Home > Uncategorized > Iceland did not do well. But it did better. Because of sound economic and financial policies.

Iceland did not do well. But it did better. Because of sound economic and financial policies.

In the curious case of the Icelandic economy the admirable economist Tyler Cowen misses the wood for the trees. The situation is simpler than he indicates:

Iceland

A) Thanks to financial machinations of out of control banks Iceland experienced a terrible financial crisis from which it has not yet fully recovered (graph), despite capital controls and the right sizing of debts and devaluation ( Mind:  devaluation does not seem to increase exports. See this recent ECB study, look here for J.W. Mason on this. Devaluation might however direct domestic demand from imported to domestic goods).

B) It did, however much better than, for instance, the Baltic states (and Ireland, see below), which did not only experience a terrible financial crises, too (albeit not as bad as the Icelandic one) but were on top of this the victims of austerity policies aimed at depressing domestic purchasing power and transferring wealth to international creditors.

Cowen does mention it but does not seem to grasp the implication: external devaluation does lead to relatively higher prices for imported goods (because of the extreme current account deficits of these countries this was, however, not a bad thing) – but unlike the internal devaluation embraced by the Baltic countries it does not lead to relatively higher prices for domestic goods and, especially, services. Which means that there will be a shift from spending on imported stuff to spending on domestic stuff, which mitigates the decline of domestic employment, income and production. This is the road travelled by Ireland and, though long and bumpy, it at least enabled Iceland to prevent the worst consequences of deregulated finance gone wild. The Baltics, however, deepened the crisis because they did not grasp the implications of basic macro econmics. To enable savings which were needed to pay back the debts they slashed government and private spending but, when push came to play, these savings evaporated as cutting spending did not lead to higher savings but to less income, employment and production and therewith to lower savings. How often do we have to say this: cutting domestic spending and wages does not automatically lead to higher exports and will, therefore, depress the amount of funds available to pay back debts.

Did I already mention that Icelandic demographics are much more favorable than the Baltic ones? It will take some time, but the tiny but more or less stable Icelandic population will once be larger than the declining Estonian one. Might this difference in especial birth rates at least have something to do with people having a kind of long run basic trust in their government that it will do (or that they can force it to do!) what is arguably best for the population? Hmmm… something to ponder.

See also this Krugman post which shows that the development of employment in austerity country Ireland followed the Baltic pattern. And I fully agree with Cowen that in the cases mentioned above forceful reflation would have been the better option. The main take away – in case of crisis, choose for work and income, not for financial wealth and debts.

  1. June 11, 2015 at 4:53 pm

    Greece demonstrates pretty well that the point of devaluation is not competitiveness but to redirect consumer spending from imports to domestic goods.

    The textbook example of lower wages -> cheaper goods -> more exports makes abstract sense but I don’t know what real economy is like that.

    – Will global consumers switch from Apple products to Chinese products because Chinese labour is cheaper than… no wait!

    – If a low-tech country like Greece or Venezuela doesn’t produce goods that the rest of the world wants to buy, would the world like those non-existent products cheaper?

    – In a globally competitive, price-sensitive industry like tourism do we really think that devaluation will bring price discipline and the market power of global booking firms won’t?

  2. June 12, 2015 at 6:11 am

    Reblogged this on ashishbarua1.

  3. Vidar
    June 13, 2015 at 12:18 am

    Devaluation of the Icelandic krona didn’t increase export of goods since Iceland mainly exports seafood and aluminum. The government sets the fishing quota so devaluation won’t increase exported quantity. Aluminum is traded in USD so devaluation of the ISK doesn’t matter. The only positive thing regarding the devaluation is tourism. In 2014 the number of tourists was more than three times the population. But the big problem with the devaluation was close to 20% inflation. About 90% of Icelandic households have inflation-linked mortgages.

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