Iceland Shows Banks Are Not Too Big To Fail

Few nations were hit harder initially by the financial crisis in 2008 than Iceland. It’s economy had grown rich around four very large (relative to Iceland) banks that were players in the big global casino financial industry expansion.  In the U.S., U.K., and most other large developed countries governments responded with large bank-bailout packages.  The economic logic is that the banks and the banking system is too interconnected, too large, and too important to let it fail.  There’s a part of this argument that has economic truth.  To the extent that the creditors (depositors) of a bank are ordinary citizens and businesses in the country, letting a bank fail will have disastrous macroeconomic consequences.  But this is only true to the extent that these ordinary depositors get wiped out and lose their deposits.  Depositors were in large part not protected in 1929-33 when banks failed across the U.S. and that led to worsening of the Great Depression. It also led to the creation of Federal Deposit Insurance Corporation.  The FDIC is still on the job protecting little depositors (and our economy).

But in the Great Global Financial Crisis, the U.S. government didn’t just try to rescue the little depositors, it rescued the banks themselves.  There’s a huge difference. In rescuing the banks as corporations, the government rescued the large wealthy depositors who should have known better. They rescued the shareholders who selected the managers that caused the banks to get in trouble. They rescued the very management teams that had just failed so spectacularly.  At the time, the argument made by the government for rescuing the banks was that they were “too big to fail”.  This little phrase, often abbreviated as TBTF, came to be a short-hand logic for bailing out the banks.

The problem is that the economic justification for a “bailout” calls for protecting the little, ordinary depositors, not the banks.  In practice, that’s what FDIC does. It “rescues” the little depositors when the bank fails.  It lets the bank and it’s management fail. But the Bush and Obama administrations did not do that. Instead they bailed out the banks and the bank shareholders, arguing there was no alternative.

Iceland, however, shows there was an alternative. Iceland rescued (guaranteed) deposits by ordinary Icelanders and let the banks themselves fail. It has worked pretty well. Much better than Ireland’s approach that rescued the banks themselves. From the New Zealand Herald by way of Daily Bail:

Unlike other nations, including the US and Ireland, which injected billions of dollars of capital into their financial institutions to keep them afloat, Iceland placed its biggest lenders in receivership. It chose not to protect creditors of the country’s banks, whose assets had ballooned to US$209 billion, 11 times gross domestic product.

The crisis almost sank the country. The krona lost 58 per cent of its value by the end of November 2008, inflation reached 19 per cent in January 2009, GDP fell 7 per cent that year and the Prime Minister resigned after nationwide protests.

But with the economy projected to grow 3 per cent this year, Iceland’s decision to let the banks fail is looking smart.

  • “Iceland did the right thing by making sure its payment systems continued to function while creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. “Ireland’s done all the wrong things, on the other hand. That’s probably the worst model.”

 

Ireland: “Responsible” Policy Punishes Citizens for Bankers’ Sins

Poor Ireland.  For some unknown reason, the Irish seem doomed to suffer under the misguided rule of others, despite being the source of great music, culture and a brew so good      For centuries, the oppressor was the English.  In this century Ireland has fallen under the boot of the bankers and The Powers That Be (TPTB) who have have fallen under the sway of “responsbile austerity”.  There is a lesson here for America if we would only listen and pay attention.

Earlier in this century, before 2007, Ireland apparently had left it’s history of poverty and oppression to become the poster child for success via globalization. It’s GDP boomed (see graph). It attracted foreign direct investment and many foreign firms, including Google and others. It was called the Celtic tiger. GDP per capita had risen to the second highest in Europe behind Luxembourg. It was following the recommended path towards financial globalization that conservative right-wing economists have been pushing for several decades.  The right-wing Heritage foundation praised it’s financial deregulation, low tax, and nearly non-existent taxes on foreign corporations as the key to success.  And by conventional measures like GDP it appeared to work.

But in 2007, things began to turn down.   Seems Ireland had developed a highly skewed and unequal distribution of income (like the U.S. today). It had become overly dependent on a property and housing boom with 12% of GDP resulting from new construction (kinda like the U.S.).  And much of the apparent GDP increases were illusion – the result of the difference between GDP and GNP – meaning life really wasn’t as good as the GDP numbers suggested.  (See  GDP vs. GNP to learn the difference between GDP and GNP and how it distorts things for Ireland but not the U.S.).  Then the Global Financial Crisis came.  Ireland got hit pretty hard. The housing market tanked. Bank loans started going bad in large numbers.  Now it should be noted that these were all private-market loan decisions.  They were the result of foreign investors making private contracts to take on the risk and make loans to people in Ireland (and outside) to buy Irish property.  But when the loans began to go bad in large numbers, the large (mostly) Euro banks’ who had made the loans had their solvency threatened.  And with that, the profits of Euro investors in those Euro banks were threatened.  The Irish government was urged to be “responsible” by taking the responsibility away from the banks and investors who made the loans.  The Irish government guaranteed the banks’ loans after the fact.  As Paul Krugman recounts:

The Irish story began with a genuine economic miracle. But eventually this gave way to a speculative frenzy driven by runaway banks and real estate developers, all in a cozy relationship with leading politicians. The frenzy was financed with huge borrowing on the part of Irish banks, largely from banks in other European nations.

