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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Reykjavik here I come – so let me tell you about Singapore

As I am writing this I am getting ready to fly to Iceland. Iceland is a country that have had massive impact on my thinking and on my professional life over the last 6 years so it is always with a bit of a special feeling when I fly to Iceland.

Back in 2006 I co-authored a report on the Icelandic economy. In the report – “Geyser crisis” – we basically forecasted doom-and-gloom for the Icelandic economy. That report did not make me popular in Iceland and has taken some time to convince people in Iceland that I do not have anything against the country and the people living there. In fact I always enjoyed going to Iceland. However, whenever I go to Iceland some wild things seem to happen. A week or so after we published the Geyser crisis-report in March 2006 I went to Iceland. That was pretty wild in itself.

Then I went to Iceland again literally one week after the entire Icelandic financial system collapsed in October 2008. That was not a pleasant experience as that the Icelandic economy was on verge of collapse and the government was very close to default. The crisis had serious economic and social consequences and particularly 2009 and 2010 was very hard years for the Icelandic people. However, I am happy that the Icelandic economy has been in recovery for sometime now, the financial sector is back on its feet and the government has moved far away from default thanks to serious fiscal consolidation (a triple “fiscal cliff” to be exact).

The next time I went to Iceland was in April 2011 – one day after the Icelandic people had voted “no” in the so-called Icesave referendum. The Icelandic government and the elite in Iceland was in shock. However, I brought a positive message with me to Iceland. I was not overly worried and our macroeconomy forecast was relatively upbeat on growth. Luckily that have turned out to be more or less right in the sense that the recovery has continued (note I got a lot of things wrong in that report – most notably that we were far to negative on the outlook for unemployment).

So now I am going to Iceland again and yes I will be presenting a new forecast on the Icelandic economy tomorrow (Wednesday) in Reykjavik. However, this time around the feeling is not as tense as in March 2006, October 2008 or in April 2011. In fact “normality” seems to have returned to the Icelandic economy and even though I will not reveal anything about our new macroeconomic forecast for Iceland I will promise that it will not be a new “Geyser crisis” report.

Monetary debate takes centre stage in Iceland

In Iceland there has been a fierce public debate since 2008 about the future of the Icelandic króna and monetary and exchange rate policy. The Icelandic government has campaigned for EU membership and at a later stage euro adoption. Others have argued that Iceland should replace the Icelandic króna with the Norwegian krone or even the Canadian dollar. And most people in Iceland are skeptical about going back to a freely floating króna again and many seem to think that the free float played a major role in the Icelandic collapse in 2008 – I disagree with this view, but can easily understand the fears of a freely floating exchange rate for a country of 320,000 people. Furthermore, it is not surprising that most people in Iceland today are favouring getting rid of the króna. After all it is hard to argue hard that monetary policy has been successful in Iceland. In the 1970s and 1980s the country was struggling with very high inflation and there is no doubt that the inflation targeting regime that was put in place in 2001 did not work well and the Icelandic central bank surely has to take a lot of blame for the crisis. So the debate goes on.

I will not be weighing in on my views of the difference options being discussed in Iceland on currency and monetary reform directly. I think a number of the ideas being discussed have merits, but this is not the place and the time to discuss those ideas. Instead I want to describe the workings of the Singaporean monetary set-up. So why is that? Well, first of all there are some similarities between Singapore and Iceland – both are small (though Singapore’s population is 10 times as big as Iceland’s), very open high-income economies and both economies are highly sensitive to external shocks such as supply shocks, financial shocks and trade shocks. So maybe there are lessons to be learned from Singapore’s monetary regime that could be relevant to policy makers in Iceland. I am not necessarily arguing that Iceland should copy what they are doing in Singapore, but rather I try to broaden the debate regarding monetary policy in Iceland.

The exchange rate as policy instrument 

Here is how the Monetary Authority of Singapore (MAS) describes the Singaporean monetary regime:

Singapore’s monetary policy has been centred on the management of the exchange rate since the early 1980s, with the primary objective of promoting medium term price stability as a sound basis for sustainable economic growth.  The choice of our monetary policy regime is predicated on the small and open nature of the Singapore economy.

