ICELAND'S ECONOMIC AND FINANCIAL CRISIS

I recently presented my recent paper on Iceland's economic and financial crisis (link) in the European Parliament in Brussels (link). Three days ago, the publication of the paper has also been approved by the SSRN (link).

Let me briefly touch the evolution of Icelandic crisis. The roots of the Icelandic financial crisis go back to late 1980s, when the Icelandic economy recovered from subsequent periods of high, volatile and unpredictable inflation. In 1983, the annual inflation rate reached as high as 100 percent. Throughout the 1980s, the economic policymakers were gradually abandoning the Keynesian doctrine. Until the oil shocks plunged the country into rampant inflation and fragile economic growth, it was widely believed that a little higher inflation is the price of low unemployment.

The period from late 1980s to early 1990s had been an important milestone for Iceland's macroeconomic recovery alongside the change in the political tide. The central bank was granted independence in inflation targeting, the government pursued a wide array of structural and economic reforms to boost the economic growth. Corporate tax rate had been reduced from a near 50 percent bracket, labor and product markets were liberalized and the financial sector was in the beginning of the privatization. The beginning of the 20th century was an unusually favorable period for Iceland's macroeconomic stability. Aside from one of the world's best institutions and governance, Iceland is perhaps the only developed country with favorable long-term demographics. The share of the population above the age thresold of 65 is only 11 percent. For instance, in Italy more than 20 percent of the population is in the age thresold of 65 and above. Iceland's favorable demographic outlook and a bold move towards defined-contribution pension system make the country the only developed nation with stable and fiscally solvent social security transition in the long-run. (total assets of pension funds as a share of GDP stood at 114 percent of the GDP in 2008 - more than any other OECD nation).

In 2001/2002, Iceland fell into a short-lived recession, mostly as a result of external imbalances and current-account adjustment to the global economic slowdown. In spite of the favorable macroeconomic outlook, Iceland's central bank failed in terms of the inflation targeting. From 1980 onwards, Iceland has had the most volatile inflation rate in the OECD, surpassing countries with unstable inflation such as Greece. Between 1980 and 2009, the average standard deviation of inflation was 20.45 percentage points, almost 20 times the deviation of inflation in countries with the least volatile inflation (Austria, Germany, Netherlands). Behind the unpredictable inflation rate was an unprecendent development of banking and financial industry. Iceland maintained high interest rate to contain inflationary pressures which were the main threat to macroeconomic stability since 1980s. Consequently, there was a large interest rate differential between Iceland and the rest of the world.

In a small and open economy such as Iceland high interest rate differential triggered "carry trading" against uncovered interst parity. Investors thus borrowed in Icelandic currency and invested in Icelandic stock and bonds in search of high short-term yields and then, after a certain period of time, swapped it into safer currencies. In the mean time, Icelandic currency (Krona) strongly appreciated and created an artificial wealth illusion which stimulated imports and further boosted economic growth towards an incredible 7 percent in 2007. The central bank raised the key interest rate further to contain potential inflationary pressure. Consequently, massive capital inflows strengthened krona's appreciation.

At the same time, the banking industry expanded abroad and enjoyed significant return on equity as a result of high interest margins on short-term loans in Krona-denominated loans. Icelandic banks were recognized as well-managed and, at the same time, enjoyed favorable ratings from Fitch, S&P and Moody. Three largest banks (Kaupthing, Glintir and Landsbanki) grew for more than 10 times the country's GDP. These banks easily expanded abroad as world interest rates converged towards zero. In such circumstances, banks offered loans in foreign currency and enjoyed strong interest margins from short-term loans in domestic currency. Icelandic households avoided loans in Icelandic currency given high interest rate but had significant foreign currency loan portfolio offered at very low rates. In a few years, loans in foreign currency exceeded domestic money supply by several times.

From 2004 onwards, Iceland's banking industry emerged as one of the most over-leveraged in the world. High leverage could be sustained as long as the global interbank marked was stable. When the subprime mortgage crisis spread across the U.S, there were early signs that Iceland will likely experience a significant contraction and current account deficit. For example, Danske Bank from Denmark warned in 2006 how disastrous could be the Icelandic crisis:

“On most measures, the small Icelandic economy is one of the most overheated in the OECD. Unemployment stands at 1 percent, wage growth is above 7 percent, and inflation is running above 4 percent despite a strong ISK. The current account deficit is closing in on 20 percent of the GDP. The Icelandic central bank has been hiking rates substantially in order to cool the economy and rates are now above 10 percent. Based on the macro data alone, we think that the economy is heading for a recession in 2006-07. GDP could probably dip 5-10 percent in the next two years and inflation is likely to spike above 10 percent as the ISK depreciates markedly. However, on top of the macro boom, there has been a stunning expansion of debt, leverage and risk-taking that is almost without precedence anywhere in the world. External debt is now at 300 percent of the GDP while short-term external debt is just short of 55 percent of the GDP. This is 133 percent of Icelandic export revenues.”

