Three small, open European economies — Iceland, Ireland and Latvia – experienced 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. 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.
The purpose of this Policy Contribution is to compare the policy responses in, and the adjustments made by, the three countries. Based on this comparison, it draws lessons for exchange rate policy, internal devaluation, capital controls, banking sector restructuring and fiscal consolidation. It makes a strong case for a European banking federation.
The policy choices to resolve crisis were based on currency regimes.
There was a broad consensus at the outbreak of the crisis that real exchange rates in all three countries should be depreciated to help economic recovery – which has indeed happened during the past three years, but through different means and to different degrees.
The differences are partly related to exchange rate regimes and partly to policy choices. 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 devalue2. 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 (Table 2), 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.
He explains this superbly using Unit Labour cost formula. And then decomposes all these various factors which led to recovery in each of the three economies (See Table 4 and its explanation).
The it discusses how each country differed in its bank rescues.
- Ireland govt. took the liabilities of the whole banking sector which is seen as the biggest error. >Later when they wanted to give it up, they were dissuaded for its impact on Euroarea banks!
- Iceland allowed banks to fail as it never had the resources to bail them out
- Latvia was saved as most were foreign bank subsidiaries with parents based in Scandinavian economies. As Scandinavian economies suffered lesser, parent banks took care of most of the pains. Only one major local bank-Parex- was nationalized
The outcomes have accordingly differed:
- Among the 184 countries included in IMF (2011d), Latvia suffered from the greatest fall in output in 2009 (18 percent), and also during the three years from 2007 to 2010 (22 percent). Ireland (fifth place) and Iceland (seventh place) are also among the worst performers in the ranking of cumulative output loss from 2007 to 2010, with drops in output of ten and nine percent, respectively.
- In Iceland the massive current account adjustment was to a great extent fostered by export growth. Among the 34 countries for which Eurostat publishes constant price data on exports of goods and services, Iceland was the only country where there was a growth in 2009 compared to 2008 (Figure 4). Exports also started to recover in Ireland and Latvia in 2010, a trend forecast to continue by the European Commission (2011b). However, Ireland and Latvia are only in the mid-field compared to the performance of other countries
- There was a similar collapse in investment in all three countries, and so far investment has started to recover only in Latvia.
- Private consumption went into free fall in both Iceland and Latvia. The adjustment in Ireland was smaller, but is ongoing, while in Iceland and Latvia private consumption growth has resumed.
- Iceland experienced a modest (5 percent) drop in employment from 2007 to 2010 (Table 7), while job losses were much more dramatic in Latvia (17 percent) and Ireland (13 percent). The number of jobs in Latvia fell below the level of early 2000 – though there has been a slight recovery in employment since early 2010 (see the third panel in the third row of Figure 1).
Barring this, he also points how share of each sector has changed in GDP and employment in the three economies pre and post crisis. Employment in Constructiondeclines in all three (much lesser in Iceland). Where as employment picks up in Iceland and Ireland in Public sector from 2007.
In output terms, industry delcines sharply in Latvia but rises in Iceland and Ireland.
- External devaluation (Exchange rate) works better than internal devaluation (wages, costs etc).
- Though rise in productivity is welcome, but social impact of rising unemployment is very large
- Negative impact of Capital controls has not really been visible in Iceland. So it could be seen as a strategy
- Iceland shows letting faulty business banks fail is not that bad a choice
- Political will and effective institutions matter to achieve large adjustments
Superb stuff. Very well analysed. I mean it could be used as a basic framework to understand the crisis policies for each country.