The return of Iceland?

Amidst all the gloom surrounding Europe, Iceland's apparent recovery from the depths of despair should be a cause for some celebration.The FT has a nice story that chronicles the Icelandic saga over the past five years.

Iceland's story till its meltdown in 2008 is classic Bubble Economics 101. The aggressive financial deregulation of early 2000s led to massive capital inflows and over-leveraged local banks. Asset prices inflated, construction activity boomed, businesses borrwed heavily in foreign currency and purchased assets abroad. Then the music stopped and the bubble burst, leaving the banks heavily leveraged, especially with foreign loans.

Iceland's recipe for restoring normalcy was to let its banks collapse and default on their loans. In contrast to countries like US, UK, and Ireland which injected billions to prop up their too-big-to-fail banks, Iceland let its inflated banking sector collapse. In 2008, the three biggest banks by assets – Kaupthing, Landsbanki and Glitnir - defaulted on $85bn of debt. This led directly to the collapse of the currency, the government and much of the economy. While the domestic assets of Iceland’s lenders were protected – costing the state 20% of GDP, according to the IMF – the lion’s share of the collapse was borne by foreign creditors.

Capital controls were introduced to prevent money leaving the country. The kroner underwent over 50% devaluation against the euro in 2007-08, which contributed towards restoration of national competitiveness. A rebound in tourism and fishing exports, boosted by the devaluation, have been critical drivers of the recovery. 

Iceland's economic recovery has been slow but unmistakable. As Paul Krugman has pointed out, the contrast with Latvia, which followed the orthodox prescription of fiscal consolidation and austerity, is stark.

On every parameter, the Icelandic economy has been making slow progress. In February, Iceland’s debt was upgraded from “junk” to investment grade by Fitch, the rating agency.

The FT article writes approvingly,

In August, Iceland completed a three-year IMF-supported restructuring programme, including loans of $10bn, and has started borrowing again on global credit markets. It has been held up by the IMF as a model of crisis management. GDP is set to expand by a respectable 2.5 per cent this year – which, added to last year’s 2.5 per cent, solidifies the sense of a country on the mend. The figures contrast with the 0.3 per cent contraction the European Commission expects in the eurozone this year.

But normalcy is still some distance away. The households and business balance sheets remain over-leveraged and it will be sometime before consumption and business investment will return to normalcy.  

The average household has suffered a 30 per cent fall in purchasing power since 2008. The private sector remains heavily indebted, with household debt levels exceeding 200 per cent of disposable income and corporate debt 210 per cent of GDP, according to Fitch. Partly because of this, domestic companies are reluctant to invest.

No light at the end of the tunnel - fiscal austerity Vs currency devaluation

I blogged a few days back about why currency devaluation is the most effective route to regain competitiveness. David McWilliams has an excellent graphic that captures the power of external devaluation.



The graphic reveals both the reality and the counter-factual. After it sharply devalued its currency in late 2008, Iceland's wages fell sharply and it quickly regained its labour competitiveness. The counterfactual - if Iceland had remained within Eurozone - is indicated by the Icelandic wages with respect to Euro, which would have remained very high. So McWilliams advocates an exit from Eurozone for Ireland as the "least extreme option".

"Iceland in one sharp devaluation has achieved what Ireland and Latvia are supposed to achieve over years of grinding down wages. If we are supposed to achieve Icelandic levels of wage competitiveness, we will have to shrink the economy over the next few years. By having their own currency the Icelandics did in a few weeks what we have been trying — unsucessfully — to do over four years... no economy in the world has ever emerged from a recession like ours without changing its exchange rate. The reason is that it simply can’t be done. There is no evidence anywhere, ever, that shows that a country can operate a successful “internal devaluation” — particularly an economy carrying as much debt as we have."

