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How Iceland Became Paperland

Economics / Credit Crisis 2008 May 10, 2011 - 06:30 PM GMT



Diamond Rated - Best Financial Markets Analysis ArticleAndy Duncan writes: If you believe in a Creator, then you must acknowledge that He (or She) possesses an incredible sense of humor. Without this, how do you explain Iceland?

Fortunately for us, and particularly perhaps for the Irish, the Greeks, and the Portuguese, this deific challenge is detailed gloriously in the new book, Deep Freeze: Iceland's Economic Collapse, written by Professors Philipp Bagus and David Howden, which is freely downloadable for your Kindle or iBook pleasure via the Ludwig von Mises Institute.

In much the same way that East Germany and West Germany formed the perfect means of comparing complete socialism and partial socialism, the isolated case of Iceland forms an almost perfect storm of a standalone test tube to examine the money-crank experiment of fiat paper currency — a diabolical pathway to fiscal hell followed by all of the world's short-sighted and feeble-minded governments (and all of the personally selfish, corrupt individuals within them) since 1971, when Richard Nixon took the Bretton-Woods US dollar off the final tattered shred of a voluntarily accepted commodity money standard. This thereby allowed an almost infinite abuse of power amongst government officials around the entire world, predicated upon the oil-based momentum and former preeminence of the dollar as the pyramidal fulcrum of the exploded Bretton-Woods global currency system.

With the final link to gold cut and the pyramid finally floating free, it was merely a question of how long it would take for reality to catch up with the almost-infinite paper-currency bubble that the world's central planners were about to blow up, to test these new, unknown limits of financial-paper gravity.

As with all my favorite books, Bagus and Howden come at the problem from an unorthodox angle. To be cunning, however, they begin straightforwardly enough for an Austrian-based book:

The real reasons for Iceland's collapse lie in intrusions by the state into the workings of the economy, coupled with the interventionist institutions of the national and international monetary systems.

So far, so predictable. But then, immediately following this bland opening, there's this:

Iceland's crisis is the result of two banking practices that, in combination, proved to be explosive: excessive maturity mismatching and currency mismatching.

Say what? I awoke at once from my cortical slumber.

What on earth were Bagus and Howden talking about?

Would they be gentle with me? Would they explain the Icelandic situation in ways a man could understand even when he was drinking a beer and stoking up a barbecue, even when he had (temporarily, you understand) forgotten everything he is supposed to know professionally during a working week, while he wears a suit?

Luckily for me, they could.

Iceland has something in common with other developed economies that the recent economic crisis has affected: its banking system was heavily engaged in maturity mismatching. In other words, Icelandic banks issued short-term liabilities in order to invest in long-term assets.

And so the book continues, delving into areas of fiscally obscured complexity, to explain this convoluted Icelandic smorgasbord of financial impropriety. They render its hidden colors into daylight in much the same way that Sun Tzu explained the art of war: comprehensible chunks of knowledge are levered out from spirals of incomprehensible chaos, chapter after chapter, to enable even a simple barbecuing man such as myself to understand the whole thing.

But Bagus and Howden go even further than that: they also enable our steak-eating, tong-wielding hero to understand how such a situation can be fixed and how it can be prevented from happening again.

To satisfy Rothbardian respectability along their route, the authors also mark their book with the usual de rigueur badges of Austrian authenticity — e.g., quotes from the master himself, Ludwig von Mises, including one of my favorites from The Theory of Money and Credit:

For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized." Only thus can the danger of insolvency be avoided.

Iceland thus broke Mises's golden rule, first expressed almost a century ago. It therefore paid the predictable consequence, just as the rest of the government-loving world will pay the predictable price when it finally faces up to the similar silvered rule of Max Keiser, that all paper currencies invariably shrivel away to nothing.

