Sunday, February 19, 2012

Iceland and the Banks

Recent news on Iceland is that the ratings agency Fitch has now determined that Icelandic debt is safe:
Fitch raised Iceland's sovereign rating by one notch, to BBB- from BB+, meaning that the country's debt is now "investment grade".

Iceland's economy imploded under a mountain of debt in 2008, forcing an International Monetary Fund bailout.
Since then, the debts of its neighbours have sparked a crisis in the eurozone.

Fitch said the decision "reflects the progress that has been made in restoring macroeconomic stability, pushing ahead with structural reform and rebuilding sovereign creditworthiness".

In 2008, its three banks failed under their enormous foreign debt, which at one point was larger than the Icelandic economy.

The value of the Icelandic krona plunged, which made its exports more competitive. The new government of 2009 was allowed to carry on borrowing and spending for another year before spending cuts kicked in.
Ignoring the uselessness of the ratings agencies in general, the upgrade is a response to the positive trajectory of Iceland's economy. In 2011, the previously devastated economy grew by 3% overall, and unemployment has fallen by over 1% since 2011. I say previously devastated, as Iceland (as I am sure you will all remember) had the most almighty banking meltdown (in relation to the overall size of the economy). However, when confronted with the lunacy of the debts racked up by the banking system, Iceland did something very different to the majority of economies when confronted with bank failure; they did not bail out the banks.

The rather odd thing is that the sky did not fall upon Iceland, there was no apocalypse, and now the economy is in recovery mode. It should be remembered that, as its financial system collapsed, Iceland went to the IMF for a bailout. The purpose of the loan, was as follows (from the IMF):

The program had three objectives: to stabilize the exchange rate, put the public finances on a sustainable path, and restructure the financial system. All three of these objectives were met by the time the program expired. This was really an enormous achievement, given the severity and depth of the crisis that Iceland faced at the time.

The exchange rate had depreciated sharply in the run-up to the crisis, and there was a deep concern that it would plummet in a disorderly way. This is why capital controls were imposed.
The government had to use its balance sheet to recapitalize the banks and rebuild the financial system. This meant that public debt became very high. Therefore, public finances needed to be restored. During the past couple of years, the government has taken a number of fiscal measures that have put the country’s finances back on a sustainable path.

Finally, restructuring the banking system was obviously a huge challenge. The size of the banking system was equivalent to about 1,000 percent of GDP before the crisis. It now stands at 200 percent of GDP, so there has been an enormous downsizing. The core banking system has been recapitalized and is fully functioning, a significant achievement for the authorities.
In light of the financial meltdown, the ISK took a battering, and one of the key objectives of the IMF was to stabilise the currency the central banks raised interest rates to a whopping 18% and implemented currency controls:

Severe currency controls were imposed in November after the Central Bank attempted unsuccessfully for two days to peg the krona against the euro. The controls involved daily currency auctions for imports of certain necessities, but these failed to prevent the krona from weakening further. A new currency regime in early December supported by the first tranche of the IMF stand-by agreement led to the value of the krona rising by 25% in the three days to December 9th. Since then, however, the currency has retreated, losing most of these earlier gains. A law restricting all currency flows related to capital-account transactions and requiring exporters to deposit all foreign currency with domestic banks was passed in late November. The legislation will prevent foreign investors that hold more than Ikr500bn of krona-denominated assets from exporting these assets for up to two years.
Perhaps most interestingly, this is the fiscal position moving out of the crisis:

The 2009 central government budget that was presented to the Althingi (parliament) in mid-December already provides for substantial expenditure cuts on both current and capital spending, as well as an increase of 1 percentage point in personal income tax rates. These cuts will make the deepening economic recession, including an expected fall of 20% in domestic demand, even worse, but are considered necessary by the government. The deficit on the public finances in 2009 is forecast by the government to be just over 10% of GDP, which the IMF has accepted, deeming any further expenditure cuts as likely to cause possibly irreparable damage to the economy. However, the IMF will be expecting further fiscal consolidation measures in order to reduce the deficit from 2010. We expect the deficit to be slightly higher than the government's estimate, at around 11-12% of GDP, but also that any reduction achieved in 2010 will be fairly modest.
It is rather surprising, but I was unable to find much detail on the spending cuts, despite looking as some Icelandic websites (probably a poor search term?). However, I did find some detail from a rather unusual source, which is the World Socialist Website:
On June 26, a comprehensive agreement was announced between Iceland’s government, trade unions and employers’ organisations, containing plans for sharp public spending cuts and tax hikes. The “stability pact” had been under negotiation for several weeks and is in response to pressure from the International Monetary Fund (IMF) for the government to seek a balanced budget by 2013.

