Ireland went for the bank bailout option – Iceland didn’t. Guess which country is doing better economically? Yup, Iceland. Iceland told the banks to shove off, whereas Ireland begged for forgiveness and got it in the form of a bailout. That’s not all they got. They also got more debt for the tax payer to pay off, a slower economy and a higher unemployment figure. See, this is what happens. The banks make shoddy deals and collapse under their debt burden. The EU happily helps their banker mates out with bailouts. The bailouts go to the banks first to pay off their dodgy debt, leaving the tax payers to pick up the tab. Clever aren’t they! So, no matter how stupid their economic decisions, the banks get the benefit of the bailouts, whilst the citizens get the benefit of paying for it for the rest of their lives. Iceland was clever. They allowed their banks to fail and capitalised a new banking sector and bingo, the economy has recovered. Moral of the story? DON’T reward bad economic decisions with tax payers money.
To bail out or not to bail out?
The most definitive answer to that central question for managing banking blowups comes from Iceland and Ireland, home to two of the biggest financial bubbles of the past crisis.
More than three years after the two national governments made opposite decisions — Iceland only protected depositors, while Ireland also extended a broad guarantee to bondholders — there is little doubt among economists that Iceland chose the wiser path.
Iceland, which had its investment-grade rating restored in February by Fitch Ratings, has stabilized net debt at 65% of gross domestic product and returned to financial markets.
Meanwhile, Ireland, still on credit life support after saddling taxpayers with bank-related debt equal to 40% of GDP, remains a potential land mine in the euro area’s road to recovery.
Ireland’s government said this week that it will put the new European Union fiscal compact in front of voters in a referendum in coming months. Approval is needed to continue to access a credit line from the euro zone’s sovereign rescue fund, but it’s no slam-dunk.
The risk is that Irish households, struggling with high debt levels and diminished job prospects, will see the vote as a chance to shed bank liabilities and seek a Greek-like debt restructuring.
“In light of the initial Irish ‘No’ to the EU Treaty in the June 2008 referendum,” Fitch said, it sees a possibility of another rejection.
The disparate ways in which Iceland and Ireland addressed their bank crises provide only a partial explanation for Iceland’s recent, dramatic economic outperformance.
Iceland’s jobless rate of 7.2% in the third quarter was half that of Ireland’s 14.4%. Iceland is expected to see growth of 2%-2.5% this year, down from a near 3% pace in 2011. As for Ireland, its central bank estimates growth of less than 1% in both years.
Iceland has been aided by a swift adjustment of its currency, the krona, which boosted the competitiveness of domestic production.
For Ireland, by contrast, the euro has impeded its adjustment because its exchange rate is to a large extent determined by Germany’s economic strength.
Still, analysts put great weight on Iceland’s decision not to bail out its banks.
Unlike countries such as Greece and Italy, which entered the financial crisis with high sovereign debt levels that infected their banks, Iceland and Ireland are examples of countries whose problems were bank-focused.
In a sense, they faced a choice of whether to sandbag their economies by nationalizing excessive bank debt. Ireland’s policymakers, in the heat of the crisis, didn’t believe they had an alternative.
Iceland’s path was far from the mainstream, but it is becoming conventional wisdom.
“Iceland’s unorthodox crisis policy response has succeeded in preserving sovereign creditworthiness in the face of unprecedented financial sector distress,” Fitch wrote.
At a recent conference on Ireland’s recovery, Financial Times chief economics commentator Martin Wolf said he regarded “protect(ing) the sovereign from the banks” as “the single most important rule in economic management.”
Citigroup economist Willem Buiter told the Reykjavik conference that a central lesson of Iceland’s experience is: “Do not bail out financial institutions.”
In some ways, the country of 320,000 had little choice because its banking sector had grown to 10 times the size of its economy in what Buiter called an episode of “national collective madness.”
Iceland’s three biggest banks would default on $85 billion in debt. Instead of taking those debts as its own, Iceland’s government capitalized a new banking sector from scratch that was free of toxic assets.
While Iceland did not execute to perfection, Buiter said the principle was sound: “Don’t cripple the new lending activities of a bank. Go for the good bank/bad bank model.”
If Iceland’s approach has become the new conventional wisdom, that doesn’t mean it can be applied safely. Economists have warned that it isn’t “scalable” as long as Too Big To Fail is a reality.