Latvia Is No Success

Anders Aslund of the Peterson Institute is fairly certain that austerity during depressions works:

After five years of financial crisis, the European record is in: Northern Europe is sound, thanks to austerity, while southern Europe is hurting because of half- hearted austerity or, worse, fiscal stimulus. The predominant Keynesian thinking has been tested, and it has failed spectacularly.

The starkest contrasts are Latvia and Greece, two small countries hit the worst by the crisis. They have pursued different policies, Latvia strict austerity, and Greece late and limited austerity. Latvia saw a sharp gross domestic product decline of 24 percent for two years, which was caused by an almost complete liquidity freeze in 2008. This necessitated the austerity that followed.

Yet Latvia’s economy grew by 5.5 percent in 2011, and in 2012 it probably expanded by 5.3 percent, the highest growth in Europe, with a budget deficit of only 1.5 percent of GDP. Meanwhile, Greece will suffer from at least seven meager years, having endured five years of recession already. So far, its GDP has fallen by 18 percent. In 2008 and 2009, the financial crisis actually looked far worse in Latvia than Greece, but then they chose opposite policies. The lessons are clear.

The notion that Latvia is somehow a success story is just absurd.  Latvia has shed some ten percent of its workforce during the economic turmoil — that would be like more than 20 million people emigrating out of the USA, or 4 million people emigrating from Britain. This is why the unemployment rate has fallen somewhat.  And Latvia’s economy is still deeply depressed, far, far below its pre-crisis peak. Would we be calling Britain and America success stories if millions and millions of people were leaving and output was still far, far, far below its pre-crisis peak?

This video from last year shreds the notion of Latvia as some kind of austerity-driven paradise:

The truth is that the binary choice between stimulus and austerity is false. The real decision is how best to produce productivity, creativity, entrepreneurship and growth. It is possible to do this without any debt-fuelled stimulus, and without any immediate fiscal contraction, by (for example) attracting more foreign investment, using bailed-out banks to provide business finance to the unemployed, and deregulating small businesses and entrepreneurs.

The fiscal trick is in learning to cut spending during the boom — something which very few governments have ever mastered, but which is necessary for long-term fiscal sustainability. In the United States during the mid-2000s, tax revenues were high, and growth was moderately strong. This gave the Bush administration a false sense of leeway that allowed them to embark on massive debt-fuelled spending at precisely the wrong time, starting two wars, and creating large-scale domestic spending programs like Medicare Part D and No Child Left Behind. If the Bush administration had cut spending during the boom, not only would it have offset some of the potential for bubbles in housing and stocks, but it would have left the American government in a much stronger financial position come the downturn.

Yesterday’s prosperity didn’t last forever (leaving us with collapsed tax revenues, and massive budget deficits) and today’s depression doesn’t have to last forever either, so long as we have the courage to create the environment for small business and entrepreneurs to thrive, and then to cut, cut, cut during the next boom. Trying to balance the budget in the way Anders Aslund seems to endorse is a road to deeper depression, extreme unemployment, and potentially to millions and millions of people leaving to look for work elsewhere.

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There’s a Problem With Kicking the Can Down the Road

There’s a problem with kicking the can down the road

Ben Bernanke, (December 12 2012)


I’ve taken this quote out of context — Bernanke was actually talking about the fiscal cliff, and not monetary policy. But kicking the can down the road is exactly what Bernanke is doing in his domain.

Instead of letting the shadow banking bubble burst and liquidate in 2008, Bernanke has allowed it to slowly deflate, all the while pumping up the traditional banking sector with heavy, heavy liquidity:

Shadow vs Traditional Cumulative Q3

It’s been one long, slow brutal grind:

The Fed continues to fight a losing battle, in which it has no choice but to offset any ongoing deleveraging – be it through maturities, prepays, or counterparty failure, or just simple lack of demand for shadow funding conduits – in the shadow banking system.