The belief that fiscal austerity would generate contractionary expansion is yet another example of failure to think beyond stage one. In fact, McWilliams himself provides the explanation as to why internal devaluation cannot work,

"When people are laid off, it is very difficult to get a new job because no one is spending in the economy. The government is not spending and the people are not spending. But what about the the much heralded export-led growth which postulates that foreigners will buy loads of Irish goods, more than compensating for the fall in domestic spending?

Well it doesn’t happen, partly because Irish wages don’t fall as we can see in the chart, so Irish goods are no more competitive than they were a few years ago. Yes, exports have risen, but nowhere near enough to offset the local contraction. This is why unemployment has trebled in three years and why emigration is running at over 1,000 people a week. It is not that the policy of internal devaluation is not working, it can’t work. It has never worked anywhere, ever."

Massive cuts to public expenditure and social protection, wage freezes, and tax increases mean that Ireland has been subjected to one of the most severest austerity programs. As Guardian reported, fiscal adjustment in Austerity's Child is the equivalent of €4,600 per person, the largest budgetary adjustments seen in the advanced economic world in recent times. Annual adjustments of €3-4 bn are proposed until 2015. The evidence in favor of contractionary expansion is surely missing.

News from Spain, another country experimenting with fiscal austerity, too is dismal. Spain's plight is a representative of the slippery slope associated with fiscal austerity. As austerity bites, aggregate demand slumps, and public revenues fall, the deficit widens and the debt-to-GDP ratio increases. Another danger is that once the fiscal consolidation targets are announced and if governments fail to meet them, the bond markets will react adversely, thereby raising the yields on sovereign bonds.

Spain’s new prime minister, Mariano Rajoy, last week admitted that the country faced wider than expected budget defict (it is estimated to be atleast two percentage points higher above the government's target of 6%) and announced a further package of austerity involving tax increases and spending cuts amounting to $19.3 billion. This is deemed necessary to maintain bond market confidence.

Though it is on target to cut the budget deficit by €16.5bn (£14bn) in 2012 through sweeping cuts, it is now being estimated that the economy will contract up to 0.3% in the final three months of 2011 and again in the first quarter of the new year. Its unemployment rate at 21.5% is already the highest in Europe and youth unemployment rate is at a whopping 45%.

Spain's problems come from the serious budget shortfalls faced by its 17 autonomous regions which have spent recklessly in the past decade and continues to do so. As a Times report writes, in recent years, the regions and municipalities have racked up debts, offering generous public services and investing in a wide range of projects, some of them bordering on the ridiculous. The Bank of Spain recently announced that regional debt had surged 22% to $176 billion in September from $144 billion the year before. And there is a strong feeling that there remain tens of billions of dollars in 'hidden' regional debt yet to be discovered.

The austerity-leads-to-growth evidence is missing

The three most cited examples of fiscal austerity in the face of economic contraction as the preferred strategy to restore economic normalcy are Ireland, Latvia, and United Kingdom.

A year on after it received a 67.5 billion euro bailout, Ireland represents a very mixed macroeconomic picture though the social impact of austerity has been much more damaging. In 2010, Ireland passed the most austere budget in the country’s history, and public sector pay cuts were a centerpiece of the government’s reform effort. Though green shoots of economic growth are back, exports have been rising, and deficit is shrinking (it fell from 32% in 2010 to estimated 10% for 2011), public debt burden far from plateauing and declining has been rising, albeit slower than earlier, and bond yields have been climbing. Most damagingly, unemployment rates are climbing and nearly 40,000 Irish have fled the country this year alone in search of a brighter future elsewhere.



More worryingly, as this Times report indicates, the platform for sustaining short- to medium-term growth looks shaky.

"Salaries of nurses, professors and other public sector workers have been cut around 20 percent. A range of taxes, including on housing and water, have increased. Investment in public works is virtually moribund... government is announcing an additional 3.8 billion euros in tax increases and spending cuts for 2012 that will affect health care, social protections and child benefits. Retail sales fell 3.8 percent in October from a year earlier as spending was down even on things like school textbooks, shoes and other basic goods... welfare payments have steadily been reduced even as the unemployment rate has ticked up to 14.5 percent, and is forecast to remain high at least through next year."

