http://www.imf.org/external/pubs/ft/survey/so/2011/CAR110311A.htm
As policymakers
continue to grapple with the problems facing the crisis-hit countries in
the euro area and the clouded outlook for the global economy, attention
has turned to Iceland, which three years ago saw its entire banking
system crumble in just a few days.
Private creditors ended up shouldering most of the losses relating
to the failed banks, and today Iceland is experiencing a moderate
recovery. Unemployment is declining, and the government was able to
return to the capital markets earlier this year.
“What was seen as a disaster for Iceland three years ago is
increasingly being seen as good fortune with the passing of time.
Icelanders may have lost their financial system but instead they were
spared the burden of nationalizing private debt,” said Árni Páll
Árnason, Minister of the Economy.
Just as Iceland’s financial crisis stands out in terms of its sheer
scale, so does its unconventional path to recovery. “Iceland zigged when
all the conventional wisdom was that it should zag,” Nobel Prize winner
and New York Times columnist Paul Krugman said at a conference in Reykjavik,
aimed at distilling the lessons of the crisis and discussing the challenges
ahead.
Key to Iceland’s recovery has been an IMF-supported program
worth $2.1 billion that ended in August this year. “The less travelled
Icelandic route gained credibility in the eyes of the world through
cooperation with the Fund,” Prime Minister Jóhanna Sigurðardóttir told the
conference.
Collective madness led to crisis
“Iceland, in the decade and a half leading up to the crisis, was an
example of collective madness,” said Willem Buiter, chief economist at
Citigroup, a remark that elicited spontaneous applause from the more
than 300 participants, many of them Icelandic policymakers, academics,
and members of the public.
Buiter was referring to Iceland’s banking system, which grew to be 10
times larger than the country’s economy in the span of just five years.
Supporting three globally active banks beggars belief when your economy
is the size of that of Iceland, with a population of just over 300,000,
he said.
The sheer scale of the economic collapse meant that Iceland was
forced to think outside the box as it sought to address the crisis. The
policies that were adopted included capital controls to prevent massive
capital outflows and a disorderly depreciation of the exchange rate,
allowing the banks to fail and not socializing the losses, and a
decision not to tighten fiscal policy during the first year of the
program, which helped protect the country’s welfare state, IMF resident
representative Franek Rozwadowski said.
The welfare state was used to soften the impact on households, and
benefits were redirected to lower income groups, according to Stefán Ólafsson
from the University of Iceland. The result was that inequality in Iceland
actually decreased during the program, he said.
Useful test case
“Iceland’s heterodoxy gives us a test of economic doctrine,” Krugman
said. Comparing Iceland to Ireland and Latvia (both members of the
European Union), he argued that the former has fared much better than
the latter in terms of growth and jobs.
And despite warnings that economic Armageddon
would follow Iceland’s decision not to accept liability for the losses
of private banks, credit default swaps on sovereign debt are now much
lower in Iceland than in Ireland, where the state assumed full
responsibility for bank losses, he said.
“Iceland has done fine in terms of regaining not total, but
reasonable confidence in its sovereign debt. The idea that there would
be a huge reputational penalty for allowing private sector parties to go
bust and default on their external obligations has not turned out to be
true.”
Another Nobel Prize winner in economics, Professor Joseph Stiglitz of
Columbia University, also endorsed Iceland’s policy response. “What
Iceland did was right. It would have been wrong to burden future
generations with the mistakes of the financial system,” he said in pre-recorded
remarks screened at the conference.
Other speakers who strongly supported Iceland’s decision not to bail
out the banks included MIT professor and former IMF chief economist
Simon Johnson, who also warned that the world’s financial system remains
“a big house of cards.”
Capital controls remain bone of contention
The question of how and when to lift the capital controls that were imposed in
October 2008 elicited heated debate.
Capital controls have proved to be an expensive mistake, and there
still is no viable strategy for lifting them, Vilhjálmur Egilsson of the
Confederation of Icelandic Employers said. This argument was supported
by Jon Danielsson of the London School of Economics.
Capital controls send the wrong signal to investors and are holding
back recovery. They should not have been imposed in the first place, he
argued.
But many of the other panelists disagreed. “We need to be open to a
wide range of policy tools when helping small, open economies deal with
capital inflows and outflows,” IMF Mission Chief Julie Kozack
said in response to a question from the audience. The IMF has
recommended that Iceland keep the controls in place until a number of
conditions are met so that the economy is not undermined by a sudden
outflow of capital. “A conditions-based strategy for lifting the capital
controls is what Iceland needs now,” IMF Deputy Managing Director Nemat
Shafik said.
Krugman also warned against underestimating the danger of lifting the
controls too quickly. It’s wrong to base your economic policy on what
you want your image to be, he said in response to Danielsson.
Choosing an exchange rate regime for the future
The question of whether Iceland should give up the krona and adopt
the euro was another key topic. Here also, views were sharply divided.
Iceland is in a race against time as the krona is bound to start
appreciating soon, and the only answer to the perpetual swings in the
value of the currency is to adopt the euro, said Gylfi Arnbjörnsson, President
of the Icelandic Confederation of Labor.
But Martin Wolf of the Financial Times urged caution in “replacing
the fun of being Iceland with the fun of being Ireland.” Krugman, for
his part, said he really wondered about this enthusiasm for joining the
euro, noting that Iceland does not fit neatly within the euro area
because of the resource-based nature of its economy.
“It’s a matter of politics where you belong. Let’s make the currency
more robust,” said Gylfi Zoega, a professor at the University of Iceland
who was featured in “The Inside Job,” the film by Charles Ferguson
about the global financial crisis. Johnson for his part suggested
Iceland adopt inflation targeting as a way of managing the exchange
rate.
Lessons for the IMF
What, then, should the IMF take away from its cooperation with Iceland? The
Fund learned three main lessons, Shafik said.
•When countries have a clear strategy in mind, as was the case in
Iceland, it becomes much easier for the IMF to engage and provide policy
support and advice.
•There are clear advantages to having a heterodox toolkit―more tools are better
than fewer.
•Iceland set an example by managing to preserve, and even strengthen, its
welfare state during the crisis.
Recent IMF research
has shown that countries tend to grow faster and more consistently when
income distribution is more equitable, so the Fund is now paying much
more attention to these issues in its programs, she said.
For his part, Finance Minister Steingrímur Sigfússon
praised the IMF for its flexibility and willingness to engage. “There
are lessons to be learnt from our cooperation with the IMF. Not from the
program as such because that’s easy to put on paper, but from how this
cooperation evolved, and how it should be: Based on mutual trust and
cooperation, and leaving as much space as possible to elected
politicians to take the decisions and do the hard work to select their
own rules. As long as they deliver, it’s up to them.”
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