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.


It's funny how so many people can take it as a given that "bankers" among thousands of banks in dozens of countries all can have been expected to engage in systematically criminal behavior. At some level of generalization, can we start to question the perspective of the generalized accusers? As with any generalization, there are clearly specific instances that prove the general accusation, especially in the 2006-2008 period where many banks were in desperation mode and, as with the S&L crisis, some would choose modes of operation that would lead down a dicey path. But, the broader complaints have a "First, kill all the lawyers." or a "We started having seizures after we were visited by an apparition of Goody Parson." quality about them.

Your argument proves the point. More than a thousand "bankers" were jailed as a result of the S&L crisis. The difference with subprime was that the institutions involved were many times bigger and more powerful. As was the fraud.

And remember Enron? We came up with Sarbanes Oxley after that, which specifically prevents CEOs from pretending they didn't know what was going on. Yet that's what all the banker CEOs said. None of them had any idea why they were getting paid so much money. There was some little department somewhere that was suddenly spinning off massive profits and it never occurred to any of them to ask what was going on. There were bankers making more money than the CEO himself in some cases, but still they didn't ask anything! The revelation that the subprime mortgage industry was a fraud came to them like a bolt from the blue!! Imagine the shock they must have got...

The difference with Enron is that many C-Suite and upper level management were directly implicated in abetting fraud. Most financial institutions don't leave such clear fingerprints. You run into a Steven Cohen problem, where you can only point to high pressure incentives and lax internal auditing responses to infer fraudulent behavior.

The simple answer to this problem is some form of strict liability, where lack of knowledge or intent are not adequate defenses. Then the incentive is to rout out potential risks before they cause damage.
Forcing execs at systemically important banks to hold some portion of their wealth or bonuses in junior debt of their own institutions, to be wiped out in the case of a bailout, does a lot to realign incentives.

I think the better answer is the lay out ahead of time how the systematically important banks would be disposed of in the event of a bankruptcy, thereby negating the claim that a bankruptcy would be 'disorderly' (which was the bullshit the Top. Men. were pushing at the time of the crisis) and therefor impossibly bad. Anyone doing business with those banks would go into any deal knowing where they would fall in the bankruptcy feeding trough.

The executives at those banks are incidental. Its the bailouts that matter.

"Forcing execs at systemically important banks to hold some portion of their wealth or bonuses in junior debt of their own institutions, to be wiped out in the case of a bailout, does a lot to realign incentives."

You do not care much for freedom or liberty I see.

To be fair, it is only apparent that louis doesn't care about the liberty and freedom of others. I'm sure clutches onto his own shred of freedom.

They are free not to take the job.

In the days of yore, bank managers had to put up personal performance bonds that indeed would be forfeit if the bank went belly up.

These could be tied to the size of the bank, and the managers position.

Thus, no one is saying you can't build a mega bank, but man is that personal performance bond going to be large.

Putting bankers in jail who were criminally negligent (SOX) in abetting fraud is generalizable.
More should have gone to jail -- the "financial system" would suffer an earthquake with AIG and many other Big Banks going belly up, BUT main street would still be able to get loans for good projects from middle banks. Neither main street nor the world really depends on the Big Banks in the long or middle term, and when money is involved, the mid term is shorter than a quarter. The Fed should have lLet all the big banks fail and instead just pump in money to the best middle banks to pick up the bargains the Big banks sell in fireside sales.

All the big banks had highly paid analysts, and lawyers, who had access to the work and warnings of Dr. Michael Burry, and others (see The Big Short):
>> The work follows people who believed the bubble was going to burst, like Meredith Whitney, who predicted the demise of Citigroup and Bear Stearns; Steve Eisman, an outspoken hedge fund manager; Greg Lippmann, a Deutsche Bank trader; Eugene Xu, a quantitative analyst who created the first CDO market by matching buyers and sellers; the founders of Cornwall Capital, who started a hedge fund in their garage with $110,000 and built it into $120 million when the market crashed; and Dr. Michael Burry, an ex-neurologist who created Scion Capital despite suffering from blindness in one eye and Asperger's syndrome. << wikipedia

Of course, the highly paid lawyers and analysts would actually have to read the voluminous, and boring, CDO agreements -- the job they were highly paid to do but nobody really checked that did so.

