Market monetarism in Iceland?
By Scott Sumner
Matt Yglesias has a good post discussing how Iceland defied the conventional wisdom and still did better than countries like Ireland (which is arguably the country that had the most similar economic crisis.) Matt says Iceland did 4 things:
1. Let the big banks fail.
2. Reject austerity.
3. Devalue and embrace inflation.
4. Use capital controls.
I’m going to argue that Iceland did three important things:
1. Let the big banks fail.
2. Embrace austerity.
3. Promote strong NGDP growth, after a stumble in 2009.
I’m not an expert on Iceland, but am anxious to learn. I realize that it’s so small that the data can be very hard to interpret, and that any lessons may not carry over to larger countries. But I still think there might be some useful lessons here, at least for smaller European economies. Here is some data I found for Iceland’s NGDP:
Obviously NGDP fell in 2009, just as in the US. But Iceland had a far more severe crisis than the US. It’s reasonable to assume that without monetary stimulus (which led to high inflation and a sharp devaluation) the NGDP in Iceland would have fallen more sharply, as it did in other small crisis-ridden countries. Also notice than NGDP bounced back really strongly. Of course growth was even stronger before the crisis, but arguably Iceland was in an overheated boom prior to 2008, so (just as in Estonia and Latvia) it’s not clear where the trend line is. Small countries are much more susceptible to random shocks. Matt’s post shows that the unemployment rate did better than in Ireland:
Matt Yglesias says Iceland rejected austerity, and supports the claim with this graph:
Sorry, but I don’t see it. The crisis caused the debt to balloon, presumably due to the big cost of paying off depositors of failed banks, and the effects of the recession itself. But then Iceland started reducing debt as a share of GDP, from 101% to 86.4% in just three years. That’s much better than the US and UK, which supposedly had austerity. The budget deficit in Iceland was 7.8% of GDP in 2009, but only 0.9% of GDP in 2013–better than the US and far better than the UK. So if the US and UK practiced austerity, what’s so different about Iceland?
I see capital controls as a side issue, and don’t know enough about the situation to comment. But the key decisions were clear. Try to prop up NGDP growth with an expansionary monetary policy, rather that wasteful fiscal stimulus, and don’t rescue the banks. It didn’t work perfectly (Iceland had a recession) but it probably cushioned the blow relative to other small countries that were tied to the euro, and hence did not have the flexibility to prop up NGDP. Boosting NGDP can prop up the labor market even during periods when RGDP is falling due to unavoidable shocks.
I said that whereas Matt Yglesias saw four key factors, I saw only three. To be honest, there’s really only one key factor. It’s the NGDP, stupid. Talking about a major business cycle without mentioning NGDP is like talking about the Cleveland Cavalier’s prospects for pulling off the greatest upset in NBA finals history without mentioning their “small” forward.