Thursday, October 27, 2011

Icelandic Airhead Economics

Update: Krugman's latest column continues the same narrative: (1) financial deregulation causes all of our problems, (2) inflation is the answer, and (3) despite massive inflation, which has slashed real wages, Iceland has not seen its standard of living fall.

I also find it interesting that he praises Iceland for letting the banks fail when, at the same time, he also has claimed that Washington needed to bail out Wall Street. Indeed, as is pointed out below, maybe it would have been prudent to let ours fail, too.

Although Krugman writes of the "path not taken," the path he calls for is government control of the economy, easy money (inflation), central bank financing of government spending via the printing press, and capital controls. I would suggest that this is EXACTLY what is occurring today. If anything, the central banks and governments have blown up even bigger financial bubbles.

However, I would like to suggest another path: a real profit and loss system, not crony capitalism, and certainly not central bank financial tricks. End Update

As I write this, Paul Krugman is in Iceland and anyone who wants to watch him in a webcast can do so. Last month, when flying home from Latvia, we passed by Iceland and I can say that from the air, it is a barren place.

Its economy also has been barren, suffering a huge fall in about everything after its own speculative bubbles had fallen apart. Not surprisingly, Krugman claims that this was due to free markets, deregulation, and probably Milton Friedman, and the cure has been inflation and capital controls. Thus, Iceland is his poster child for doing things "correctly."

There is another perspective, and Tim Cavanaugh at Reason Magazine offers a very good and believable scenario, one that chronicles the same events as Krugman acknowledges, but adds something that Krugman has conveniently left out: how Iceland's central bank engaged in the worst kind of moral hazard.

Cavanaugh notes:
For every government-driven bad improvement you can find in the west, you’ll find boom-era Iceland taking it to the next level. Where the U.S. Federal Reserve’s promise to backstop financial institutions was merely implicit, the Central Bank of Iceland in 2001 gave an explicit guarantee to big banks, making it inevitable that they would become bloated with risky and ultimately toxic assets. Our own government-sponsored—and as of 2008, government-owned—entities Fannie Mae and Freddie Mac made a hash of responsible lending by buying mortgages in the secondary market (and as we now know, lying about the poor quality of debt on their books). But Iceland’s government-run Housing Financing Fund managed to do even worse, lending directly to borrowers and competing with private lenders on both interest rates and loan quality. By mid-decade 90 percent of Icelandic households had government loans, and no-money-down home purchases were as common in Iceland as they were in Florida. (Emphasis mine)
You see, Krugman always assumes that free markets, be they in finance or anything else, have nothing to keep them from running over the cliff, and only the stern hand of government regulation can save the markets from themselves. Yet, we know that a profit-and-LOSS system provides its own brakes, provided that governments don't try to override market verdicts, as they have done in the USA, Iceland, and Europe. As he always does, Krugman only tells part of the story.

As Cavanaugh notes, there is much more to the story than Krugman wants to admit. Iceland was not able to get much of anything resembling a bailout, and had to face the crisis alone:
This international neglect turned out to be Iceland’s saving grace. The crisis ended almost as quickly as it had begun. The Organization for Economic Co-operation and Development expects Iceland’s economy to grow by 2 percent this year and next. That’s not enough to replace the post-2007 loss, but it’s more than enough to return to the pre-boom trend line, and it’s much stronger than the performance of Portugal, Italy, Ireland, Greece, and Spain, affectionately know as the PIIGS economies. Iceland’s long-term interest rate, a not-inconsiderable 8 percent, compares well with a rate of over 13 percent for Greece, which is astounding when you consider that Iceland endured a default that Greece, in name at least, has so far avoided. The difference in unemployment—5.8 percent for Iceland against 16 percent for Greece—is even more striking. Iceland expects to have a balanced budget in 2013.
And then this, contradicting Krugman:
Paul Krugman naturally draws the wrong conclusion, contending that Iceland saved itself through rapid inflation and capital controls. This is like saying the March tsunami gave the people of Tohoku a nice chance to go swimming: Iceland’s central bank tried desperately to control the kr√≥na’s collapse before giving up. Nevertheless, Erlingsdottir is right: The “grownups”—a center-left coalition led by Social Democrat Johanna Sigurdardottir—are back in charge and have done their best to double down on the bad policies of the past, including reducing fish quotas when local fishermen most need to be producing and selling. The government is also, in the face of strong popular opposition, moving toward E.U. membership, which has worked out so beautifully for other troubled European economies.

