Forget Moscow: get on the plane to Reykjavik!
Ex ECB board member Lorenzo Bini-Smaghi has a piece in tomorrow’s FT where he says Ireland is the model that Cyprus should follow. Really? To be sure, Ireland has done well. But there is a better example – from outside the eurozone. It’s Iceland, not Ireland, that has pioneered the way for small open economies with bloated financial sectors.
The first thing that the Icelandic government did when facing the meltdown of its banking system in September 2008 was to stop the exchange rate collapsing by imposing strict capital controls. The second decision was to let the banks collapse – their assets were 10 times Iceland’s GDP, so a state rescue would have immediately bankrupted the state. Next, they protected domestic depositors. They accepted the inevitability of a deep recession – but took measures to encourage a quick recovery.
The strategy worked. Unemployment jumped sharply, but then fell back, because of the country’s flexible labour market and net emigration; inflation also soared, then came down. Growth resumed from 2011 onwards.
Allowing the banking sector to collapse, wiping out not only shareholders but much of foreign depositors’ money, protected the rest of the economy from permanent damage.
The key advantage was to ring-fence the sovereign – Iceland itself. The socialisation of private sector losses was reduced to a minimum – banks were not permitted to transfer their losses to the taxpayer. The banks’ foreign currency liabilities themselves were seven times Iceland’s GDP.
The cost of saving the domestic part of the banks was heavy. Only in Ireland was the cost of supporting banks larger as a proportion of GDP than in Iceland. Only some of these losses will ever be recovered. But the losses on assets were born mainly by foreign depositors. This trick could not be repeated for larger countries such as the US or Germany.
The government laid the basis for recovery immediately by announcing and implementing a clear and consistent fiscal policy. They allowed automatic stabilisers to operate fully -but at the same time announced a tight programme of long-term fiscal consolidation. Interest rates were cut and real rates turned negative – a programme that was only possible because of capital controls.
How important was the fact that Iceland had its own currency? This can be greatly exaggerated. Devaluation of about 30% against the long-term average exchange rate helped mainly as a quick method of cutting real wages by raising the prices of imports, and depressed demand for imports.. Much of Iceland’s exports are inelastic – for example, the supply of fish is fixed by natural factors not prices. The lower exchange rate helped tourism. But exchange rate flexibility offered no panacea. Even now it is possible that Iceland might apply to enter the eurozone in the future.
For Cyprus, that would mean letting the costs fall on uninsured depositors (the euro is a “foreign currency” for Cyprus as it has no control over its monetary policy), letting banks fail and starting new banks for domestic depositors and insured deposits.
This is contrary to the old received wisdom, espoused for example by the IMF before Iceland. The former received wisdom had four components:
- Rescue the banks – Iceland let them go
- Squeeze the economy – Iceland let the budget deficit rise to protect employment
- Open the current account to natural adjustment – Iceland slapped on controls
- Hold the currency if possible through high interest rates – Iceland engineered a devaluation and cut rates as soon as it could.
Behind all these, the main difference was that Iceland broke the link between the sovereign and the banking system in a brutal but effective way. Both the central bank and the state were throughout the crisis and remain today fully solvent and current with all obligations (though this is helped by the court ruling that the old, failed deposit protection fund does not have a recourse to the treasury).
Mr Sarris – get on the plane from Moscow to Iceland now!
Comments from the Bundeskanzleramt…
My mole in Germany’s Bundeskanzleramt detects signs that Mrs Merkel has chosen to make a stand on Cyprus. Enough is enough. Let it leave the eurozone if necessary, and descend into chaos. The chance of contagion to other debtor countries is a risk that will have to be taken. It can be contained. Debtor countries have to witness what happens to countries that wilfully fail to curb financial excesses or take their medicine.
Meanwhile, The Money Trap’s agents have obtained a document…
… from a well-placed source near the Kremlin
Russia’s finance ministry said today that Cyprus had sought a further 5 billion euros (4.2 billion pounds) , on top of a five-year extension and lower interest on an existing 2.5-billion euro loan from Moscow. But what does Nicosia have to offer Moscow? Here are the conclusions of a Memo addressed to the government of the Russian federation (GRF). It recommends that Moscow should use this crisis to achieve a number of state ends, as follows:
- Condemnation of Eurozone action as both unwise and possibly illegal, and very harsh on Cyprus. Offer of sympathy to the Cypriot government. Objectives – embarrass EU, be seen to uphold international law, position GRF as a friend of Cyprus.
- Offer to renegotiate loan finance for Cypriot government. Seek warm-water naval facilities and preferential treatment for Russian hydrocarbon expertise in developing Cypriot gasfields. Objectives – protect value of existing financing, tighten grip on useful client state, protect against loss of Syrian facilities, create opportunities for future co-operation in the hydrocarbon sphere.
- Offer to make good any losses suffered by Russian citizens as a result of EU tax levies. Objectives – create a debt of gratitude owed by oligarchs and others to GRF,
- Threaten to impose a tax surcharge on gas exports to Northern Europe: objective – to remind Germany that unilateral action against Russia is not without consequences.