What If Ireland Defaults? (19 page)

Conclusions

Overall, Russian experiences in the post default adjustment reveal a number of important lessons for the peripheral countries of the Eurozone that are witnessing a similar crisis today.

Rapid recovery from the default is possible, even when such a default takes place without proper planning and contingent hedging, under favourable external conditions. Reforms, especially structural reforms of market institutions related to the underlying causes of the crisis, promote long-term growth and recovery and do contribute positively to the defaulter's ability to return to funding markets within a short period of time. Furthermore, these positive aspects of post-default recovery are reinforced for countries with no past history of defaults. Disruptions to normal functioning of the banking system and economic transactions in the short run represent one of the two core downside factors in the default scenario. The other is the significant reduction of real savings levels due to bankruptcies and devaluations of banks. Both of these factors require serious contingency planning and the creation of systemic responses that can help mitigate their adverse impacts on the overall economy. However, as experience in Russia shows, even extremely painful after effects of the default, such as a collapse of private savings, can be effectively mitigated by aligning fiscal reforms with the objectives of helping adversely impacted households to rebuild their savings and wealth. In Russia this was achieved through robust repayment of accumulated government liabilities toward state pensioners and employees, as well as through the creation of a benign personal income tax environment combining low rates of income taxation and a flat tax system of income tax. Lastly, in the case of Russia, the default on sovereign debt can be seen as a catalyst for real and sustainable long-term reforms of the economic institutions. While this process is far from complete, the Russian economy performance since 1998–1999 has been impressive.

Endnotes

¹
Nadmitov, A. (2004) ‘Russian Debt Restructuring: Overview, Structure of Debt, Lessons of Default, Seizure Problems and the IMF SDRM Proposal', paper presented at the International Finance Seminar, Harvard Law School, available from:

, pp. 5–6.

²
Krivka, A. (2006) ‘The Experience of Russia in Reforming Tax System: Achievements, Problems and Perspectives',
Vaduba Management
, Vol. 2, No. 11, pp. 73–74.

³
Moody's Investors Services (2007) ‘Sovereign Default and Recovery Rates, 1983–2006', Global Credit Research Note, June.

⁴
R.G. Gelos, R. Sahay and G. Sandleris (2004) ‘Sovereign Borrowing by Developing Countries: What Determines Market Access?' IMF working paper no 221, November 2004.

⁵
Organisation for Economic Co-Operation and Development (1997)
OECD Economic Surveys: Russian Federation 1997
, OECD: Paris, 1997-19.

⁶
H. Huang, D. Marin and C. Xu (2003) ‘Financial Crisis, Economic Recovery and Banking Development in Former Soviet Union Economies‘, CESifo working paper no. 860, February 2003, available from:

.

⁷
Euromoney
(1999) ‘Russia, The Newly-Wed and the Nearly Dead', 10 June, available from:

.

8

Iceland: The Accidental Hero

Elaine Byrne
and
Huginn F. Þorsteinsson

Elaine is an assistant professor of Politics in Trinity College Dublin and a political columnist. Her website is
www.elaine.ie
. Huginn is a philosopher and adjunct professor at the University of Akureyri. He was the policy adviser to the Icelandic Minister of Finance (2009–2011) and is currently the adviser to the Minister of Economic Affairs and Minister of Fisheries and Agriculture.

The boom to bust story of Iceland's economy is well documented. After a number of years of sensational economic growth from 2002 to 2007, the economy began to destabilise with dramatic consequences in October 2008. Within a span of less than a week, the entire financial sector, ten times the gross domestic product (GDP) of Iceland, went bust. The stock market was nearly wiped out. The economic outlook was not favourable. Interest rates and inflation were at 18 per cent. Unemployment sharply rose from 1 per cent to 9 per cent. Government revenue was rapidly evaporating but government expenditure had surged. The Icelandic króna (ISK) was in free fall and the reputation of the country was in absolute tatters. The entire financial sector had collapsed lock, stock and barrel.

The three main banks, Glitnir, Kaupthing Bank and Landsbanki, collapsed creating significant turmoil in the financial markets. This in effect shut down the foreign exchange market and caused a dramatic depreciation of the króna. The immediate consequences were the nationalisation of these three banks, which accounted for 85 per cent of the banking system. The International Monetary Fund (IMF) immediately intervened with a $2.1 billion package in order to avert a further meltdown of the Icelandic economy.

Iceland's situation was so bad that Poul M. Thomsen, the IMF's mission chief for Iceland, described it as ‘unprecedented.' Thomsen recalled how ‘the sense of fear and shock was palpable—few, if any, countries had ever experienced such a catastrophic economic crash.' Others pointed to Iceland as the canary in the coal mine. Even the word ‘Iceland' came to have certain connotations linked to it, such as reckless banking and financial catastrophe. Greek and Irish politicians, overwhelmed by their own growing economic problems, were keen to stress that they were not Iceland.

