Economic Recession in the Coronavirus Era
Prof. Rafi Melnick | May 17, 2020
The economic crisis in the wake of the outbreak of the Coronavirus pandemic and the steps to combat it that the world faces - and the Israeli economy within it, present a challenge unprecedented in the modern age. Economists recognize the fact that business cycles of expansion and contraction are part of the realities of our lives, and that different shocks have the force to cause shifts in the economy from periods of prosperity to periods of recession, and vice-versa. To understand business cycles, theoretic models have been developed, and parallel to them policy tools to stabilize the economy; however, the recession which we are in the midst of is fundamentally different from what we are familiar with. Economic activity has stopped not due to some fundamental economic problem that needs to be addressed—such as a flaw in the financial markets as in 2008-2009. Rather, it was stopped by governmental act to shut-down economic activity in order to flatten the curve of contagion and safeguard—as much as possible—the public's health. In economic terms, curtailment is on the side of supply. This basic understanding has three meanings: 1) Conventional policies for dealing with economic recession are not effective at this stage because they lack the power to move the wheels of the economy as long as the workforce is under lockdown. 2) The depth of the recession hinges on the length of the period the public needs to shelter-in-place and is prohibited from returning to work. 3) Only in the second stage, when the lockdown is lifted will we need to formulate policy to return the economy to full employment and growth.
There is no unique way to measure the harm to the economy one can expect from the Coronavirus pandemic; we can conduct an estimate of the initial detriment in the first stage we are in the midst of at the time of this writing. Table 1 compares the drop estimated in the GDP released by the International Monetary Fund (IMF) for 2020, to drop during 2009 at the outset of the great financial crisis.
The Table shows that the Coronavirus crisis is deeper than the financial crisis of 2009—an event that is considered the greatest crisis since the 1930s. The force of the expected drop in income in 2020 has not been seen in the period since the close of the Second World War, and constitutes an unprecedented shock. On the one hand, the uncertainty surrounding the nature of the virus and how it operates, and future economic/medical policy on the other, prevent us from establishing a reliable estimate of the overall impact of the pandemic.
If one assumes that without the pandemic Israel's economy would have grown in 2020 at a rate of 3.5%, then according to the IMF, the loss in potential GDP stands at 137.2 billion NIS. An alternative approach is to calculate the blow according to direct lost income: Based on the monthly GDP of Israel, and assuming that economic activity in the months of March and April was between a third to half the norm, then the loss of GDP is estimated to be between 116.7 and 163.3 billion NIS. Two factors need to be noted here: This figure is an aggregate estimate and it is not shared equally. Moreover, the gap in income distribution in Israel is among the highest among the OED nations and it will deteriorate.
Another outstanding characteristic evident in Table 1: The good performance of the Israeli economy during the 2009 crisis, which, while the Israeli economy's growth dipped, it was still favorable compared to other countries, which experienced negative growth. However, in 2020 the estimated blow to Israel is similar to that in other countries. In contrast to the economic situation when the 2009 crisis broke out - when Israel was in better shape than today, with a balanced budget - the country has entered the current crisis with a structural deficit that constricts the degree of freedom at Israel's disposal to deal with the crisis.
One needs to differentiate between policy objectives and tools at different stages, since what is suitable for the first stage is not suitable for the second stage, and vice-versa. That is, in the first stage, as long as Israel is under restrictions on employment, compared to the second stage after such restrictions are lifted.
Policy objectives in the first stage:
- To prevent bankrupt of businesses that are fundamentally healthy.
- To provide minimal means of existence for the populations stricken economically.
- To support the health system.
Although conventional policy tools—the monetary policies of the Bank of Israel and the fiscal policies of the government—are not effective in dealing with the situation in the first stage, this does not mean that the central bank and the government have no role to play. Just the opposite: They have an essential role in minimizing the damage and in assisting the public to get through this period with the minimum of damage humanly possible.
The role of the Bank of Israel is, with the aid of all the tools at its disposal, to prevent slipping down the slope into a financial crisis - that is, detriment to the ability of the banks and other financial institutions to function. This is an objective of paramount importance, since economic research teaches us that a recession accompanied by a financial crisis is always worse that one without such a crisis. The Bank of Israel can prevent the financial crisis by providing the liquidity the market needs. The Bank of Israel should not flinch from taking unconventional steps such as "quantity expansion" - in short, acquisition on the open market of all kind of bonds - government and corporate bonds. The Bank must provide ample sources of credit though the banking system at interest rates that do not deviate from those of the Bank of Israel, and in a stress scenario, the Bank of Israel should even extend credit to the government directly.
