Posted by: Dirk | October 1, 2013

Iceland’s advantages of not having joined the euro zone

Recently, the Guardian reported that Iceland’s bank New Landsbanki cannot repay its debt:

New Landsbanki, the state-owned Icelandic bank forged in the midst of the 2008 Icesave scandal, has asked for more time to repay a £1.5bn bond that is threatening to destabilise Iceland‘s recovering economy.

At a meeting on Friday in London with creditors to the old bank, which include the British and Netherlands governments, Icelandic negotiators are understood to have said New Landsbanki will go bust if it is forced to stick to a steep repayment schedule, in euros, from the start of next year.

Moreover, the Central Bank of Iceland has said publicly the country cannot support the schedule. “The repayment profile … is too heavy for the economy. The bonds will have to be extended or refinanced,” it said.

New Landsbanki was formed five years ago by taking the Icelandic assets of the failed bank out of the administration process, in return issuing the bonds that are soon due to be repaid.

This, naturally, is not good news. However, if Iceland would be inside the euro zone, it is not hard to imagine what an alternative scenario could look like. Iceland’s bank would have been bailed out by Iceland’s government, Iceland’s government would then have to be bailed out itself. Access to European funds would have been delivered only by accepting a harsh austerity program that shrinks the welfare state and puts most of the financial burden and social stress on the relatively poor.

Instead, Iceland has an actual unemployment rate of 4.4 percent. Since it is fluctuating seasonally more than elsewhere because of the climate, is must be added that the maximum unemployment rate in Iceland this year was 7.5% in May, according to Statistics Iceland. The activity rate – “activity rate is the ratio of the labour force to the total population” – was 84.3 percent. In absolute terms that is a lot, much more than in the US, and it is only a little below the value of the same months in the years before.

So, given the experiences of countries inside the euro zone Iceland is doing relatively well. The reason is that private debts have not been transformed into public debts, probably because that wasn’t an option in the first place. Iceland’s banks had balance sheets that were a multiple of GDP before the crisis. So, the financial burden was shifted to the banks and households that lent to Icelandic banks. And this leads to an interesting situation: banks that have mismanaged face huge losses. That is a survival constraint if there ever was one and surely leads to more diligence in the future.

Of course, households should not lose money from schemes like icesave because it is impossible or impracticable for households to judge the financial health of a bank. After all, even banks didn’t do it right, as the fall out from icesave and Lehman Brothers shows. Depositor insurance then is a must to guarantee the stability of the financial system and stop bank runs and capital flight, which by the way runs counter to the policies imposed on Cyprus. The whole Iceland episode shows how important it is to regulate the banks and out rule behaviour that puts huge risks on balance sheets protected by little amounts of equity.

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