There are three main features of the exchange rate system in Singapore.

1. The Singapore dollar is managed against a basket of currencies of our major trading partners.

2. MAS operates a managed float regime for the Singapore dollar with the trade-weighted exchange rate allowed to fluctuate within a policy band.

3. The exchange rate policy band is periodically reviewed to ensure that it remains consistent with the underlying fundamentals of the economy.

So the Singapore dollar is neither a freely floating currency nor is it a fixed exchange rate. Rather the Sing dollar should be seen as MAS’s key policy instrument. However, while MAS is using the exchange rate as a policy instrument it is not trying to achieve a particular level for the exchange rate as such, but rather use the exchange to ensure “medium term price stability as a sound basis for sustainable economic growth”. So in that sense MAS is a flexible inflation targeter in the same ways as for example the Swedish Riksbank or the Australian Reserve Bank. But contrary to most central banks – including the Icelandic central bank Sedlabanki – which use interest rates to hit the inflation target – MAS instead uses the exchange rate.

I see two very clear advantages to this operational set-up compared to “interest rate targeting”. First, there will never be a problem with a lower zero bound. You can weaken the currency as much as you want. Second, as the exchange rate is freely floating within the “policy band” so the market will gradually be telling MAS was direction to move policy to ensure that it hits it’s inflation target (or any other nominal target). In reality one can think of this as parallel to Scott Sumner’s idea of using futures to hit an NGDP target.

Some have suggested that MAS is using this Basket, Band, Crawl (BBC) set-up to reduce volatility in the real effective exchange rate and to ensure that the real effective exchange rate is aligned with economic fundamentals. An early proponent of this view was John Williamson. An alternative interpretation instead stresses the nominal exchange rate and sees the nominal exchange rate as a tool to achieve nominal targets. This view has been most forcefully made by Bennett McCallum – See for example here.

This discussion is really similar to the impact of devaluations and revaluations. While most economists and commentators seem to think about devaluations as having an impact on the real exchange rate (competitiveness) I – and other monetarists – would instead stress the impact of changes in nominal variables – the exchanges rate, the money base/supply, prices and nominal GDP. See for example my earlier post here.

Empirical research have tended to support the McCallum view of the Singaporean monetary regime – see for example this paper. Hence, MAS conduct changes to the currency basket and band to ensure it’s nominal target (“price stability”), but MAS is not targeting the real exchange rate. In that sense MAS is “monetarist” in its thinking about the exchange rate regime.

Furthermore, it should be stressed that even though the Singaporean system probably has reduced currency fluctuation compared with a purely free floating Singapore dollar that is not the stated purpose of the policy. The exchange rate is a policy instrument and not the ultimate target of monetary policy.

A lack of transparency a key flaw

While I certainly think that Singaporean monetary regime has some clear advantages compared with “interest rate targeting” – particularly that there is no zero bound problem – I would also highlight some problems. First, one can certainly discuss whether the best ultimate target for the central bank is an inflation target. Obviously MAS’ is not a totally traditional inflation targeter in the sense that it targets “price stability” in a more broad sense. However, the important thing here is not the ultimate policy target, but the operational framework of using the exchange rate rather than interest rates to achieve the central bank’s ultimate nominal target (inflation, the price level or NGDP).

My second objection is more fundamental. I consider it to be a major problem with the way MAS conducts monetary policy that it is not very clear on “the numbers”. Hence, MAS is not clear about what “price stability” is. Is it zero inflation? Is it an inflation target and what kind of inflation measure are we talking about. Furthermore, while MAS is using a “basket of currencies” as the policy instrument it is not entirely clear what currencies are in the basket and what weights the different currencies have. Finally, MAS is not clear when it describes the “fluctuation band”. Is it 5% or 15%? We really don’t know. So if other central banks were to move in the direction of a Singaporean style monetary regime then I would recommend it to be much more specific on the numbers than MAS tend to be.

Further reading on Singapore’s monetary regime

Lin Tian gives a good overview in this paper.

Stefan Gerlach the present deputy governor in the Irish central bank and former colleague of Icelandic central bank governor Mar Guðmundsson in BIS discusses the relative merits of Hong Kong’s currency board and Singapore’s monetary set-up in this paper.

