Poul Thomsen wrote an article on the IMF’s blog site about Iceland that I would like to highlight. They bear repeating given the economic problems in Europe and the US. The IMF worked with Iceland to stabilise the economy and avoid default after the country got into trouble during the credit crisis in 2008. He draws four principal lessons from the ordeal. They are:
- First, a team of lawyers was put to work to ensure that losses in the banks were not absorbed by the public sector. In the end, the public sector did of course have to step in and ensure the new banks had adequate capital, but it was insulated from vast private sector losses. This was a major achievement.
- Second, the initial focus of the program was exclusively on stabilizing the exchange rate. Here, we reached for unconventional measures, notably capital controls.
- Third, automatic stabilizers were allowed to operate in full during the first year of the program—effectively delaying fiscal adjustment. This helped support the economy at a time of severe strain.
- Fourth, conditionality was streamlined and focused on the key issue at hand—rebuilding the financial sector. While there are some issues in the broader economy where reforms will eventually be needed, these were not a part of the program.
I’ll comment briefly before sending you off to the IMF blog.
On the first bullet, Jon Danielsson did a good overview of what went wrong in November 2008. (See “Iceland: a cautionary tale for small nations”.) This is the problem principally in Ireland and Spain where the housing bubble created a banking crisis. Spain has stopped well short of taking on the burdens of its banking sector but Ireland has paid the price with Government debt to GDP rising from a low 25% to a large 100%.
Soon after Danielsson’s piece, I warned about Ireland:
It remains to be seen whether there is a sub-current of panic about the fragile Irish banking system that could lead it to Iceland’s fate. In fact, commentators like Wolfgang Munchau have argued that the single currency is a boon to the likes of Ireland because it prevents currency attacks like the one Iceland suffered, leading to its downfall.
However, a run on Irish banks is what would ultimately bring the Irish down. After all, it is the Government bank guarantee which creates the vulnerability. The Irish Government needs to make some contingency planning because an Icelandic fate is not out of the question. It need not worry about a currency run, but a bank run is still possible.
There are two ways to skin a cat. - Is Ireland the next Iceland?, Nov 2008
Ireland, therefore, shows us what happens when the sovereign and the banking sector become one.
Too big to bail has always been a problem for Europe’s undercapitalised banks. And I drew up a list of the largest European banks by assets when the stress tests were conducted last year. That list will tell you which banks are too big to bail, meaning that taking on their liabilities would cause the Icelandic problem. However, the sovereign debt crisis in Europe has created the same problem throughout Europe, with banks imperiled by their holding of sovereign debt.
On bullet two, there has already been a lot of talk about Euroland’s periphery’s inability to devalue. Devaluation helps support export-led growth at the expense of inflation. Iceland had the opposite problem. As with Argentina and Russia, which actually defaulted, sovereign problems for Iceland led to a currency collapse and made foreign currency liabilities enormous. That is the opposite problem of what Greece has.
While capital controls were controversial (see Iceland: Welcome back to the 1950s), they were absolutely necessary to prevent bank runs. I expect we may see something similar - even in Euroland - if we get retail deposit runs.
The Bank of Japan, the Bank of England the Federal Reserve, and soon the European Central Bank will all be buying government bonds, engaging in the so-called currency wars which will create tensions in emerging markets. How will EM countries react?
Here’s Willem Buiter from February 2009:
I predict that at least some of the emerging market countries of CEE and the CIS will impose capital controls before long. I recommend that emerging markets everywhere consider this option seriously.
On bullet three, automatic stabilizers do need to be allowed to operate in full.
Procyclicality is one of the structural flaws of the euro zone; there is no federal agent to do counter procyclical budgeting during a recession. Thus, the euro zone business cycle will invariably be volatile, making current account imbalances a lightening rod for intra-European recrimination.
This is a recipe for disaster. And it will lead to huge volatility in the business cycle, deadweight economic losses and growth underperformance. If you hear anyone telling you this is a good mechanism for reining in deficit spending, you will know they haven’t thought through the effects of procyclicality. - What is pro-cyclicality?, Aug 2011
How does fiscal consolidation affect the economy? Please read the IMF’s own conclusions from 2010 linked in the last sentence. They are consistent with what Poul Thomsen is saying categorically about Iceland and what the Troika in Greece have said about Greece: Expansionary fiscal consolidation doesn’t work. Do we need any more evidence than that?
On bullet four, Thomsen says the IMF punted. So I think this sums it up
- Sovereigns should not step in and assume all of the banking sector’s liabilities
Capital controls are sometimes unavoidable
Pro-cyclical fiscal policy is bad for recovery