The "market working" would have put lots of them bust, and the shareholder lawsuits would likely find negligence -- that's the market justice which gov't is constituted to provide.
But failed to do so.
Gov't failure, not market failure -- but naturally the gov't folk, and media, all blame "the market" and/or greedy bankers. (I also blame greedy bankers but think the gov't should have put more in jail. Lots more.)

There are 323,000 people in Iceland. Nothing they did can be generalized.

+10 (Obviously! , except the putting bankers in prison part, we should study that...)

Sure, if someone broke the law or committed fraud, they should be prosecuted.

But it could be argued that even doing that is a matter of scale. When, for example, you need the same people who should be prosecuted to buy at a high price the $trillion dollars worth of debt let alone the how many trillions that need rolling over every year, a few words here and there may keep the prosecutors occupied elsewhere.

In a small place like Iceland, jail may be preferable for the bankers than being spit on or slapped around when they go out to get groceries.

Nothing they did can be generalized, including this:

"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."

If there are only six stocks trading on the exchange, this is nowhere near enough of a sample set to extrapolate that the same thing would happen in another setting.

I guess it was generalizable enough to discuss a couple of years ago:

They could fall back on their commodity based economy. I believe the puffin is currently trading at 7.54 salmon.

Who could have predicted that a financial system run by fishermen would stink?

The bankers will just start speculating on herring.

"Capital controls are also not an option for many economies, including those that are serious about being financial centers or having reserve currencies"

1) Capital controls worked a treat for Malaysia in '98/'99.

2) There are two 'financial centres' to speak of globally. What's your point?

3) There is one reserve currency. What are you talking about?

"..the flight of foreign capital is very often not a problem in the first place"

Tell that to Indonesia after 1998.

I have to agree with Carlospin here, sadly. Financial repression works. The USA practiced capital controls of sort, with fixed FDIC deposit rates and fixed exchange rates, for decades after WWII. Also this TC sentence is wrong: "Neither mentions that a major part of the Icelandic recipe was letting foreign deposit holders twist in the wind." - I can see the day when the USA repudiates on all foreign debt holders, but honors US citizen debt holders up to some limit for debt held as of a certain date. This would wipe out a lot of problem debt for the USA and allow it to start anew.

So foreign debt holders would then sell at a discount to US citizens. But this sounds a lot like a perfectly competitive market, so wouldn't the discount shrink to near zero?

@Ricardo - you could make resale illegal, after a certain cutoff date. Kind of like what might happen to Greek with the Euro and what happened in Cyprus already.

I suspect that if there was a war with China, we would suspend their debt holdings or outright cancel them.

Not to mention that in today's world, the flight of domestic capital can be a real problem.

I suspect its success is discounted here for reasons of mood affiliation — what could sound scarier to the Koch Bros crowd than putting corrupt plutocrats in jail?

Why would that be scary to the Koch brothers at all?

They have money so corrupt. They are [thought to be] conservatives so corrupt.

Do you live in Minneapolis?

Stocks fell with 90%, so? We all know that stock prices are margin prices and not indicative at all of the value of the entire stock of stocks.

When your retirement depends on stocks, price is more important than value.

If you're young, a massive stock crash is the best thing that can happen to your retirement. Broad stock indices will recover in a few years and meanwhile you'll be buying cheap stocks on the upswing.

If you're old, dividends matter for your retirement more than capital appreciation. Dividends reflect spending and income rather than asset prices, so if a crisis destroys spending and income that's bad. Better to hit asset prices instead.