PS In the US the fiscal cliff discussion seem to be the only thing people can talk about. To me it is incredible that the importance of monetary policy is ignored in this discussion. The fiscal tightening in Iceland we have seen in Iceland since 2008 is around tree times as big as the ultimate fiscal cliff would be in the US. The Icelandic economy has recovered anyway. Why? Monetary policy…Somebody should write a paper about the Icelandic policy mix after the crisis and the fairly robust recovery in the economy despite strong fiscal consolidation.

PPS I think Icelandic policy makers could be inspired by lessons from Singapore. However, other countries might certainly also benefit from studying Singapore – in particular I suggest that the Czech central bankers fly to Singapore to learn about how to conduct monetary policy in a export-oriented small open economy.

PPPS and to my favourite football team in Iceland - Áfram Stjarnan!!

Update: I have had a great day in Reykjavik – so let me share this picture from my visit to the Icelandic central bank and here is my comments on capital controls.

 

Sedlabanki

Boom, bust and bubbles

Recently it has gotten quite a bit of attention that some investors believe that there is a bubble in the Chinese property market and we will be heading for a bust soon and the fact that I recently visited Dubai have made me think of how to explain bubbles and if there is such a thing as bubbles in the first bubbles.

I must say I have some experience with bubbles. In 2006 I co-authoured a paper on the Icelandic economy where we forecasted a bust of the Icelandic bubble – I don’t think we called it a bubble, but it was pretty clear that that is what we meant it was. And in 2007 I co-authored a number of papers calling a bust to the bubbles in certain Central and Eastern European economies – most notably the Baltic economies. While I am proud to have gotten it right – both Iceland and the Baltic States went through major economic and financial crisis – I nonetheless still feel that I am not entire sure why I got it right. I am the first to admit that there certainly quite a bit of luck involved (never underestimate the importance of luck). Things could easily have gone much different. However, I do not doubt that the fact that monetary conditions were excessive loose played a key role both in the case of Iceland and in the Baltic States. I have since come to realise that moral hazard among investors undoubtedly played a key role in these bubbles. But most of all my conclusion is that the formation of bubbles is a complicated process where a number of factors play together to lead to bubbles. At the core of these “accidents”, however, is a chain of monetary policy mistakes.

What is bubbles? And do they really exist? 

If one follows the financial media one would nearly on a daily basis hear about “bubbles” in that and that market. Hence, financial journalists clearly have a tendency to see bubbles everywhere – and so do some economists especially those of us who work in the financial sector where “airtime” is important. However, the fact is that what really could be considered as bubbles are quite rare. The fact that all the bubble-thinkers can mention the South Sea bubble or the Dutch Tulip bubble of 1637 that happened hundreds years ago is a pretty good illustration of this. If bubbles really were this common then we would have hundreds of cases to study. We don’t have that. That to me this indicates that bubbles do not form easily – they are rare and form as a consequence of a complicated process of random events that play together in a complicated unpredictable process.

I think in general that it is wrong to see any increase in assets prices that is later corrected as a bubble. Obviously investors make mistakes. We after all live in an uncertain world. Mistakes are not bubbles. We can only talk about bubbles if most investors make the same mistakes at the same time.

Economists do not have a commonly accepted description of what a bubble is and this is probably again because bubbles are so relatively rare. But let me try to give a definitions. I my view bubbles are significant economic wide misallocation of labour and capital that last for a certain period and then is followed by an unwinding of this misallocation (we could also call this boom-bust). In that sense communist Soviet Union was a major bubble. That also illustrates that distortion of  relative prices is at the centre of the description and formation of bubbles.

Below I will try to sketch a monetary based theory of bubbles – and here the word sketch is important because I am not actually sure that there really can be formulated a theory of bubbles as they are “outliers” rather than the norm in free market economies.

The starting point – good things happen

In my view the starting point for the formation of bubbles actually is that something good happens. Most examples of “bubbles” (or quasi-bubbles) we can find with economic wide impact have been in Emerging Markets. A good example is the boom in the South East Asian economies in the early 1990s or the boom in Southern Europe and Central and Eastern European during the 2000s. All these economies saw significant structural reforms combined with some kind of monetary stabilisation, but also later on boom-bust.

