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Source link: http://archive.mises.org/16165/rethinking-icelands-recovery/

Rethinking Iceland’s Recovery

March 22, 2011 by

Like many economic events, the key lies not in what is immediately apparent — explosively large banks — but in those causes and conditions that are veiled. Politicians, pundits, and the population of the Icelandic nation have had a difficult time explaining how such a large financial sector could develop in the first place. FULL ARTICLE by David Howden

{ 11 comments }

augusto March 22, 2011 at 8:18 am

Prof. Howeden,

Could you please clarify the following point?

You say, ” As an increasing amount of funding was made in foreign denominations, the CBI was increasingly unable to honor these obligations should they come due. Any central bank has the ability to inflate only the domestic money supply. While it’s easy, then, to honor domestically (and nominally) denominated debts, a significant failing occurs when foreign liabilities are added to the mix.”

My understanding of the above is that the Icelandic banking sector would be in trouble should it have to make reimbursements in foreign currencies, since the Icelandic central bank can inflate only the domestic money supply.

Yes, the Icelandic deposit insurance Fund is clear in saying that “Yes. No distinction is made between deposits in Icelandic krónur and those in other currencies. The Fund can reimburse the value of the deposit balance in Icelandic krónur.”

In other words, the Fund will pay in krónur, not in foreign denomination. I understand that this preserves the Icelandic Central Bank’s ability to inflate the money supply in order to “honor” deposits in foreign currencies.

Am I wrong?

Colin Phillips March 22, 2011 at 8:56 am

If you had $100 in an Icelandic bank, and the CBI had to pay you out in Kronur, they’d have to print $100 worth of Kronur. But, when they do so, the value of the Kronur goes down, so they actually only pay you $90 worth, say. So they have to print more. In this case the answer is easy enough – print $200 worth of Kronur, and hope that by the time it’s printed those Kronur will be worth at least $100. The problem for the CBI was that it was not only $100 of foreign-denominated deposits, it was a great deal more. If there were enough, you could design a situation where no amount of inflation will be able to pay the debt.

A. Viirlaid March 22, 2011 at 11:03 am

augusto Colin Phillips is exactly right.

The problem for little Iceland and her ‘big’ central bank is that the Central Bank of Iceland cannot print Euros and British Pounds to solve their problems.

If my Euro deposit of one million Euros into a bank in Iceland is earning me 10% a year in interest, and then the system implodes, forcing the CBI to make good on a TOTAL of BILLIONS in such individual deposits, how can the CBI on its own fill that gap?

If the CBI tries to monetize all of those debts that the Icelandic commercial banks owe to its depositors via its own “Money-Printing Press”, it would debase the Icelandic króna to a value of close to zero (as happened to German money in the Wiemar Republic in 1923).

So taking (relatively “real” paper) money from foreign nations was the only ‘solution’ for Iceland and her central bank after the collapse.

Of course as Dave Howden writes, the Central Bank of Iceland is foolish to create the Moral Hazard by making the guarantee of being the ‘backstop’ in the first place.

Another issue that Philipp Bagus and Dave Howden properly raise is whether the Banking Industry is “deserving” of the support from such an automatic Central-Bank-Supplied Bail-Out Mechanism that other industries can only DREAM about.

This support (even if it comes from a nation’s central bank) ultimately is extracted FROM The Very Real Wealth of The People of a Nation — even if printed in net-new money by that nation’s central bank. There is no such thing as Free Money.

As Dave Howden intimates, the Broken Money Systems that rely on the ‘backing’ of central banks at their system-cores (to support the value of Fiat Paper Money and the value of deposits gone bad via bad loans and an implosion of credit) will all eventually fail.

We are seeing the first stages of this in America and Europe today. This crisis (of 2008) is far from over. It is just in the second inning IMHO.

As the article points out, a system that has so much Moral Hazard at its core is just asking for trouble — nay, it is GUARANTEEING such periodic trouble. The fact that both bankers and depositors “do not seriously care how much risk they are taking” is driven by the fact that they know that the central banks of the world will always BAIL THEM OUT.

