Zsolt Darvas offers a useful meditation in \”A Tale of Three Countries: Recovery After Banking Crisis,\”a December 2011 working paper for Bruegel, a Brussels-based think tank. In effect, Darvas offers a case study approach by picking three small economies that went through a broadly similar banking crisis, but reacted with different policy choices.He starts this way (footnotes and references to tables and figures omitted):
\”Three small, open European economies —Iceland, Ireland and Latvia with populations of 0.3, 4.4 and
2.3 million respectively—got into serious trouble during the global financial crisis. Behind their problems were rapid credit growth and expansion of other banking activities in the years leading up to the crisis, largely financed by international borrowing. This led to sharp increases in gross (Iceland and Ireland) and net
(Iceland and Latvia) foreign liabilities. Credit booms fuelled property-price booms and a rapid increase in the contribution of the construction sector to output – above 10 percent in all three countries. While savings-investment imbalances in the years of high growth were largely of private origin, public spending kept up with the revenue overperformance that was the consequence of buoyant economic activity. During the crisis,
property prices collapsed, construction activity contracted and public revenues fell, especially those related to the previously booming sectors. All three countries had to turn to the International Monetary Fund and their European partners for help.\”
Darvas points out that \”the crisis hit Latvia harder than any other country, and Ireland also suffered heavily, while Iceland exited the crisis with the smallest fall in employment,despite the greatest shock to the financial system.\” What policy difference across the three countries might explain this pattern?
Iceland let its currency depreciate as part of its policy response, while Ireland was locked into the euro and Latvia stayed fixed with the euro.
\”Ireland has been a member of the euro area since 1999, and therefore adjustment through the nominal
exchange rate against the euro was not an option. Latvia has had a fixed exchange rate with the euro since 2004, and Latvian policymakers chose not to exercise the option to devalue. Both Ireland and Latvia decided to embark on a so called ‘internal devaluation’, ie efforts to cut wages and prices. Iceland has a floating exchange rate. When markets started to panic and withdrew external lending, given the size of the country’s obligations, there was no choice but to let the currency depreciate. The Icelandic krona depreciated by about 50 percent in nominal terms– depreciation would have been sharper without
capital controls …\”
In Iceland, the banks were allowed to fail. In Ireland, the government assumed the liabilities of the banks. In Latvia, most banks were foreign-owned and absorbed losses.
\”In Iceland, where credit to the private sector reached 3.5 times Icelandic GDP, the combined balance sheet of banks reached an even greater number, and banks heavily borrowed from the wholesale market, the government did not have the means to save the banks. Therefore, there was no choice but to let the banks default when global money markets froze after the collapse of Lehman Brothers in September 2008….
In Ireland, the balance sheet of Irish-owned banks was 3.7 times GDP in 2007 … . The Irish government guaranteed most liabilities of Irish-owned banks. … Taxpayers’ money was used to cover bank losses above bank capital (which was wiped out) and subordinated bank bondholders (whose loss is estimated to be about
10 percent of Irish GDP in the form of retiring €25 billion subordinated debt for new debt or equity of
€10 billion). …
In Latvia about two thirds of the banking system was owned by foreign banks (mostly Scandinavian banks), which assumed banking losses and supported their Latvian subsidiaries, thereby making the lender-of-last-resort role of the Latvian central bank less relevant. … According to the ECB’s data on consolidated banking statistics, the loss incurred by foreign banks was about 5.7 percent of GDP and the loss of domestic banks about 3.6 percent of GDP by 2010 – a large amount, but well below the banking sector losses in the two other case study countries. IMF calculated that bank support boosted the public debt/GDP ratio by about 7 percentage points of GDP by 2010.
Iceland introduced capital controls; Ireland and Latvia did not.
\”Due to fear of further capital outflows and additional depreciation of the Icelandic krona, in late 2008 strict capital controls were introduced in Iceland. This has locked in non-resident deposits and government paper holdings in Iceland and locked out Icelandic krona assets held outside the country, in addition to prohibiting
transfers across the border by both residents and non-residents.\”
Comparing the outcomes across these three countries, Latvia\’s GDP fell 25%, with an employment drop of 17%. Ireland had a GDP decline of 10%, with a fall in employment of 13%. Iceland had the biggest shock to its financial system, but had a GDP decline of 9%, and a fall in employment of 5%.
Without overinterpreting the lessons to be learned from this three-country comparison, a few themes do emerge.
1) Latvia was fearful of allowing its currency to depreciate against the euro. But the Iceland example suggests that in time of crisis, if you have the flexibility to let your exchange rate fall, do it. Of course, Ireland was locked into the euro without such flexibility.
2) Think twice before socializing bank losses. Iceland didn\’t take this step; Ireland did. As Darvas writes: \”Little is known about what would have happened to financial stability outside Ireland in the event of letting Irish banks default, but one thing is clear: other countries have benefited from the Irish socialisation of a large share ofbank losses, which has significantly contributed to the explosion of Irish public debt.\” The result is that while Iceland and Latvia have their public debt under control, it has risen by much more in Ireland. Darvas writes: \”Before the crisis, gross government debt was below 30 percent of GDP in all three countries, but started to balloon quickly. … [B]ank support boosted Irish public debt by about 40 percent of GDP, Icelandic public debt by about 20 percent and Latvian public debt by about 7 percent. Since Iceland and Latvia gained bettercontrol over the budget deficit than Ireland – partly due to the difference in bank support –European Commission forecasts stabilisation of the debt ratio in the two countries, but in Ireland a further 20
percentage points of GDP increase is expected till 2012.\”
3) In the short run of the time during and immediately after the crisis, imposing capital controls hasn\’t seemed to hurt Iceland\’s economic recovery. But it\’s not clear when or how these controls will be loosened over time.
Of course, applying lessons from particular countries is always tricky. But economic recovery has started in all three of these countries. As Darvas writes: \”If the adjustment experiences of the three countries could be a lesson for other countries, such as the Mediterranean countries of the euro area, should be the subject of a different study.\”