Then the bubble burst, and those banks faced huge losses. You might have expected those who lent money to the banks to share in the losses. After all, they were consenting adults, and if they failed to understand the risks they were taking that was nobody’s fault but their own. But, no, the Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations.

Before the bank bust, Ireland had little public debt. But with taxpayers suddenly on the hook for gigantic bank losses, even as revenues plunged, the nation’s creditworthiness was put in doubt. So Ireland tried to reassure the markets with a harsh program of spending cuts.

Step back for a minute and think about that. These debts were incurred, not to pay for public programs, but by private wheeler-dealers seeking nothing but their own profit. Yet ordinary Irish citizens are now bearing the burden of those debts.

When the Irish government took on the bad debts made by private banks in order to save large international investors from the consequences of their bad choices , it naturally led to a large increase in the Irish government debt to GDP ratio. So in return for the good (?) deed of rescuing international investors, banks, and bond buyers from the consequences of their investments, those investors, banks, and bond-buyers have punished the Irish government by driving interest rates on Irish bonds to high levels.  The speculators smell another Greece.  Talk of bailouts began earlier this month. And, finally with interest rates rising and the speculators circling like sharks, the Irish government accepted a “bail-out” earlier this week from the Euro central bank and IMF, the usual TPTB.

I’m not sure that it should really be called a “bail-out” though.  It’s actually a strange deal like something out of  Alice in Wonderland or a George Orwell novel.  In return for the Irish government agreeing to cut spending even more, raise taxes, and punish it’s already suffering people, the Irish government gets a large credit line so it can borrow even more money in the future.  Of course, by cutting spending and raising taxes in the middle of a serious, deep recession and when it has no control over it’s monetary policy (Ireland is in the Eurozone), it will, of course have even larger deficits than is planned or expected and will need to borrow that money.  Which will only kick the can down the road to some point in the future when another “bail-out” is necessary.  God save us all from such “bail-outs”.

What  could the do instead?  Well, first off, long-term policy should be focused on growth by investing in infrastructure and education and research, much like Finland does and not in globalization and chasing multi-national banks and corporations who play shell games.  More directly, the Irish government should consider what Iceland, that other small European island in the North Atlantic did.  As Krugman also observed in the same article:

Part of the answer is that Iceland let foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts. As the International Monetary Fund notes — approvingly! — “private sector bankruptcies have led to a marked decline in external debt.” Meanwhile, Iceland helped avoid a financial panic in part by imposing temporary capital controls — that is, by limiting the ability of residents to pull funds out of the country.

And Iceland has also benefited from the fact that, unlike Ireland, it still has its own currency; devaluation of the krona, which has made Iceland’s exports more competitive, has been an important factor in limiting the depth of Iceland’s slump.

None of these heterodox options are available to Ireland, say the wise heads. Ireland, they say, must continue to inflict pain on its citizens — because to do anything else would fatally undermine confidence.

But Ireland is now in its third year of austerity, and confidence just keeps draining away. And you have to wonder what it will take for serious people to realize that punishing the populace for the bankers’ sins is worse than a crime; it’s a mistake.

But to follow the Iceland example requires two things.  First, Ireland would have to leave the Eurozone and return to issuing and controlling it’s own currency. And, second, it’s politicians would have to the well-being of the Irish people above the claims and self-interest of the banks and large international investors.  I say not gonna happen.

Wall Street on the Tundra | vanityfair.com

Excellent, though long, article on the current economic crisis and Iceland.  Iceland is a small country that joined the globalized finance and banking bubble in a big way in the last 10 years.  The credit crunch and US housing price declines of 2007-09 have brutally punished this small northern Atlantic country.

Read all about it here at Wall Street on The Tundra from Vanity Fair. Here’s their intro.

Iceland’s de facto bankruptcy—its currency (the krona) is kaput, its debt is 850 percent of G.D.P., its people are hoarding food and cash and blowing up their new Range Rovers for the insurance—resulted from a stunning collective madness. What led a tiny fishing nation, population 300,000, to decide, around 2003, to re-invent itself as a global financial power? In Reykjavík, where men are men, and the women seem to have completely given up on them, the author follows the peculiarly Icelandic logic behind the meltdown.