So what’s causing the recovery? The plain-sight answer is the one nobody will consider. Iceland is coming back specifically because its banks went out of business. That happened in spite of strenuous public efforts, but the removal of the tiny nation’s colossally bloated financial sector turns out not to have eliminated all that much value.
There are some things to keep in mind. First, Iceland is substantially poorer than it was before. More people have work, but their real wages have fallen substantially from where they were before the crisis began. Currency crises have a way of exposing the problems, something Krugman does not want to admit, and the combination of default, inflation, and letting its banks implode means that Icelanders have received a huge dose of reality, and reality can suck at times.

Second, for all of the talk about rates of unemployment and having its exports being cheaper because of the decline in the country's currency relative to other currencies, inflation hardly is the miracle "cure" that Krugman claims it to be. Yes, inflation has cut the real wages Icelanders earn by substantial amounts, which means they have received a real cut in pay, which in turn makes their labor substantially cheaper. However, they still have to produce something, and that means directing resources to the sustainable lines of production in Iceland's economy.

Yes, I know that Krugman is a "macro" guy, and they look only at GDP figures. Thus, according to the Keynesians, World War II was a time of unprecedented prosperity because (1) everyone had work, and (2) GDP was high. What else do we need to know about the economy?

While Krugman has been touting bailouts and even having the Fed directly purchase government bonds to finance the government's operations (as though this were a magic elixir instead of the fraud it really would be), he forgets that Iceland's crisis was SO big that its central bank could not bail out anyone, despite an explicit promise from the central bank that it would backstop all losses. Furthermore, it never occurs to him that if we get rid of the moral hazard, we also get rid of the systematic wild speculation.

Instead, he continues to call for easy money, but he also wants that money to be tightly regulated, which in the end means that banks lend only to those firms that have a track record. One of the reasons there was so much pressure for deregulation in the 1970s and early 80s was that a large number of firms based upon the new high technologies and the new reality of telecommunications could not get capital from the usual lending sources.

For example, Ted Turner in setting up CNN, went to Michael Milken because the banks would not touch his cable news idea. Likewise, we never would have seen funding of a number of other familiar companies had the old regulatory structure remained. Unfortunately, what Krugman demands is both the old structure AND policies of easy money, which simply is not possible. Furthermore, his call for the Fed to be buying bonds wily-nily does not exactly speak to getting rid of the moral hazard that put us in this position in the first place.

If there is a lesson in Iceland, it is not what Krugman might be telling us. First, Iceland experienced the unthinkable: the utter collapse of its banks, but it lived to come back another day. On our front, for all of the dire talk of what might have occurred has the government not bailed out Wall Street, I believe that while the economy would have taken a hit, we already would be climbing well out of that hole and would in a full-fledged recovery.

Instead, we are in a depression, and Krugman is claiming that inflation and bailouts are the key to changing our economic direction. In other words, we can have prosperity and a free lunch, too. Just inflate.


Anonymous said...

Anderson, are your government-is-always the problem views any more nuanced than Krugman?

PaulTheCabDriver said...

The power of faith is amazing. Often times, it completely blinds the adherent to reality. In the case of Krugman, his faith is in the omnipotent State and its ability to fix everything. Krugman is wrong in this, as are his followers. But they will not learn. Instead, they cling tenaciously to their idol. it is sad really.

Pete said...

I use the example of Iceland's banks collapsing and leading to quicker recovery all the time.

Every time I see people try to paint the example Iceland as a success of government intervention, I laugh.

Bala said...

"Anderson, are your government-is-always the problem views any more nuanced than Krugman?"

Once a person explicitly takes the extremely nuanced position that the introduction of violence into the voluntary exchange society (which is what government is) is the problem, on what grounds do you raise the question of how much more nuanced his position is than Krugman's?

Good way of showing that you are a statist who does not understand the difference between voluntary exchange and violent exchange. All you shills sound the same, in any case.

gorangers said...

You might want to accurately portray Krugman's argument.

Where you claim that he only tells a part of the story in the latest NYtimes op-ed he actually writes, "Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver."

Seems like he mentioned a lot of the story.

Where you claim that Krugman argues that Iceland is now prosperous, he actually writes "Iceland hasn’t avoided major economic damage or a significant drop in living standards. But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable; the social safety net has survived intact, as has the basic decency of its society. “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph."

You also claim that Krugman supported the bailouts when he has consistently been critical of the program here - here here and here

Finally, you claim that Iceland let its banks "go under," which is not true. Iceland did exactly what Krugman advocated for - they were nationalized and put into public receivership (the FME), after which they were restructured.

Calgacus said...

