Iceland offers risky temptation for Ireland as recession ends

The Telegraph
December 10/10

Logo of Iceland's Left-Green Movement

Iceland has finally emerged from deep recession after allowing its currency to plunge and washing its hands of private bank debt, prompting an intense the debate over whether Ireland might suffer less damage if adopted the same strategy.

The Nordic economy grew at 1.2pc in the third quarter and looks poised to rebound next year. It ends a gruelling slump caused largely by the "New Viking" antics of Landsbanki, Glitnir and Kaupthing, the trio of lenders that brought down Iceland's financial system in September 2008.

The economies of the two "over-banked" countries have both contracted by around 11pc of GDP, but Iceland has achieved it with inflation that devalues debt, while Ireland has done it under an EMU deflation regime that raises the burden of debt.

This has led to vastly different debt dynamics as they enter Year III of the drama. Iceland's budget deficit will be 6.3pc this year, and soon in surplus: Ireland's will be 12pc (32pc with bank bail-outs) and not much better next year.

The International Monetary Fund said Iceland has turned the corner, praising Reykjavik for safeguarding its "valued Nordic social welfare model".

"In the event, the recession has proved shallower than expected, and Iceland’s growth decline of about minus 7pc in 2009 compares favorably against other countries hard hit by the crisis," said Mark Flanigan, the IMF's mission chief for the country.

Total debt will peak at 115pc, before dropping to 80pc by 2015 in what the IMF called "robust debt dynamics". Meanwhile. Ireland's debt will continue rising for another three years to 120pc of GDP. The contrast will be very stark by the middle of the decade. Iceland may have a lower sovereign debt than Germany by then.

Iceland's president, Olafur Grimsson, irritated EU officials last month when he said his country was recovering faster because it had refused to bail out creditors – mostly foreigners.

"The difference is that in Iceland we allowed the banks to fail. These were private banks and we didn't pump money into them in order to keep them going; the state should not shoulder the responsibility," he said.

The comments came just as the EU authorities were ruling out investor "haircuts" in Ireland, making this a condition for the country's €85bn (£72bn) loan package.

Dublin has imposed 80pc haircuts on the junior debt of Anglo Irish Bank but has not extended this to senior debt, viewed as sacrosanct.

The Irish press reported that EU officials "hit the roof" when Irish negotiators talked of broader burden-sharing. The European Central Bank is afraid that any such move would cause instant contagion through the debt markets of southern Europe.

Comparisons between the Irish and Icelandic banks must be handled with care. Iceland is tiny. It could walk away from liabilities equal to 900pc of GDP without causing a global systemic crisis.

Ireland is 12 times bigger. The balance sheets of Irish banks are $1.3 trillion (£822bn). The interlocking ties with German, Dutch, Belgian, and British banks create a nexus of vulnerability. Bondholder defaults would risk contagion to Spain and Portugal, where the banks rely heavily on foreign capital markets.

Of course, banks are only half the story. Nobel economist Paul Krugman said Iceland has been able to eke out recovery sooner because it never joined the euro.

"Iceland devalued its currency massively and imposed capital controls. And a strange thing has happened: although it experienced the worst financial crisis (anywhere) in history, its punishment has been substantially less than that of other nations," he said, referring to Baltic states pegged to the euro.

Two years later, the krona is down 30pc, aluminium smelters are firing on all chimneys to meet export demand and local produce has displaced imports, including such exotica as vegetables and tomatoes grown in greenhouses.

Lars Christensen from Danske Bank said Iceland had come through "relatively unscathed" given the devastation of its banks but warned that it is still too soon give the all clear. "Iceland is a frozen crisis, and I am still worried what will happen when they lift capital controls," he said.

There is a better model for Ireland than Iceland, according to Mr Christensen. "People should be looking at Kazakhstan, which didn't bail out any creditors and let the three biggest banks fail, yet avoided a recession by letting the currency plunge and using monetary stimulus," he said.

Whether Ireland can learn anything from the Kazakh solution is a neuralgic issue. Ireland cannot resort to exchange and monetary stimulus without leaving the euro, which would be traumatic for all kinds of reasons, and illegal according to the ECB.

Ireland's EMU membership is not an economic policy. It is part of Ireland's larger strategy to escape Britain's shadow and build a different kind of country.

With a highly open economy, it has attracted investment from US and European companies precisely because it is fully committed to the EU Project.

Yet the underlying tale of Ireland and Iceland, and the tale of the 1930s, is that a devaluation shock may cause a violent crisis – that looks and feels terrible while it happens – but the slow-burn of policy austerity and debt deflation does more damage in the end.

Also see Land of the IceSlaves?