Take for example Latvia that became independent in 1991 after the collapse of the Soviet Union. After independence Latvia underwent serious structural reforms and the transformation from planned economy to a free market economy happened relatively fast. This lead to a massively positive supply shock. Furthermore, a quasi-currency board was implemented early on. The positive supply shock (which played out over years) and the monetary stabilisation through the currency board regime brought inflation down and (initially) under control. So the starting point for what later became a massive misallocation of resources started out with a lot of good things happening.

Monetary policy and “relative inflation”

As the stabilisation and reform phase plays out the initial problems start to emerge. The problem is that the monetary policies that initially were stabilising soon becomes destabilising and here the distinction between “demand inflation” and “supply inflation” is key (See my discussion decomposion demand and supply inflation here). Often countries in Emerging Markets with underdeveloped financial markets will choose to fix their currency to more stable country’s currency – for example the US dollar or in the old days the D-mark – but a policy of inflation targeting has also in recent years been popular.

These policies often succeed in bringing nominal stability to begin with, but because the central bank directly or indirectly target headline inflation monetary policy is eased when positive supply shocks help curb inflationary pressures. What emerges is what Austrian economists has termed “relative inflation” – while headline inflation remains “under control” demand inflation (the inflation created by monetary policy) increases while supply inflation drops or even turn into supply deflation. This is a consequence of either a fixed exchange rate policy or an inflation targeting policy where headline inflation rather than demand inflation is targeted.

My view on relative inflation has to a very large extent been influenced by George Selgin’s work – see for example George’s excellent little book “Less than zero” for a discussion of relative inflation. I think, however, that I am slightly less concerned about the dangers of relative inflation than Selgin is and I would probably stress that relative inflation alone can not explain bubbles. It is a key ingredient in the formation of bubbles, but rarely the only ingredient.

Some – George Selgin for example (see here) – would argue that there was a significant rise in relatively inflation in the US prior to 2008. I am somewhat skeptical about this as I can not find it in my own decompostion of the inflation data and NGDP did not really increase above it’s 5-5.5% trend in the period just prior to 2008. However, a better candidate for rising relative inflation having played a role in the formation of a bubble in my view is the IT-bubble in the late 1990s that finally bursted in 2001, but I am even skeptical about this. For a good discussion of this see David Beckworth innovative Ph.D. dissertation from 2003.

There are, however, much more obvious candidates. While the I do not necessarily think US monetary policy was excessively loose in terms of the US economy it might have been too loose for everybody else and the dollar’s role as a international reserve currency might very well have exported loose monetary policy to other countries. That probably – combined with policy mistakes in Europe and easy Chinese monetary policy – lead to excessive loose monetary conditions globally which added to excessive risk taking globally (including in the US).

The Latvian bubble – an illustration of the dangers of relative inflation

I have already mentioned the cases of Iceland and the Baltic States. These examples are pretty clear examples of excessive easy monetary conditions leading to boom-bust. The graph below shows my decompostion of Latvian inflation based on a Quasi-Real Price Index for Latvia.

It is very clear from the graph that Latvia demand inflation starts to pick up significantly around 2004, but headline inflation is to some extent contained by the fact that supply deflation becomes more and more clear. It is no coincidence that this happens around 2004 as that was the year Latvia joined the EU and opened its markets further to foreign competition and investments – the positive impact on the economy is visible in the form of supply deflation. However, due to Latvia’s fixed exchange rate policy the positive supply shock did not lead to a stronger currency, but rather to an increase in demand inflation. This undoubtedly was a clear reason for the extreme misallocation of capital and labour in the Latvian economy in 2005-8.

The fact that headline inflation was kept down by a positive supply shock probably help “confuse” investors and policy makers alike and it was only when the positive supply shock started to ease off in 2006-7 that investors got alarmed.

Hence, here a Selginian explanation for the boom-bust seems to be a lot more obvious than for the US.