In chapter 3, "The IMF, Moral Hazard, and the Temptation of Foreign Funds," Bagus and Howden really begin to expand their tag-team onslaught against the common enemy of our current Keynesian paper money, as they drill further into the deeper core of an underlying problem:

In some ways, Iceland's financial crisis could be recorded in the history books as much like the crises in Mexico, Russia, Brazil, Argentina, or any number of Asian nations. However, it differs in two major ways. First, the extent of its boom and subsequent collapse are much greater than anything experienced in the aforementioned developing countries. More important, and more puzzling, is the fact that Iceland is the first developed country to suffer a financial calamity of this scope since the Great Depression.

Using the idea of Iceland as a perfect example, Bagus and Howden tease out every centrally planned machination designed to manipulate and cajole the world's productive populations into unknowing governmental fiscal servitude.

As Richard Cantillon noted in his Essay on Economic Theory, enslaved humans usually produce for their masters about half the amount of finished goods that freed slaves produce for themselves. The great trick of the world's elite may therefore have been to yoke the rest of us into debt slavery, without us realizing it, to feed their insatiable greed for power over the rest of us and to extract wealth from the rest of us, thereby avoiding Cantillon's half-production trap, and thereby avoiding the need for they themselves to be in any way useful to anyone else.

Thus, taxpayers may grumble at the trillions of paper money tickets used to bail out the failed financial entities owned by the elites, but they'll grudgingly go along with it, so long as they feel that they in some way they control the public "servants" that rule over them, who are of course beholden to these elites via the instruments of public debt employed by our rulers to keep buying power-enhancing votes from the ruled.

As an aside, if we examine the current Irish situation, in which each Irish taxpayer has been saddled with a debt of €500,000 (and rising) as against an average salary of €35,000 (and falling), then we can see just how far down the green-baize casino table the debt-slavery dice have been rolled by these elites. I wonder if they continue to believe that nobody in Ireland will ever read Murray Rothbard's article, "Repudiating the National Debt," as summarized in this quote:

In order to go this route, however, we first have to rid ourselves of the fallacious mindset that conflates public and private, and that treats government debt as if it were a productive contract between two legitimate property owners.

This heads-we-win, tails-we-win situation is, of course, in direct contravention of the iron rules of proper Schumpeterian capitalism, in which creative successes succeed and destructive failures fail, to the huge benefit of society — particularly productive, talented people — and to the short-term harm of unproductive untalented wastrels. These losers thereby have entrepreneurial resources withdrawn from their grasping unlucky fingers and must rejoin the rest of us proles in the ranks of the employed, while those few who have proven themselves good at directing capital to fulfill the needs of the many are allowed to get on with this vital job with resources liberated from the bankrupt losers, plus profits from their own earned successes. Real laissez-faire capitalism is thus almost magical in its self-balancing efficiency.

Perhaps one fine spring morning, after coming really close in the 19th century, we might even try it.

Our current elite experiment in insidious debt slavery has therefore lasted just over 40 years. However, as this latest slavery construct collapses and the world reawakens to the 4,000-year-old benefits of honest money, Bagus and Howden explain the how and why of these obfuscated debt-slavery mechanisms via the litmus paper of Iceland and its own horrific, acidic experience, in a transparent way that clears the misty opaqueness of how these elites have managed to keep this self-serving shell game going this long.

Nobody is more within the beating heartstrings of this supposedly untouchable club of elites than the International Monetary Fund, which in my own view should rename itself the Soviet Unification Corporate Kleptocracy (or SUCK) to telegraph to the rest of us what it is really all about. (That they even considered Gordon Brown as their next grossly overpaid puppet figurehead perhaps tells you everything you need to know about this malignant self-serving organ.)

The authors begin their examination by highlighting the explicit public purposes of the IMF:

The Fund originally had four goals: 1) promotion of exchange rate stability, 2) cooperation of monetary policy, 3) expansion of international trade, and 4) to function as a lender of last resort.

To cut a long story short, the IMF lost the last three of these purposes in 1971.

