The latest bailout will put every Irish man, woman and child on the hook for an additional €20,000, regardless of whether they lent a “helping” hand to produce such an imbalanced state of affairs. While the morality of indebting innocent citizens to save culpable bankers is questionable, it may be time to reassess if there was a better roadmap to recovery that the Irish could have followed.
In late 2008 a popular joke circulated about Ireland’s future: What’s the difference between Ireland and Iceland? One letter and about six months.
Iceland was quickly descending into its deep nadir. A decade of highly inflationary monetary policy had left the Icelandic economy awash with credit. Money flowed into the stock market, consumers’ goods, housing and, eventually, foreign investments. Secured by an explicit bailout guarantee from the Central Bank of Iceland, the domestic banking industry soon ballooned to 1,100 percent of 2008 GDP. Activity was centralized in a mere three banks, which together controlled 80 percent of total Icelandic banking assets. Secured by a stable krona exchange rate, banks, entrepreneurs, and individuals increasingly borrowed in foreign-denominated debts – primarily Swiss Franc, Japanese Yen. Eventually 80 percent of total consumer borrowing was concentrated in these two currencies.
Ireland’s recent excesses were no less impressive. Private non-financial sector debt soared to almost 200 percent of GDP, among the highest in the Eurozone. The Irish government’s budget deficit for 2010 is reckoned to amount to over 32 percent of GDP.
While the Icelandic government decided to nationalize the banking sector, it soon became apparent that the size of it problems dwarfed the ability to deal with it. Instead of inflating the money supply, the Central Bank of Iceland effectively filed for bankruptcy. Indeed, given the size of the banking sector’s foreign-denominated debts it is unlikely that the CBIcould have inflated its troubles away – adverse exchange rate movements would have cancelled any positive effects from printing new krona to pay off foreign debts.
By choosing the bankruptcy path rather than continued bailouts, the Icelandic economy fell into a deep immediate decline.* Within months of Iceland’s “bankruptcy”, its stock market had fallen more than 95 percent from its 2007 highs. The krona depreciated by 60 percent against the euro. While such drastic adjustments were devastating for the short-run, they were necessary to provide entrepreneurs with the essential signals to aid economic recalculation, and to promote coordination. The decline in the krona exchange rate provided domestic producers the necessary cost advantages to recommence becoming exporters to the world. At one point Iceland, a country with no domestic automotive production facilities became a net exporter of autos as the devalued krona made export of the surplus stock of vehicles profitable.
The combination of a general unease to lend to the Icelandic government and a devalued exchange rate made it increasingly difficult for the Icelandic government to continue running budget deficits. Austerity measures that other countries have discussed, but lack the commitment to enact came into place – not necessarily by choice, but by necessity.
Ireland’s inclusion to the Eurozone made it impossible to correct its situation through an exchange rate decline. As exit from the Eurozone was a political impossibility, a stream of bailouts and guarantees – implicit and explicit – became the norm for Icelandic investors and politicians. Ever increasing amounts of public sector debt piled on an already unsustainable situation. Banking imbalances worsened, yet the situation was never fully addressed until the credit markets dictated that it could not continue. With Irish politicians unable to secure affordable credit on the bond markets, a concerted bailout from the EU, ECB and IMF was pushed upon the newly domesticated Celtic Tiger.
It is instructive to evaluate how each country has fared in the two years since this global crisis erupted. While Ireland’s nominal GDP remains in freefall, Iceland’s has stabilized and is starting to show faint signs of recovery. Real wages, which have been negative in Ireland for over two years started showing positive growth in Iceland earlier this year. As inflation has stabilized in Iceland, the country is showing strong signs of recovery. A significantly devalued krona has allowed the country to return to competitiveness, with commensurate growth in its GDP. In contrast, the lone piece of good news coming from Ireland this past week was that a portrait of Brian Cowen had finally been found to hang in Ireland’s national parliament, Leinster House.
Iceland’s pain was severe, but at least short-lived. Ireland’s recovery is still nowhere on the horizon, despite two years of investor uncertainty concerning and continually worsening situation. While the old joke asked pejoratively what the difference was between Iceland and Ireland, today is a good time to revisit the question. If Ireland could become Iceland in 6 months and one letter it would be a miraculous recovery. With some dedication and perseverance, the Irish could turn their economy around. Saying goodbye to the euro would be a step in the right direction.
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*This is not to imply that the Icelandic case was free of bailouts. Several international consortiums provided emergency liquidity support to the government. What Icelandic policymakers did not pursue was a continued propping up of an unsustainable oversized banking sector, one which was impotent to combat the effects of higher interest rates or a liquidity constrained world. Philipp Bagus and I document Iceland’s boom and bust in our forthcoming book “Deep Freeze: Iceland’s Economic Collapse” (Auburn, AL: Ludwig von Mises Institute).