The role of Moral Hazard - policy makers as “cheerleaders of the boom”

To me it is pretty clear that relative inflation will have to be at the centre of a monetary theory of bubbles. However, I don’t think that relative inflation alone can explain bubbles like the one we saw in the Latvia. A very important reason for this is the fact that it took so relatively long for investors to acknowledge that something wrong in the Latvian economy. Why did they not recognise it earlier? I think that moral hazard played a role. Investors full well understood that there was a serious problem with strongly rising demand inflation and misallocation of capital and labour, but at the same time it was clear that Latvia seemed to be on the direct track to euro adoption within a relatively few years (yes, that was the clear expectation in 2005-6). As a result investors bet that if something would go wrong then Latvia would probably be bailed out by the EU and/or the Nordic governments and this is in fact what happened. Hence, investors with rational expectations rightly expected a bailout of Latvia if the worst-case scenario played out.
The Latvian case is certainly not unique. Robert Hetzel has made a forcefull argument in his excellent paper “Should Increased Regulation of Bank Risk Taking Come from Regulators or from the Market?” that moral hazard played a key role in the Asian crisis. Here is Hetzel:

“In early 1995, the Treasury with the Exchange Stabilization Fund, the Fed with swap accounts, and the IMF had bailed out international investors holding Mexican Tesobonos (Mexican government debt denominated in dollars) who were fleeing a Mexico rendered unstable by political turmoil. That bailout created the assumption that the United States would intervene to prevent financial collapse in its strategic allies. Russia was included as “too nuclear” to fail. Subsequently, large banks increased dramatically their short-term lending to Indonesia, Malaysia, Thailand and South Korea. The Asia crisis emerged when the overvalued, pegged exchange rates of these countries collapsed revealing an insolvent banking system. Because of the size of the insolvencies as a fraction of the affected countries GDP, the prevailing TBTF assumption that Asian countries would bail out their banking systems suddenly disappeared.”

I would further add that I think policy makers often act as “cheerleaders of the boom” in the sense that they would dismiss warnings from analysts and market participants that something is wrong in the economy and often they are being supported by international institutions like the IMF. This clearly “helps” investors (and households) becoming more rationally ignorant or even rationally irrational about the “obvious” risks (See Bryan Caplan’s discussion of rational ignorance and rational irrationality here.)

Policy recommendation: Introduce NGDP level targeting

Yes, yes we might as well get out our hammer and say that the best way to avoid bubbles is to target the NGDP level. So why is that? Well, as I argued above a key ingredient in the creation of bubbles was relative inflation – that demand inflation rose without headline inflation increasing. With NGDP level targeting the central bank will indirectly target a level for demand prices – what I have called a Quasi-Real Price Index (QRPI). This clearly would reduce the risk of misallocation due to confusion of demand and supply shocks.

It is often argued that central banks should in some way target asset prices to avoid bubbles. The major problem with this is that it assumes that the central bank can spot bubbles that market participants fail to spot. This is further ironic as it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles. Further, if the central bank targets the NGDP level then the potential negative impact on money velocity of potential bubbles bursting will be counteracted by an increase in the money supply and hence any negative macroeconomic impact of the bubble bursting will be limited. Hence, it makes much more sense for central banks to significantly reduce the risk of bubbles by targeting the NGDP level than to trying to prick the bubbles.NGDP targeting reduces the risk of bubbles and also reduces the destabilising impact when the bubbles bursts.

Finally it goes without saying that moral hazard should be avoided, but here the solutions seems to be much harder to find and most likely involve fundamental institutional (some would argue constitutional) reforms.

But lets not worry too much about bubbles

As I stated above the bubbles are in reality rather rare and there is therefore in general no reason to worry too much about bubbles. That I think particularly is the case at the moment where overly tight monetary policy rather overly loose monetary policy. Furthermore, contrary to what some have argued the introduction – which effective in the present situation would equate monetary easing in for example the US or the euro zone – does not increase the risk of bubbles, but rather it reduces the risk of future bubbles significantly. That said, there is no doubt that the kind of bailouts that we have see of certain European governments and banks have increased the risk of moral hazard and that is certainly problematic. But again if monetary policy had follow a NGDP rule in the US and Europe the crisis would have been significantly smaller in the first place and bailouts would therefore not have been “necessary”.

