Iceland on mend in spite of refusal to bail out banks

ICELAND’S decision not to bail out its banks and to use state money to help hard-pressed households and lower income groups has left it in a much better place than Ireland, according to two Nobel prize winning economists and IMF experts.

A report from the IMF that lent the country $2.1 billion said that Iceland is experiencing a moderate recovery, unemployment is declining and the government was able to return to the capital markets earlier this year.

The fund, which is lending €22bn to Ireland, said that Iceland’s unusual policies provide a good test case. “Iceland set an example by managing to preserve, and even strengthen, its welfare state during the crisis,” said IMF deputy managing director Nemat Shafik.

As a result, inequality has actually decreased during the programme, in contrast to Ireland where the EU/IMF programme demands a cut in social welfare and wages of the lower paid to encourage employers to create jobs and an incentive to others to come off the dole.

Recent IMF research shows that countries tend to grow faster and more consistently when income is distributed more evenly, so the fund is now paying much more attention to these issues in its programmes, she said.

Nobel prize winning economist Paul Krugman told a conference in Iceland that its unorthodox polices going against conventional wisdom offered a lesson to other countries in similar circumstances.

“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,” he said.

Iceland had fared much better than either Ireland or Latvia in terms of growth and jobs. And despite warnings that economic armageddon would follow the decision not to accept liability for the losses of private banks, now credit default swaps on sovereign debt were 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,” he added. In January when Iceland returned to the markets to borrow they were offered twice as much as they sought.

Professor Joseph Stiglitz, another Nobel Prize winning economist, agreed. “What Iceland did was right, It would have been wrong to burden future generations with the mistakes of the financial system,” he said. This view was supported by former IMF chief economist Simon Johnson.

The Icelandic banking collapse was worse than Ireland’s, in that its banks were worth 10 times the country’s GDP compared to about six times in Ireland. But the crisis has cost Ireland about 50% of its GDP to date compared to 20% in Iceland.

Their agreement with the IMF was to postpone any cuts for a year, after which they split tax increases and spending cuts evenly compared to Ireland 80% cuts on spending. They increased corporation tax from 12% to 18%, increased income tax and VAT and introduced a wealth tax.

Iceland was not tied to the euro and so unlike Ireland could allow its currency to devalue — it lost up to 90% of its value at one stage and inflation hit 18% hugely increasing the cost of living. Unemployment jumped from 2% to 9%.

To offset the big number of mortgage holders in negative equity and those holding loans in foreign currencies, the government introduced a debt forgiveness scheme reducing mortgages to the new value of the property, and subsidised interest payments.

The country of just over 300,000 people introduced capital controls to prevent money flowing out of the country and an uncontrolled currency depreciation.

The next step now is to lift these controls without upsetting the gradual return to normalcy, according to the IMF.