Thus, according to the Keynesians, World War II was a time of unprecedented prosperity because (1) everyone had work, and (2) GDP was high.

According to everyone sane, according to everyone alive at the time it was a time of unprecedented prosperity in the USA.

Saying that WWII did not cause enormous prosperity in the USA is something that could only be said in public around now, and somewhat earlier by the lunatic fringe called "academic economics" - because the people whose first hand memories refuted this crazy fictional alternate universe history aged & died off.

It is not a matter of statism vs. libertarianism to understand money correctly. Austrian "money" is a crazy figment of the imagination, and never existed anywhere. Money is a creature of the state. Even more fundamentally, money is always a relationship of credit/debt & never a thing like a commodity, like gold. It is a fundamental category mistake made by modern mainstream economics, including confused "Keynesians" like Krugman.

Basically, MMTers have one core recommendation. The government must guarantee everyone a job. Because the government is the cause of unemployment. Otherwise there is no reason whatsoever to expect full employment. Once one realizes what money is, the idea of a monetary economy without a job guarantee is seen to be insane.

William L. Anderson said...

I think I accurately portrayed what Krugman said. First, he notes that Iceland had a default and its banks failed. Austrians have recommended both for the USA and Europe.

Second, Krugman has supported bailouts for the USA and Europe, and that has included bailouts for banks. How he reconciles this with Iceland's experience, I am not sure.

Third, Krugman also believes that it ultimately was inflation that returned Iceland's economy to a better state of things. He also makes that point clear.

How he can say that massive inflation and a real wage cut has not reduced the standard of living in Iceland makes no sense to me. A cut in real wages also is a cut in standard of living, period. Like most Keynesians, Krugman recognizes that if real wages are out of kilter with the rest of the economy, there will be more unemployment. He also has said elsewhere that raising the minimum wage is a good economic "stimulus." Again, these two points are mutually-exclusive.

Read what Krugman has said over the year, and see if what he has claimed then matches what he is claiming about Iceland. Of course, I realize that Krugman believes that the State is not beholden to the Law of Scarcity and the Law of Opportunity Cost, since printing money creates a "free lunch."

gorangers said...

First, you are reading too much into a single word in an editorial column. Krugman notes that the Icelandic banks (Glitinir, Landsbanki, and Kaupthing)failed, by which I would venture he means they were placed into public receivership. They were not allowed to simply liquidate as you insinuate in your blog post. Regardless of what Krugman wrote, the fact is the banks were not allowed to simply fail, but were effectively nationalized.

Second, Krugman has been highly critical of bailout plans and was an advocate of nationalization if you recall. Where is your evidence that he has consistently supported bailouts? I provided you with a number of links to his writing from 2008-2009.

Third, Krugman makes clear that the maintenance of a safety net, the national restructuring of banks, and public stimulus put Iceland in a situation that was better, but could be worse. That is far more nuanced than the way you portray his argument.

Krugman never says that Icelanders are better off than before their financial crisis - only that they would have been much worse off today if had not been for those policies. You seem to imply that he thinks Iceland is all hunky dory right now, and that is not what he says.

Finally, where as Krugman has a causal story that explains Iceland's more rapid, yet still slow, recovery, I am still waiting for your argument. Tim Cavanaugh's piece spends paragraphs describing Iceland and Krugman and then two sentences on what he thinks happened - the banks were allowed to fail(which is not entirely true). Where is the causal story?

William L. Anderson said...

I will ask one question. Had we had the financial system that Krugman demands, would we even be making these comments on the Internet? Would there even have been an internet?

Look at all of the ventures that were financed OUTSIDE of the banking system that Krugman claims was adequate. (He has rewritten history, but that is to be expected.)

Krugman has demanded nationalization of banks, easy credit, and strict government regulation. Please explain to me how that system would work, and how it actually would manage to finance anything but politically-connected ventures. In other words, more Crony Capitalism, which Krugman claims to be against. (Except when it involves frauds like "green energy.")

Mike Cheel said...

"Anderson, are your government-is-always the problem views any more nuanced than Krugman?"

When is government not the problem again?

gorangers said...

That is avoiding the point of the thread and is an untenable counter-factual. Krugman, despite what you may think, is not an advocate of a controlled economy but is writing about reactions to depression economics.

Krugman has also explained very clearly how the restrictions on capital, the devaluation of the krona, the repudiation of debt, and the maintenance of a social safety net facilitated a recovery that was far less painful in other countries.

He has neglected to mention the fact that Iceland is not part of the Euro and that it did have imposed austerity from the IMF.

Tel said...