In this context, as Paul Krugman has repeatedly pointed out, the experience of Iceland, which went against conventional austerity, is instructive. Faced with a unsustainable external debt, run up by its reckless banks, Iceland let its bankers go bust and even expanded its social safety net. It also imposed capital control. Instead of internal devaluation through wage freezes, Ireland devalued the kroner. While, like others, it did suffer sharp output contraction, it has managed to keep unemployment rates from getting out of control.



In fact, this direct comparison of the Latvia and Ireland, is very stark. Even on output contraction, the austerity experiment appears a relative failure.



Admittedly, Iceland had its currency and could manage an external devaluation, and regain competitiveness and put the economy on recovery path. The Eurozone economies do not have that and other sovereign instruments to tide over such crises. But United Kingdom has the option of currency devaluation and other regular instruments, and still choses austerity.

More than a year on into its austerity program involving cutting 600,00 public sector jobs, the British economy appears no close to recovery. Early last week, the British chancellor of Exchequer has admitted that growth would be slower than forecast and "debt will not fall as fast as we’d hoped". This meant additional austerity measures, including pay freezes for two more years beyond 2015. The initial plan to eliminate budget deficts has been pushed back by two more years to 2017 and Britain would now require to borrow an additional £111 billion, or $172 billion, through 2015.

A report by the Office for Budget Responsibility has forecast that the British economy will grow 0.9% his year, less than the 1.7% predicted earlier, 0.7% next year, and 2.1% in 2013. It also predicted that debt as a share of GDP would peak at 78% in the fiscal year ending in 2015, higher than the 71% initially predicted. The output gap is expected to persist well past 2017, and the November 2011 estimate shows it worsening since the March 2011 estimate.



The austerity and the squeeze on public spending is expected to take a heavy toll on the GDP growth, as seen by this graphic. The contributions of government compensation, procurement, and investment to the economic growth is set to decline strongly in the years ahead.



Given the inevitability of output contraction and the difficulty of accommodation due to fiscal space, the only immediate political economy issue of concern is how to mitigate adverse consequences of the the slowdown on the nation's population. Atleast on this count, all the aforementioned experiences show that austerity fails.

For more on the social impact of savage austerity, see this report on Lithuania. It achieved a fiscal adjustment of 9% of GDP by cutting public spending by 30% (incluing slashing public sector wages 20-30% and reducing pensions by as much as 11%), raising corporate taxes to 20% from 15%, value added tax from 18% to 21%, and also taxes on a wide variety of goods. In Britain, the wages of austerity are taking an increasing toll and the winter of discontent appears to be making a comeback with nationwide strikes and protests.

Update 1 (2/2/2012)

The FT writes that "after the initial stimulative boost, fiscal policy began to steadily contribute less and less to growth until finally becoming a drag for most of last year and part of the prior year. That’s why the federal contribution to growth is roughly a wash during the recovery."



The CBPP graphic hilights the true magnitude of the austerity. In fact, the cuts backs in state and local government spending make it the worst period since 1944. As CBPP writes, "state and local governments have cut deeply their spending on schools and other public services for three straight years. In fact, economic output from state and local governments fell by 2.3 percent in 2011 — marking the steepest drop since the wartime economy of 1944. By reducing economic activity, these cuts have slowed the economic recovery."



David Leonhardt maps the evolution of the US economic growth over the past four years with respect to the trends in private and public sector consumption growth rates.

Portugal follows, where is the "confidence fairy"?

So finally, after months of speculation, and faced with spiralling borrowing costs, Portugal bows to pressure and follows Greece and Ireland in seeking an emergency financial bailout from the European Commission. It is being estimated that the country would need about 75 billion euros ($106.5 billion) in assistance and the conditions of the assistance is expected to be worked out soon.