The role of the government here is to prevent, as much as possible, that businesses that are fundamentally healthy will collapse. The economic logic for this is that recovery of bankrupt businesses is hard and extended, perpetuating high unemployment for an extended period. The government needs to declare a moratorium on payment of debts, taxes, municipal taxes and mortgages; it also needs to institute a special arrangements on rental payment that need to be in place for as long as this stage of the crisis lasts. It must provide the unemployed and weaker sectors of the population with minimum means of existence to prevail as long as the country is in this stage of the crisis. The very nature of the economic turmoil we are experiencing is one for which no form of insurance was available, and this is a situation where the government needs to intervene and provide a safety net. The economic blow is not shared equally by all the population: salaried employees who were fired or sent home on leave-without-pay receive from Bituach Leumi (National Insurance) unemployment payments; the self-employed, on the other hand (especially the small businesses) have been left without financial reserves and need special consideration. It is important not to adopt means of assistance that are universal, since they don't differentiate between those in need and others, and therefore are wasteful. Lastly, the government needs to underwrite the country's health needs to deal with the pandemic: Provision of the resources the health system needs to function meeting the health crisis at hand. This is all the more so, in light of the state of the health system prior to the crisis, burdened by ongoing shortages of resources.
As a result of the above steps, in the initial stage, the government deficit will grow significantly under the combination of dropping revenues and additional expenditures. Against the backdrop of a deficit at the outset of the crisis, the deficit can be expected to rise in 2020 to two-digit levels. If one takes into account the drop in tax revenues in March-April (which I estimate to be in the vicinity of 41 billion NIS), and if one adds payouts to the unemployment and those on leave-without-pay, along the with structural deficit of the public sector at the outset of the crisis, the deficit can be expected to be in the vicinity of 12% of the GDP. It is important to note: One should not view this deficit as a problem, but rather as part of the solution, essential to deal with the situation created—analogous to a cancer patient undergoing chemotherapy.
It is hard to assess how long the present stage will last; it hinges on how the pandemic develops, but at each stage one needs to consider the health cost in lives and the economic cost - which can also be measured in lives. That is, the longer this stage goes on, the more the economic cost will increase. I don't intend to expand here on an exit strategy plan beyond what has already been said. At the time of writing, it appears that the exit process from the lockdown has already begun and a significant portion of economic activity will be possible under a regime of 'social distancing' limitations necessary as long as the danger of a renewed outbreak of the Coronavirus exists.
This raises the question: Will lifting supply restrictions and allowing the country to return to normal economic activity, in and of itself, be enough to return the economy to full employment? A forecast by the IMF and the Bank of Israel for growth in 2021 was carried out, in my opinion, under certain overly optimistic assumptions. The IMF forecasts a growth rate of 4.7% in the United States and the Euro Bloc, and a higher average than this among European benchmark countries. The IMF forecast for the Israeli economy is 5%, while the Bank of Israel's puts forecasted growth at 8.7 percent. I fear that these assessments are based on the assumption that entering the crisis did not stem from defined economic problems, and thus, the ability of the workforce to return to the state that existed prior to the crisis will be smooth and without any particular interference. I want to offer a number of points that raise doubts about such optimism.
- Meeting the challenge of returning the economy to full employment will be prolonged: Past experience with the labor market indicates that return to full employment will be slow. Employers will take a 'wait and see' attitude until the uncertainty narrows, before returning their employees Furthermore, it is plausible that businesses will take advantage of the situation to initiate efficiency measures and changes in the way they operate that will be expressed in cutbacks in employment levels and thus one can expect high unemployment levels for an extended period.
- Changes in household perceptions about their income: High unemployment, lack of job security and uncertainty about the labor market will narrow public expectations regarding future income, diminishing demand in private consumption.
- The Coronavirus led to a sharp drop in the capital markets: This will have a negative wealth impact on private consumption. In addition, the public's desire to restore dwindled savings will bring about cutbacks in private consumption, as well.
- Indecisiveness in the business sector regarding investments: Levels of investment in the business sector were very low on the eve of the Coronavirus crisis. It can be expected that this will continue after the crisis - that is, one should not expect a rise in the level of investments in the business sector until the situation stabilizes.
- The exports situation: In the export domain difficulties will arise against the backdrop of a global economic recession and a reduction in world trade.
- Government attitudes: The government's desire to reduce the weight of the public debt will lead to proposals to restrain public spending (relatively speaking), and to raise tax rates which, if anticipated or acted on, will have a dampening effect.
