A mir­a­cle in Ice­land and in Ire­land, a long slog

The Washington Post Sunday - - TAKING STOCK - BY MATT O’BRIEN matt.obrien@wash­post.com More at wash­ing­ton­post.com/ wonkblog

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?

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