‘Ireland is not an Iceland which has somehow acquired a series of foreign obligations and saddled them on its taxpayers' observed the late Brian Lenihan in his Dáil contribution of 1 April 2010. In his address to the Irish Taxation Institute earlier that year, the Minister for Finance argued that those who advocated for the Icelandic approach – the 100 per cent bank nationalisation – were wrong. Lenihan even felt it necessary to point out the folly of Icelandic policy with the use of an exclamation mark in his presentation to the tax consultants, accountants, barristers, solicitors and other financial professionals in attendance: ‘Only one country has followed this approach in this crisis: Iceland!'
¹

Within eighteen months of this address, the IMF/ECB/EU troika had intervened in Ireland and the entire Irish banking sector was nationalised or part nationalised. Ireland experienced the deepest and fastest contraction of any western economy since the Great Depression. The Governor of the Central Bank, Patrick Honohan, described it as ‘the most expensive [banking crisis] in history.' By August 2011, the European Central Bank (ECB) and the Irish Central Bank had pumped €150 billion into Ireland's six banks. The gag ‘What's the difference between Iceland and Ireland? One letter and six months', first aired in January 2009 on the BBC daily current affairs programme
Europe Today
, was now on Ireland. Even
The Economist
magazine got in on the act, referring to the Irish economy in February 2009 as ‘Reykjavik-on-Liffey'.

Yet, in the three years since the 2008 Icelandic collapse, the Nordic country has made a remarkable and noteworthy economic recovery. The IMF approved the final loan tranche in August 2011, marking the end to a 33-month rescue package. The Finance Minister, Steingrímur Sigfússon, subsequently announced that ‘All the program objectives have been achieved.' Nemat Shafik, IMF Deputy Managing Director and Acting Chair, likewise stated ‘Key objectives have been met: public finances are on a sustainable path, the exchange rate has stabilized, and the financial sector has been restructured.'
²
The economy has stabilised, fiscal adjustment has been successful, economic growth is picking up and the sovereign financed itself successfully in the bond market in May 2011 on what were considered good terms.

Iceland and Ireland – The Difference Is More than a Letter

Ireland and Iceland share remarkable parallels. Both countries enjoyed enormous growth at the beginning of the twenty-first century but by the end of the first decade were clients of the IMF. This growth was, in part, fuelled by a large expansion of Irish and Icelandic financial institutions. A housing bubble, an immense increase in purchasing power and excessive lending to companies and households also occurred. Much of the policy implementation was similar. The regulatory powers of supervisory authorities were relaxed as the market was regarded as adequately self-regulating. Taxes on capital gains, corporate tax and taxes on high income were lowered because they were thought to discourage growth in the economy. The Irish Minister for Finance, Charlie McCreevy, reduced income tax rates to 42 per cent and 20 per cent in Budget 2001, earning a rebuke from the European Commission, which reprimanded Ireland for its expansionary budget policy.

The Icelandic and the Irish governments in the early to mid-2000s were thought to be daring and were lauded for being so. Accordingly, Icelandic entrepreneurs earned the moniker ‘Finance Vikings', whilst Ireland became the ‘Celtic Tiger'. The two countries served as paradigms of how increasing freedom in the market place served to ensure that everybody would benefit from growth. The neo-liberal economic philosophy – the rising tide lifts all boats – was virtually unquestioned.

Iceland and Ireland have more in common with each other than with the PIG countries facing grave economic difficulties accessing the sovereign debt markets – Portugal, Italy and Greece. Iceland's and Ireland's economic collapses stem from crises within their banking systems. This was not the case in Portugal, Italy and Greece, where a public debt problem has been gradually mounting. Yes, their banks are in trouble but not in the same manner as in Iceland and Ireland. Spain's difficulties may be more akin to Iceland's and Ireland's but there are other issues that explain its weaknesses such as unemployment, which was a reality before the European financial crisis.

Nonetheless, there are important dissimilarities between the Irish and Icelandic cases. Iceland is a very small economy in the sense that the country's population of only 300,000 is just a quarter that of Ireland's capital city, Dublin. An argument can therefore be made that even though Iceland's crash was harder hitting than Ireland's, the difference in the size of the economies has allowed the Icelandic case to be more manageable. It is easier after all to turn a small tugboat around than a large tanker.

Iceland is not a member of the European Union and had the policy option to devalue its own independent currency, unlike Ireland. The devaluation of the króna, by more than half, has been difficult for Icelandic households and companies as many of them had foreign exchange-linked loans. However, it has been helpful in creating a considerable trade surplus by boosting earnings in the export sector. A devaluation of the Irish currency would have served a small, open, trade-dependent economy like Ireland's well. Ireland is particularly vulnerable given its dependence on high levels of foreign direct investment and internationally traded services sectors. Ireland's exports, for instance, accounted for 105 per cent of GDP in the September 2011 Quarterly National Accounts.

