Default, depreciation, and controls

15/6/2015

By Martin Sandbu

Crisis resolution à la carte

Since Iceland's banking system collapsed in late 2008, the small island state has served as a pioneering counter example to Europe's way of handling a debt crisis. When Icelandic banks, which had grown to 10 times the country's annual income, could no longer refinance their debt, Reykjavik did three things. It restructured the banks, letting creditors fight for the scraps while new banks continued to serve the local economy; it let the currency plummet; and it imposed foreign exchange controls, preventing foreigners from repatriating their investments en masse. Eurozone leaders took a different course on all three counts. First, they chose to bail bankers out instead of writing down debts. The second policy, devaluation, was not available to them short of leaving the euro. And third, except for Cyprus, they avoided controls on capital flows.

Iceland was back in the global financial spotlight last week with news that it was about to lift the limits on moving money out of the country, seven years after foreign exchange controls were put in place. It has generated the usual chorus of approval, with both Matthew Yglesias and Paul Krugman pointing out that on some important measures - unemployment above all - Iceland had a better crisis than Ireland, the closest comparison. Tyler Cowen begs to differ - there is no generalisable model here, he argues.

There are certainly lessons to be learned from Iceland, but it behoves us to look at the main policies separately. The fact that Iceland was forced willy-nilly into "debt repudiation, capital controls, and massive devaluation", as Krugman succinctly summarises it, does not mean that this particular triplet is optimal for countries with a choice in the matter. That includes eurozone ones. So let's take them one by one.

First, debt. An overhang of old debts is a brake on growth; hence policies that can quickly bring about "deleveraging" - a reduction in indebtedness - should help bring stagnant economies back to life. But how do you best reduce indebtedness? The fastest way by far is simply to write debts down. Here is a chart of Icelandic and Irish banking debt as a proportion of the countries' GDP:

If deleveraging is what you want, repudiation gets you there the fastest. Cowen's surly judgment is that this was a "transfer of wealth to the domestic economy" from foreigners which, he implies, was wrong. But this gets things the wrong way round. The Icelandic government, by guaranteeing part of the foreign depositors' claims, did for them more than European law required. If anything, the transfer was from Reykjavik to foreigners.

Second, devaluation. Much is made of the supposed advantage of having your own currency in a crisis. There are two versions of this argument. One is that an independent currency allows you to inflate away your debts. This is, of course, the same as the previous point. But it was through restructuring, not inflation, that Iceland reduced its overhang. And a policy of debt restructuring is just as available inside the euro; the tragedy is how long it has taken its members to accept this.

The other asserted advantage of devaluation is that it will boost your local economy through greater exports. Yglesias claims that Iceland "let the value of its currency tumble ... as the country's export industries rapidly gained ground in international markets." But they did no such thing, as the below chart of Iceland's share in world merchandise exports shows:

In practice, exports are often much less sensitive to exchange rates than simplistic theory would suggest: Britain's disappointing exporting record after a huge depreciation in 2008-09 is a case in point, as is the failure of Greek exports to pick up despite a huge real depreciation (brought about by falling wages rather than a falling currency).

Finally, the foreign exchange controls. Jon Danielsson and Ásdís Kristjánsdóttir have put together the best guide to Iceland's capital controls - why they were put in place to begin with, and how they are now being lifted. In light of the previous point, note that the main intention of the controls was of course to prevent a fall in the currency. So it is inconsistent at best to praise both Iceland's depreciation and its exchange controls. Worse, the comprehensive nature of the controls has paralysed investment as well as placed extraordinary constraints on ordinary freedoms (such as Icelanders' ability to emigrate), as Danielsson has explained before.

So why did they do it? In part to avoid a collapse in the currency, and in part because the IMF told them to. But the option was always available of either letting the currency fall as far as it wanted in the short run - in which case the amount of real resources taken out by creditors would be low - or to tax the most volatile or speculative money flows on the way out - which would have the same effect. Indeed, the current plan to lift controls in effect do this (a tax of nearly 40 per cent is involved, as the guide above explains), so it seems Iceland is finally getting around to doing something it could have done years ago.

In sum, the lessons we should draw from Iceland are nuanced - there is no real argument for copying their entire policy package wholesale. Instead, we should distinguish what worked from what didn't or was counterproductive. Most unambiguously, debt can and should be written down radically. Devaluation, however, does not seem to buy you anything extra - so the eurozone should keep its focus on debt restructuring rather than speculating, let alone encouraging, any country's exit. Finally, capital controls may be considered - but if they should be as narrowly tailored as possible to hit only those flows that genuinely must be avoided.

Πηγή

Η δημοσίευση στα ελληνικά εδώ.