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Wednesday, June 27, 2012

Deep Freeze: Iceland’s Economic Collapse

In this short but highly illuminating book, economics professors Philipp Bagus and David Howden (both of whom are schooled in Austrian theory, both fellows at Britain’s Cobden Centre, and both currently teaching in Spain) explain the collapse of Iceland’s economy in 2008. Why bother with the difficulties of that little nation (population of only 313,000) in the remote North Atlantic? The Icelandic debacle stemmed from exactly the same governmental blunders that have caused so many other boom-and-bust cycles around the globe. Iceland’s horrible recent experience has important lessons for Americans—indeed for people everywhere.

The key insight of Ludwig von Mises was that artificial credit expansion will initially lead to a boom in certain sectors of the economy, but the boom cannot be sustained indefinitely. Once the artificial stimulus of cheap credit ends, as it eventually must, the overexpanded sectors must contract. The misallocation of resources becomes apparent. Workers must be released, and overextended firms must cut back or go bankrupt. Government policies set this train of economic mistakes in motion, and once it’s going, they often propel it faster and faster. Bagus and Howden demonstrate that Iceland’s collapse—the first such implosion in a developed nation since the Great Depression—fits the Austrian theory of the business cycle perfectly.

Iceland’s boom was rooted in a 2001 decision by the country’s central bank (the CBI) to act as lender of last resort for all Icelandic banks. That let loose the problem of moral hazard. Knowing that they could depend on the CBI to come to their rescue, commercial banks began to operate without much concern for the level of risk. To make matters worse, the CBI also lowered reserve requirements for commercial banks, enabling them to make more loans from the same deposit base, and it drove down interest rates. Icelandic banks found that to compete among themselves, they had to undertake increasingly risky loans, often denominated in foreign currencies where interest rates were even lower than in Iceland. The authors explain, “Artificially low interest rates in Europe, the U.S. and Japan deceived entrepreneurs about the availability of real savings not only in their own currency areas, but in Iceland.” Icelandic banks engaged in massive short-term borrowing around the world to finance long-term investments.

Much of that investment went into housing, just as in America, aided by the government’s Housing Finance Fund (HFF). The HFF was even worse than our atrocious mortgage twins, Fannie Mae and Freddie Mac. Bagus and Howden observe that while Fannie and Freddie had low mortgage standards, HFF had none at all. Everyone could get a low-cost mortgage. Another huge long-term investment was the construction of two aluminum smelting plants. Icelanders also splurged on lots of high-end automobiles during the boom.

The prosperity bubble had other effects too, particularly in the financial sector and the labor force. During the boom, many young people were drawn into banking and finance, which were “hot” fields, and away from Iceland’s traditional productive industries, especially fishing and related commerce. Bagus and Howden do an excellent job of driving home the vital point: Cheap credit distorts a nation in many ways.

The air went out of the bubble in 2008 when foreigners realized that Iceland’s currency was terribly overvalued. The inflow of cheap funds that the banks were hooked on stopped. The CBI tried to keep the party going, but that was (and should have been known to be) hopeless. The economic crash swept over the country like a tidal wave: defaults, foreclosures, abandoned projects, unemployment. At one point hunger was even a real prospect until several Scandinavian governments made an emergency loan to Iceland so that food importers could pay for shipments.

By now Iceland’s severe turmoil has subsided, and it is slowly adjusting to normalcy, putting labor and capital back to profitable use. Many housing projects stand uncompleted; many of those luxury cars have been shipped off to bargain hunters elsewhere. The situation is akin to a once hard-working individual who wagered his wealth on a big gamble, lived it up for a while on early winnings, but has now been wiped out and has to start over.

The authors end by explaining how nations can avoid the boom-and-bust cycle that did so much damage to Iceland: sound money and banking. Money needs to be based on gold. Banks must never be led to think that their losses will be covered by the government. Moreover, the State must refrain from actions that manipulate interest rates and steer capital into politically favored uses. Boom-and-bust is not a feature of laissez faire; it’s a bug of government planning.