Iceland's Economic Crisis

Barry B from Debt Prison asked in Common FSK topics:

have you paid attention to the situation in iceland with the collapse of their economy?

I was vaguely aware of it, but haven't been following the details.

I found this blog about Iceland's problems, but I wasn't very impressed by the content. The best summary I could find via Google was Wikipedia's version. (I feel dirty linking to Wikipedia.)

Here's the short summary of the problem.

In the US, banks had dollar-denominated assets and dollar-denominated liabilities. During a recession/depression, the value of bank assets decreases due to the Compound Interest Paradox. The Federal government and Federal Reserve are the issuer for dollars. They merely printed enough new dollars to bail out the banks.

In Iceland, the banks had Euro-denominated assets and Euro-denominated liabilities. As in the rest of the world, asset prices crashed. However, Iceland's government does not have the power to issue Euros. The "print new money to bail out banks" trick couldn't be pulled off.

Subprime mortgage bonds weren't just bought in the USA. They were bought by other countries, eager to invest their dollar surplus. When the market for these bonds imploded, it affected other countries in addition to the USA. In this manner, economic problems in the USA were exported to other countries.

Other countries are eager to keep a stable exchange rate with the US dollar, because they like exporting to the USA. When the US dollar starts inflating, other countries must inflate in lockstep to keep a stable exchange rate. In this manner, the USA exports its inflation to other countries. Other countries are inflating their own fiat money, with the profits going to US financial industry insiders.

The USA (and to some extent the EU now) have a special perk that no other country gets. They get to issue loans in their own money. This means that, technically, they can never be bankrupted as they merely print new money to pay off their debts. Other countries have a problem where their international debts are Euro-denominated or dollar-denominated. During a global recession/depression, they can't pull off the "print new money to bail out banks" trick like the US Federal government and Federal Reserve.

There were other problems cited in the article.

Like in the USA, banks in Iceland lobbied for looser regulations and loaded up on leverage. Unlike the USA, banks in Iceland could not lobby Iceland to print new money to bail them out, because their debts were Euro-denominated.

During boom times, Iceland's banks kept refinancing their Euro-denominated loans for bigger and bigger amounts. Inflation was working in their favor. They were making huge profits. Now, we are in the recession/depression phase of the business cycle. Iceland's banks are no longer able to refinance their debt. They have gone from "technically insolvent" to "actually insolvent".

Most large banks are technically insolvent at any given time. "Level 3 accounting" encourages large banks to load up on assets that they don't have to "mark-to-market". Banks use huge leverage ratios, profiting from inflation over time. During a recession/depression, banks and businesses that aren't "too big to fail" go bankrupt, and the rest qualify for a State bailout.

Iceland may be eligible to join the EU. Politicians in Iceland said "If we join the EU, we're ceding our sovereignty."

Iceland tried to peg its fiat currency at 131 krona per Euro. When a government tries to keep a currency peg in contravention of market forces, professional currency traders say "Woohoo!! Free money!!" The wealth Iceland's government squandered on the currency peg mostly wound up in the pockets of currency speculators.

Iceland's government also froze foreign currency exchanges and foreign accounts. This exacerbates the problem. Why would someone import/export from Iceland, if you aren't going to be able to convert your profits to local money?

Without such restrictions, if the krona is devalued relative to the Euro, then the incentive is for foreign investors to buy assets in Iceland, limiting the disparity. By placing currency trading restrictions, Iceland exacerbated the problem.

Iceland is inflating its own money to bail out bankers and insiders. The average person in Iceland is losing his savings to inflation.

Also, most of the liabilities of Iceland's banks are owned by insiders. Iceland's government didn't say "Let the banks go bankrupt! We'll print new money to redeem small individual depositors, but institutional and large investors are SOL. We'll capitalize new banks instead of bailing out the failing ones." That criticism applies to the USA as well.

Of course, the correct solution "Use gold as money!" is never mentioned by policymakers. State violence and State regulation demands people use the local fiat money. Substitutes are outlawed.

It's the usual "Problem! Reaction! Solution!" paradigm. The State causes a problem. People say "OMFG!! This is awful!" The solution is always more power for the State. The State regulations that caused the problem in the first place are never named.

The blame for all financial crises boils down to:

1. Limited liability incorporation is evil. Limited liability incorporation gives bank management a free put option to declare bankruptcy and cheat creditors and depositors. Limited liability incorporation encourages aggressive/dishonest accounting by a nearly insolvent bank.
2. Negative real interest rates are evil. Negative real interest rates provide subsidies to insiders at the expense of productive workers. Only insiders may borrow at the cheapest interest rate. They get first dibs on newly printed money.
3. Regulation of banking and money is evil. People are not allowed to boycott the State-issued fiat money and use real money instead. (Gold and silver and other metal coins are real money.) Further, regulation encourages consolidation of the banking industry.
4. "Too big to fail" is an evil concept. Instead of bailing out failing banks, new banks could be funded instead. If the State wants to protect small individual depositors, then new money should be printed to reimburse them for their loss. (In a true free market, accounting associations would guarantee bank deposits. The members of the accounting association would be assuming personal liability for any loss.) Large investors and institutional investors *SHOULD* lose when their bank goes bankrupt. That's the reason you have credit ratings. "Too big to fail" merely bails out insiders at the expense of the average person. "Too big to fail" encourages dishonest behavior, and it makes "small enough to fail" businesses not viable. Why should I run a small business if my competitor is "too big to fail"?

The correct solution to all banking crises is "There should be no State regulation of money at all!", which is a special case of "Who needs a government anyway?" That solution is never publicly discussed in a mainstream media source. In practice, a repeal of all laws forbidding gold and silver to be used as money would be functionally equivalent of returning to a gold standard. Given the free choice, no rational person would use paper money over real money. A paper monetary system *ALWAYS* fails, because the people who print the paper can never resist the temptation to print more money and give it to themselves.

Also, the gold standard is banned internationally via treaties. As condition for WTO and IMF membership, countries are banned from using a gold standard. Politically connected insiders love joining the WTO and IMF, because some of the money from the loans is spent on kickbacks for the politicians' backers. During the inevitable recession/depression, the international debt is cited as an excuse for reducing the living standard of the average person. Income taxes and the inflation tax are raised to pay the illegitimate foreign debt.

Another problem with financial crises in smaller countries is "Individuals are responsible for the debts of politically connected insiders!" Individuals always pay the cost of State bailouts in the form of money supply inflation and taxes. People lose their saving to inflation, either gradually or all at once.

Let me know if there's anything else you want me to write about. "Small country gets ruined by financial crisis and foreign debt!" is not news to me. The international monetary system is set up that way on purpose! I haven't written about Iceland's economic crisis, because my reaction is "I've heard that story before. It's not interesting." Plus, none of the news sources and blogs I follow mention Iceland much.