in how they are ruled and with whom they have peace. In that context, Israel will be so much better off if it is seen as strengthening responsible and democratic Palestinian leaders.

This is such a delicate moment. It requires wise, farsighted Israeli leadership. The Arab awakening is coinciding with the last hopes for a two-state solution between Israelis and Palestinians. Israeli rightists will be tempted to do nothing, to insist the time is not right for risk-taking — and never will be — so Israel needs to occupy the West Bank and its Palestinians forever. That could be the greatest danger of all for Israel: to wake up one day and discover that, in response to the messy and turbulent Arab democratic awakening, the Jewish state sacrificed its own democratic character.