The bailout became inevitable after the steep increases in Portugese borrowing costs in the past few weeks.



There have been repeated downgrades by credit-rating agencies (twice last month alone) which have sent yields on Portuguese government debt to their highest levels since the introduction of the euro. Last week Portugal sold 455 million euros (about $646 million) in one-year Treasury Bills at an average yield of 5.9%, up from 4.33% since mid-March. Similarly, the yield on 550 million euros of six-month bills was 5.12% compared to just 2.98% in an auction in early March. The emergency financing will ensure that Portugal can meet its 20 billion euros of borrowing requirements for the year.

Last May, the European Ministers agreed to provide 80 billion Euros to Greece over three years as part of a package in which the International Monetary Fund provided an additional 30 billion euros. Then, in November, they also agreed to a rescue package worth up to 85 billion euros for the Irish government. Further, last month, following Greece's adoption of extensive austerity measures, they also agreed to cut the interest rate charged Greece to help ease its debt burden. However, Ireland's refusal to accede to French and German requests to raise its low corporate tax rate of 12.5%, has meant that no such benefits have been given to Ireland.

The bailout will be arranged from the eurozone’s €440 billion rescue fund, the European Financial Stability Facility, which was set up last year to meet such contingencies. It is being hoped that the Portuguese bailout request may help reduce the risk of contagion to other countries, most notably Spain, by ring-fencing the euro’s three weaker economies.

However, if Greece and Ireland are any evidence, the standard European prescription of fiscal austerity to get the "confidence fairy" singing again and the economy back on the growth track appears not to be working. In a clear indication that its fiscal austerity was not doing much, the sovereign ratings of Greece, which was already downgraded to junk status, was again lowered by S&P to BB– from BB+.

Also, the cost of insuring debts and cost of borrowing has been rising unabated for both Ireland and Portugal despite the severe austerity measures and the emergency bailout package. In fact, as the graphic shows, after a brief drop in the immediate aftermath of the May 2010 bailout, the 10 year bonds have risen from about 7.25% to 12.75 today, while the CDS spreads have doubled, touching 1000 points.



In case of Ireland too, the same story has been repeated with both bond yields and CDS spreads. In Ireland's case, the fiscal austerity, which has been much more severe and has been in operation for more than two years now. Inspite of this, the bond yields and CDS spreads have been rising unabated all the while.



However, fears about Spain being the next in the domino to fall may be slightly exaggerated, atleast for now. Its CDS spreads have fallen dramatically since the beginning of the year and bond yields too have remained stable, albeit at a high 5-5.5% range.

Update 1 (9/4/2011)

Underlining its hawkish stance on inflation, in an unanimous decision, the European Central Bank (ECB) raised its benchmark policy rate to 1.25 percent from 1 percent. Inflation in the euro area rose at an annual rate of 2.6 percent in March, up from 2.2 percent in February and above the bank’s target of just under 2 percent. Since October 2008, the ECB had, in response to the sub-prime crisis and Great Recession, slashed rates from 4.25 percent to 1 percent by May 2009.

This is in contrast to the Federal Reserve, which continues to stimulate the American economy, as well as the Bank of England, which early this week left its benchmark interest rate at 0.5 percent despite higher inflation. In fact, like the $600 bn QE II in the US, the Bank of England too is continuing with its £200 billion ($325 billion) bond-purchase plan.

The rate increase could have dire consequences for Greece, Ireland and Portugal, where they are already having severe problems borrowing money at reasonable rates. More worryingly, the rate hike will also increase the pressure on Euro to appreciate, thereby weakening the competitiveness of European exporters.

This Economist article points to the fact that unlike Greece, Portugal does not have the problem of mountainous public debts or recklessly leveraged banks. Its problem is more structural - lack of competitiveness manifested in high input costs and excessive bureaucracy. It is inconceivable that austerity can do anything to overcome these problems.

