Irreverent Economics

From Panel Discusssion – Bubbling Forth, or Fifth?

A vox article written with Ragnar Arnason.

I was an organizer and a panelist in a debate on the LSE perspectives on the sovereign debt crisis yesterday. The podcast is here. It was a lively event. Here are my opening remarks.

This crisis is not about Greece, in same way as the 2007 crisis was not about subprime. Instead, we should be thankful to the Greeks for being so irresponsible.

The sooner the better we can focus on the real problem the better we are, so thank you Greece for focusing our minds. After all, the costs of a Greek default will be couple of percentage points of eurozone GDP, easily manageable

On a general level, we could say this is a systemic crisis in making with 2 sub crisis

1. a banking crisis or a confidence crisis or liquidity crisis
2. Sovereign debt

Let us talk about the banks first. They do have considerable exposure to Greece, and let us be clear about this a key reason is government. In their wisdom, Greek debt is considered safe when it comes to capital while lending to AAA rated Microsoft attracts a significant capital charge. This in spite of the fact that Greek debt was A before the crisis started.

Fortunately, banks have been quite active in writing down Greek debt, even though some are more vulnerable than others. In a way, the crisis demonstrates which banks are weakest. In this, it is interesting to note when the European authorities run stress tests on European banks they assume no sovereign can default.

The second crisis is a sovereign debt crisis. Again, if it was only about Greece it would not be a problem. Even though we can question the morality of having poor well-run countries like Slovenia subsidize much richer Greece. The elephant in the room is Italy. It also is irresponsible but is much bigger. What the European authorities are debating is not the Greek bailout but really the Italian bailout

Each sub crisis is serious but not in any way systemic. What makes it systemic are European politics. They have 2 choices. They can decide to bailout or default. You may have a preference for either of those options but regardless, either will solve the crisis.

Instead, they opted to muddle through. Every time Greece needs another 5 billion, every euro zone country has to agree, a big political fight ensues, newspaper headlines spell doom. It is this uncertainty is creating a systemic crisis.

If Europe will suffer a systemic crisis it is because of its dysfunctional political structure and the shortsightedness of its national leaders. Indeed, if we look at history, none of the really big crisis are created by the financial system. Instead they were all created by politicians. And therefore, inappropriate policy response has been the main cause of all the world’s biggest financial crisis. With that in mind, how can we really expect the politicians to regulate the financial system.

I took part in a conference sponsored by the IMF, the government of Iceland and the Central bank of Iceland. The video of my session is here.  My main take from the event is that the only people who were truly happy with the IMF programme were the IMF people themselves, and they don’t seem to have a fully realistic view of either the Icelandic economy or their perception in Iceland.

The IMF staff have an inflated view of their abilities and contribution to Iceland’s recovery along with an ironclad conviction that they are right. Which they are not, as I discuss here.

They seem to have embraced Krugman’s liking of “unorthodox economics” view in their writeup: Iceland’s Unorthodox Policies Suggest Alternative Way Out of Crisis. Its worth noting that the IMF insisted on very orthodox measures, like extreme interest rates, hawking back to their 1997 Asia crisis advice.

Finally, none of the foreign stars in the conference let an almost complete lack of knowledge about Iceland prevent them from making detailed comments about the economic situation in Iceland. Pathetic really.

A vox piece on IMF and Iceland

Iceland has just become the first industrialised country to graduate from an IMF programme in over 30 years. The IMF claims the programme has been an unqualified success:

Iceland has successfully completed its Fund-supported programme. Key objectives have been met: public finances are on a sustainable path, the exchange rate has stabilised, and the financial sector has been restructured. Strong policy implementation has underpinned this success (IMF 2011).

This was the first time the Fund had mounted a rescue operation for one of the richest and most developed countries in the world, closely interlinked with the northern European economies. With the Fund’s expertise honed on crises in less-developed countries, there have been doubts about its ability to successfully execute the Icelandic programme.

The facts don’t match the claims

Based on the current state of the Icelandic economy, the Fund’s claim of success does not stand up to scrutiny.

• Public finances are not on a sustainable path,
• Exchange rates are not fully stable even with capital controls,
• Investment has collapsed, and
• The financial sector is dysfunctional.

At the same time, the Fund forced Iceland to impose a high interest-rate policy at the time when every other developed economy was doing the opposite.

• Iceland is in a recession.¹

GDP has declined by about 11% since the crisis of October 2008, but modest and volatile growth has returned, sustained primarily by an increase in private consumption catching up after two years of austerity. Worryingly, export growth is low, even with a sharp fall in the exchange rate, while investment is at a record low.

Business investment rates in Iceland equalled the EU average from 1995 to 2008, according to Eurostat.

• Over the past two years the investment rate in Iceland collapsed to 10% whilst the EU only suffered a small decline to 17%.

This means Iceland had the second lowest investment rate in Europe in 2010, after Ireland. That is not surprising when, according to the OECD, Iceland had the highest number of restrictions on foreign direct investment among member countries in 2010 (Kalinova et al 2010).

• Government debt, central and local, equals annual GDP and is rising.

The government enjoys a primary surplus if we exclude one-off items, but considering the annual flow of revenue and expenditures, it runs a primary deficit. Government revenue and expenditure increased sharply in the bubble years and the government has had difficulties in adjusting to the revenue shock after the crisis. It raised taxes and reduced expenditures, but in order to get it is financing on a sustainable level it needs to do more, but is hindered by a strong opposition to its fiscal policies. Firm IMF encouragement for taking the necessary measures towards sustainable public finances would have been useful.