The global interbank market froze after the failure of Lehman Brothers when the crisis spread globally. At that time, CDS rates on Icelandic banks rose as investors demanded higher premia given the significant magnitude of financial risk. Bond spreads literally exploded. The three largest banks filed for bankruptcy. When the banks failed, gross external liabilites rose to more than 900 percent of country's GDP. Given spare fiscal and monetary capacity, the central bank failed to act as a lender of the last resort and the bailout such as Bear Stearns seemed implausible. The country fell into the deepest and most significant crisis ever experienced by a small country in a peace-time history. The recession, which lasted for more than year, was marred by turbulent inflation rate, stunning negative output gap and high unemployment rate.

The prospects for the Icelandic recovery were initially bleak due to unemployment surge, current account deficit and high public debt. In 2010, the recovery prospects seem more favorable with economic growth rate returning to 4 percent level by 2014. There's also been a lot of debate about Iceland's potential EMU membership - mostly in the light of Icesave deposit repayment to Dutch and British taxpayers. As I thoroughly discussed in the paper, Iceland is not an optimum currency area mostly because adjustment to common monetary policy would require a substantial exchange rate alignment which would inevitably result in inflationary wage pressure and seriously deteriorate country's macroeconomic stability in the long run.

OUTLOOK FOR THE NORWEGIAN ECONOMY

Norges Bank has recently published Monetary Policy Report 3/2009 (link) and a comprehensive list of figures and charts including major macroeconomic trends in Norway and abroad (link). Time series on unit labor cost, output gap and other macroeconomic indicators are interesting to observe, especially because Norges Bank has been the first central bank in Europe to announce a targeted increase in interest rate to mitigate midterm inflationary outlook. Here (link) is a closer look at NIBOR and monthly interest rate dynamics in Norway (link).

AN INSIGHT INTO ICELAND'S FINANCIAL CRISIS

Hannes Gisurarsson's opinion in the WSJ (link) summarized the timeline and details that flipped Icelandic economy into the financial crisis as well as the political turmoil in the country.

"Moreover, Mr. Oddsson is one of the few Icelanders who sounded the alarm bells before the crisis hit the island. At a breakfast meeting of the Icelandic Chamber of Commerce in November 2007 -- a year before the banking collapse -- the governor said: "Iceland is becoming uncomfortably beleaguered by foreign debt. At a time when the Icelandic government has rapidly reduced its debt and the Central Bank's foreign and domestic assets have increased dramatically, other foreign commitments [by private banks] have increased so much that the first two pale into insignificance in comparison. All can still go well, but we are surely at the outer limits of what we can sustain for the long term."

ICELAND SOVEREIGN CREDIT REPORT

Moody has maintained Iceland's negative outlook on economic and financial crisis (link).

CDS IN ICELAND

In Forbes, there is a brief article (link) on credit default swap in Iceland in the wake of credit crunch and external shocks that affect macroeconomic stability.

ICELAND'S INFLATION

From WSJ's Real Time Economics (link):

"Iceland’s central bank Tuesday unexpectedly raised its key interest rate by 125 basis points to 15%, citing higher-than-expected inflation, strong demand and the falling value of the country’s currency, as Johan Carlstrom writes this morning. The euro has climbed more than 20% against the krona this year, and the central bank said the krona’s real exchange rate is very near a long-term historical low reached in November 2001. Inflation, meanwhile, is trucking along at a 6.8% year-over-year rate, which is far higher than the central bank’s 2.5% target. (By comparison, the U.S. dollar is down about 5.3% against the euro since the start of the year and the consumer price index was up 4.0% year over year in February.) ... In Iceland, investors found a lucrative way to take advantage of those low rates: They borrowed vast sums in places like Japan (where rates are near 0%), and invested the money in places like Iceland, where rates stand at 11.5%. The maneuver, known as the “carry trade,” has emerged as one of the most popular hedge-fund strategies in recent years. But it can leave an economy vulnerable if the speculative money suddenly reverses direction."

THE ECONOMIC PERFORMANCE OF ICELAND IN 2008

The IMF estimated that Iceland's economy could slid into a mild recession in 2008. Meanwhile the rate of inflation is estimated to reach 3,3 percent (link).

The empirical data has shown that Iceland experienced one of the highest coefficients of fiscal revenue elasticity, whether it is measured in terms or relative changes in private consumption or in terms of effective real exchange rate. On the other hand, rigorous tax reform in previous decade returned a soaring growth of fiscal revenue which reflects the broad range of revenue elasticity as well as the effects of tax cuts on supply side of the economy and fiscal parameters.

