Hot Money & Cross Border Finance: The Example of Iceland, Part 2. Post Crash to Present Dilemma
Treacherous future still ahead? A look into why the Icelandic government imposed controls over movement of international funds across its borders & its current negotiations to lift those capital controls
LYNN FRIES, TRNN PRODUCER: Welcome back to The Real News. I’m Lynn Fries in Geneva. And welcome back to part two of our conversation on Iceland’s boom, bust, capital outflow management with Robert Wade, political economist at the London School of Economics. Professor Wade was awarded, among many distinctions, the 2008 Leontief Prize in economics for advancing the frontiers of economic thought.
We pick up our conversation where we left off in part one, as Iceland, hailed as the Nordic Tiger that could do no wrong, imploded, this in October$nbsp;2008–a perfect storm of collapse for the Icelandic banks, credit system, currency, stock market and house prices. When the Icelandic crisis came, the IMF was well prepared. Our guest explains.
PROF. ROBERT WADE, LONDON SCHOOL OF ECONOMICS: The IMF had been watching Iceland quite carefully. And as recently as September$nbsp;2008, the IMF had sent a mission to Iceland, and so that when the crisis came, the IMF was very well prepared. And after an initial hesitation, when the government tried to get Russia to give it a large loan–and the Russians at first seemed quite interested to give a large loan–the government appealed to the IMF.
The IMF came in immediately. And one of the first things the IMF insisted on was that Iceland impose controls on capital outflows. And one reason was because the IMF was preparing to give an emergency loan to Iceland to tide it over this collapse so that it could continue to import food and fuel and pharmaceuticals and other basic essentials. The IMF absolutely did not want this loan to go straight out the door to repay the bank creditors. And in order to avoid that happening, the IMF said to the government, you must impose capital controls.
FRIES: The IMF, however, had always been very hostile to the idea of capital controls on both inflows and on outflows. Our guest commented that back in Washington, the head of the IMF mission to Iceland basically told the IMF Board there was no choice: capital controls were needed, and needed immediately.
WADE: That was one of the first steps that the government did take, to impose capital controls on outflows that were intended to be temporary but which in fact have lasted right up till today, that is to say, for five years. And there’s certainly is a lot of criticism of the government for not having lifted the controls before now. A second step that the government took, and with a lot of IMF help, was to restructure these failed banks and to take out or to distinguish between the old banks, or the ex-banks, the failed banks, and to create new banks, which were able to take deposits and issue bonds, to be available for Icelandic residents, that is, to serve the domestic economy, so that with these two steps–the capital controls, bank restructuring and also a gradual fiscal consolidation, that is to say, a gradual cut in public spending and a gradual increase in taxes–and the IMF very much endorsed the gradualism of that approach. It did not call for dramatic austerity. With these three steps, Iceland, within about two or three years, sort of hit bottom, began to recover. And actually, compared to, for example, Ireland or the Southern European countries, such as Greece, for example, Iceland has recovered reasonably well compared to these other cases, even though certainly the economy had suffered a great loss.
FRIES: Iceland’s current president places the country’s recovery into a broader historic context. Addressing the Icelandic experience, his following statement was part of a June$nbsp;2013 lecture titled “Democracy or Financial Markets: Are We at Historic Crossroads?” Quote: “The financial crisis has led us to a crossroads where we are faced with choices that history rarely brings to our table. The place of democracy in our societies has again become a burning issue, the will of the people challenging the power of financial markets.”
Our discussion of Iceland’s boom, bust, and capital outflow management brings us to the issue of household debt, and so too the power of financial markets. While Iceland has recovered comparatively well, the current prime minister, as widely reported, argues household debt is hindering development of the Icelandic economy. The negative impact of the collapse in house prices and currency from the 2008 Icelandic bank collapse continues to burden owners of household loans, notably household mortgage loans. Household debt relief was a major swing vote in the Icelandic General Elections of 2013 and is tied to the issue of capital control management and the power of financial markets. Our guest explains.
