Postcards From Reykjavik

Includes: EWJ, GREK, VGK
by: Eric Parnell, CFA


The experience of Iceland and Greece since the calming of the financial crisis roughly seven years ago is an exercise in contrast.

Both economies were rocked to the core during the crisis. But one has been on the mend in the many years since, while the other is still reeling.

No pain, no gain.

The experience of Iceland and Greece since the calming of the financial crisis roughly seven years ago is an exercise in contrast. Both economies were rocked to the core during the crisis. But one has been impressively on the mend in the many years since, while the other is still reeling and is struggling to lift itself from the brink. What has been the key difference between the two? The suffering of the necessary pain to move beyond the crisis.

In the case of Iceland, it had no choice but to take a full dose of its medicine and then some in the wake of the financial crisis. It was not part of the eurozone, and its private banks had taken on so much debt that it more than overwhelmed the ability of Iceland's government to even think about trying to stage a rescue. Failure was not only an option, it was effectively the only choice.

While extraordinarily painful at the time and with residual effects that remain ongoing today, this failure afforded Iceland a number of advantages moving forward. First, the failure of its private banks resulted in the effective elimination of the country's external debt. Also, the reversal of capital flows and a meaningful devaluation of the Icelandic krona helped produce current account surpluses that supported the government in righting its fiscal ship and servicing its remaining obligations. In short, Iceland took a big spoonful of economic pain without any sugar, but by taking it down all at once, it provided itself with the ability to climb its way back out toward a new phase of growth.

All of this stands in stark contrast to so many other countries around the world that repeatedly resorted to "whatever it takes" to avoid enduring the pain that might have helped finally propel their economies out of the financial crisis once and for all. One such economy is Greece (NYSEARCA:GREK), which has suffered under the weight of an increasing debt burden from which it cannot escape as well as a euro currency that remained strong for years in the post-crisis period and came with conditions imposed by neighboring euro member nations. The result has been an economy that continues to struggle mightily with periodic stints back toward the brink of crisis.

So what has been the path of these two economies since the outbreak of the financial crisis? The following four charts show the dramatic contrast.

Iceland's real GDP bottomed in early 2010 and has been steadily on the mend ever since. Greece's Real GDP, on the other hand, continued to fall through 2014 and has at best stabilized since.

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Iceland's unemployment rate peaked just above 9% in early 2010 and has been steadily falling since to below 3% today. By comparison, Greece's unemployment rate jumped from the single digits up to near 30% by late 2013. Since then, it has gradually faded below 25% but still remains very high by historical standards.

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Iceland's inflation rate has stabilized since the calming of the financial crisis in a steady low single digit rate range. Greece, on the other hand, saw its inflation rate spike near 20% in 2010 and has since been mired in deflation since late 2013.

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And since the calming of the financial crisis in early 2009, Iceland's stock market has been steadily climbing more than tripling from its lows, while Greece's stock market is lower by nearly -40% roughly seven years on.

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So what then has been the best path out of the financial crisis? Has it been to slowly peel the Band Aid off painful inch by inch? Has the answer been to agonizingly prolong the inevitable by repeatedly bending to the will of creditors that are seemingly doing their best to follow their way down the rabbit hole toward an even greater fiscal and monetary crisis? How has the approach of repeatedly trying to paper over the problem worked for Japan (NYSEARCA:EWJ) since December 31, 1989? Or is the answer instead to recognize the losses, accept the pain and suffer the consequences so that your economy can eventually put the crisis behind it and find a new sustainable path to growth?

Nobody ever said that turning and facing the pain is easy. After all, the post-World War I adjustment in the United States during the depression of the early 1920s was certainly not easy, but the economic cleansing that came by forgoing fiscal policy intervention and aggressively low-interest rates helped provide the basis for the period of economic prosperity that followed over the rest of the decade. And Iceland provides a modern day example of how these same principles still apply today.

Unlike Iceland, the developed world has far greater policy firepower to help direct and guide this overdue cleansing process in an orderly manner. Unfortunately, much of this firepower has been badly squandered over the past seven years as monetary policy makers have overcompensated in their policy accommodation while fiscal policy makers have not only dithered but accumulated more debts along the way, thus creating new imbalances in the process.

Time still remains to change course and allow this cleansing to proceed in an orderly way. And the U.S. Federal Reserve under Chair Janet Yellen deserves credit, even if it is coming a bit too late, for having brought U.S. monetary policy from a boundless asset purchase program in QE3 at the end of 2013 to having raised rates for the first time two years later in December 2015.

But the time is drawing near. It is time for the rest of the world to recognize that fighting against the natural economic flow with absurd programs such as negative interest rates are only prolonging the inevitable at this point. Recessions serve an important purpose in cleansing the excesses from an economy, and it is time to allow this process to play itself out in as orderly a way as possible. For the longer policy makers wait, the more explosively negative and unruly the final outcome will be once misguided global economic policy is finally overwhelmed by the realities it persists in trying to ignore.

As the case of Iceland has shown, economies can survive from what may seem the direst of circumstances. And while the adjustment can certainly be painful, the foundation of sustained economic growth that follows can prove worthwhile for generations to come.

If and when global policy makers finally allow the economy to move with the flow remains to be seen. Until then, we can expect more of the same uncertainty as investors are left to wonder what potential instability lurks around the next market corner. Fortunately, we can position for the markets to go down just as we can for them to move higher. And the opportunity set in this regard now appears substantial in what are now overly inflated global capital markets in many instances. It should be an interesting journey over the next few years.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.