Update 1 (15/4/2011)

The British austerity plan (aimed at lowering its budget deficit from a high 10% of GDP) appears to be having its predicted impact - retail sales plunged 3.5 percent in March, the sharpest monthly downturn in Britain in 15 years; a new report by the Center for Economic and Business Research forecasts that real household income will fall by 2 percent this year.

Update 2 (20/4/2011)

Nice graphic on the EU's emergency bailout fund.



Update 3 (4/5/2011)

Portugal has accepted an international (EC, ECB and IMF) aid plan of 78 billion euros ($116 billion). Under the three-year plan, the deficit would need to be lowered to 5.9 percent of gross domestic product this year, 4.5 percent in 2012 and 3 percent in 2013. Last year, Greece secured a bailout package worth 110 billion euros and Ireland 85 billion euros.

Update 4 (16/2/2012)

Times chronicles how austerity is leading Portugal down the cliff. See also this Room for Debate on Portugal.

Iceland Vs Ireland?

Almost alone among those who faced the depths of the financial crisis, Iceland refused to bailout its financial institutions. It placed its biggest lenders in receivership and chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion (11 times GDP). In other words, the creditors, not the taxpayers, shouldered the losses of banks.

The krona lost 58% of its value by the end of November 2008, inflation spiked to 19% in January 2009 and GDP contracted by 7% that year. The Prime Minister Geir H. Haarde resigned after nationwide protests.

As a Bloomberg report argues, if early signs are any indicator (with economy projected to grow 3% in 2011), then Iceland’s decision to let the banks fail is looking smart and may provide important lessons for others. The GDP grew for the first time in two years in the third quarter, by 1.2%, inflation is down to 1.8%, the cost of insuring government debt has tumbled 80%, and banks have bounced back into the profitability.

The three biggest Icelandic banks - Kaupthing Bank hf, Landsbanki Islands hf and Glitnir - who had indulged in the spectacular lending spree at home and overseas were seized by regulators on October 6, 2008. The Bloomberg report writes,

"The government negotiated with the creditors, almost all of them outside the country, including mutual funds and hedge funds in the US and the UK and European banks and pension funds. Kaupthing’s creditors agreed to take an 87% stake in Arion, and Glitnir’s creditors now own 95% of Islandsbanki. Glitnir’s biggest creditor as of June was Dublin- based Burlington Loan Management Ltd., followed by Royal Bank of Scotland and DekaBank Deutsche Girozentrale, the fund manager for Germany’s state-owned savings banks.

Glitnir’s 8,500 creditors and Kaupthing’s 28,000 expect to get about 30 cents on the dollar for their claims, based on secondary-market prices of the banks’ debt and asset valuations by the resolution committees. About half of Kaupthing’s creditors are German depositors who had Internet accounts, have gotten their principal back and are seeking interest payments.

Landsbanki’s creditors opted for a promissory note from successor NBI hf instead of a stake in the new bank. Landsbanki had collected about $5 billion of overseas deposits through branches in the U.K. and the Netherlands. Iceland didn’t guarantee those deposits at the time it seized the bank, as it did for domestic customers, leading to a dispute with the British and Dutch governments. In December, Iceland agreed to compensate the U.K. and the Netherlands in full for their payments to Icesave depositors, as the Landsbanki accounts were known. Payment, including interest of about 3 percent, will be made over 35 years."

In contrast, Ireland guaranteed all the liabilities of its banks when they ran into trouble and has so far injected 46 billion euros ($64 billion) as capital so far to prop up these banks. The result is an unsustainable debt burden that could swell to twice its GDP, up from 94% now and the near certainty of a sovereign debt default. It is a widely held feeling in Icleand that if it had guaranteed all the banks’ liabilities, they would have been in the same situation as Ireland.

See this Vanity Fair article by Micheal Lewis on Ireland. Micheal Mandel has an excellent series of graphics that puts the role of external sector, exports/imports and financial profit repatriations, on Ireland's economic fortunes in perspective.