ec4024 lecture 14: iceland and ireland: fair and unfair comparisons

ICELAND & IRELAND: FAIR AND NOT-SO-FAIR COMPARISONS

Dr Stephen Kinsella/stephen.kinsella@ul.ie/stephenkinsella.net

––MAY YOU LIVE IN INTERESTING TIMES

LAST TIME

A Rule-Bound SGP Causes Problems

for Ireland wrt Fiscal ReformTime to Break the Rules

Iceland.

What’s the situation now,

How did it happen,

What lessons are there

for Ireland in 2009?

Today

WHAT I WANT YOU TO KNOW

Iceland’s economic situation is a direct outcome of its institutional history.

History Matters.

Remedies for Iceland’s problem: Either join EU or kill its indigenous banking system.

Or: Pray.

Compare: Ireland experienced the same boom, the same bust

Contrast: But, we’re in the EU.

WHAT HAPPENED?Oct 2008, All 3 big Icelandic banks fail & nationalisations abound.

Nov 2008, IMF called in

UK ‘Attacks’ Icelandic economy

Speculative Attacks continue

WHY?History

Pre 1990‘s: Icelandic economy previously highly regulated & politicized

1990‘s+: financial liberalization with weak prudential regulation and supervision

Privatised banks pursued highly leveraged positions

Imprudent monetary policy-Inflation targeting

Lack of Prudential regulation

Speculative Finance: The Minsky Hypothesis

0

3.75

7.5

11.25

15

2003 2004 2005 2006 2007 2008

Inflation % yoyInflation target

0

2

4

6

8

2003 2004 2005 2006 2007 2008

Real GDP Growth

10X

MINSKY MOMENTS1.Idea: Credit markets will breed their own reversal

2.How?

1.Cheap interest rates lead to increased lending.

2.This leads to increases in leverage (L/D ratio).

3.Perverse incentives breed dodgy lending via financial innovations (Junk bonds/CDOS) ensues.

4.Something changes, dodgy loans default, banks fail, unless they get bailed out by Big Bank/Big Govt.

WHAT COULD HAVE BEEN DONE?

Dropped Inflation Targeting sooner (Danielsson)

Introduce Prudential regulation sooner

Listen to the experts (Buiter & Sibert)

WHAT IS TO BE DONE?

Join the Euro (Lane/Buiter *& Sibert)

Big risks even then

PARALLELS WITH IRELAND

Boom fueled by cheap money, perverse incentives, and light regulation destabilised financial system

This lead to shocks in the real economy as bank lending dried up. UE increased, GDP collapsed.

UNFAIR COMPARISONS

NEXT TIME