IMF Survey: Iceland's Unorthodox Policies Suggest Alternative Way Out of Crisis
IMF News, November 3, 2011
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Bibliographic details
- Published: November 3, 2011
Background and context
- Publication date: November 3, 2011.
- Three years earlier Iceland’s entire banking system “crumble[d] in just a few days.”
- Iceland’s banking system had grown to be 10 times larger than the country’s economy in the span of just five years.
- Population reference: “just over 300,000.”
- IMF-supported program size: $2.1 billion; the program ended in August this year (relative to the publication).
Key policies adopted and immediate outcomes
- Policy mix implemented:
- Capital controls to prevent massive capital outflows and a disorderly depreciation of the exchange rate.
- Allowing the banks to fail and not socializing the losses (private creditors shouldered most losses).
- Decision not to tighten fiscal policy during the first year of the program to help protect the welfare state.
- Outcomes and impacts:
- Private creditors ended up shouldering most of the losses relating to the failed banks.
- The government was able to return to the capital markets earlier in the year.
- Iceland is experiencing a moderate recovery: unemployment is declining.
- The welfare state was used to soften the impact on households; benefits were redirected to lower income groups.
- Inequality in Iceland decreased during the program.
Assessment by economists and commentators
- Supportive assessments:
- “What was seen as a disaster for Iceland three years ago is increasingly being seen as good fortune with the passing of time.” — Árni Páll Árnason, Minister of the Economy.
- “Iceland zigged when all the conventional wisdom was that it should zag.” — Paul Krugman.
- “The less travelled Icelandic route gained credibility in the eyes of the world through cooperation with the Fund.” — Prime Minister Jóhanna Sigurðardóttir.
- “What Iceland did was right. It would have been wrong to burden future generations with the mistakes of the financial system.” — Joseph Stiglitz.
- Simon Johnson and others endorsed the decision not to bail out the banks.
- Critical observations:
- “Iceland, in the decade and a half leading up to the crisis, was an example of collective madness.” — Willem Buiter; referred to the excessive banking expansion.
- Simon Johnson warned that the world’s financial system remains “a big house of cards.”
Capital controls: debate and policy stance
- Timeline: Capital controls were imposed in October 2008.
- Arguments against capital controls:
- “Capital controls have proved to be an expensive mistake, and there still is no viable strategy for lifting them.” — Vilhjálmur Egilsson.
- Capital controls send the wrong signal to investors and are holding back recovery. — Jon Danielsson.
- Arguments in favour / IMF stance:
- “We need to be open to a wide range of policy tools when helping small, open economies deal with capital inflows and outflows.” — IMF Mission Chief Julie Kozack.
- The IMF has recommended that Iceland keep the controls in place until a number of conditions are met so that the economy is not undermined by a sudden outflow of capital.
- “A conditions-based strategy for lifting the capital controls is what Iceland needs now.” — IMF Deputy Managing Director Nemat Shafik.
- Krugman warned against lifting controls too quickly: “It’s wrong to base your economic policy on what you want your image to be.”
Exchange rate regime debate
- Positions presented:
- Pro-euro argument: “Iceland is in a race against time as the krona is bound to start appreciating soon, and the only answer to the perpetual swings in the value of the currency is to adopt the euro.” — Gylfi Arnbjörnsson.
- Caution / alternative views:
- Martin Wolf: urged caution in “replacing the fun of being Iceland with the fun of being Ireland.”
- Paul Krugman: questioned enthusiasm for joining the euro, noting Iceland’s resource-based economy does not fit neatly within the euro area.
- Gylfi Zoega: “It’s a matter of politics where you belong. Let’s make the currency more robust.”
- Simon Johnson suggested adopting inflation targeting as a way of managing the exchange rate.
Lessons for the IMF and policy implications
- Three main lessons the IMF drew from cooperation with Iceland (Nemat Shafik):
- When countries have a clear strategy in mind, it becomes much easier for the IMF to engage and provide policy support and advice.
- There are clear advantages to having a heterodox toolkit―more tools are better than fewer.
- Iceland set an example by managing to preserve, and even strengthen, its welfare state during the crisis.
- Research-based implication:
- Recent IMF research shows that countries tend to grow faster and more consistently when income distribution is more equitable; the Fund is paying much more attention to these issues in its programs.
- Icelandic government perspective:
- Finance Minister Steingrímur Sigfússon praised the IMF for flexibility and willingness to engage, emphasizing cooperation “based on mutual trust and cooperation, and leaving as much space as possible to elected politicians to take the decisions.”
Key quotations and illustrative judgments
- “Icelanders may have lost their financial system but instead they were spared the burden of nationalizing private debt.” — Árni Páll Árnason.
- “The idea that there would be a huge reputational penalty for allowing private sector parties to go bust and default on their external obligations has not turned out to be true.” — Paul Krugman (on sovereign confidence and credit default swaps).
IMF Survey: Iceland's Unorthodox Policies Suggest Alternative Way Out of Crisis — November 3, 2011.