Post–Bretton Woods, central banks — especially those outside the satellite control of the Federal Reserve — started to argue with each other over monetary policies vis-à-vis China and the United States. International trade agreements (for all their faults) have sidelined the IMF's purpose on trade, and floating exchange rates have meant that the IMF stopped being necessary as a lender of last resort, as in 1972 the Greek central bank could print as many drachmas as it needed to fund the fiscal deficits of the Greek government. Obviously, we have seen a slight resurgence of this former IMF role, when emasculated governments such as the ones in Ireland, Portugal, and Greece have had to beg for ECB euro support — but that is an entire story in itself, as previously covered by Bagus in The Tragedy of the Euro.

However, do government bureaucracies, such as the IMF, wither away and die when the mandate for their original creation withers away? Hardly. Grasping hold of that first straw, and its Keynesian-mandated role to "manage" exchange-rate stabilities, the IMF has evolved from a reactive backstairs 1950s organization into a proactive 21st-century regime, popping up all over the world to enhance "stability." With self-aggrandizing policies trying to turn the SDR (Special Drawing Rights) currency into a new global Soviet currency, the IMF has carved out an even-larger niche than the one it previously occupied in its former Bretton-Woods existence, and thus forms the first layer in our cake of Icelandic fiscal destruction.

Having plotted out this layer, Bagus and Howden locate a central tendril in our search for understanding:

In normal markets, lenders make loans to borrowers, and borrowers may enter bankruptcy. The debts are settled via a bankruptcy procedure in the court system; 'this is how market economies are supposed to work.' Risky countries, and, more importantly, their creditors, view the guarantee of bailouts as an insurance policy. Investors are less cautious about investing in developing economies as the IMF has implicitly guaranteed to cover their losses in the event of a financial calamity.

This led directly to the following:

This underpricing of risk led Icelandic banks to take on liabilities denominated in foreign currency. It also caused an increase in international speculation in Iceland as foreigners were lulled into thinking the króna was less risky than its fundamentals would have suggested.

One of the cats is thus out of the bag.

Bagus and Howden then move onto currency mismatching, which once again bears the usual imprimatur of government interference in the natural working of free markets, thus wrecking them:

As Icelandic interest rates were relatively high, investors indebted themselves in dollars, euros and yen at low interest rates and invested the proceeds in Icelandic assets. Like maturity mismatching, this is risky. When the currency that has been invested depreciates relative to the currency that is loaned, there may be considerable losses, resulting in the insolvency of the investors exploiting the carry trade.

As with maturity mismatching, the question that comes to mind about currency mismatching is why did Icelandic banks engage so heavily in this risky practice? And for that matter, why does anyone? The answer relates to implicit government guarantees. Because of implicit government guarantees, especially the possibility of obtaining IMF assistance in dire circumstances, people start to believe that exchange rate risk is reduced.

Indeed, the authors even quote the former CEO of Kaupthing, Armann Thorvaldsson:

I always believed that if Iceland ran into trouble it would be easy to get assistance from friendly nations. This was based not least on the fact that, despite the relative size of the banking system in Iceland, the absolute size was of course very small. For friendly nations to lend a helping hand would not be difficult.

Ho, ho, Mr. Thorvaldsson.

But how many of us think similarly? How many of us think that if we blow our private pension on a mid-life crisis, then "our government" will come along and sort it all out for us? Well, perhaps we Austrians may be in a small minority of people who try to stand on their own two feet. However, Mr. Thorvaldsson would perhaps have been right in his assumption, on an Icelandic collapse, if the rest of the world had failed to apply for the same credit-crunch begging bowl at exactly the same time that he and his friends did.

This kind of welfare-mentality and moral-hazard thinking was exacerbated in Mervyn King's "Nice" decade, when the British, European, US, and Japanese governments exported their monetary inflation to the conveniently remote sinkhole of Iceland:

Via currency mismatching, the main economies exported their credit expansion to Iceland. Thus, artificially low interest rates in Europe, the U.S., and Japan deceived entrepreneurs about the availability of real savings not only in their own currency areas but also in Iceland.

