12.27.2010 0

The Icelandic Model Disproves “Too Big to Fail”

By Bill Wilson –

In 2008, there were two competing wisdoms about what to do about failing financial institutions in the wake of the economic crisis. The first said to do nothing and allow institutions that behaved irresponsibly and became overleveraged during the housing bubble to fail. The second said that those institutions were so interconnected, and that the losses they were facing were so insurmountable, that their failure would have spawned a worldwide depression. In short, they were too big to fail.

Implicit in the latter wisdom is that the ability to extend credit beyond the scope of the economy was necessary for prosperity. In other words, those banks just had to continue lending to keep money flowing through the economy. This portrayed the crisis as one of liquidity rather than of solvency.

In the U.S., obviously, policymakers opted for bailing out the financial institutions to, they said, keep credit available in the wider economy. The Federal Reserve opened its lending facilities to investment firms that bet poorly on mortgage-backed securities (MBS), derivatives and other financial instruments. Congress put mortgage giants Fannie Mae and Freddie Mac into conservatorship. The $700 billion Troubled Asset Relief Program was sold on the premise of taking toxic securities off the books of the banks. Then it was quickly converted into a “bank recapitalization” fund, and next the Fed stepped in to buy $1.25 trillion of the toxic MBS.

This, we are told, saved the nation and indeed, the world, from a complete economic collapse. It took the bad bets made in housing and transferred the losses to the government because, thought the policy wonks, those losses could be absorbed by taxpayers. Countries like Ireland and Spain have adopted this model, guaranteeing the financial institutions against losses after their own housing manias went bust. Others, like Iceland, refused to bail out the banks and let the bank’s bondholders eat the losses.

Perhaps this is owed in part to the fierce liberty of the Icelandic people. These are the same people who remained neutral in World War II. The Germans wanted an air base there, but the government told the Nazis to pound sand. The British countered with their own offers of assistance, but they were unwanted, too.

Physically, Iceland forms where the North American and European tectonic plates meet. Politically, it seems that it too has adopted models from both sides the Atlantic. While it has European-style socialism in parts of the economy, it maintains an independence that is distinctly North American.

Although its parliament has applied for accession to the European Union, the people have come to their senses and are rebelling against the decision, coming out two-to-one against, reports The Telegraph’s Daniel Hannan. Also, a March 2010 Capacent Gallup poll found that 69 percent of its citizenry does not support the adoption the euro as a currency.

It has a flat tax system and a low corporate tax rate, but it also has a national sales tax. It has a government-run health care system, but it also has strong property rights for native Icelanders. Its energy sector is largely self-sufficient with geothermal and hydroelectric facilities, although it has to import many other natural resources. It many ways, it remains a modern model of a free, sovereign people who refuse to be pushed around, but yet are not completely isolated.

So, its decision to go against the grain and forego a banking bailout has become something of a testing ground economically. Who is better off, those who bailed out the financial sector, like Ireland, or those that did not, like Iceland?

Certainly, the case for “too big to fail” in Iceland would have been compelling. As noted by Bloomberg News, at the time the crisis hit in 2008, “the banks had debts equal to 10 times Iceland’s $12 billion GDP.” By the logic of “too big to fail,” Iceland’s decision to let the banks fail should have completely destroyed the economy. Businesses should have closed down shop completely from an inability to meet payroll as credit ceased to exist.

But that did not happen. Surely, a recession did follow the largest financial crisis per capita in human history. It immediately resulted in a massive devaluation of the Icelandic currency, the krona, in foreign exchange markets. And although the recession was steeper in terms of GDP compared to Ireland, its unemployment is and will remain lower, according to data by the Organization of Economic Cooperation and Development: 8.1 percent projected in 2011 for Iceland versus 13.6 percent for Ireland.

So too is Iceland’s budget picture better off than Ireland’s, according to the Bloomberg News report, citing European Commission estimates: “Iceland’s budget deficit will be 6.3 percent of gross domestic product this year… compared with the 32 percent shortfall in Ireland… [And] Iceland’s budget will be in surplus by 2012, compared with Ireland’s deficit of 9.1 percent of GDP”. How can this be?

“The difference is that in Iceland we allowed the banks to fail,” Iceland President Olafur Grimsson told Bloomberg Television. “These were private banks and we didn’t pump money into them in order to keep them going; the state did not shoulder the responsibility of the failed private banks.”

Finance Minister Steingrimur Sigfusson says that a bailout would have been impossible: “There was not a question that we would rescue the banks; they were far too big.” They were completely overleveraged. According to the prevailing wisdom here across the pond, their failures should have been a financial doomsday.

But it wasn’t. Apparently, the damage that Wall Street can inflict on Main Street should it fail is not as cataclysmic as is widely believed. New York Times’ Paul Krugman makes the same point: “The moral of the story seems to be that if you’re going to have a crisis, it’s better to have a really, really bad one. Otherwise, you’ll end up taking the advice of people who assure you that even more suffering will cure what ails you.”

So, because Iceland let the financial institutions, and not the taxpayers, bear the losses of the financial collapse, the country remains essentially solvent. In contrast, Ireland is in deep trouble, and just had to accept an €85 billion bailout from the European Union. Shucks. Trillions of dollars later in bailouts and “stimulus,” should we have just done nothing after all?

In the U.S., the worst may yet be ahead, although, the current 9.8 percent unemployment rate and a national debt at almost 100 percent of the GDP is certainly bad enough. Our budget picture is so bad that the Federal Reserve will soon be, if it is not already, the top lender in the world to the U.S. government — more than China or Japan.

Moody’s has threatened to shift the credit outlook of the nation to negative as soon as 2011, and to downgrade our Triple-A credit rating by 2018 if the accumulation of debt is not reduced drastically.

This may ultimately result in a sovereign debt funding crisis where interest rates go through the roof, inflation too would rise, and the dollar’s status as the world’s reserve currency would be threatened.

Of course, it’s not too late, but if that happens, it may be that the U.S. traded a severe recession that would have resulted from letting financial institutions fall for a national default that threatens to destabilize the global economy once again. “Too big to fail” will have become too big to save. Certainly a recession, even a sharp one, would have been better than losing the status of the world’s economic superpower. Too bad we were not more like Iceland.

Bill Wilson is the President of Americans for Limited Government.

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