Old people don't rely on dividend income alone, since few stocks pay dividends. You can't take stocks to the grave anyway, so it makes sense for them to sell a fraction of their stocks periodically. Short term asset price matters.

Yes, but the very fact of Iceland's non-generalizable actions having some success can be generalized. Remember the paradigm at the time, which was that crisis management is generalized, therefore as applicable to Iceland as larger countries, and e.g. excluded capital controls.

Iceland bucked the trend, and did it its own non-generalizable way, and got some success. So bucking the trend - looking for non-generalizable solutions, might be the generalizable takeaway.

'what could sound tougher than putting bankers in jail?'

Shooting them?

Cowen's support for austerity and criticism of anti-austerity is due to his mood affiliation with the perception that we must suffer for our sins, or maybe mood affiliation with people who own shares and residents of the United Kingdom, but since we don't have a definition of mood affiliation, it is difficult to say for sure.

(1) Do you disagree with me on a topic?

(2) Do you disagree with me on another topic?

Sounds like you are just mood affiliating from that other topic to this one.

I think Tyler should use the term less and just describe the mood and affiliation more. Here he just wants to claim that people who like going hard after bankers like Iceland for doing so, and then start to believe Iceland's other responses must have been praiseworthy too.

I think that in actuality it is much more likely to be a conscious decision by the commentators involved, if it is happening. They want to jail more bankers, so they want any country that did so to seem like it succeeded overall and made many other smart decisions along the way.

I don't think of the latter as mood affiliation, since it is a conscious rhetorical choice rather than an unconscious bias. But maybe mood affiliation has a more general meaning than I thought.

The mood affiliation meme is one of the funniest things about this blog. Saying others are biased is not a persuasive argument for anything, especially because everyone has biases, priors and moods to affiliate.

Krugman's chart is idiotic. Icelandic peak employment wasn't based on anything particularly unusual; they just had massive growth in fairly labour-intensive financial services mostly involving foreign depositors and lending to foreigners, without any obvious employment consequences. Irish peak employment was based on a massive property bubble. Krugman can't be an idiot, so he must know about this property bubble and simply chooses not to mention it because it would weaken his rhetoric.

The Iceland experience may not be generalizable, which may explain why Krugman compared Iceland to Ireland rather than, for example, the U.S. Speaking of mood affiliation, there seems to be a prejudice for judging monetary and, especially, fiscal policies based on the policies themselves rather than the outcome; for those like Cowen, it seems no amount of experience is sufficient proof for a policy he disapproves. Whatever. But here's something to ponder: "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?" Certainly not here, as aggressive monetary stimulus not only stopped the fall but has inflated the values of stock (and many other assets) above precrisis levels. Does Cowen approve the policy, monetary stimulus to stop the fall and inflate the values, or does he prefer the Boettke approach, which is to eschew both monetary stimulus and fiscal stimulus and let markets correct the excesses and imbalances? "[H]ow many other countries could endure that or would accept it?" Countries? How many very wealthy owners of stock whose fortunes are collapsing before their eyes would accept it? And how many economists would experience a conversion not unlike that of Paul on his way to Damascus?

I wonder what happened to the idea that investors are responsible adults who should be expected to understand that actions have consequences.

Interestingly, debt renegotiation, massive devaluations, and capital controls all have analogues in the way private sector capitalism has successfully addressed financial failure and allocated its costs.

Iceland is not particularly generalizable, but it is a good reason why I do not much worry about US government debt being held by foreigners. If it's really too much debt, that's going to be the foreigners' problem, no?

The largest holder of US government debt is the US government [Federal Reserve, Social Security, other US retirement funds] and the second largest is US citizens.

I blame the Obama administration for not invading Iceland. They allowed an anti-banker communist ideology to grow in the North Atlantic. Of course that all fits in with the Left's plan.

