Was the Geyser crisis caused by a negative supply shock?

I am writing this while having a small break between meetings and interviews in Reykjavik. It has been a great day, but also a busy day in Iceland’s capital for me. Today’s meetings and talks have been educational for me and it had made me think about a lot of issues regarding the Icelandic economy. I always find that meetings “on the ground” educate me about the economies I am analyzing rather than just looking a the numbers.

I strongly believe that the Great Recession was caused by a monetary shock in both the US and in the euro zone. However, I don’t think that that (necessarily) was the case in Iceland. Rather some of the meetings today have made me think that the shock to the Icelandic economy in 2008 was a negative supply shock rather than a negative demand shock. Take a look at the graph below.

Iceland RGDP NGDP

It is pretty clear – Icelandic nominal GDP (NGDP) growth continued to growth strongly all through 2007 and 2008 and even spiked in the Autumn of 2008 (as the Icelandic krona collapsed). So if anything Icelandic monetary conditions easied rather than tightened through 2008 – contrary to what we saw in the US or the euro zone.

On the other hand real GDP (RGDP) growth started to slow already in 2007 and continued to slow sharply during 2008.

With NGDP growth accelerating and RGDP growth decelerating inflation increased through 2008. If one don’t know the story of the “Geyser crisis” these numbers would lead one to conclude that the Icelandic economy was hit by a negative supply shock rather than a negative demand shock.

This is interesting as it indicates that the Icelandic crisis was not necessarily caused by monetary policy failure – at least not in the monetarist sense of an excessive tightening of monetary conditions.

So how can we explain this supply shock? Normally we would think of a supply shock as a increase in for example oil prices. However, in the case of Iceland the shock has to be found in the financial sector and related sectors. From 2004-5 the financial sector as share of GDP grew strongly in Iceland and the general perception among investors was that Iceland had very strong comparative advantages in the production of financial services. However, as jitters started to emerge in the global financial markets in 2007 investors probably started to doubt how brilliant an idea it was that Iceland should be a “financial hub” and that led to a significant down-revision of growth expectations for the entire Icelandic economy. This was the negative supply shock.

This also means that there there was not a monetary “answer” to the Icelandic crisis. The only thing the central bank could do was to acknowledge the fact that investors had been too positive about the long-term growth potential of the Icelandic economy and try to keep nominal GDP growth on track.

That said, in the later part of 2008 we also saw a sharp monetary contraction and NGDP dropped sharply and the Icelandic central bank obviously could have counteracted that, but initially failed to do so. However, judging from the graph above the primary shock was a real shock rather than a nominal shock.

In the years following 2008 we have actually seen additional negative supply shocks. First of all the draconian capital controls put in place in response to the crisis has seriously increase “regime uncertainty” in Iceland which is certainly having an negative impact on investment growth. Furthermore, numerous policy issues regarding debt restructuring, taxation and the settlement of the so-called Icesave case are likely also adding to “regime uncertainty”. Second. the negative shock to the Icelandic economy has also meant that a large number of Icelanders was leaving the country to look for job opportunities in for example Norway. Hence, we have continued to see a negative supply shock to both K (capital) and L (labour) and that is clearly reducing the growth potential of the Icelandic economy.This in my view helps explain why Icelandic inflation has stayed elevated despite the sharp drop in growth.

Therefore, I think that it is reasonable to conclude that the (perceived) growth potential of the Icelandic economy is somewhat smaller today than was the case prior to the crisis. As a consequence it is much harder to argue that monetary easing necessarily is warranted in Iceland – contrary to for example in the euro zone where monetary easing clearly is warranted.

Concluding I believe that there was very serious policy mistakes made in Iceland in the run up to the collapse in 2008 and in the imitate aftermath. However, a lack of monetary easing did play a significantly smaller role in Iceland collapse than for example was the case in the US and the euro zone. In that sense the Icelandic crisis was more Hayekian than Hetzelian.

HT Mar

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7 Comments

  1. My interpretation of Iceland’s experience in the Great Recession is that it was indeed a “supply shock”, at least from the point of view of Icelandic policy makers. Iceland’s status as a financial hub made it’s own economy sensitized to the economy’s (and monetary policies) of other financial hubs, chiefly the US. No amount of policy easing in Iceland could have really deflected the disaster, but policy easing in the US or the EU could have. Iceland’s now lower growth potential seems like a consequence of the country’s apprehension to rebuilding itself as a financial hub.

    Reply
  2. Have you read P. Bagus book on Iceland? What do you think of it.

    The biggest problem, it seams to me is that the CB clearly stated that it will not let banks go broke. I think they sad that flatout in 2003.

    Reply
    • Nickikt, nope I have not read Bagus’ book. I must however say that I am a bit skeptical about a book that was produced this fast by somebody who did not follow developments in Iceland closely prior to the crisis. In general the Icelandic collapse was complicated and a simplified Austrian explanation is not enough to explain what happened. It seems to me the Bagus’ book was written to fit Austrian theory. But I should stress that I have NOT read it and I have little know of Bagus’ background so I apologies if I am unjustly unfair to him and his book.

      Reply
      • nickikt

         /  December 8, 2012

        I was also skeptical and I agree that the it kind of is that way. Im not an expert on Island either, so I cant really say if what he rights is true.

    • Saturos, nope my middle name is not Seier, but yeah we are both Danish bankers with libertarian inclinations and we nearly have the same name. And yes, we do know each other. The other Lars, however, owns his own bank and a cycling team. I work for a bank and prefer football to cycling,

      Reply
  1. Duncan Brown’s interesting NGDP wonkery | The Market Monetarist

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