Iceland: The economic model to follow?

21st June 2012

Creating growth after the crisis

Back in 2008 the Icelandic banks defaulted on $85 billion, leaving the island's population buried under a burden of debt, and furious with their politicians and bankers for the country's economic collapse.

Now however, Iceland's economy looks set to outgrow both the euro area and the developed world on average, according to estimates by the Organization for Economic Co-operation and Development (OECD).

The OECD reckons Iceland's economy, which grew 2.9% last year, is set to go up 2.4% this year, compared to growth of just 0.2% in the euro area and 1.6% across the OECD area, as reported by Bloomberg.

Unorthodox approach to defaulting on debt

Yet Iceland has spurred this economic miracle without bailing out the bankers with untold billions.

Instead, Iceland did "everything the International Monetary Fund (IMF) or the global economic establishment thinks you should never do", according to Allister Heath, editor of business daily City A.M., when "it allowed banks to go bust, it defaulted on its debt, it reneged on international deals and so on, putting taxpayers first".

US commentator Cenk Uygur also highlighted the divergent Icelandic approach on this episode of The Young Turks.

Uygur described the Icelandic success story as based on nationalising the banks, indicting the bankers who caused the mess and bailing out 25% of the population by forgiving debt that exceeded 110% of property values.

 "The lesson to be learned from Iceland's crisis is that if other countries think it's necessary to write down debts, they should look at how successful the 110% agreement was here," said Thorolfur Matthiasson, an economics professor at the University of Iceland in Reykjavik.

David Dayden also praised debt deleveraging for successfully bringing back the Icelandic economy, when writing on FDL.

Dayden contrasted the US reaction to its housing crisis, where the US refused to write-down debt as rewarding bad actors and causing moral hazard, and instead poured money into "back-door" bank bailouts.

He said: "Guess what? Debt write-downs do work. They generate a wealth effect among the population, and they help to end balance-sheet recessions and bring about economic growth.

"The facts reveal that austerity is counter-productive, while debt forgiveness is extremely productive."

Doubts about Iceland's example

Some commentators cast doubt on the success or otherwise of Iceland's approach.

Responding to the Bloomberg coverage, Ólafur Garðarsson described the 110% way as "an utter failure".

He said: "A quarter of all households in Iceland are in financial crisis mode, unable to make mortgage payments and in many cases not even able to buy groceries, let alone medicines and other necessities. Another quarter of households are on the brink of financial ruin."

Samúel Erlendur Lárusson also posted his concerns that even though currency-indexed loans were ruled illegal, they are "still being collected as the government refuses to take any action against the banks".

Mr Lárusson forecast that "few, if any of the indicted bankers will face anything more than minor fines".

Here on Mindful Money, Simon Ward, chief economist at Henderson, warned in his blog that Iceland's economic growth since devaluing the krona has not been significantly higher than in Balkan states that pursued austerity measures to defend euro exchange rates pegs.

At City A.M., Heath acknowledged that there were lots of downsides to Iceland's policies, with devaluation pushing up Iceland's prices by a quarter, capital controls pushing away investment and mass mortgage write-offs unfair when savers lost money.

However Heath also considered that other troubled economies could still learn from the Icelandic model. He said: "Sometimes total collapse followed by a swift rebound works better than a long-drawn out death.

"A sanitised version of what Iceland did – default, debt write-offs, shutting bust banks and devaluation – combined with dramatic supply-side reforms would undoubtedly make more sense for an economy such as Greece.".


More on Mindful Money:

What can the eurozone learn from Latin America?

Who's to blame for the Eurozone crisis? We all are

How to survive the Eurozone apocalypse

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