There is one very major difference between Iceland and the USA, and it is absolutely critical that this not be ignored.

In Iceland, people at all levels admitted that mistakes had been make. In the USA there are still people trying to claim that Fannie and Freddie had no part in the bubble blowing.

Thus the Icelandic people are in a position to learn from their mistakes.

Tel said...

"Had we had the financial system that Krugman demands, would we even be making these comments on the Internet? Would there even have been an internet?"

That's a very fascinating question.

Early Internet development was mostly public money (military money). However, there's a lot of people today with the strange idea that the Internet was the birth of computer networks. Nothing could be further from the truth.

Actually, a great many privately-funded corporate networks already existed before any work started on Internet Protocol. I'm talking about IBM, Apple, Digital Equipment Corp, Apollo (the workstation, not the space station), Novell, and others. These were all proprietary designs, that is to say, the owners of the networks made it difficult for other people to build compatible equipment. They protected their inventions in the belief it would boost their profits.

When Internet Protocol came out, all their standards were published openly (search for RFC standards), they did not seek to make a profit (depending on public money, they were required to publish), and they encouraged all comers to build to their specifications. In particular, the large universities took an interest (e.g. Berkeley, where BSD Unix came from) and what became Sun Microsystems started out as Stanford University Networks. Note that the BSD Internet source code was also published for free and Microsoft took this code as the starting point for their network stack, allowing them a quick jump into Internet Protocol.

Once Internet Protocol reached critical mass, it became the protocol that everyone wanted to talk to, so all the other private protocols were hammered. Novell hung in there for a while then gave up and switched over to Internet Protocol, Apple gave up their proprietary design and rolled over.

It's a good example of the power of a public standard, coupled with multiple private implementations of that standard, all compatible with one another.

The "intellectual property" regime is a very different place to regular physical property. Economists still seem to be struggling to come to grips with this.

Anonymous said...

The stupid is in full feathered display with the statist drones today.

Anderson, are your government-is-always the problem views any more nuanced than Krugman?

An assertion of relativism is not the same thing as a refutation. It gets you absolutely nowhere, so, do your self a favor, expunge that unsorted thinking from your mental hardware.

Finally, you claim that Iceland let its banks "go under," which is not true. Iceland did exactly what Krugman advocated for - they were nationalized and put into public receivership (the FME), after which they were restructured.

What the Hell do you think Anderson and other market oriented critics mean when they say let the banks go under? Where are they going to go, in receivership! It would be a much lovelier world if Goldman Sachs had to admit it was no longer a viable market entity and had done so.

No one is arguing for a simple process of liquidation that doesn't actually exist as an option without resorting to a fraudulent representation of assets and liabilaties. You seem to not to know what the legal framework of receivership actually means.

Here you go, sport:

In law, receivership is the situation in which an institution or enterprise is being held by a receiver, a person "placed in the custodial responsibility for the property of others, including tangible and intangible assets and rights."[1] The receivership remedy is an equitable remedy that emerged in the English Chancery courts, where receivers were appointed to protect real property.[2] Receiverships are also a remedy of last resort in litigation involving the conduct of executive agencies that fail to comply with constitutional or statutory obligations to populations that rely on those agencies for their basic human rights.[3] Various types of receiver appointments exist:[1]

a receiver appointed by a (government) regulator pursuant to a statute;
a privately appointed receiver; and
a court-appointed receiver.[1]

The receiver's powers "flow from the document(s) underlying his appointment – a statute, financing agreement, or court order.

The receiver may run the company in order to maximize the value of the company’s assets, sell the company as a whole, or sell part of the company and close unprofitable divisions.

That's right, a settling of legalities that often leads to what you obfuscate. That being liquidation.

Anonymous said...

When Anderson says to let the banks go under, it is safe to assume he means that they are to be placed in receivership because that is process upon which our legal system has developed over the centuries to deal with non viable business entities. Above, Anderson's critic obfuscates the fact this normally involves the liquidation of assets. The process is handled in this manner to avoid the fraud that can occur when assets and liabilities are accounted properly. Who but the most ardent defenders of cronyism would believe this would not be a more perfect and lovelier world if Goldman Sachs had to admit to non market viability and had been placed in receivership?

Tel, it needs to be noted that for many years it was illegal for companies to develop a commercial presence on the internet. It was not really that long ago, actually. How quickly we forget these things.

gorangers said...

@anonymous - no need to be arrogant and insulting. No one here is a drone or stupid - address the argument instead.