Read also:
Anthony Arnett: Toward a Robust Fiscal Framework for Iceland; Motivation and Practical Suggestion, IMF Working Paper 07235, International Monetary Fund, 2007 (link)

NORWAY'S OIL SAVINGS AND PETROLEUM FUND

More than a year ago, I noticed an article written by Stefan Karlsson entitled "Norway's National Day" where the author explain how Norway's oil-savings policy and also the recycling of savings accumulated from Norway's oil exports redirected into oil fund which invests into foreign securities and creates huge trade and current account surpluses. In fact, Norway is the third largest exporter of oil in the world after Russia and Saudi Arabia.

Using PPP measure of the GDP, Norway is the 6th wealthiest country in the world, having a per capita GDP at $46,300 USD, surpassing Ireland and the United States (link). High GDP per capita in terms of purchasing power parity is the result of gigantic increases in the GDP in recent decades due to high oil prices and oil exports which benefited the Norwegian economy. It would be a mistake to think that Norway's economic policy reflects its gross domestic product. Public ownership remains high (link). Welfare policies tend to contain a degree of inefficiency and fiscal sustainability (link) is risky in a long term perspective as the petroleum and pension fund are set to decline in its size subject to strong dependency and ageing population pressures (link).

SWEDISH LESSONS ON SCHOOL CHOICE

Marek Hlavac, a visiting fellow at the Adam Smith Institute proposes that if British prime minister Gordon Brown really wants to enforce a legislation that would improve standards in the UK's quality-falling school system, then he should consider the Swedish-styled reform choice from 1992:

"Affluent parents can afford to send their children to a private school, or move into the catchment area of a good state school. The disadvantaged, however, often have no choice but to have their children assigned to a state school, often of low quality, by their Local Education Authority. The widespread application of the surplus places policy, furthermore, prevents good state schools from expanding and rules out the establishment of a new school, if there are spare places in an existing state school nearby. That's like the state banning a busy restaurant from laying extra tables because there are spare places in an unpopular one next-door – absurd."

Source: Marek Hlavac, A Lesson from Sweden (link)

In 1992, Swedish government, under the chairmanship of Carl Bildt, introduced voucher in the education system by allowing parents to send their children to any school they choose, whether it be municipal, independent or religious.

15 years after the implementation of education reform, the sector of the independent schools has grown rapidly (link). And the outcomes improved as well. For example, in 1992 Sweden spent $7,000 USD per pupil, while the outcome resulted in falling middling scores on international tests despite the fact that Sweden's spending per pupil was more than in any other country in the world.

Distorting inefficiencies of government-owned education system are perhaps the most powerful practical evidence of the inefficiency of monopoly structures in the market. Higher price at a fixed supply of education products combined with comparatively lower quality trippled by the lack of choice in satisfying consumer's utility of education surely evinces a measure-based indicatior of the inferiority of government-run education system.

The essence of education reform based on voucher-type financing is that a certain amount of money for covering the costs of education is not transfered to schools, but instead contributed to individuals while having a competition among schools, competing to attract new students through the channels of innovation, choice, perspective and a rock-bottom incentive to deliver the best quality under the lowest possible price - the way the competitive forces of supply and demand work in product markets.

In fact, education is a product purchased by the consumer (student) at a certain price compensated by the quality which a student receives after he pays the product price of education.

Imagine the world in which Ericsson would be the only supplier of cell phones and government the only supplier of networks. In the absence of competiton in this particular product market, Ericsson's quality of cell phone supply would starting falling while prices would grow constantly and customer satisfaction with Ericsson's cell phones would quickly start to shrink and the inefficiencies would occur tremendously.

The mechanics of the government-run education system is similar. The fact is that progressive education system embrace the generalized curriculum, disregarding the education based on outcome such as the competitiveness of the future graduates in the labor market. It often happens that the guidelines of knowledge supply in the state schools is not matched by the real world.

The answerable question of how to solve the inefficiency of government-run education is to let the enforcement of competitive forces in the education sector while giving students and parents the ability to choose where and how they want to invest in education which, as Benjamin Franklin once said, always pays the best interest.

Read also:

Ron Sunseri: The Swedish Model; The Failure of Progressive Education, Wall Street Journal, Tuesday, April 7, 1992 (link)

Friedrich August von Hayek: Intellectuals and Socialism, The University of Chicago Law Review, pp. 417-420, 421-423, 425-433, Spring 1949 (link)

Staffan Waldo: School Vouchers and Public School Productivity - The Case of the Swedish Large Scale Voucher Program, SIFAE, 23 March 2006 (link)

FCPP Publications: School Vouchers in Sweden (link)

Friderik Bergstrom, Mikael Sandstrom: School Choice Works! The Case of Sweden, Vol. 1, Issue 1, Milton and Rose Friedman Foundation, December 2002 (link)

FISCAL POLICY AND STOCKHOLM SYNDROM - SWEDEN'S SLOW-MOTION SUPPLY-SIDING

Here is a cut from Greg Mankiw's Principles of Economics (chapter 8):

"In Sweden in the early 1980s, for instance, the typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial disincentive to work. Studies have suggested that Sweden would indeed have raised more tax revenue if it had lowered its tax rates."

