[ISL] On how the recovery of Iceland from 2008 was not so miraculous

[rfmcdonald]

The New York Times' Jenny Anderson reported from Iceland as it prepares to lift post-2008 capital controls, noting how it recovered with an eye towards how it might serve as a model of some kind for Greece.

Iceland is not Greece. As a tiny island with a population of 320,000, it was able to muster political will more easily than most countries. (Meeting the prime minister is no big deal to locals.) Greece has a population of 11 million, a gross domestic product that is $242 billion, or 16 times Iceland’s, and a history of political antagonism and government corruption. The two countries blew themselves up, though in different ways. Greece, as a nation, spent too much; in Iceland, the private banks went on a bender that ended badly.

But Iceland came out the other side of disaster in part because it had its own currency, which devalued, and it imposed draconian capital controls. If Greece ends up with its own currency, it would most likely descend into an economic Hades in the months after dumping the euro before even having a chance to emerge on the other side.

Yet, even as Iceland is in the bloom of health, its comeback is about to be tested again. The government recently announced it would start to lift capital controls imposed at the peak of the crisis. Meant to last a few months, the controls have been in place for seven years, creating a shelter under which Iceland has mostly thrived.

Their success, paradoxically, has made their removal all the more precarious.

“They worked better than anyone expected them to work,” said Sigmundur David Gunnlaugsson, the prime minister. “But they of course are not a sustainable situation for an economy.”

Anderson goes on at length, noting the specific policies adopted. Matt O'Brien of the Washington Post's Wonkblog crunches the data, noting that the much-mooted miraculous recovery of Iceland is actually not that, starting off by comparing Iceland with Ireland.

Both countries' banks went bust, both got bailed out by the International Monetary Fund, and both did austerity afterward. But despite these similarities, Iceland's recovery has been better than Ireland's. Specifically, its economy is 1 percent bigger than it was before 2008, while Ireland's is still 2 percent smaller. That's more surprising than it sounds since Ireland's crisis was merely catastrophic and Iceland's was completely so. But more than that, Iceland is doing better even though—or, for the most part, because—it did everything you're not 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 getting ready to lift. Not all of it helped, but enough of it did that the question has become how much of a role model Iceland should be for everyone else. And the answer is: It depends!

Iceland might have been 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 their economy by offering people overseas, especially in the Netherlands and Britain, higher interest rates than they could get at home. Then, armed with this cash, Iceland's bankers went on a historically ill-advised buying spree. They bought foreign companies, they bought foreign real estate, they even bought 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, and it wasn't that hard to tell. All you had to do was look for five minutes. That's what Bob Aliber, a professor emeritus at the University of Chicago, did in 2006 after he heard a talk about Iceland that might as well have been a neon sign flashing financial crisis. What he found convinced him, as Michael Lewis tells us, to start writing about Iceland's crash even before it happened.

And then it did. Short-term lending died after Lehman Brothers went bankrupt, and Iceland's banks were collateral damage. Although, to be honest, they were so mismanaged that collapse was inevitable (which is why some of their high-level execs have been sent to jail). But in any case, Iceland's government couldn't afford to bail out its banks that had gotten so much bigger than its economy. The only choice was to let them go under. In other words, Iceland's banks were too-big-not-to-fail. That was 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. It needed the money to protect domestic deposits, cushion the economy's free fall, and keep their currency, the krona, from crashing much more. In all, Iceland got $4.6 billion, with $2.1 billion of that coming from the IMF and the other $2.5 billion from its Scandinavian neighbors.

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 than Ireland or Portugal or Spain or 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 also increased interest rates all the way up to 18 percent in the immediate aftermath of the crisis to rein in inflation. It gradually cut interest rates afterward, but it wasn't until 2011 that they reached a "low" of 4.25 percent.

There was no economics-revamping miracle on Iceland, it turns out.