"We have no economic experience with this event," says Prof. Rafi Melnick. "The global economy has no experience with it, either. It differs significantly from the 1930s crisis, although the extent of the damage that it will cause can reach the same scale."
Melnick, a former provost at the Herzliya Interdisciplinary Center, has a profound knowledge of the Israeli economy. He served on the Bank of Israel Monetary Committee, was an adviser to the minister of finance and the Prime Minister's Office, and held a series of senior positions in Israeli financial corporations. He developed the "Melnick Index," which evaluates the level of activity in the Israeli economy in real time. We asked him to analyze in simple terms what distinguishes the current crisis from other crises, how deep the coming recession will be, and how decision-makers can cope with it.
"Today's events," he says, "begin with direct damage to production - what economists call the supply side. Supply chains are not arriving, because people are in isolation and are not going to work. Plants are closing, not because of a lack of demand, but simply because they are shutting down production. As a result of the damage to the supply side, output is falling, and the world is going into recession. The question of whether this recession will develop into a bigger crisis depends on how we respond."
Melnick says that the problem is that "all of the usual tools for handling an economic recession are not so effective, because fiscal and monetary policy won't get people back to the factories."
"Globes": Explain what you mean.
Melnick: "Usually, when the economy slows down or goes into a recession, there are two tools at the policymakers' disposal. The first is the fiscal side, meaning the state budget. In a recession, it is recommended to increase government spending, reduce the tax burden, and increase the deficit, so that the economy receives the missing demand and resumes normal activity. In other words, if demand from the private sector vanishes, the government can enter the vacuum and try to make up for what's missing.
In addition to the government, which controls the budget, there are the central banks, which are responsible for monetary policy, and can also contribute when there are problems with demand. "On the monetary side," Melnick explains, "cutting the interest rate encourages demand by lowering financing expenses, thereby easing the situation."
When the problem comes from the supply side, however, things get more complicated. "These tools are of no help at all when there is direct damage to the supply side. The problem is how to put the business back into action. I don't know if economists have tools for dealing with this challenge. We'll have to get through it somehow, and try to ease matters, so that an element of demand isn't added as well."
How is this liable to happen?
"First of all, people are living in uncertainty, fear, and anxiety, so they're saving more. As a result, the demand for private consumption is dropping, and this is further aggravating the situation." To the decrease in private demand, Melnick adds the decline in investment by the business sector, which is not making new investments. "There are fears in both consumption and investment, which will further aggravate the recession. We add to this the fact that unemployment will lower income, and that will further depress demand," he says.
Melnick says that this combination is liable to do "great damage to the economy and deepen the recession, depending on the length of time that the world will be more or less in closure. I have no idea how long this will continue. It's a matter for the doctors. The longer we're in closure, though, the deeper the recession will be."
There is concern that even when we can leave home, the economy will not return to what it was.
"In the positive scenario, a vaccine or drugs that can treat the disease effectively will be found. If either of these two things happens, the return to activity will be very rapid." Before the outbreak of the epidemic, Melnick says, the world, and certainly the Israeli economy, was not in a crisis. "We were in a slowdown, but the world was more or less growing. Unemployment was low, and we had more or less overcome the 2008-2009 crisis. The factories that have been closed down now were not closed because of a crisis, but because people didn't go to work. As soon as people go back to work, the economy will emerge very quickly from the problem."
Meanwhile, however, there are hundreds of thousands of unemployed, and companies are going bankrupt. It will be hard to renew activity.
"This is really where government policy comes into play. Up until now, the economists' mantra was a "balanced budget." The balanced budget did quite well for us. We had quite a few achievements, especially in Israel. Today, however, the government has to take the mantra of (former European Central Bank President) Mario Draghi, who said that he would do 'everything necessary' to put the economy back into action. The deficit isn't what's important now. In Israel, we have more degrees of freedom than the rest of the world, because we're entering this period with a relatively low ratio of debt to GDP. The government has to inject demand, inject money, and even money directly for households, so that unemployment doesn't affected private consumption."
A financial crisis must be prevented
What is the scale of the recession that you foresee?
"There is no doubt that there will be a real decline in economies' output, including in Israel. There is no doubt that there will be a very significant rise in the unemployment rates. Fortunately, the world is entering this situation with relatively low inflation, so the starting point is all right. But unemployment rates will rise - I don't want to make estimates, but it will definitely be over 10%. In the 2008-2009 crisis, global unemployment rates exceeded 10%, but not in Israel. This time, it will also happen here."
