Iceland's Crunch

You've got to feel for Iceland. Not only do you have an economy in recession and a plunging currency, but you also have to put up with columns from LSE professors using 20-20 hindsight to tell you that you were obviously going to end up in this mess all along.

Robert Wade, in the FT, pulls no punches: "the size of the accumulated macroeconomic imbalances beggars belief," he says, but then just comes up with a list of percentages of GDP. In Iceland, anything looks big as a percentage of gross domestic product, because there's very little produced domestically. That's why Icelandic businesses were so keen to expand abroad in the first place. But then Wade's article gets even weirder:

How could such a minnow exercise so much leverage? The answer starts before 2000, when most of the banks were still publicly owned and run like government departments. Real interest rates were low and even negative for long periods. Facing excess demand for credit, the banks operated like political patrons, allocating credit to favoured business clients. The resulting inefficiencies in resource allocation were offset by ever-rising amounts of debt relative to equity and by the longest hours of work in western Europe. These factors helped Iceland to become one of the most prosperous countries in the world in terms of per capita income and several indicators of quality of life.

If there's any kind of causal chain hidden in that paragraph, I can't see it. I'm reasonably sure Wade's not saying that if your banks operate like political patrons then you're bound to end up as one of the most prosperous countries in the world - but it kinda seems that way.

Wade goes on to complain that Iceland's banks "operated like hedge funds, financing their expansion largely from foreign borrowings rather than domestic deposits". Are hedge funds known for funding in foreign currencies? It makes sense to me that if you're investing abroad, it makes sense to borrow abroad as well - especially when the total domestic deposit base is far too small in any case to fund your investments. Besides, would Wade have preferred that Iceland's banks fund their foreign adventures with the money of their domsetic depositors?

Wade is so keen to blame lax regulation for all Iceland's ills that he even complains that high interest rates had the effect of strengthening the currency. Well, yes, that is a well-known effect of high interest rates. Would he prefer that interest rates had been kept low?

Nowhere does Wade mention the real cause of Iceland's present troubles - that it's got the smallest free-floating currency in the world, which is easily buffeted by international capital flows going in and out of the carry trade. "A more Scandinavian model where finance does not rule the economy" is all well and good, but wouldn't have prevented what happened in Iceland. On the other hand, if Iceland had joined the euro, the problems would never have arisen in the first place.