Besides the question of “deserving” or even “too big to fail” or “too important to The Overall Economy to allow Failure to Occur” (which drive politicians and central bankers to periodically ‘save’ their breaking money systems during such inevitable system-design-inherent collapses) THERE IS ALSO THE QUESTION that Dave Howden focuses on WHICH IS that “IS THIS ANY WAY TO RUN A MONEY SYSTEM?”

Well, it is, if you want it to fail every so often, in ever-increasing amounts of collateral damage to the Real Economy and to Real Society.

The most valuable point raised by Dave Howden in his article IMHO is that the Icelanders (like the rest of us) failed to use this tragedy to seriously address the mis-design that lies at the heart of all of the world’s nations Paper Fiat Money Systems.

This guarantees a repeat — A Great Financial Collapse REDUX.

Peter March 22, 2011 at 8:54 am

Great article! Just a little typo has to be fixed: “so many do think that they central bank will be able to solve the eventual funding gap.”

A. Viirlaid March 22, 2011 at 1:47 pm

Are deposits in foreign branches of Icelandic banks guaranteed by the Fund?

Yes. The Fund’s guarantees extend to all customers of Icelandic banks and their branches, both domestic and foreign, irrespective of legal address. Foreign deposits with subsidiaries of Icelandic banks are guaranteed by the guarantee funds in the countries concerned.

On first reading, it seemed as though the blanket coverage by the “Fund” extends to deposits made into in Iceland’s banks at their foreign-located remote branches.

But then this phrase — “…are guaranteed by the guarantee funds in the countries concerned.”.

I thought: Are the “guarantee funds in the countries concerned” part of the “Fund”?

Well, to get the answer I used the link provided in the article and found this excerpt:

Where do owners of deposits in foreign branches turn if an Icelandic bank becomes insolvent?

Because of the supplemental deposit insurance that some foreign branches of Icelandic banks have with foreign guarantee funds, the Fund has concluded collaboration agreements with a large number of foreign guarantee funds.
The agreements guarantee collaboration between the Icelandic Fund and its foreign counterparts in the event of a crisis.
If supplemental deposit insurance exists, foreign deposit owners should turn to the guarantee fund in their home country.
If such supplemental deposit insurance is not in place, they should turn to the Icelandic Depositors’ and Investors’ Guarantee Fund.

Jono March 22, 2011 at 8:12 pm

But but but.. I watched the documentary Inside Job where Matt Damon told me that the Icelandic banking system was due to ‘deregulation’.

Matt Damon mentioned the word deregulation about 30 times in this dumb movie, which shows the effects but not the cause of the financial collapse.

I wonder…since the Icelandic banking crisis, were more or less powers given to their central bank ?

J Cuttance March 22, 2011 at 8:40 pm

you mean…Matt Damaahhn…

Jay March 22, 2011 at 8:30 pm

Don’t central banks just borrow from the Fed’s discount window to cover foreign currency debts? That’s what the Australian central bank (RBA) did to prop up the Australian dollar back in 2008. The Fed is, of course, quite happy to oblige – they all scratch each others’ backs to help keep their respective banking cartels going (they have to in a world of internationally connected capital markets).

frank cochran March 22, 2011 at 10:53 pm

http://www.thepoint.com/campaigns/campaign-0-1462/memberships

Please donate to help make this film possible.

“The flowering of human society depends on two factors: the intellectual power of outstanding men to conceive sound social and economic theories, and the ability of these or other men to make these ideologies palatable to the majority.” – Ludwig von Mises

Colin Phillips March 23, 2011 at 3:14 am

Cool, will do, thanks.

Jukka M March 23, 2011 at 5:32 am

Speaking of moral hazard…

This reminds me of when back in 2007 a co-worker of mine said he was planning to deposit some money to Kaupthing bank. At that time Icelandic banks were advertising with aggressively high interest rates here in Finland. My friend was suspicious at first, but then learned that the deposits are guaranteed up to a certain limit, so he ended up “investing” just that amount.

No doubt many others went through similar considerations and then – thanks to the deposit insurance – ended up depositing in Icelandic banks lured by the high interest rate.

P.S., some of the user contributed tags in this article are, shall we say, less than appropriate.

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