Governments around the world have already committed themselves to a major assistance plan. What is needed here?
"The first thing, and this is critical, is to prevent the crises from developing into a financial crisis - at all costs. All of the conclusions that we drew from an analysis of business cycles in history show us that when the recession is accompanied by a financial crisis, it is much worse. The government should therefore supply the necessary liquidity to banks, financial concerns, and businesses. The government moved in this direction when it gave guarantees for credit, but I think that it's not enough."
"The problem wasn't the availability of credit; it was the cost of credit. In my opinion, the government should provide resources for providing credit without interest in order to prevent the collapse of good businesses through the banks, because the banks can tell which businesses are better and which aren't so good. If good businesses fail because of liquidity problems, it will be very bad, because when we emerge from the crisis, these businesses will no longer exist. In other words, I propose providing interest-free loans through the banks, or through a committee, with participation from the Bank of Israel, that will be able to spot good businesses in order to assist them.
"Furthermore, tax payments, VAT, income tax advances, and municipal property tax should be postponed immediately. All of the measures taken are in the right direction, and should be expanded. To demand today that businesses allot liquidity to tax payments is something that will only worsen the crisis.
"In addition, the period of eligibility for unemployment compensation should be significantly lengthened. If I compare Israel's welfare policy to what prevails in Europe, we're very stingy in both the duration of eligibility and in the conditions for eligibility for unemployment benefits. We have to do exactly the opposite. We have to be generous with both the unemployed and people put on unpaid leave.
"Finally, I think that the government should also take action to reduce anxiety and panic as much as possible. The market is trying to assess the depth of the crisis, and to correctly price assets. If the government reduces panic, however, it will help."
The markets are plummeting.
"There are three basic factors in the falls on the stock exchanges. In the past two years, there was a kind of bubble in the markets, and part of what's happening now is that this bubble is deflating. Another factor is the market's assessment of the coming recession. The third factor is panic. We can't do much about the first two factors, but we can do something about the third. If the government proposes a well thought-out plan, it will alleviate the panic. The question is whether a leader will come and present to the people a well-constructed and credible overall plan, so that the market will respond correctly, not all sorts of nonsense about how sneezing spreads germs."
Bank of Israel should even buy shares
As for the Bank of Israel, Melnick says, "The problem on the monetary side is that there aren't many degrees of freedom. Interest rates are close to zero, and you can't cut them. I think that we'll have to repeat what we did in 2008 - quantitative easing. The Bank of Israel will have to enter the markets and buy bonds in order to prevent the market from collapsing. I'm so extreme in this policy that I wouldn't rule out the option of the central bank buying shares - not in order to protect the shareholders - the goal is to prevent panic, a financial crisis, and collapse of enterprises."
This week, the Bank of Israel used the foreign currency reserves to inject liquidity into the financial sector. In retrospect, what do you have to say about the Bank of Israel's purchases of dollars?
"This policy contributed to the economy's good performance. When I look at it today, Israel's $130 billion in reserves are a great asset for financial and economic stability."
You spoke about giving money directly to households. This sounds like what they call dropping money from helicopters.
"I don't rule out direct payment to households. Instead of collecting taxes, the government can distribute a negative tax. Why am I saying these strange things now? Because I look at the 1930s, when conservatism ruled policy. The government continued its balanced budget policy, and the central bank didn't inject liquidity into the system. The world remained in a crisis for a decade, and the US reached 25% unemployment. Our lesson from history is not to do what they did then - to do exactly the opposite."
The Melnick plan - Measures for dealing with the approaching crisis
1. The government should do whatever is needed to get the economy going again. The deficit is not a consideration.
2. The government should inject demand, inject money, and even money directly into households.
3. The government should find a way to provide resources through the banks of interest-free credit in order to prevent good businesses from collapsing.
4. The period of eligibility for unemployment benefits should be extended significantly, and generosity in eligibility for unemployment benefits should be practiced.
5. The Bank of Israel should device a quantitative easing program for buying bonds on the markets, and perhaps also shares.
Melnick, 72, holds a PhD in economics from the University of California at Berkley. He was a member of the Trajtenberg Committee on Socioeconomic Change.
Published by Globes, Israel business news - en.globes.co.il - on March 22, 2020
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