Academic journal article Independent Review

The Icelandic and Irish Banking Crises: Alternative Paths to a Credit-Induced Collapse

Academic journal article Independent Review

The Icelandic and Irish Banking Crises: Alternative Paths to a Credit-Induced Collapse

Article excerpt

Standard illustrations of an Austrian business cycle (ABC) center on a central bank-controlled money supply being expanded so as to lower the market rate of interest below its natural (i.e., savings- and investment-determined) level. The result is a discoordination between consumption, savings, and investment manifested in two forms: malinvestment along the temporal structure of production and/or overconsumption (Friedrich Hayek [(1935) 1967] focuses on the former, whereas Ludwig yon Mises [(1949) 1998] and Roger Garrison [2001] utilize a combination of the two). Although this approach has wide appeal based on its use of "the" interest rate as a general cause of economic downturns, it suffers from its near-exclusive focus on the central bank-controlled money supply as the unique source of the artificially low interest rate.

This paper uses Iceland and Ireland's recent banking crises to demonstrate that although centralized monetary authorities can create artificially low interest rates via monetary expansion, this method is not the sole method for doing so. Both countries are compelling cases for examination because the extent of their recessions is formidable. Ireland's main stock index, the ISEQ, fell nearly 80 percent between 2007 and 2008, and Iceland's (now-defunct) ICEX15 collapsed more than 97 percent. Per capita gross domestic product (GDP) in Iceland declined 30 percent from peak to trough, and Ireland's GDP fell 12 percent over the same period. (The equivalent decline in the United States was about 5 percent.) The use of these countries is also appealing because their crises offer similar symptoms--large buildups of debt that propagated speculative banking activity and unsustainable consumption patterns. These two countries are also interesting in that their debt buildups have several common denominators: increases in the money supply, inflation, and low real interest rates enticed what are now identified as excess debt levels. A general theory, such as ABC theory, is useful to explain why these disruptions to the money side of the economy trigger such widespread effects. By focusing on changes to risk perceptions in each economy, I can illustrate that the general theory holds true with less onus placed on the central bank. In this way, this essay is influenced by Tyler Cowen's book Risk and Business Cycles (1997, especially chapter 3), which phrases a traditional ABC in terms of increased risk taking through manipulations to the natural rate of interest.

In particular, I contrast three sources of disruption on the money side of the economy that promoted debt buildups in each country. First, and consistent with the traditional exposition of an ABC, I explore what role each country's central bank had in setting interest rates too low and in expanding their money supplies too quickly to be sustainable. Second, I assess the assets in which banks in each country focused their investment activities--equity in Iceland and real estate lending in Ireland. Finally, I discuss the guarantees secured by governmental or institutional arrangements that skewed risk perceptions and led to artificially high risk-adjusted returns. I conclude by giving a summary view of the effects of these three disruptions and why it is important that ABC theorists move toward giving a more holistic account of crises that includes these additional factors.

The Lead-Up to Iceland's Bust

When the Central Bank of Iceland (CBI) floated the krona in March 2001, it also adopted an inflation-targeting regime. Under this regime, the CBI targeted yearly consumer price inflation of 2.5 percent. Despite this target, Iceland's annual inflation rate averaged 4.7 percent from 2001 to 2006 and peaked at 9.4 percent in 2007. By its own admission, it had done an unsatisfactory job at targeting inflation over this period (CBI 2007, 12-13). Part of this error can be explained in part by a faulty inflation-targeting model (as discussed in Bagus and Howden 2011, 16-18) and in part by the large influx of foreign bank funding) With inflation remaining above target for most of the early 2000s, artificially low real interest rates spurred domestic borrowers to take on increasing amounts of debt. …

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