While economists were busy debating the merits of austerity or stimulus, Iceland staged one of the fastest recoveries on record. Garyn Tan takes a look at the lessons for policymakers.
2018 will mark 10 years since the collapse of Lehman Brothers, when the worst financial crisis since the Great Depression became global.
In responding to the downturn, many governments, including the US and Australia, turned to Keynesian policies – programs of deficit spending to boost ailing demand. Other countries, like Ireland and Greece, had austerity forced upon them as bail-out conditions from the International Monetary Fund (IMF) and the European Union.
Austerity describes budgetary measures intended to reduce government deficit (by cutting spending or raising taxes). Advocates of austerity argue that reducing government deficit avoids default risk, boosts confidence and encourages lower interest rates. Many have cited the now infamous 2010 Reinhart and Rogoff study which found that economic growth contracts substantially when government debt to GDP exceeds 90 per cent (the results of the study would later be undermined by coding errors discovered in the calculations).
Keynesians argue the opposite – that government spending is exactly what the economy needs in order to pick up the slack left behind by the private sector and curb unemployment. The efficacy of stimulus spending comes from the multiplier effect. Each dollar spent by the government has ripple-like effects as recipients of the initial stimulus spend their money, recycling the stimulus back into the economy.
Like many debates in economics, the battle of austerity versus fiscal stimulus in times of economic crisis has descended into theology, and misses the point entirely. What is the underlying motive of a government in crisis response? To protect economic growth? To control inflation? Or to protect its citizens?
The failing of modern economic policy has been the wholesale assumption that in targeting growth, the welfare of a nation’s citizens will surely follow. We might do better if our priorities are flipped – target welfare, with the understanding that (sustainable) growth is implicit. The distinction is crucial, and to see why, we should take a look at Iceland’s recovery from the Global Financial Crisis.
Relative to the size of its economy, Iceland’s financial crisis was the largest in the world. The crisis came following the collapse of the country’s three largest banks – Glitnir, Landsbanki and Kaupthing – which at the time had amassed assets that were a whopping 10 times as large as Iceland’s annual GDP. It was therefore a surprise to many when the country staged one of the speediest recoveries on record, returning to growth in 2011.
Iceland did embark on a path of financial consolidation in 2009 after a bailout by the IMF, shortly after the crisis. Taxes were increased (particularly on higher incomes), spending reduction reforms were made in health and education, and public sector pay was cut. Importantly, however, social benefits were safeguarded. Initially, these cuts led to a sharp decline in GDP of 7 per cent. So how did Iceland return to growth just two years later?
The rest of Iceland’s policy response was a defiance of economic orthodoxy. In a climate where banks were deemed “too big to fail,” Iceland found that its three big banks were in fact “too big to save.” The banks were nationalised and split into domestic and foreign operations, with the government guaranteeing domestic deposits whilst abandoning the foreign operations side. A program of private debt forgiveness was implemented, easing the debt burdens for a quarter of the population. The currency was allowed to devalue by almost 60 per cent from the end of 2007 to 2008, restoring competitiveness and flipping the trade balance into surplus. In 2009, capital controls were introduced to put a floor on the currency and contain inflation.
Viewed from the lens of economic ideology, Iceland’s actions look confused. But from the perspective of a country whose objective is to stabilise the economy while also supporting its citizens, these policies make a lot more sense.
It would be foolhardy, of course, to generalise the specific actions taken by Iceland as a lesson for other economies. With a population of just over 300,000, Iceland benefited enormously from the nimbleness of its economy, transitioning almost instantly from the ruins of the financial sector to the boom in tourism propagated by its cheap currency. In any case, many other developed economies which have variously implemented either stimulus, austerity, or stimulus and then austerity, have likewise emerged from the shadow of the Great Financial Crisis.
What makes the story behind Iceland’s recovery important is not simply that it recovered. Iceland’s recovery is important because of its priorities – the decisions made about who to protect, and who to shoulder the cost of recovery.
This can be seen in the movements of Iceland’s Gini coefficient, which is a measure of a country’s income inequality. In the years prior to the crisis, Iceland’s Gini coefficient was rapidly trending towards increasing inequality. During the downturn, and in the years after, this trend reversed, suggesting that the government’s policies also led to a redistribution of income back to levels seen before the financial boom that precipitated the economy’s collapse.
There is one more key difference between the Icelandic recovery and the experience of the rest of the world. Iceland is the only country to have prosecuted and jailed bank executives in connection with the crisis. As many as 26 bankers went to jail, with charges ranging from fraud, market manipulation, and embezzlement to breach of fiduciary duty and making fraudulent loans.
Considering the riven political landscape and the rise of ugly strains of populism across the developed world, perhaps in the long run, this will prove to be the most illustrative difference. Unlike everybody else, Iceland got closure.