In chapter 5, "The Consequences of the Boom: Malinvestments," Bagus and Howden further analyze the consequences of even more government interventions, both explicit and implicit, to explain how the financial-services industry in Iceland grew so large (to the detriment of more traditional industries), to where fishermen's sons wanted to become derivatives traders and apply the Black Scholes Merton equation to contango aluminum option futures.

With the Central Bank of Iceland (CBI) backing all risky bank investments in 2001 as a "lender of last resort," the Icelandic government expanded mortgages and long-term house building via their own Freddie Mac-type organization, the Housing Finance Fund (HFF). They also encouraged other long-term capital-intensive investments, such as aluminum smelting.

Iceland thus became a bullet train heading at 100 miles an hour into a future upheld via a paper Valhalla rainbow of massive fiat-money infusions, which could fall away at any time.

And the problem for Iceland was this. You could take out a large mortgage in euro or yen, but if push came to shove, the Central Bank of Iceland could only print króna.

But who cares when the sun is shining? Between 2000 and 2008, house prices in Iceland increased 300 percent. And as we all know, house prices can only go up — even in a small country like Iceland, which relies upon fishing, high-tech goods, and geothermal energy to make ends meet.

The train-wreck scenario was thus pumped and primed, as the Keynesians like to say:

In 2007, after ten years of growth, the big three Icelandic banks, Kaupthing, Glitnir, and Landsbanki, owned assets in excess of 1100 percent of Iceland's GDP, comprising nearly eighty percent of the island's total banking assets. An oversized and unviable banking model had developed. The pretense under which this system developed — that a central bank stood ready and able to bail it out if it came under pressure — would be called into question as the crisis progressed.

Oh dear.

After working through the timeline, in concise detail, Bagus and Howden then explain the three main props of the necessary restructuring process, which I'll summarize below:

Malinvestments — those misdirected resources and entrepreneurial errors — need to be liquidated. Prolonging their existence prevents the economy from moving production and consumption patterns to those that are conducive to long-term growth.

An oversized financial sector is not necessary for the country, nor is it healthy. It has removed resources from those areas where Iceland has a real competitive advantage. The financial sector needs to be allowed to shrink down to the size required by Iceland's economy.

Lastly, the consumption-led boom bred a new type of Icelander. The inflationary economy of the boom years increased the time preference of the nation. Icelanders need to regain their traditional prudence about credit and spending.

To conclude, Bagus and Howden defend the free-market system beloved of Austrians and explain how the Icelandic economy was no such thing. This is in the finest tradition of Misesians everywhere. We should never give in to Keynesian evil and try to placate it with weasel words. We should always proceed boldly against it and smash it into the rancid dustbin of history where it belongs.

I can therefore heartily recommend this book to anyone who wants to understand how governments have gotten us into our current mess, and how they are currently using their own weasel words to try to push the blame for this onto those of us who believe in freedom and liberty, and the costs for wasteful government spending onto hapless taxpayers. They would like us to forget, of course, that they were "in charge" the whole time, and were happy to receive enormous personal payments and pension rights while they were all chancellors, prime ministers, presidents, foreign secretaries, and central-bank governors, pontificating to the rest of us on how they had abolished the processes of boom and bust in their nice decades of bubble expansion and gold sales.

Somehow, however, none of the subsequent bubble collapse was anything to do with them.

In the meantime, the rest of us should read Deep Freeze, particularly anyone in Ireland, Greece, Portugal, Spain, Belgium, or France, or anyone else who is going to be forced to shoulder the risks of private banks to enable their governments to keep borrowing and spending in their name, and dragging them into the abyss of old age poverty and along the road of tax debt serfdom, while Iceland itself recovers, having refused to toe the line on IMF austerity.

Bravo, gentlemen. A fine book indeed.

Andy Duncan works as an independent educational consultant and project-management professional within the quantitative-finance industry. See Andy Duncan's article archives.

This review originally appeared at the Cobden Centre, May 2, 2011.

© 2011 Copyright Andy Duncan - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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