Yesterday, Iceland’s prime minister, Sigmundur Gunnlaugsson, announced a plan that will essentially close the books on his country’s approach to handling the financial crisis — an approach that deviated greatly from the preferences of global financial elites and succeeded quite well. Instead of embracing the orthodoxy of bank bailouts, austerity, and low inflation, Iceland did just the opposite. And even though its economy was hammered by the banking crisis perhaps harder than any other in the world, its labor didn’t deteriorate all that much, and it had a great recovery.
How did Iceland pull it off? – Let the banks go bust
For starters, rather than scrambling to mobilize public resources to make sure banks didn’t default on their various obligations, Iceland let the banks go bust. Executives of the country’s most important bank were prosecuted as criminals.
Iceland was nonetheless hit by a very serious recession that caused its debt-to-GDP ratio to soar. But even after several years of steady increases, the government didn’t panic. It prioritized recovery. And when recovery was underway and the ratio began to fall, the government let it fall gently.
Devalue and accept inflation
There’s no free lunch in life, and no country recovers from a severe recession without some bad things happening. But while most developed countries have gone through years of grindingly high unemployment paired with super-low inflation, Iceland did the reverse. It let the value of its currency tumble, which naturally brought about higher prices.
But as a result, the country’s export industries rapidly gained ground in international markets. Unemployment rose, but maxed out at a modest 7.6 percent before falling steadily to a very low level. In the US and Europe, the priority has been on low inflation to protect the asset values of the wealthy. Iceland prioritized jobs, and it worked.
Impose temporary capital controls
In the context of bank defaults and a plunging currency, the government felt it was necessary to impose an additional measure — capital controls, regulations restricting Icelandic citizens’ ability to take their money out of the country. This is a serious violation of free market orthodoxy. More importantly, it can be a major hassle to ordinary people’s lives and an impediment to starting new businesses. In some countries, like Argentina, capital controls become a breeding ground of corruption and mischief.
That leads some to believe that no matter how well heterodox policies workeconomically, they’re ultimately doomed to political failure.
Iceland shows that’s not the case. Getting policy right is difficult, but it can be done. And the upside to doing the right thing — devaluing the currency massively, then imposing capital controls to contain the fallout, then ending the capital controls once the economy recovers — can be enormous. Iceland has had a rough time over the past seven or eight years, but so have a lot of other countries. Things are looking up there now because the country’s leaders had the wisdom to reject elements of the self-satisfied conventional wisdom that have proven so harmful elsewhere.