In light of all the above, I expect that the supply constraint that characterized the first stage of the crisis will become a demand constraint in the second stage. Against the backdrop of this fundamental prognosis, the objectives and the policy needed in the second stage need to be addressed.
Policy objectives in the second stage:
- To return the economy to full employment.
- To put the economy on the road to growth led by increases in productivity.
The challenge the government and the Bank of Israel face: To quickly change their economic approach that was suitable to realities in recent years, but is not suitable for dealing with the present crisis. These are not normal times: One cannot depend only on market forces to pull the country out from the looming economic depression, without massive assistance of the government and the Bank of Israel. That is, in immediate terms, policy needs to embark on rehabilitation of aggregate demand in order to return the economy to full employment.
An appropriate step to achieve the two objectives is to initiate massive government investment in the economy infrastructures. This need arises from both the desire to stimulate demand in the economy, as well as to assist the economy to embark on a path to economic growth.
Such investments are also needed due to the lag in public capital inventory in Israel compared to benchmark countries. The shortage in public infrastructure in general and transportation in particular has been found to be an important factor in explaining the gap in productivity that exists between Israel and benchmark countries. The scope of investment in infrastructure needed is twice the government's budgets in practice. In recent years, the government invested approximately 2% of the GDP, while the investment required is 4% - that is 56 billion NIS per annum. The Israeli economy needs to be put on the road to growth based on productivity growth - which is the only factor that can bring about a long-term rise in standard of living in Israel.
At this stage, the government also needs to provide governmental sources for credit by the financial system. Loans must be given at minimal interest rates that will enable businesses stricken economically to return to normal functioning as quickly and as fully as possible. In addition, the Bank of Israel must play a positive role in supplying enough liquidity so that bankruptcies that can be expected among plants and businesses hardest hit by the lockdown and unable to pay back their loans will not evolve into a financial crisis. In other words, if the country will face a financial crisis, the recession is going to be longer and severer.
It is important to ensure that the workforce sent home on leave-without-pay will return to their original workplaces. One can assume that those on leave-without-pay are the good workers in their place of work. The government needs to provide incentives for the reemployment of such persons in the workforce. A rapid return to such workers' places of employment will preserve the employer-employee relationship so crucial to the labor market. One cannot expect full success in this department, for one should not reject efficiency moves on the margins as out of hand, and such steps may even be desirable.
The Coronavirus crisis has increased awareness of the fragility of the health and welfare system. A high priority should be assigned to allocating budgets in these two areas.
Growth that will lead to improvement of productivity requires broad-based economic reforms. While reforms cost money, in the present situation, this should not be a deterrent: Reforms are needed in order to streamline the performance of local markets and increase competitiveness of various branches. This is also an opportunity to deal with monopolies and branches that enjoy excessive levels of protection.
Addressing the public debt that will be created in the first stage as a result of deficits as well as those that will come in the second stage should be delayed by at least two years—that is, until the 2023 budget. Premature attempts to deal with the deficit will encumber rapidly returning to full employment and placing the economic on a growth trajectory led by enhanced productivity.
Finally, the big question: How much will all this cost us, or how large a budget can Israel afford to expend, without putting the financial stability of the economy in jeopardy? As a point of departure, the public debt of Israel stands at 60 percent of the GDP—an achievement attained after long and prolonged efforts. One of the underlying reasons for such an endeavor was to give the economy a degree of budgetary leeway precisely to deal with challenges of a magnitude of the one we now face. My assumption is that even if the debt climbs to 80 percent of the GDP—an addition of 280 billion NIS, this will not deteriorate into financial instability and the debt will still be lower than the public debt in most OECD nations. Leadership courage is needed to carry out the plan suggested here, but the alternative will be more painful and costly—and is avoidable.
 Such an extreme step, a 'doomsday weapon' if activated, would require amendments to current law.
 It appears this is, at best, an underestimation.
 In this regard, see the working paper prepared by the IDC's Aaron Institute for Economic Policy: "Highlights of Economic Policy for Exiting the Lockdown" (Hebrew).
 Re: Those European nations that were defined by the Aaron Institute as comparable to Israel. These countries include Austria, Ireland, Belgium, Denmark, Holland, Finland and Sweden.
 The labor market is characterized by lengthy adjustment processes; in professional terms this phenomenon is called hysteresis (an event in the economy that persists into the future, even after the factors that led to that event have been removed).
 A drop in permanent income.
Authored by Prof. Rafi Melnick.
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