Tuesday, December 21, 2010

Iceland Is Not A Good Example For Running An Economy

. Tuesday, December 21, 2010

Krugman posts the above graphic showing GDP declines in the Baltics as compared to Iceland. He uses it to argue that the Baltics, which chose internal devaluation rather than sacrifice their exchange rate pegs to the Euro, did much worse than Iceland, which had no currency peg to defend, and so devalued their currency rather than their internal economy. The below picture, covering roughly the same time period, shows this:

Ignore that sharp downward tick at the end and what you see is that the krona fell by roughly half against the euro from the end of 2007 to its 2009-2010 levels, which then stayed fairly constant. To which Krugman says:

Now it’s true that the Baltic countries have been able to maintain their fixed exchange rates. And this is crucial because ….?

I'm not sure if "crucial" is the right word, but a 50% currency devaluation hurts a small open economy like Iceland quite a lot. Before the crisis Iceland mostly produced two goods: fish and finance. It imported almost everything else, and many of those imports came from the eurozone. When its currency dropped in value by 50%, that means that those imports became 100% more expensive. This represents a huge drop in standards of living.

Krugman approvingly references this IMF report on Iceland, noting:

Iceland, as even the IMF says, has been able to “preserve the Nordic social model”; there has been a lot of distress, but not much extreme hardship.

Yes, but according to that report Iceland has only been able to preserve the Nordic social model by exploding sovereign debt from under 30% of GDP pre-crisis to over 115% of GDP now. Of course, servicing that debt becomes much more expensive when the krona is devalued. The IMF also suggests that to get its fiscal house in order Iceland will need to go on its own austerity program to run a 6% of GDP primary surplus over the medium-run. Also note that the Icesave situation has not been resolved; Iceland may yet need to redistribute funds to depositors in Britain and the Netherlands. This will be much more expensive with a devalued currency, but Iceland's IMF funding is contingent upon reaching an agreement.

None of this is to say that the Baltics have had it any better. Output and employment losses have indeed been more severe there, partially because they kept their exchange rate pegs, but also because they are just generally not as well developed politically or economically as Iceland (a member of the OECD with strong economic ties to Europe's center, remember). The point is that these crises are just not easily resolved. The choice between internal devaluation and currency devaluation is not simple for small open economies. Both involve major reductions in standards of living, even if only one of them shows up in the GDP statistics.


Iceland Is Not A Good Example For Running An Economy




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