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The miraculous story of Iceland

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What's the difference between Iceland and Ireland? Back in 2009, a bit of gallows humor held that the answer was one letter and six months. In other words, it was only a matter of time before Ireland's banks brought down their economy just like Iceland's had.

Iceland might have been the most obvious bubble ever. During the mid-2000s, it went from being an Arctic backwater that specialized in fishing and aluminum smelting to an Arctic backwater that specialized in global finance. Iceland's three biggest banks grew to 10 times the size of their economy by offering people overseas, especially in the Netherlands and Britain, higher interest rates than they could get at home. Then, armed with this cash, Iceland's bankers went on a historically ill-advised buying spree. They bought foreign companies, they bought foreign real estate, they even bought foreign soccer teams. But with it all, they bought the dregs. The problem, in other words, was that Iceland's banks were not only paying high prices for questionable assets, but also promising to pay their depositors high interest rates. This was about as unsustainable as business models get, and it wasn't that hard to tell. All you had to do was look for five minutes. That's what Bob Aliber, a professor emeritus at the University of Chicago, did in 2006 after he heard a talk about Iceland that might as well have been a neon sign flashing financial crisis. What he found convinced him, as Michael Lewis tells us, to start writing about Iceland's crash even before it happened.

And then it did. Short-term lending died after Lehman Brothers went bankrupt, and Iceland's banks were collateral damage. Although, to be honest, they were so mismanaged that collapse was inevitable (which is why some of their high-level execs have been sent to jail). But in any case, Iceland's government couldn't afford to bail out its banks that had gotten so much bigger than its economy. The only choice was to let them go under. In other words, Iceland's banks were too-big-not-to-fail. That was a lot easier, though, when letting the banks fail meant letting foreigners lose their money. Iceland's government, you see, guaranteed its own people's deposits, but no one else's.

But now it was Iceland's government that needed a bailout. It needed the money to protect domestic deposits, cushion the economy's free fall, and keep their currency, the krona, from crashing much more. In all, Iceland got $4.6 billion, with $2.1 billion of that coming from the IMF and the other $2.5 billion from its Scandinavian neighbors.

This is where the story that Iceland broke all the financial rules begins to fall apart. In a lot of ways, the IMF's intervention was typical. Iceland sharply reduced spending—introducing more austerity than  than Ireland or Portugal or Spain or Britain or even supposed budget-cutting superhero Latvia did, as economist Scott Sumner points out. Only Greece has done more. Not only that, but Iceland also increased interest rates all the way up to 18 percent in the immediate aftermath of the crisis to rein in inflation. It gradually cut interest rates afterward, but it wasn't until 2011 that they reached a "low" of 4.25 percent.

So Iceland had a bigger financial crisis, did more austerity, and had higher interest rates than Ireland, but has still managed to recover more. How is that possible? Well, it's not just that Iceland let its banks go bust, while Ireland bailed its out. Reality is a little more complicated. It's true that Ireland ran up a lot of debt guaranteeing its banks, but it's also true that it restructured that debt in 2013 in a way that effectively cut 40 percent of it. That's a quiet default, or at least half of one.

No, the biggest difference between the two is that Iceland has its own currency and Ireland has the euro. See, when the crisis hit, both countries discovered that their now-burst bubbles had just masked how uncompetitive they'd become. Their people were getting paid too much, relative to the rest of the world, for the work they were doing. There are two ways to fix this. You can get paid the same with money that's worth a little less or you can get paid a little less with money that's worth the same.

This might sound like a distinction without a difference, but it's not. People don't like taking pay cuts—economists even have proof!—so the only way to get them to do so is to fire enough people that they're happy to take any wage greater than zero. But even if that works, it doesn't for the economy. That's because lower wages make it harder to pay back debts that aren't lower. People have to set aside more of their money, in percentage terms, to pay back what they owe, so they have less to spend on everything else—which means businesses that don't have as many customers don't have as much reason to invest. It's self-defeating. Iceland was able to avoid this kind of downward spiral, though, because its currency collapsed nearly 60 percent between the end of 2007 and the end of 2008. Voilà, competitiveness regained.

Ireland, on the other hand, didn't have its own currency to devalue, intentional or otherwise. It had the euro. So instead of cutting wages by cutting its currency, it had to cut wages by, well, actually cutting wages. That's never easy, but it's especially hard when the government is cutting back at the same time. The result was what its backers kept claiming was an austerity "success" story where unemployment only recently reached the single digits.

If anything, the real surprise is that Iceland hasn't done even better. After all, slicing your labor costs in half should, in the short-run, be a big boost to exports and tourism. And it has. The problem, though, is it hasn't been enough one to lift the rest of the economy. Why not? Well, part of it is the austerity. But another part is a private sector that's been weighed down by two things. First, Iceland might be the worst place in the world to borrow money. Most mortgages are indexed either to a foreign currency or inflation, so the former doubled when the krona crashed and the latter, well, inflated when inflation subsequently took off. The perverse result is that devaluation and inflation have actually made Iceland's household debt problem worse, not better. That's why the headlines about Iceland writing off 13 percent of GDP of household debt are so misleading. That's just making up for the fact—and maybe not even then—that Iceland's bizarre borrowing laws have pushed up their households' debt burdens so much.

Then there are the capital controls. The IMF made Iceland put them in place after the bottom fell out to keep it from falling any further. The worry was that foreigners who owned krona-denominated assets in the failed banks would sell them en masse, and, in the process, make the currency's 60 percent drop to that point look quaint. So the government stopped letting people move their money out of the country. This stabilized the krona, which, on the plus side, stabilized inflation. But on the minus, keeping money in the country also kept money out. Foreigners didn't want to invest someplace where their money would be trapped. And that's at least part of the reason Iceland's private investment has still been so much lower than it was before. The good news, though, is that Iceland now has a plan to tax some of these foreign krona-holders and to get the rest to turn their short-term assets into long-term ones. In other words, Iceland should be able to lift its capital controls. It only took six and a half years.

Iceland's recovery has become a myth wrapped in a legend inside a legend. It let its banks fail, slashed household debt, let its currency collapse, put capital controls in place—and now it's doing better than those countries that did austerity! In reality, Iceland let its banks fail for foreigners, wrote down household debt only after their laws had made it worse, had no choice but to watch the krona plummet, but, at the same time, tried to keep it from plunging too far by limiting how much money people could take out of the country . Oh, and it did more austerity than any country not named Greece. The truth is a more complicated place.

The lesson is that in a crisis—don't forget those three words—you can get a lot of things wrong and still be okay as long as you default and devalue. You can do a lot of austerity and make life impossible for borrowers and prevent people from investing in your country for years longer than you probably should have. You just have to get the big question right—what currency should I use?—and you'll have a decent enough recovery. The right monetary policy, in other words, can cover up a lot of mistakes.

The question now is what Greece thinks of this.