Saturday, April 27, 2013

The Iceland Experiment—A Lesson in Austerinomics

Popular Economics Weekly

Today’s parliamentary elections in Iceland will pose a difficult choice for Icelanders. Polls show conservatives have the lead—a so-called Center-Right coalition that was in power when Iceland’s own housing bubble burst and its kronar currency lost most of its value compared to the euro.

The resulting austerity measures required for an IMF rescue included capital controls still in place that has kept much of the money from Dutch and English investors in Iceland’s banks. But the devaluation of the kronar has also made its products much more competitive and resulted in 7 quarters of 2.5 percent plus GDP growth since Iceland’s emergence from its own Great Recession.


Graph: TradingEconomics

This is partly because in June 2010, the nation’s Supreme Court gave debtors a break: Bank loans that were indexed to foreign currencies were declared illegal. Because the Icelandic krona plunged 80 percent during the crisis, the cost of repaying foreign debt more than doubled. The ruling let consumers repay the banks as if the loans were in krona.

These policies helped consumers erase debt equal to 13 percent of Iceland’s $14 billion economy. Now, consumers have money to spend on other things. It is no accident that the IMF, which granted Iceland loans without imposing its usual austerity strictures, says the recovery is driven by domestic demand.

Iceland’s recovery is based on the growth in exports, tourism and domestic consumption. Exports and tourism grew because its devalued kronar made its products and services cheaper, while domestic consumption grew because incomes weren’t diminished. In fact, its current problem is some 4 percent inflation, which is actually healthy, because it means Icelanders incomes are growing rather than shrinking as in euro zone countries.

We know now from both Iceland and Cyprus banking crises that Iceland’s choice not to join the euro zone was a wise one. Simply put, Icelanders haven’t lost their purchasing power, whereas Cypriots will be condemned to serial devaluations of their incomes that will result in serious suffering for years to come. The same can be said for Ireland, Portugal, and even Spain and Italy, because they remain in the euro zone.

Why? Because being in the euro zone means the only way they can restore competitiveness is to reduce the production cost of their products, which means cutting their wages and salaries, since they cannot devalue the euro.

The lesson is obvious for so-called austerinomics—or the policies of austerity in particular required by Germany and the Nordic countries for heavily indebted countries in the euro zone. Diminish the debt loads by both writing off or otherwise reducing the debt loads as Iceland has done, while stimulating more growth, particularly among consumers. The result is that Iceland’s sovereign debt rating has been restored to investment grade by Moody’s.

A well-known American Economics Professor Brad Delong has said it best:

“I had always thought that policy makers well understood the basic principle of macroeconomic management,” said Professor Delong. “This principle has gone out the window…The working majority in the U.S. Congress is taking its cues from the Saturday Night Live character "Theodoric of York, Medieval Barber". It believes that what the economic patient needs is another good bleeding of rigorous austerity, and that is putting further downward pressure on employment and production.”

The U.S. is still going through its own trial by fire, in other words. Conservatives here also insist on reducing debt by cutting government payrolls while reducing spending and that is eliminating literally millions of jobs from government and private payrolls that will only increase the debt load due to reduced revenues, and so reduce economic growth at a time when more growth than ever is needed.

Harlan Green © 2013

Follow Harlan Green on Twitter:

No comments: