Ready to surge? Iceland has wrestled itself out of recession. (Adam/Flickr, CC BY-SA)
Disgruntled Icelanders recently forced their prime minister to quit, and are threatening to hand power to self-styled pirates
at an early election. But whereas other European voters are culling
traditional parties out of weakness, Reykjavik’s are rebelling out of
strength. In contrast to eurozone countries (core as well as periphery)
that remain deeply constrained by excessive external debt, Iceland has
just paid down its foreign obligations by a cool $61 billion, returning them to the safe 2006 level.
The country that suffered proportionally the world’s biggest financial collapse in 2008 is now set to boom again as it diversifies from fish, tourism, and aluminum into renewable energy and information technology.
Its GDP, already among the highest in the world per capita, is back
above the pre-crisis level and set to rise (on central bank forecasts)
by 4 percent in 2016 and 2017—twice the eurozone and U.K. rates.
Although its overgrown banks were one of the causes of the global
financial crisis, Iceland responded to their meltdown in the opposite
way from the rest of Europe—and against the received wisdom of most
economists. It allowed its currency to fall in value—an option
unavailable to eurozone members, which had to ratchet down wages and
prices through “internal devaluation.” It nationalized the big banks
that had run up unsustainable debt, rescuing only the fraction that served the domestic economy. It imposed capital controls
so that the banks’ creditors and other foreign investors couldn’t
withdraw their money. Locals, including pension funds, couldn’t invest
abroad.
Let’s Get Fiscal
The central bank also tightened monetary policy. Its policy rate
peaked at 18 percent in 2009, and was still at 5.75 percent this month.
In the U.K., eurozone, and the United States, central banks pushed their
rates to near-zero and applied quantitative easing. Defying the
austerity that prevailed across Europe, Iceland then allowed fiscal
policy to take the economic and social strain. In particular, public
money was used to relieve households of the debt that would otherwise stop any spending recovery.
Economist Paul Krugman, perhaps shielded from the orthodoxy by a
Nobel prize, has repeatedly drawn attention to the way these policies
allowed rule-breaking Iceland to recover far earlier than less afflicted eurozone peers—even Ireland, the poster child for conventional “adjustment policies.”
Until now, critics had one powerful riposte to this improbable ray of
Nordic sunshine. They said it was a false dawn. They argued that the
whole recovery was only achieved on the back of draconian capital
controls, in place since November 2008. Removing them would be painful,
but failing to lift them promptly would have equally dire consequences.
Foreign investors would despair of getting their trapped cash
back—making it impossible for Icelanders to borrow again even for worthwhile investment far away from banking.
The critics said that domestic investors’ savings would, with nowhere
else to go, turn the already strong tourism and stock market investment
booms into overheated bubbles whose bursting unleashes more trouble.
Emerging from capital controls is notoriously tricky, especially when
they’ve been in place for eight years and when it’s a small, open
economy with a narrow productive base of mainly cod-fishers and
whale-watchers. And so the pessimists have tended to hint that when the
controls lift, the whole fairy-tale escape story will unravel.
In this nightmare exit scenario, Iceland’s currency (the kronur) will
plunge as foreign funds flee, never to return. Interest rates will rise
even higher to rescue the exchange rate, choking-off investment, without
stopping the runaway inflation sparked by imports getting more
expensive. The weaker kronur will leave the country struggling to
service its remaining foreign debt, despite its recent reduction.
Kronur Capitalism
In practice, Iceland has regained economic strength inside its gilded
cage—to the extent that it can now step outside, melt it down, and
resell the gold. The current account surpluses permitted by the
devaluation, and the nationalized bank assets that regained value after
the economy’s return to growth, have enabled the repayment of so much
foreign debt that the rest will be manageable, even if the currency
sinks when controls go. It’s a stark contrast to the eurozone and
especially Greece, which had to ask its creditors for debt relief that
will not begin until 2018.
The chances of a kronur crash have diminished because the current account is back in surplus
(foreign transactions bring in more money than they take out), and
because foreign investors are again being attracted to Iceland. They
like its high interest rates, growth prospects, and investment
opportunities. Icelandic households and businesses can live with higher
borrowing costs because they’ve paid down their debts, while incomes have been rising fast.
Although a remote island with a population of 300,000 and unique natural resources
could be dismissed as a special case, Iceland’s remarkable renaissance
makes its remedies a serious challenge to the orthodoxy. Krugman is not
the only one to find useful lessons in this Nordic saga.
The IMF, which used to insist on free capital movement as precondition
for assistance and recovery, has published research which assigns
capital controls a valuable role in maintaining stability in a world of volatile international money flows.
Privateers, Not Privatizers
The sting in this unlikely tale turns out to be political, not
financial. The recovery was laid out by the Social Democrats and Green
Party in Iceland in a 2009–2013 coalition, and taken towards completion
by a coalition of the Independence Party and Progressives. However,
Icelandic voters appear to have rounded on all the political groups that
used to serve as government and opposition. The Pirates—launched in Iceland in 2012
as a campaign for more democracy and freedom of information—have led
recent opinion polls with a commanding 40 percent, and are well placed
to lead any government formed after early elections this autumn.
Neo-liberal orthodoxy could still return—in the form of David
Oddsson, who (as finance minister, prime minister, and central bank
governor) was an architect of the financial liberalization that preceded
the 2008 crash, and who has joined an unusually crowded field. But if normal politics is restored, it’s only because highly abnormal economics made good the elites’ past mistakes.
Alan Shipman is a lecturer in economics at The Open University in the U.K. This article was originally published on The Conversation.
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