Deep Freeze: Iceland's Economic Collapse
It's rare that I move past simple book recommendations to outright urging you to read something. This book is so good it requires urging. This the story of Iceland's economic boom and bust. The full text has been made available for free by the authors (Phillip Bagus and David Howden) and can be read here.
In a crisp 125 page treatise that weighs in equally on theoretical and empirical analysis, Bagus and Howden uncover the root causes of Iceland's rise and catastrophic collapse. Chapter 2, for example, analyzes the tremendous amount of maturity mismatching in the bank assets of Iceland's TBTF top 3 banks. Chapter 4 looks at the currency mismatching of these same institutions. Chapters 1 and 3 detail the theoretical analysis that lays the framework for understanding the concepts at a deeper level. However, if you are already familiar with concepts like moral hazard, malinvestment, credit expansion, or Austrian Business Cycle Theory it's probably safe to skip ahead. Chapter 5 details some of the grossest examples of malinvestment during the boom phase. From there, the crash and ensuing interventions are analyzed. Finally, ideas for reform are presented.
Maturity mismatching occurs when a bank takes on short term debt while loading up on long term assets. Short term debt must be constantly rolled over, obviously. Though it is a risky operation, it is also very profitable. Long term rates are typically higher than short term rates and banks profit from the spread.
Borrowing short and lending long has long been known to be hazardous to a bank's health. At some point in our recent past, it became not only an accepted practice, but an encouraged one. Indeed, even as the wreckage of Iceland was laid before us, IMF economists/technocrats were advising Icelandic banks to increase the maturity mismatching! At the height of the crisis Iceland's 3 largest banks (which accounted for roughly 80% of Iceland's banking sector assets) were short the equivalent of half of the country's GDP in liabilities due in 3 months.
Take a moment to let that sink in.
Yes, that's right. In order to fulfill the obligations that banks had made in the next three months minus short term assets, the people of Iceland would have to be twice as productive as they normally were and hand all of that productivity over to the banks.
Takng this evidence under consideration, I wonder about other areas of life IMF technocratic advice might be useful. If I fell down the stairs would Jack Boorman advise me, "your problem is that you didn't pick up enough speed to offset the fall. Try taking the elevator to the top floor and jump out the window."
When it comes to currency mismatching, it's all about risk, or rather, the reduction of perceived risk due to continuous and ever expanding IMF intervention in the foreign exchange markets. Much like the situation with maturity mismatching, the Icelanding banks took the carry-trade concept and reductio'd ad absurdum.
Iceland's economic boom/bust, in fact, can be looked at as the logical outcome of taking illogical technocratic economic management ideas and implementing them to the fullest. Iceland didn't just try a little here and there. Guided by the IMF and the Central Bank of Iceland, coupled with the typical government interventions (Iceland's HFF played the Fannie/Freddie role), Iceland wholeheartedly embraced, nay, exceeded all expectations in what technocratic utopia could make possible!
It's a good thing we've stopped listening to these kinds of charlatans. Oh wait....
Enjoy the read.
David in Qatar