Trillions and trillions of liquidity later, Bernanke is barely keeping the system afloat:

Shadow vs Traditional Combined Q3_0

The reduction in shadow liabilities remains a massive deflationary and depressionary force (and probably the main reason why a tripling of the monetary base has not resulted in very severe inflation). We could have taken the pain in one go back in 2008 — let the failed banks and failed sectors fail, let the junk be written down, and let all efforts go toward rebuilding a more robust system less sensitive to counterparty risk. But we chose to kick the can down the road, and try to reinflate the biggest bubble in history through helicopter drops to the financial sector, the outcome of which has been booming incomes for the rich, and a total lack of growth and opportunity for the poor (except, perhaps for the dubious “opportunity” to join the masses of the long-term unemployment and claim a slice of the increasingly unsustainable welfare pie).

We chose the path of Japan (which has spent the last twenty years depressed) not the path of Iceland (which is emerging from its depression). We chose to kick the can down the road. Like Bernanke said, there is a problem with that. No amount of buying financial sector assets up to an unemployment or inflation or NGDP target — which empirically seems to do more to enrich the financial sector and the big banks than to create jobs  — will fix that. The system is rotten, and the debt load is unsustainable.

The Icelandic Success Story

Emotionally, I love Iceland’s financial policies since the crash of 2008:


Iceland went after the people who caused the crisis — the bankers who created and sold the junk products — and tried to shield the general population.

But what Iceland did is not just emotionally satisfying. Iceland is recovering, while the rest of the Western world — which bailed out the bankers and left the general population to pay for the bankers’ excess — is not.

Bloomberg reports:

Few countries blew up more spectacularly than Iceland in the 2008 financial crisis. The local stock market plunged 90 percent; unemployment rose ninefold; inflation shot to more than 18 percent; the country’s biggest banks all failed.

This was no post-Lehman Brothers recession: It was a depression.

Since then, Iceland has turned in a pretty impressive performance. It has repaid International Monetary Fund rescue loans ahead of schedule. Growth this year will be about 2.5 percent, better than most developed economies. Unemployment has fallen by half. In February, Fitch Ratings restored the country’s investment-grade status, approvingly citing its “unorthodox crisis policy response.”

So what exactly did Iceland do?

First, they create an aid package for homeowners:

To homeowners with negative equity, the country offered write-offs that would wipe out debt above 110 percent of the property value. The government also provided means-tested subsidies to reduce mortgage-interest expenses: Those with lower earnings, less home equity and children were granted the most generous support.

Then, they redenominated foreign currency debt into devalued krone, effectively giving creditors a big haircut:

In June 2010, the nation’s Supreme Court gave debtors another break: Bank loans that were indexed to foreign currencies were declared illegal. Because the Icelandic krona plunged 80 percent during the crisis, the cost of repaying foreign debt more than doubled. The ruling let consumers repay the banks as if the loans were in krona.

These policies helped consumers erase debt equal to 13 percent of Iceland’s $14 billion economy. Now, consumers have money to spend on other things. It is no accident that the IMF, which granted Iceland loans without imposing its usual austerity strictures, says the recovery is driven by domestic demand.

What this meant is that unsustainable junk was liquidated. While I am no fan of nationalised banks and believe that eventually they should be sold off, there were no quick and easy bailouts that allowed the financial sector to continue with the same unsustainable bubble-based folly they practiced before the crisis (as has happened throughout the rest of the Western world).  

And best of all, Iceland prosecuted the people who caused the crisis, providing a real disincentive (as opposed to more bailouts and bonuses):

Iceland’s special prosecutor has said it may indict as many as 90 people, while more than 200, including the former chief executives at the three biggest banks, face criminal charges.

Larus Welding, the former CEO of Glitnir Bank hf, once Iceland’s second biggest, was indicted in December for granting illegal loans and is now waiting to stand trial. The former CEO of Landsbanki Islands hf, Sigurjon Arnason, has endured stints of solitary confinement as his criminal investigation continues.

That compares with the U.S., where no top bank executives have faced criminal prosecution for their roles in the subprime mortgage meltdown. The Securities and Exchange Commission said last year it had sanctioned 39 senior officers for conduct related to the housing market meltdown.

Iceland’s approach is very much akin to what I have been advocating — write down the unsustainable debt, liquidate the junk corporations and banks that failed, disincentivise the behaviour that caused the crisis, and provide help to the ordinary individuals in the real economy (as opposed to phoney “stimulus” cash to campaign donors and big finance).

And Iceland has snapped out of its depression. The rest of the West, where banks continue to behave exactly as they did prior to the crisis, not so much.