Tourism has exploded in Iceland since the crisis and the Eyjafjallajökull volcano in 2010 put it so much in the news. Tourism was already growing since the 1990s but it's gotten so huge that some Icelanders are getting concerned about the impact it's having on the environment and society in general

It wasn't "foreign debtors" but dept denominated in a foreign currency that got twisted in the wind. Granted, most of those holding it were foreigners but that wasn't the dividing line.

Any foreigner that owned deposits in Icelandic currency got the same treatment as an Icelander, that is, the dept was fully recapitalized by the government and then locked within the Icelandic economy.

Cowen makes a really good point that many of the costs of Iceland's "success" were externalised to other countries, which barely noticed because Iceland is so tiny. So, "beggar my neighbour" is now a good thing among Krugman and the rest of the Very Arrogant People.

Excellent and greatly understated point.

From the point of the view of the world economy, Iceland stole billions from its neighbors when it instituted capital controls and refused to honor its contractual obligation to pay out claims on its depositor insurance.

Iceland did not have the resources to cover these losses in any scenario so it's understandable that they did what they did but we shouldn't pretend this decision didn't have a huge impact on their recovery.

The latest estimates that I've seen show around $9B in foreign assets currently frozen by the Icelandic government and they're demanding a 39% tax to withdraw those assets.

Iceland's total GDP is around $16B so if all of the assets were withdrawn the tax revenue would equal about 22% of total GDP. (9/16 * .39)

Imagine if Britain tried stealing the equivalent of 22% of its GDP from foreign investors and you'll see why this model isn't even remotely generalizable.

Isn't Iceland tremendously better off as a result of the financial crisis? As I understood it, the banks borrowed enormous amounts from foreigners, threw away part of it in stupid investments, consumed a good bit of the rest (or invested, if you like, in big boats and houses), and presumably saved a lot (and didn't put it *all* in Icelandic banks). Then the banks went bankrupt, leaving foreigners holding the bag and Icelanders living in the big houses. Has anybody done a computation of how much Iceland got out of this?
To be sure the stock market went down 90%, but if it first went up 120% that's a net gain. And a loss of 90% of the value of the Icelandic stock market may be trivial compared to the gains from foolish foreign depositors.

Down 90% after going up 120% is not a net gain...

Right. Suppose it went up 10,000%. Same point. Maybe 3 banks represented the entire increase. They went bust, but that just means the value of their extremely leverage capital went to zero.

Capital controls are also not an option for many economies, including those that are serious about being financial centers or having reserve currencies.

Who wants to be a reserve currency or financial center? Exchange controls are a necessary first step to getting out of the Euro.

I don't remember Tyler having a problem generalizing Latvia's experience. Another small country where unemployment dropped because 15% of the population just up and left. Of course that hasn't been going so well lately so best not to mention it anymore.

What does seem to be very much generalizable is the use of the euphemism "capital controls" to mean a politically ordered confiscation and conversion of private financial assets.

The term "capital controls" sounds like a soft intervention in which people are merely forbidden to convert domestic currency into foreign currency or move a foreign or shared currency out of the national banking system.

What it really means is that private parties with financial claims on a country's banks - eg deposits - are deprived of those and given some other kind of claim of far less value. When the claims are on private entities, such as bank deposits, "capital controls" are a kind of protection from creditors extended to debtors that avoids the usual bankruptcy and/or deposit insurance system. For claims on the state, such as currency that was freely exchanged made not so, "capital controls" are a kind of quasi-default.

The growing political acceptability of "capital controls" and generally positive treatment of them by major financial media should make owners of capital wary.

Yep. And tough titties. The alternatives are worse.

"That’s a transfer of wealth to the domestic economy..."

Who in the "domestic economy" got that "wealth"??

The wealth transfer was merely to erase the liability from the frictions and rents from asset churn that vanished a large portion of the savings of innocent bystanders.

It was pure pillage and plunder.

Well we know that those who didn't follow the Icelandic example didn't have very good recoveries. We can generalize about that. Spain and Greece couldn't devalue because they're stuck with the Euro. I don't see why it matters that much whether deposit holders are foreign or domestic.

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