Speaking at the signing of the agreement, Prime Minister and Social Democrat (SDA) leader Johanna Sigurðurdóttir commented, “Now we have a map showing the route that employers and workers in both the private and public sector, together with the state and municipalities, have agreed we should follow.”

Presented as an agreement for “shared sacrifice,” it will facilitate the bail-out of the financial elite at the expense of the working class. Such an approach has been endorsed fully by the Left Greens, the junior partners in the governing coalition. Finance Minister and party leader Steingrimur J. Sigfússon insisted that, given the economic climate, “this is a hard choice but unavoidable.” [my comment; see below]

The government has given way entirely to the dictates of the IMF. In total, the government will save 70 billion kronur (€390 million) through spending cutbacks and reorganisation over the next three years, while at the same time increasing income taxes and charges on everyday items such as soft drinks to meet a budget gap of 170 billion kronur over the next four years. The planned tax hikes will account for up to 58 billion kronur.
Essentially, what we see in the case of Iceland is a tempory backstop from the IMF, combined with deep reform of the economy. The IMF originally insisted on bailing out the losses taken from Icesave, but referendums prevented this:

Yet, while the U.S. and the rest of Europe were busy with the unpopular business of propping up failed banks with taxpayer dollars, Iceland headed in the opposite direction. It guaranteed the deposits of citizens, but refused to pay off many foreign investors. And even when the government tried to pass a bill that would pave the way for the repayment of some US$8 billion worth of deposits that angry U.K. and Dutch governments had covered for their citizens, Grímsson stepped in—not once, but twice—so that the deal could be put to a referendum. He later said the decision was an effort to reaffirm the importance of democracy and civil society in Iceland. “There were a lot of people who predicted it would be the downfall of Iceland, that we would be isolated in the world and become the Cuba of the North,” he told CBC Radio in a recent interview. “But the fact of the matter is, the people of Iceland twice were able to exercise their democratic will, and now Iceland is coming out of this crisis and establishing recovery earlier and more effectively than other European countries.”

In short, the IMF loan bought time to allow a restructuring of the economy to make it more competive, and to effectively ensure that the country 'lived within its means'. Some have argued that this picture is too rosy, and I will therefore let the critic have their say:

Though Arnason agrees with the government’s general response to the crisis, he argues that many foreign observers have conveniently ignored key details when they marvel at Iceland’s “recovery.” In particular, he says a decision to prolong strict capital controls, used to stabilize the country’s plummeting currency by preventing money from leaving the country (Icelanders who move away need permission to take their financial assets with them), now threatens the country’s key industries—the same ones that are supposed to lead Iceland back to economic health. “Basically, the currency controls distort economic prices and prevent Iceland’s budding export industries from developing,” he says.
As regular readers would guess, I would not have favoured capital controls over an extended period (although could just about accept them as a brief emergency measure). The major advantage that Iceland had was that the country did not follow the bailout route, and this makes an interesting comparison with Ireland. The comparison between Ireland and Iceland has not gone without comment with this from the Irish Indendent (also see this from Reuters):

Here, we search for weaker countries with which to compare ourselves and suck up to the bureaucrats. Our leaders first picked on Iceland. We're not like Iceland, they trumpeted. We're not militant like those silly Icelanders who voted to reject a deal that would have forced them to pay the debts of reckless bankers.
Tell us what to do and we'll do it, our leaders said. We're submissive Ireland, not aggressive Iceland. To austerity and beyond!

How did that work out? Both countries took a hiding, as they were bound to in a world dominated by bankers and their political friends.

But here's another couple of numbers. End of 2010, unemployment in Ireland, 13.9 per cent. And in Iceland, 7.7 per cent.
Of course, another key difference between Iceland and Ireland is that Iceland has its own currency, and the devaluation of an overvalued currency (the country was pre-crisis a miracle economy) saw the economy become more competitive in respect to its real wealth generating industries (e.g. aluminium, fishing, tourism).