Still, the authorities have significantly reduced the risk of a sovereign default, and chalked up a notable success when Iceland was able to tap the international capital markets earlier this year, borrowing $1 billion at 6%.

Requiring orthodox monetary policy

Most economies faced a negative shock at the same time as Iceland and the reaction of their monetary authorities was generally monetary expansion through low interest rates and quantitative easing. Immediately following the collapse, the Icelandic central bank followed, but soon was forced to increase interest rates to 18% “as a condition of a proposed $2 billion loan from the International Monetary Fund” according to the Financial Times (see Ibison 2008). The IMF allowed Iceland to reduce its central bank interest rates in March 2009 and they remained in double digits until 2010. As inflation was 7% during that period, while the economy was sharply contracting, it is hard to see what benefit the Fund saw in implementing such orthodox monetary policy.

In this, the IMF seems to have been following similar conditions it imposed on the Southeast Asian countries in their 1997 crisis, subsequently widely criticised as significantly contributing to that crisis.

Since the start of the crisis, inflation has been 6% on average, now at 5%, and central bank interest rates have been steadily falling, to 4.5% now. The Icelandic monetary policy is at odds with that of other developed countries. For example, inflation in the UK exceeds Icelandic rates at 5.2% but its interest rates are below 1%. The situation is similar in the Eurozone and the US.

Interestingly, the high interest rates were often justified by reference to the need to stabilise the exchange rate, but as the IMF also insisted on capital controls, in the subsequent closed economy, low interest rates could have been used to stimulate the economy without any risk to the exchange rate.

The IMF (2011) finds that “The tightening bias in monetary policy is appropriate”. This assessment does not seem based on the available facts nor economic logic. The Fund’s demand for high interest rates was unjustified, causing significant economic damage.

Capital controls

Before its crisis, the amount of foreign hot money flowing into Iceland was close to 50% of GDP, with the government at the time highly supportive of the inflow. Anticipating the crisis, the currency market effectively closed in September 2008, with both foreign carry traders and domestic investors seeking to leave, but with few takers of the Icelandic Krona the exchange rate depreciated sharply.

After the crisis, the remaining carry traders, along with many local investors, wanted to leave, which likely would have caused a sharp short term drop in the exchange rate. As a consequence, the Icelandic government, with the strong encouragement of the IMF, imposed stringent capital controls, not only preventing the carry traders from exiting, but also requiring rarely granted government approval for Icelanders to invest abroad.

Iceland was the last OECD member country to abolish capital controls in 1993 and the first to adopt them again. While capital controls are often considered a useful tool to prevent hot money inflows, the objective and especially the implementation of the Icelandic capital controls has been different than usual current practice, they are more akin to the overarching capital controls of the 1950s than the more surgical form more common recently.

The central bank runs a strict licencing regime, rationing access to foreign currency. The immediate consequence has been the emergence of a dual exchange-rate regime, with offshore rates often 30%-40% higher than domestic rates. In turn, the government has been playing cat and mouse with currency traders, generally tightening regulations as market participants find new loopholes.

Initially, the capital controls were touted as a temporary measure to prevent a sharp depreciation of the currency, but by now the domestic economy has adapted to their presence, and become increasingly inward looking. The signs point to the controls remaining.

The capital controls have led to a form of exchange-rate stability, with the annualised volatility of the euro-krona exchange rate over the past year at 10%. By contrast, the euro-Swedish krona volatility has been 7% and the euro-dollar volatility 11%. With the presence of tightly binding capital controls, we might reasonably have expected lower exchange-rate volatility with the main trading partner.

Political risk and FDI

As noted by the OECD (2010), the Icelandic authorities have traditionally not been welcoming to potential investors, especially in its fishing sector. This anti-investment bias has worsened after the crisis with rules and conditions changing frequently. The government has been two-faced in its treatment of potential foreign investors, and its duplicity has injected fear and mistrust into the investment environment.

Unfortunately, the government has also been using the capital controls as means to implement industrial policy, politically selecting those allowed to use cheap offshore kronas to buy Icelandic assets. Such direct political selection of investors can only breed corruption, mistrust, and inefficiency.

Banking system

I discussed the banking system in an article on this site yesterday (Danielsson 2011), so to summarise, the Icelandic authorities were faced with the collapse of its entire banking system in October 2008. Instead of following best practice, splitting the failing banks into good banks and bad banks, they opted to split the banks on national lines, with the result that Iceland was left with three new banks that are unable to provide normal banking services. Subsequently, two of those banks have mostly passed into the hands of unknown foreign vulture funds, whose objective is to maximise asset recovery instead of banking.

As a consequence, Iceland has a dysfunctional banking system acting as a serious drag on economic recovery.

Conclusion

Iceland just ended the IMF programme it has been in since its crisis at the end of 2008. It is hard to see much success. The macroeconomic situation is dire, the banking system is dysfunctional, private investment has collapsed, and capital controls are here to stay. To their credit, the authorities have been successful in averting a sovereign default and regaining access to international capital markets.

Of course, we cannot blame the IMF for all of this. After all, the Icelandic government is ultimately responsible for implementing policy, even if the Fund did exercise direct authority by insisting on policy measures such as sharply raising interest rates during the worst of the crisis.

Overall, the Fund’s unqualified claim of success does not seem to be warranted.

However, little transparency exists on the IMF’s role in Iceland, and we do not know whether the Fund actively supported or even directed policy, or simply stood by while the Icelandic authorities took action. At the same time, it is unclear whether the IMF is still providing advice.