——

PS I started out mentioning the possible bursting of the Chinese property bubble. I have no plans to write on that topic at the moment, but have a look at two rather scary comments from Patrick Chovanec:

“China Data, Part 1A: More on Property Downturn”
“Foreign Affairs: China’s Real Estate Crash”

 

 



Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

It’s Sunday night in Copenhagen and I have just returned from a trip to Dubai. I should really write a long post about Dubai, but I will keep it short.

Dubai really reminded me of Iceland – in the sense that both places should NOT really have seen the bubbles we saw. Both Dubai and Iceland had a property market boom, but one can hardly say that there is any serious supply constrains in either Dubai or Iceland. Both Dubai and Iceland seem simply to be “unreal” – or at least that was the case in the boom years.

To me it is pretty clear that we had a bubble in both places and the bubbles have now busted. But why did we have bubbles in Iceland and Dubai? Well, the easy answer is easy money, but I think that that explanation is too simple. And was it local monetary policy or was it US monetary policy that was too easy?

Fundamentally I think that moral hazard played a large role in both Iceland and Dubai – and guess what, both Iceland and Dubai have been bailed out by better off cousins – in the case of Iceland primarily by the other Nordic governments and in the case of Dubai by the big bother in the UEA – Abu Dhabi. But then why did we not have bubbles in other places where the risk of moral hazard was equally big? Again I like to stress that one should never underestimate the importance of luck or the opposite and this is probably also the explanation this time around.

However, Dubai made me think that Market Monetarists really need to take the issues of it bubbles serious. Market Monetarists disagree on this issue. Scott Sumner tends downplay the risk of bubbles – or rather that monetary policy cannot do much to avoid bubbles (other than target NGDP). David Beckworth on the other hand has done interesting work with George Selgin on why overly loose monetary policy might lead to misallocation. My own position is that I used to think that it mostly was easy monetary policy that was to blame and that is what led me – in my day-job – to warn against boom-bust in Iceland and Central and Eastern Europe in 2006-7. I have since come to think that moral hazard also play a role in this, but I am now returning to the monetary issue. However, while I think overly easy monetary policy led to misallocation in Iceland and Dubai and I am not really sure that that is the case in the US as NGDP never really increased above it’s Great Moderation trend prior to the outbreak of the Great Recession in 2008. That might, however, be due to measurement problems and other measures nominal spending seem to indicate that monetary policy indeed was too loose prior to 2008.

So what kind of model can explain the kind of bubbles we saw in for example the Baltic economies in 2004-8? And here I return to David Eagle – an economist whose work has not been fully appreciated, but I have been trying to change that recently.

David’s starting point is an Arrow-Debreu (A-D) model in which he analyse the impact of changes in nominal spending on the economy and on allocation. Furthermore, David uses his model(s) to analyse how different monetary policy rules – NGDP targeting, Price level targeting and inflation targeting – influence allocation (including lending).

David mostly has used his theoretical set-up to look at the impact of negative shocks to NGDP, but my thesis is that David’s model set-up might be useful in analysing what went wrong in Iceland and Dubai – and In Central and Eastern Europe and Southern Europe for that matter. It should be noted that NGDP outgrew its prior trends in the “boom” years – contrary to the situation in the US.

I have not looked at this formally, but here is the idea. We have an A-D model, we introduce sticky prices and wages and a central bank with an inflation target (as Iceland have). Most of the economies that have had boom-bust have seen some kind of structural reforms that have led to positive supply shocks – for example banking reform in Iceland and a general opening of the economies in Central and Eastern Europe – or believe it or not euro membership for countries like Spain and Greece.

What happens in Eagle’s set-up? I have not done the math, but here is my intuition. A positive supply put downward pressure on prices and with the central bank targeting inflation the central bank will ease monetary policy – as inflation is inching down. In Eagle’s model this will lead an (in-optimal?) increase in lending. This increase in lending will last as long as the positive supply shocks continues. However, once the shocks come to an end then the process is reversed – and this is when the “bubble” burst (yes, yes this is somewhat beyond that scope of David’s model, but bare with me…). This by the way is very similar to what George Selgin and David Beckworth have suggested for the US economy, but I think this discussion is much more relevant for Dubai, Iceland and the Baltic States (or the the PIIGS for that matter) than for the US.