It is odd, is it not, that the necessity to bail out the banks in other countries was shouted from so many rooftops, that we were deafened with the sound of the wailing to save the banks. In light of this, perhaps the most odd discussion comes from an article I quoted from earlier:

But some question whether the response to Iceland’s collapse would work elsewhere, or whether anyone would actually want to try. Take, for example, the decision not to bail out the banks. Most agree Iceland simply didn’t have any choice. The sector’s debts, mostly in foreign currencies, were so great compared to the tiny country’s economy that guaranteeing them would have only made things worse. Iceland also benefited by not being part of the eurozone (though it now wants to join). The krona dropped like an anchor and gave export and tourism industries a boost, helping to offset some of the decimation of the financial sector.
So choosing to bail out the banks was a good idea, just because it was possible? This does not seem to be an argument at all. If Iceland had caved into bailing out the banks, we can only speculate how the economy might now look with the cost of the bailouts sitting on the government balance sheet. My own view is that the country would still be in deep troubles.

Note: The IMF lending to the country will, of itself, give an artificial boost to GDP and employment. However, the government is using the time given by the loan to transition the economy. This is very different from the rather sad example of so-called 'austerity' in the UK, where the borrowing is through bond issuance, but where the borrowing hides the underlying structural weakness of the economy. My guess is that, when coming off the IMF drip, Iceland may see a dip or period of stagnation in the economy, but I am guessing that they have made most of the adjustment necessary to reflect their real wealth generating capacity. With the UK, there has been no real adjustment yet. Perhaps it will take a dose of IMF imposed austerity to make the transition?

Note 2: Apologies for any spelling mistakes. I am not sure that the Blogger spell-checker is working, and it is sometimes difficult to spot your own (sometimes glaring) mistakes.

Note 3: I forgot to mention for newer readers; I was opposed to the bank bailouts at the time the crisis broke. Take a look through the archives, and you will find that I did not have anything good to say about them whatsoever.

Note 4: Some responses to comments on the last post...

Lemming: Yes, you are correct that some of the savings are likely to be somewhat questionable! With regards to UK debts being backed by assets such as housing (your 2nd comment), yes the argument is dubious - as the asset prices will reflect the erzats size of the economy. Let's say that the UK's real size without borrowing is 20% smaller than it appears (I calculated roughly this figure for the US economy if you remember the post, but cannot recall the number for the UK); would house prices really remain at current levels (in real terms)?

Anonymous: Thanks for the link on the necessity for Europeans to live within their means! It is a long standing theme of the blog.

Jonny: Your comment requires a much longer response, so apologies for not replying. However, good questions.....

General: As always, thanks for all of the comments, which are (as ever) well considered. Sorry I cannot respond to all, but time is limited.


  1. Cynicus, regarding your comment: "Thanks for the link on the necessity for Europeans to live within their means! It is a long standing theme of the blog."

    Former Malaysian Prime Minister Mahathir Mohamad is an extremely dubius source of qoutes to post on any blog. I know that particular article is from the BBC, but this is a man whom has made some whoppingly rasist remarks. I enjoy your blog, but that man is a lunatic.

    1. My bad! When drawing the article to Cynicus' attention, I omitted to check on other reported views of the person quoted in it. Not that that would necessarily have stopped me: a cogent argument is a cogent argument, whoever advances it.

      Meanwhile, here's another link to a BBC article in case anyone has missed it: In an intriguing constitutional innovation, the Icelanders have put their former PM on trial on charges of negligence over the 2008 financial crisis. One to watch!

  2. Hi: One other thought about an advantage Iceland would have over Ireland. This is that they control their own currency. Therefore, when the Icelandic Krona collapsed, it helped them on the export side as well. With Ireland, by contrast, by being locked into the Euro they have essentially had to take the austerity route, as they have no floating currency to cushion the fall. What do you think on this?

  3. Very nice debunk of MMT:

    1. Debunk? for a start MMT works in the system we have not the system that you want. We are not on the gold standard anymore.

      The Austrian system is serfdom for the propertyless...

      MMT is a democratic system where the people hold power through their elected government. Private Property rights hold a critical claim in that hierarchy, even if Austrians want to deny that.

      Mr. Corrigan appears to have a serious inferiority complex which he compensates for by being overly verbose.

    2. After reading it I think debunk is an appropriate term.

      If you disagree with the article then feel free to challenge some of Corrigan's assertions.

    3. Andy CFC:

      Here is another aticle for you to have a look at.

      Whilst reading all of it would be more beneficial to get the context, it is extremely long so if you want just scroll down to the section on MMT about half way down the scroll bar.

      Let me know what you think.

      Best wishes.

    4. Andy CFC:

      The section on MMT is actually a tad under 20% of the way down.


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