Posted by: Dirk | August 28, 2009

The Economic Consequences of Icesave

As the BBC reports, Iceland has voted to make good the savers who lost their money in the Icesave scheme. High interest lured savers to lend money to Icelandic banks, which collapsed early in the financial crisis because short-term financing became too difficult. An agreement had to be reached in order for Iceland to start negotiations about access to the European Union. These are some of the specifics:

The amount that will be paid is limited based on the level of Iceland’s economic output, or gross domestic product (GDP).

The country will only have to pay up to 4% of its GDP each year to the UK and 2% to the Netherlands.

No payments will be made for the next seven years, but the bill says that if the full payments have not been made by 2024 then no further payments will be made. Effectively, there is only an eight year window for the loans to be repaid.

A back of the envelope calculation should provide some first numbers. Iceland has to repay more than € bn 3.5. Iceland can repay 6% of GDP for 8 years. 2008 GDP is roughly $ bn 19 according to the IMF, which should be around € bn 13 (with the exchange rate from August 2008). 6% of this is around € 780 million a year, so after 8 years this is € bn 6.24. This looks like it’s possible to repay.

However, the whole situation is known to economist’s as the transfer problem. If you have to repay your foreign debt, your currency will depreciate since you supply your own currency and demand foreign currency on financial markets. This makes imports more expensive. Iceland is very dependent on imports, and rising import prices will be bad for growth and very likely create inflation through rising import prices. The same situation arose after WWI, when the Treaty of Versailles burdened Germany with high debts. John Maynard Keynes analyzed this treaty and concluded that it would contain the seeds for another war. Nobody has to be afraid of 320,000 Icelandic people turning viking, but I wonder whether this agreement can be honoured. Maybe Iceland joins the euro area before repaying its debt. Still, Iceland is not a country with a history of current account surpluses. I wonder what they want to sell.

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