WADE: There was, as I said, a great deal of complaint against the government of the day for having not lifted capital controls. But as the elections of April 2013 came into view, one of the minor political parties promised that if they were returned to power as the major party, they would orchestrate what the man who became the prime minister and who is from this party promised in Parliament would be, quote, the biggest writedown of household mortgage debt in world history. And this promise to write down mortgage debt was so popular that this party shot from having always been a minor party to being the major party in the elections of April 2013.
That raises the question of how this mortgage write-down was to be financed. And this party has in mind the idea that although they were always hostile to the maintenance of capital controls, they suddenly began to see that there was merit in maintaining the capital controls, that is, maintaining a whole lot of capital which was owned by hedge funds and others which was locked into Iceland, maintaining those capital controls, maintaining this capital locked in, and then negotiating with the owners of this capital, with the hedge funds and others, to take a writedown on the value of their capital in return for escaping from the capital controls.
So the negotiation was, from the government’s point of view, how much will you–that is, the foreign holders of capital which was locked into Iceland–how much will you write down the amount that we have to pay you? And we want to maximize that write down so that we can then use the value that you don’t take in order to write down the mortgage debt of Icelandic households.
So, suddenly it’s very paradoxical. This party that was very hostile to capital controls suddenly saw that they could get this enormous electoral advantage–as they did–by maintaining capital controls as a way of leveraging the foreign owners of capital to take this big writedown in order to escape the capital controls.
And all this is now, at this very moment, being played out in Iceland. It’s just not entirely clear how it’s all going to go.
The negotiations are still in the early stages. And so certainly there’s been no haircut, as it’s called, on the owners of foreign capital, and there’s been no writedown of mortgage debt. But the electorate is insistent, that is, the mortgage–the household mortgage owners in Iceland are insistent that the government honor its promise. And this promise all depends on the willingess of the owners of foreign capital to take a big haircut on their capital holdings. And so this is going to be a very complex issue. And it may hold some implications, the outcome of it all may hold some implications for countries elsewhere.
FRIES: In 2010, our guest held the view that while Iceland had many problems ahead, at least its own financial sector was unlikely to reassert dominance over Iceland’s economy again. We ask our guest if he still held that view.
WADE: Well, I think that it is unlikely to run wild again for another, what, ten, maybe 20 years until memories fade. But the point is that Iceland has limited economic options. There’s a limit to its continued prosperity on the basis of fish or aluminium smeltering or tourism, and there is a desperate hunt for diversification, for new economic activities, and they tried finance. For a time it appeared to work very successfully. And various excuses are now being put out in Iceland as to why the financial experiment failed, but these excuses are of the kind such that it would be possible–once memories fade of what a terrible time happened in Iceland after 2008, it’s possible that in another ten years or so, when memories fade, there may be another attempt to make Iceland into an international financial center in the middle of the North Atlantic. So it’s possible that we may go into another kind of boom/bust cycle, but not, I think, for another ten years or more.
In previous times, times of hard times, such as the Great Depression, for example, the financial sector has been substantially cut. But since 2008 and the onset of this current bout of hard times, the financial sector in the United States, in Britain, in much of the Western World has actually strengthened its position in the economy. For example, in the United States, if you take the six biggest banks, their balance sheets have actually grown very substantially, around about 40 percent since 2008. Their balance sheets have–around about 40 percent bigger than they were before, and so that the degree of concentration, the degree of power at the top of the financial sector in the United States is even greater than it was before 2008.
That is a really astonishing fact, and it should make everybody worried, because these banks, which were already before 2008 to big to be allowed to fail, are now even bigger, and so they can be even less allowed to fail. They’re also too big to manage, so that this is a source of great instability in not just the United States, but in the whole world economy, which has actually become a bigger source of instability than it was before 2008.
FRIES: With that concluding thought, our thanks to Robert Wade. And thank you for joining us on The Real News Network.
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