Is the Icelandic response to financial crisis generalizable?

Paul Krugman describes their policies as a mix of “debt repudiation, capital controls, and massive devaluation.”  Matt Yglesias refers to putting some of their bankers in jail.  But I say there is not a generalizable formula here.

Neither mentions that a major part of the Icelandic recipe was letting foreign deposit holders twist in the wind.  That’s a transfer of wealth to the domestic economy and furthermore it was politically palatable; it is also a choice which won’t much help any larger country where most of the deposit holders are domestic.  It is noteworthy that this kind of choice loomed large for Cyprus, another small country with a lot of foreign depositors.

Iceland is also so small that cutting off these creditors won’t much damage the broader global economy or lead to significant contagion.  Today, in a much safer macroeconomic environment, we’re not even sure the same could be said for Grexit, and Greece is a pretty small country in economic terms.

On top of all that, not paying back the foreign depositors was a transfer to Iceland.  It is easy enough to see why Icelanders might like that idea, but the objective foreign analyst, who ought not favor the more Nordic peoples above the others, also should consider the loss side of the ledger, namely in the UK and Netherlands.

What else?

Don’t forget that the value of the Icelandic stock exchange fell by 90% – how many other countries could endure that or would accept it?  That is easier to pull off when there are only six stocks trading on your exchange and those equities are not central to your savings.

Capital controls are also not an option for many economies, including those that are serious about being financial centers or having reserve currencies.  More to the point, the flight of foreign capital is very often not a problem in the first place.  And we have plenty of experience with capital controls and the overall record is at best mixed; this is hardly a neglected heterodox innovation.  The imposition of Icelandic capital controls may well discourage foreign investment looking forward, and so the “record to date” will be misleading in this regard.  This is again a way in which Iceland has transferred the costs of its adjustment into the future.  On top of that, we still don’t yet know how well the Icelandic removal of capital controls will go.

I’m all for devaluing and accepting higher inflation in a lot of crisis situations.  This part of the Icelandic recipe is generalizable.  It’s worth noting, however, that the devaluation (especially with capital controls) imposed a harsh and immediate “austerity” on the Icelandic people, namely it was very hard to buy foreign goods for a while.  In other words, rapid real wage cuts were imposed on just about everybody.  If your country can do that, great, but it needs to be outlined how most economies will manage that trick.  See also Scott Sumner’s remarks on whether Iceland avoided traditional fiscal austerity.

Given some very tough circumstances, Iceland also did a reasonable job of “ring-fencing” its banks and separating the good from bad assets.  That may be generalizable too, although it doesn’t have the polemic punch of some of their other policy choices.

Overall, the experience from Iceland, upon closer inspection, is not very easily generalizable.  I suspect it receives much of its praise for reasons of mood affiliation — what could sound tougher than putting bankers in jail?  But overall, Iceland faced very different constraints and opportunities, relative to other countries in the financial crisis.

Addendum: Here are some relevant earlier posts.


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