Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Iceland's Unorthodox Policies Suggest Alternative Way Out of Crisis

November 3, 2011

  • Iceland's unorthodox policies provide good test case
  • Decision not to make taxpayers liable for bank losses was right, economists say
  • Capital controls were necessary and are now seen as useful addition to policy toolkit

As policymakers continue to grapple with the problems facing the crisis-hit countries in the euro area and the clouded outlook for the global economy, attention has turned to Iceland, which three years ago saw its entire banking system crumble in just a few days.

Iceland's Unorthodox Policies Suggest Alternative Way Out of Crisis

Reykjavik, Iceland. The sheer scale of the country’s economic collapse forced the government to think outside the box as it sought to address the crisis (photo: Guo Lei/Newscom)


Private creditors ended up shouldering most of the losses relating to the failed banks, and today Iceland is experiencing a moderate recovery. Unemployment is declining, and the government was able to return to the capital markets earlier this year.

“What was seen as a disaster for Iceland three years ago is increasingly being seen as good fortune with the passing of time. Icelanders may have lost their financial system but instead they were spared the burden of nationalizing private debt,” said Árni Páll Árnason, Minister of the Economy.

Just as Iceland’s financial crisis stands out in terms of its sheer scale, so does its unconventional path to recovery. “Iceland zigged when all the conventional wisdom was that it should zag,” Nobel Prize winner and New York Times columnist Paul Krugman said at a conference in Reykjavik, aimed at distilling the lessons of the crisis and discussing the challenges ahead.

Key to Iceland’s recovery has been an IMF-supported program worth $2.1 billion that ended in August this year. “The less travelled Icelandic route gained credibility in the eyes of the world through cooperation with the Fund,” Prime Minister Jóhanna Sigurðardóttir told the conference.

Collective madness led to crisis

“Iceland, in the decade and a half leading up to the crisis, was an example of collective madness,” said Willem Buiter, chief economist at Citigroup, a remark that elicited spontaneous applause from the more than 300 participants, many of them Icelandic policymakers, academics, and members of the public.

Buiter was referring to Iceland’s banking system, which grew to be 10 times larger than the country’s economy in the span of just five years. Supporting three globally active banks beggars belief when your economy is the size of that of Iceland, with a population of just over 300,000, he said.

The sheer scale of the economic collapse meant that Iceland was forced to think outside the box as it sought to address the crisis. The policies that were adopted included 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, and a decision not to tighten fiscal policy during the first year of the program, which helped protect the country’s welfare state, IMF resident representative Franek Rozwadowski said.

The welfare state was used to soften the impact on households, and benefits were redirected to lower income groups, according to Stefán Ólafsson from the University of Iceland. The result was that inequality in Iceland actually decreased during the program, he said.

Useful test case

“Iceland’s heterodoxy gives us a test of economic doctrine,” Krugman said. Comparing Iceland to Ireland and Latvia (both members of the European Union), he argued that the former has fared much better than the latter in terms of growth and jobs.

And despite warnings that economic Armageddon would follow Iceland’s decision not to accept liability for the losses of private banks, credit default swaps on sovereign debt are now much lower in Iceland than in Ireland, where the state assumed full responsibility for bank losses, he said.

“Iceland has done fine in terms of regaining not total, but reasonable confidence in its sovereign debt. 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.”

Another Nobel Prize winner in economics, Professor Joseph Stiglitz of Columbia University, also endorsed Iceland’s policy response. “What Iceland did was right. It would have been wrong to burden future generations with the mistakes of the financial system,” he said in pre-recorded remarks screened at the conference.

Other speakers who strongly supported Iceland’s decision not to bail out the banks included MIT professor and former IMF chief economist Simon Johnson, who also warned that the world’s financial system remains “a big house of cards.”

Capital controls remain bone of contention

The question of how and when to lift the capital controls that were imposed in October 2008 elicited heated debate.

Capital controls have proved to be an expensive mistake, and there still is no viable strategy for lifting them, Vilhjálmur Egilsson of the Confederation of Icelandic Employers said. This argument was supported by Jon Danielsson of the London School of Economics. Capital controls send the wrong signal to investors and are holding back recovery. They should not have been imposed in the first place, he argued.

But many of the other panelists disagreed. “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 said in response to a question from the audience. 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 said.

Krugman also warned against underestimating the danger of lifting the controls too quickly. It’s wrong to base your economic policy on what you want your image to be, he said in response to Danielsson.

Choosing an exchange rate regime for the future

The question of whether Iceland should give up the krona and adopt the euro was another key topic. Here also, views were sharply divided.

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, said Gylfi Arnbjörnsson, President of the Icelandic Confederation of Labor.

But Martin Wolf of the Financial Times urged caution in “replacing the fun of being Iceland with the fun of being Ireland.” Krugman, for his part, said he really wondered about this enthusiasm for joining the euro, noting that Iceland does not fit neatly within the euro area because of the resource-based nature of its economy.

“It’s a matter of politics where you belong. Let’s make the currency more robust,” said Gylfi Zoega, a professor at the University of Iceland who was featured in “The Inside Job,” the film by Charles Ferguson about the global financial crisis. Johnson for his part suggested Iceland adopt inflation targeting as a way of managing the exchange rate.

Lessons for the IMF

What, then, should the IMF take away from its cooperation with Iceland? The Fund learned three main lessons, Shafik said.

•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.

•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.

Recent IMF research has shown that countries tend to grow faster and more consistently when income distribution is more equitable, so the Fund is now paying much more attention to these issues in its programs, she said.

For his part, Finance Minister Steingrímur Sigfússon praised the IMF for its flexibility and willingness to engage. “There are lessons to be learnt from our cooperation with the IMF. Not from the program as such because that’s easy to put on paper, but from how this cooperation evolved, and how it should be: Based on mutual trust and cooperation, and leaving as much space as possible to elected politicians to take the decisions and do the hard work to select their own rules. As long as they deliver, it’s up to them.”