Moreover, Ireland is in an IMF programme funded by the 27 EU nations under the watchful eye of the ECB. The United Kingdom made a bilateral loan on favourable interest rates to its closest economic neighbour. Iceland received significant funding from its Nordic neighbours and Poland. That may have contributed to the flexibility within the Icelandic programme, which in many aspects was unorthodox. Iceland imposed, for example, capital controls, something the IMF has traditionally been opposed to. It has also been lauded by the IMF for its commitment to the ideals of the Nordic welfare state.

Bank losses were not absorbed wholesale by the public sector, which was insulated somewhat from vast private sector losses. Poul M. Thomsen noted that the IMF ‘had to reach for policy tools that were not part of our mainstream toolkit'.
³
It was private creditors rather than the national Exchequer that ended up bearing most of the losses in the failed banks.

The IMF co-hosted a high-level conference with the Icelandic government in October 2011 to review the conclusion of its programme in the country. The IMF learned three main lessons, Nemat Shafik said:

1. When countries have a clear strategy in mind, as was the case in Iceland, it becomes much easier for the IMF to engage and provide policy support and advice.
   
2. There are clear advantages to having a heterodox toolkit – more tools are better than fewer.
   
3. Iceland set an example by managing to preserve, and even strengthen, its welfare state during the crisis.
   ⁴
   

On the other hand, the Irish government responded to the economic crisis by guaranteeing not only all deposit holders, but also most bank bondholders, in September 2008. This in effect socialised the losses and liabilities of the private sector, thereby exacerbating public debt liability. This in turn limited growth capacity because of severe internal structural problems and the inability to borrow on the markets at viable rates of interest. Irish taxpayers were obliged to undertake arduous austerity with no consequent losses for bondholders. Ajai Chopra, the IMF's mission chief for Ireland, has said that if it wasn't for contagion risks amid turmoil in European financial markets, Ireland would have significantly lower bond spreads. The problems that Ireland faces are not just an Irish problem; they are a shared European problem.
⁵

The Icelandic Fairy Tale?

When comparisons between the economic crises of Ireland and Iceland are made, it is often stated that Ireland, unlike Iceland, bailed out its banks. It is also added that the Icelandic authorities were prepared with a blueprint that saved the sovereign from bailing out the banks and made the private creditors suffer by giving them a proper haircut. Only the last part of this story has a grain of truth, but the rest is a fairy tale.

The fact is that when it comes to bank bailouts Iceland is second to Ireland in the post-2008 financial crisis. The Organisation for Economic Co-Operation and Develoment (OECD) reckons that the ‘[t]otal direct fiscal costs of the recent financial crisis amount to about 20% of GDP, which is higher than in any other country except Ireland'.
⁶
Ireland's cost is estimated to be 49 per cent of GDP. The development of Ireland's and Iceland's general government debt is almost exactly alike. Both countries lowered their public debt during the boom years. Ireland's debt was about 25 per cent of GDP in 2006 and 2007 and Iceland's stood at 28–29 per cent GDP in 2007. At the end of 2010 both countries' public debt was around 95 per cent.

However, there is an important differences as to how the banks were bailed out which has important consequences for stabilising the debt. If Iceland had followed Ireland's bank bailout example, then presumably Iceland's public debt should have been twice as high as that of Ireland as its financial system was twice the size of Ireland's when measured in terms of GDP.

So what is the crucial difference between the two countries? In essence, Iceland did not have a choice, whereas Ireland did. Iceland had no possibility whatsoever to bail out its banking system whereas Ireland did, or at least believed it had the means to do so. A belief that the European Commissioner for Competition, Joaquin Almunia, described in June 2011 as a mistake because its sweeping scope served to concentrate losses on taxpayers that would have been ‘better distributed' in the absence of an unlimited guarantee.
⁷

The pre-crash Icelandic government had watched the financial sector expand to well over ten times Iceland's GDP. It did not all of a sudden see the light and stop believing in what it considered as miraculous financial institutions and prepare for a collapse of those banks. On the contrary, the government fought valiantly to the very end to save the banks, and it cost the Icelandic taxpayer dearly.

The Prime Minister of Iceland and the Foreign Secretary went on a roadshow to Copenhagen and New York in March 2008 to assure an increasingly critical business community and the foreign press that the Icelandic banks were sound financial institutions. Despite the looming catastrophe in the banks, the roadshow occurred just seven months before the financial collapse. Extraordinarily, the chair of Iceland's Financial Supervisory Authority gave an interview, published in a prospectus for an Icesave branch which opened in Holland in May 2008. Even in the last days before the collapse the government affirmed that the banks would be backed by the sovereign. Iceland's system of financial management was compromised by regulatory capture, the influence of interest groups and political participants to shape laws and regulations in a way that is beneficial to them.

When the Icelandic banks could no longer finance themselves on international markets they turned to the Central Bank of Iceland (CBI) for financing. Their financing troubles started in 2007 but this was viewed as a temporary problem for the banks and it thought appropriate that the CBI would, as a lender of last resort, assist in financing the banks. This could only go on for a brief period as the banks were so much vastly larger than Iceland's economy. This meant that if the CBI was to keep fuelling the financial institutions external financing would inevitably be necessary.