The FME in Iceland did not merely serve as a receivership, but effectively nationalized the banks (the Icelandic government bought a 75% share in them). It then repudiated on its debt while injecting billions of dollars into the banking system to maintain the countries banking functions. The banks were later broken down into smaller entities that operate today.

I am not sure what Austrians ever envision for anything, since their policy suggestions are also mercurial and general. I am imagining that it would look something like what happened to Lehman - rapid bankruptcy and liquidation rather than a guided process that protects the broader banking system and economy.

The Fin-Reg bill in fact addresses some of the problems that came up with the Lehman liquidation with resolution authority.

Regardless, it is still very inaccurate to say that Krugman supported the bank bailouts. If you go back to his columns and blog from Sep 2008 to Jan 2009 you find support for temporary nationalization as in Iceland (and Sweden) and very tepid support for the bailout plan as the only politically feasible option.

William L. Anderson said...

This notion that nationalization of banks is a cure-all puzzles me. Unless I am mistaken, government is political, and nationalized banks will make political decisions regarding lending. (Yes, I know. Progressives believe that regulators working in a Democratic administration are the soul of wisdom and discernment and always make wise decisions only upon the merits of a loan request. They never would even think of permitting political considerations to enter the discussion.)

Furthermore, nationalization simply means taxpayers are on the hook for losses.

As for Krugman, you are correct in that he demanded nationalization of banks in return for the bailouts. However, I still do not see how nationalization cures anything.

The Keynesians accuse us of having an inordinate trust in a profit-and-loss system, but at least within a real P&L there is economic calculation that works. When everything is done politically, the calculation is going to be following the political considerations.

Austrians don't believe that entrepreneurs are always going to make the right decisions, but when they don't, there are losses. The Keynesian notion that deregulation meant that markets were free to run wild leaves out the fact that the Federal Reserve System had promised implicitly to cover the losses, so the moral hazard was built into the system.

Today, the moral hazard is even more ingrained into the system, and don't think for a second that the Solyndra Economy is going to save us. When the government takes over finance, it gives us political investment, and all of the coercion and threats in the world cannot make these things profitable.

rangerslostneednewname said...

If that is your argument now there is much less of a gap between yourself and Krugman. You both agree that banks that made bad loans should pay the price instead of the taxpayers. Krugman does not think that, as he put it then, zombie banks should just be propped up with tax payer money.

Where you disagree is on the manner in which banks as large as Lehman or Bear should be dismantled. Krugman thinks that a) if taxpayer money is going to be used to inject liquidity into the banking system that the taxpayer should get a stake in the upside in the form of ownership (and as a consequence decision on executive compensation); and b) that the process needs to be guided to prevent massive damage to the rest of the economy. Allowing Lehman to fail shocked the entire economic system, and allowing the rest of the banks to collapse and go into Chapter 11 would have potentially ruined the American economy.

Using Solyndra as an example of government investment gone awry is misleading since the facts on Solyndra are more nuanced and only one example. Regardless of your healthy mistrust of government (and the potential politicization) what was the alternative? I still don't see an alternative prescription that was a)economically effective and b) politically feasible.

William L. Anderson said...

I appreciate your point, but it is instructive to remember that when the government owns something, taxpayers are not given a personal stake in it. The State is not the people; the State is an elite group of people who have the power to have you imprisoned or killed at their whim.

If we want to understand the "ownership" issue, keep in mind that poll after poll demonstrated that "the people" did NOT want the bailouts to occur. Were you consulted? Or I? No. We simply were put on the hook for losses that a blind man could have seen coming.

As for the "orderly" drawdown of a bank, I think that there is no good way to do it. If the liquidation is quick, the recovery comes back sooner. By drawing out the whole process and by trying to prop up the zombies, we simply continue this depression.

Both Hoover and FDR did the same thing. Hoover did try to prop up the system and did NOT take Mellon's advice, contra Bernanke.

However, the liquidation occurred anyway. Has anyone actually thought about this? We cannot rewrite the Law of Scarcity and the Law of Opportunity Cost any more than we can rewrite the Law of Gravity.

Anonymous said...

The "profit and loss" system provides it's own brakes? I guess that would explain 1929-1932 pretty well, and the dramatic reversal once the policies of that period were discarded, the collapse of 1937 when they were reinstituted, and the success when they were discarded again. Also the continuing collapses and panics of the 19th century, which came every 10-15 years thanks to the lasses faire hand of non-government involvement and the rush of capitalists to profit in the short run without considering the cliff they were running of in the process.
Your belief in "the market is always right" is as suspect as someone else's "the market is always wrong." Perhaps there's a middle ground, which is pretty much the success story of the 20th century.