STAFF NEWS & ANALYSIS
Haarde's Free-Market Embrace May Prompt Backlash by Icelanders
By - October 22, 2008

The government promoted asset sales to "increase economic efficiency by eliminating the distortions inherent in state-ownership," Iceland's Prime Minister Geir Haarde said in February 2003. This contrasted with the Scandinavian welfare-based, high-tax programs of Norway, Sweden and Denmark. The tax cuts reduced 2007 revenue — about $7.8 billion — to 41.4 percent of the economy, compared with 48.9 percent in Denmark and 48.2 percent in Sweden, according to the Organization for Economic Cooperation and Development. Freed of government control, banks racked up debt that grew to 12 times the size of the economy, most of it in foreign currency loans they now can't afford to repay. The banks in turn lent to entrepreneurs, including 40-year-old Jon Asgeir Johannesson, chairman of retail investor Baugur Group hf. His company bought stores including Hamleys toy shop and clothing retailer Karen Millen, and now Johannesson is trying to sell parts of his business to raise cash and offset some of the debt held in Iceland's collapsed banks. – Bloomberg

Dominant Social Theme: Government regulation works better than free markets.

Free-Market Analysis: This article makes the point that high-tax, high-regulation Scandinavian economies work better than low-tax, low-regulation ones. In our humble opinion, it's a good example of misapplied economics and no better in its analysis of either the problem or the solution than poor Geir Haarde, who obviously had a tenuous grip on real economics himself.

It happens, we suppose, that the political class the world over does not understand markets and banking anymore than the average person. This must be so because the idea of "deregulation" of the financial sector in a fiat-money environment is naïve in the extreme. In fact, we could make the argument that the Bloomberg article is correct that high tax and high-reg regions do better during fiat-money booms and busts than those economies that are freer.

But not for the reasons that the Bloomberg article suggests!

Actually, we don't mean to the pick on the Bloomberg article, above, because it is not alone in suggesting that the "capitalist model" has failed. Article after article in the mainstream business press hits similar themes these days. "We are all Keynesians now," one commentator notably preached on a recent TV program that we tuned into. Perhaps so – but only if you believe that central banks are an intrinsic part of the free market and endless amounts of money and credit, seemingly without limit, are the normal course of affairs for business or finance.

And they are not. That's what Haarde did not understand and it's what the writer of the article excerpted above does not apparently understand either. Is that too harsh? Let's reverse it then. If Haarde did understand how markets work in a central banking environment, then he was taking an awful risk. And if the Bloomberg writer understands about a central banking economy then she(?) (Tasneem Brogger) is misleading those who read her article (which is seemingly more of an opinion).

Either you have a free-market economy or you don't. And if you don't, then you will run into trouble on a regular, cyclical basis. Having a free-market economy powered by central banking is like being a little bit pregnant. Those who participate are being forced into a position where the marketplace, and all of their entrepreneurial ambitions, are built on the foundation of government initiated money manias.

But don't take our word for it. Here's an excerpt from a very prescient academic analysis of Iceland's banking situation circa July 2008 by Willem H. Buiter and Anne C. Sibert called "The Icelandic banking crisis and what to do about it."

Regardless of the quality of the banking sector's assets, the Icelandic banks are vulnerable to a liquidity crisis. These banks are heavily dependent on wholesale financing, as well as on deposits. In a liquidity crisis, each creditor believes that other creditors will refuse to roll over existing loans and refuse to extend new credit and that this will cause the bank to fail. Thus, each creditor refuses to roll over his own loans or to extend new credit and the bank fails; the beliefs of the investors are validated. The Federal Reserve can protect solvent, but illiquid, financial firms in the United States from a liquidity crisis by acting as the lender of last resort. That is, it can extend dollar loans to a troubled firm against collateral that would be good if it could be held to maturity. As it can always issue more dollars, the Fed's ability to do this is unlimited. Likewise, as the issuer of euros, the ECB can protect any threatened financial firm in the Euro Area. The Central Bank of Iceland, however, is unable to act as an effective lender of last resort to Icelandic banks if their creditors refuse to roll over their foreign-currency loans or if they refuse to extend additional foreign currency credit. The central bank does not hold enough foreign currency to do this and it is unable to issue more. This means that, ultimately, a large internationally exposed banking sector is not viable in Iceland. Either the country must join the EU and become a full participant in the Eurosystem, so that its banks have borrowing privileges from the ECB, or its banks will almost surely eventually fail or move the bulk of their operations outside of Iceland.

We can see in this analysis that there is not a great deal of talk about "free markets" or even the regulated economies of the Scandinavian countries. That's because the relevant factors affecting Iceland and its current crisis have little to do with regulation and a lot to do with central banking. And in any event, the situation that Iceland got itself into was inordinately aggravated by what Gordon Brown and the UK did to Iceland in freezing bank assets once the financial crisis had built up a head of steam.

After Thoughts

It's fascinating to watch tomorrow's history being written today. When it comes to the financial crisis, one can see the meme being constructed – capitalism fails and socialist/Fabian-ist John Maynard Keynes makes a comeback. Government is useful after all … (Big regulation good, deregulation not.) And raise those taxes!

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