Again, I have not gone through this formally with David Eagle’s model set-up, but I think it could be a useful starting point to get a better understanding of the boom-bust in Iceland, Dubai and other places. That said I want also to stress the extent of the present global crisis is not a result of bubbles bursting (that might however been the crisis started), but rather too tight monetary policy is to blame for the crisis. David Eagle’s framework can also easily explain this.

——

PS I should really write something about the euro crisis, but lets just remind people that I think that we are in 1931. By the way the UK left the gold standard in 1931 and the Scandinavian countries followed the lead from the UK. Germany, France, Austria and other continental European countries stayed on the gold standard. We all remember how that story ended. Oddly enough the monetary faultline is more or less the same this time around. Why should we expect a different outcome this time around?

Capital controls are always wrong – also in Iceland

I have long had a interest in the Icelandic economy and my views on the Icelandic boom-bust are well know.

Iceland has come quite well through the crisis – and there is a moderate recovery underway in the economy and the debt situation has clearly been stabilised. However, there is one area where I continue to see a serious problem and that this capital controls. In the wake of the crisis the IMF more or less forced the Icelandic government to introduce draconian capital controls.

Now two Icelandic economists Ragnar Arnason and Jon Danielson have written a excellent comment on the website Voxeu.org about the capital control. You should read the comment for yourself, but here is a bit of the conclusion:

“Thus, in our view, the imposition of capital controls was both unnecessary and unjustified. Without them, the exchange rate might have temporarily fallen even further in a worst case scenario, in which case a surgical intervention in the form of a temporary tax on short capital outflows would have been a sufficient policy response. 

Instead, the IMF forced the Icelandic government to impose draconian capital controls of a type last seen in developed economies in the 1950s, causing significant short-term and long-term economic damage. The capital controls were initially touted as a temporary measure, but now three years after the event it looks like they are there to stay, and as the domestic economy adapts to their presence, they will be increasingly costly to abolish. After all, the last time Iceland imposed capital controls in the 1930s, they lasted until 1993.

The capital controls have resulted in an intrusive licensing regime, with government permission required for foreign travel and those emigrating prevented from taking their assets with them. Both are direct violations of the civil rights of Icelandic citizens and Iceland’s international commitments as a democratic European country.

Our hope is that other countries facing a similar situation will have the good fortune of receiving better advice from the IMF.”

Lets just say it as it is – I agree with every single word.

 

The “China Bluff”

Nick Rowe has a short comment on the news that EU’s rescue fund the European Financial Stability Facility (EFSF) will try to tempt China to put money into the rescue fund by issuing bonds in Euros.

It is hard to disagree with Nicks’ comment: “The whole Eurozone problem is that each Eurozone country was issuing bonds in what was effectively a foreign currency, and so it lacked an effective lender of last resort. Now, if the Telegraph is correct, the Eurozone as a whole is planning to repeat the mistake, and become just like Greece.”

But that is not really what I want to comment on, but rather Nick’s comment reminded me about what we could call the “China bluff”. Since 2008 every time a bank or a country gets into serious trouble and is on the brink of collapse a CEO or Finance Minister or even a Prime Minister will say that some wealthy investor will soon throw money into the “project”. Most often these promises of “new money” coming in turn out to be far fetched fantasies.

The Icelandic collapse in 2008 maybe the most stunning example of the “China bluff”. At that time it was not China, but rather Russia that would come to the rescue of Iceland and the Icelandic banking sector. As the entire Icelandic financial system was collapsing suddenly Icelandic officials announced that Russia would step in with a loan to help Iceland and judging from the comments one was led to think that the Russian government already had agreed to a substantial loan to Iceland. However, the whole thing turned out to be a “China bluff” – an attempt by official to turn around market sentiment by promising that a wealthy investor would save the day. We all today know that Iceland had to call in the help of the Nordic countries and the IMF to avoid a default – Russian money was nowhere to be seen.

My recommendation to investors and the like is therefore that every time an embattled bank or nation “promises” money from China, Russia or the Middle East be skeptical…VERY SKEPTICAL. It might just be the China bluff.
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Update: Marcus Nunes also has a comment on the EFSF-China story.

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