A miracle in Iceland and in Ireland, a long slog
What’s the difference between Iceland and Ireland? In 2009, a bit of gallows humor held that the answer was one letter and six months. In other words, it was only a matter of time before Ireland’s banks brought down their economy just like Iceland’s had.
The timing was a little off, but the rest wasn’t. Both countries’ banks went bust, both were bailed out by the International Monetary Fund and both did austerity measures afterward.
Despite these similarities, Iceland’s recovery has been better. Specifically, its economy is 1 percent bigger than it was before 2008, while Ireland’s is still 2 percent smaller. And Iceland is doing better, even though it did everything it wasn’t supposed to: It let its banks fail, it let its currency collapse and it implemented capital controls — limits on people taking money out of the financial system — that it’s only now ready to lift. Not all of it helped, but enough did. So how much of a role model should Iceland be? It depends. Iceland might have had the most obvious bubble ever. During the mid-2000s, it went from being an Arctic backwater that specialized in fishing and aluminum smelting to an Arctic backwater that specialized in global finance.
Iceland’s three biggest banks grew to 10 times the size of the economy by offering people overseas, especially in the Netherlands and Britain, higher interest rates than they could get at home. Armed with this cash, Iceland’s bankers went on a historically illadvised buying spree. They bought foreign companies, foreign real estate, even foreign soccer teams. But with it all, they bought the dregs.
The problem, in other words, was that Iceland’s banks were not only paying high prices for questionable assets, but also promising to pay their depositors high interest rates. This was about as unsustainable as business models get. In 2006, Bob Aliber, a professor emeritus at the University of Chicago, heard a talk about Iceland that might as well have been a neon sign flashing “financial crisis.” What he found persuaded him, as Michael Lewis tells it, to start writing about Iceland’s crash before it even happened.
And then it did. Short-term lending died after Lehman Brothers went bankrupt, and Iceland’s banks were collateral damage. The government couldn’t afford to bail out its banks, so they went under. That’s a lot easier, though, when letting the banks fail meant letting foreigners lose their money. Iceland’s government, you see, guaranteed its own people’s deposits but no one else’s.
But now it was Iceland’s government that needed a bailout— $2.1 billion from the IMF and $2.5 billion from its Scandinavian neighbors. It needed the money to protect domestic deposits, cushion the economy’s free fall and save its currency, the krona.
This is where the story that Iceland broke all the financial rules begins to fall apart. In a lot of ways, the IMF’s intervention was typical. Iceland sharply reduced spending — introducing more austerity than Ireland, Portugal, Spain, Britain or even supposed budget-cutting superhero Latvia did, as economist Scott Sumner points out. Only Greece has done more. Not only that, but Iceland increased interest rates to 18 percent after the crisis to rein in inflation. It didn’t reach a “low” of 4.25 percent until 2011.
So Iceland had a bigger financial crisis, did more austerity and had higher interest rates, but has still managed a stronger recovery. Howis that possible?
The big difference between the two is that Iceland has its own currency and Ireland has the euro. Whenthe crisis hit, both countries discovered that their bubbles had masked how uncompetitive they’d become. Their workers were paid too much, relative to the rest of the world. There are two ways to fix this: You can be paid the same with money that’s worth a little less or you can be paid a little less with money that’s worth the same.
This might sound like a distinction without a difference, but it’s not. People don’t like pay cuts, so the only way to get them to do so is to fire enough people that they’re happy to take any wage at all. But even if that works, it doesn’t for the economy. That’s because lower wages make it harder to repay debts. So people have less to spend on everything else— which means businesses that don’t have as many customers don’t have as much reason to invest. Iceland avoided this kind of downward spiral, though, because its currency collapsed nearly 60 percent from the end of 2007 to the end of 2008. Voila, competitiveness regained.
Ireland, on the other hand, had the euro. So instead of cutting wages by cutting its currency, it had to cut wages. That’s especially hard when the government is cutting back at the same time. The result was what its backers kept claiming was an austerity “success” story where unemployment only recently reached the single digits.
If anything, the surprise is that Iceland hasn’t done even better. After all, slicing labor costs in half should, in the short run, boost exports and tourism. And it has.
The problem? Well, part of it is the austerity. But another part is a private sector weighed down by two things. First, Iceland might be the worst place in the world to borrow money. Most mortgages are indexed either to a foreign currency or inflation, so the former doubled when the krona crashed and the latter, well, inflated when inflation subsequently took off. The perverse result is that devaluation and inflation have made Iceland’s household debt problem worse.
Then there are the capital controls. The IMF made Iceland put them in place. The worry was that foreigners who owned krona-denominated assets in the failed banks would sell them en masse. So the government stopped letting people move their money out of the country. This stabilized the krona, which stabilized inflation. On the downside, foreigners didn’t want to invest someplace where their money would be trapped. So Iceland’s private investment has been low. The good news, though, is that Iceland now has a plan to tax some of these foreign krona-holders and to get the rest to turn their short-term assets into long-term ones. In other words, Iceland should be able to lift its capital controls. It only took 61/2 years.
In reality, Iceland let its banks fail (for foreigners), wrote down household debt (only after the country’s laws had made it worse), let its currency collapse (had no choice), but tried to keep it from plunging too far by limiting how much money people could take out of the country. Oh, and it did more austerity than any country but Greece.
The lesson is that in a crisis you can get a lot of things wrong and still be okay as long as you default and devalue. You have to get the big question right— what currency should I use? The right monetary policy, in other words, can cover up a lot of mistakes.
The question now: What does Greece think of this?