Source: Greg Mankiw, Principles of Economics, ch.8: Laffer Curve and Supply-Side Economics, South-Western College Pub; 4th edition (February 15, 2006) (here and here)

The American published a brief article about Sweden's slow-motioning progress in the implementation of structural and economic reforms. Among the signs of genuine reform vitality, there has been a large amount of measures aim to boost the competitiveness and labor supply incentives. Unemployment and welfare benefits were cut, property taxes were abolished, wealth tax - an uninterrupted symbol of the Sweden's socialist past - was also slashed. What about market reaction? It may take a longer period for the market to respond to such incentives. But the fact that the response dynamics is slow, should not be the basis of denying any kind of policy reform. Perhaps I'm going a little bit more normative in this respect, but in economics, experience is a huge lesson. In fact, the fact that markets respond to incentives is #4 principle of economics (link)

The question regarding Sweden's recent outlook as well as broader perspective of economic and structural policy is whether shock therapies are consistent in the long-run.

The answer is, of course, interpretative and each economic school or doctrine may endorse the answer in several different ways. The answer depends on the role and credibility of fiscal policy in response to macroeconomic shocks. Among economists, there has been a widely accepted belief that countercyclical fiscal policies have stabilizing effects on the economic performance. But, the question is whether discretionary actions assume the expectation of policy and market. In fact, analyzing the broad picture on the basis of intertemporal margins is much more efficient, since the employment change and income dynamics reflect the pure effect of fiscal policy against the cyclical trend. A very detailed study on this particular subject was written by David B. Gordon and Eric M. Leeper (link) as their findings comprehend the counter-cyclical effect of fiscal policies:

"This paper highlights these expectations effects. Connecting the theory to U.S. data we find: (1) through this expectations channel, countercyclical policies may create a business cycle when there would be no cycle in the absence of countercyclical policies; (2) nontrivial fractions of variation in investment and velocity can be explained by variation in macro policies alone - without any nonpolicy sources of fluctuation; and (3) persistence in key macro variables can arise solely from expectations of policy."

SWEDISH MODEL IS LIKE A COIN: BOTH SIDES CONSIDERED

Assar Lindbeck shows how Swedish politico-economic model has two sides of the coin.

NORWAY'S FISCAL TERRORISM

Wall Street Journal investigates recent tax hikes imposed on Norwegian shipping industry by Norway's left leaning socialist government. In particular, Norwegian Minister of finance, Kristin Halvorsen's budget plan suggests the retroactive taxation of reinvested profits. Due to the impact of shipping industry on the competitiveness of the Norwegian economy in a global arena, it is doubtful whether such tax hike are grounded on the basis of detailed analysis.

Perhaps, there is only a quest for higher public spending and Norwegian government is desperately seeking new revenue source to fund a growing public expenditure. In fact, the relationship between equity and efficiency is one out of many trade-off case studies in economic analysis and higher government spending causes distortions and reduces incentives to work, save and invest as marginal tax burden (a portion of the added burden relative to tax burden in a previous period) is a penetrating source of inefficiency since firms and individuals are discouraged from further engagement in productive behavior. And shipping industry is no exception.

The overall effect of imposed taxation will affect the attractiveness of Norwegian shipping centers and, nevertheless, ship owners could reflag the vessel to nearby locations where the tax treatment of shipping industry is more favorable relative to Norwegian jursidiction, and also where created profits are not subject to discretionary taxation.

Here is a part of the abovementioned article:

"Over the past seven years, as the regime took effect, maritime employment in Norway has climbed almost 20% to about 100,000 and the number of ships on order by Norwegian fleets has risen more than threefold — keeping pace with rapid international shipping growth since the turn of the century. That boom has attracted the attention of Norway’s finance minister, Kristin Halvorsen, a member of the country’s Socialist-Left Party. Under her budget plan, all profits reinvested by the industry since 1996 would be subject to a retroactive tax. Many ship owners are considering reflagging their vessels in nearby countries, such as the U.K. and Denmark. Moving could mitigate their future liabilities, but that will be little consolation to firms that remained in Norway over the past decade and invested in their fleets, only to be betrayed by politicians."

Source: Shipping Blues, Wall Street Journal (link)