The success of fiscal austerity in Iceland (and the failure of Danish exchange rate policy)

In 2008 Iceland was hit by a massive banking crisis and the economy went into a tailspin. However, the Icelandic economy has since then recovered strongly and continues to grow robustly.

On the other hand Denmark, which was also hard hit by crisis in 2008 has essentially not recovered – at least not if we look at the level of GDP.

The graph below shows the development in real GDP in the five Nordic countries.

Nordic 5 RGDP

What do the two worst performers – Denmark and Finland – have in common? They are linked to the euro – Denmark through a pegged exchange rate regime and Finland as a member of the euro. On the other hand the three best performers Sweden, Iceland and Norway have floating exchange rate regimes.

But that is not really the story I want to tell. Rather I am interested in the importance of monetary policy in the impact on aggregate demand from fiscal policy. And here the difference between Iceland and Denmark is interesting.

The graph below shows the ‘fiscal impulse’ – measured as the %-point change in the structural budget deficit as share of GDP as measured by the IMF in Denmark and Iceland. A negative number is fiscal tightening.

Fiscal impulse

The graph shows the scale of fiscal tightening in Iceland – since 2010 fiscal policy has been tightened by accumulatively nearly 9% of GDP. By any measure this is a very sizable tightening of fiscal conditions. On the other hand there has been no fiscal tightening in Denmark – in fact there is been an accumulative easing of fiscal policy by nearly 1% of GDP in this period.

A lot of things of course explains the difference in growth in the Nordic countries, but I think that the anti-fiscal austerity crowd needs to explain how Iceland has been able to grow faster than any other Nordic country – with the exception of Sweden – while at the same time undertaking massive fiscal austerity.

The answer to me is clear – easing monetary policy has been extremely efficient in Iceland to offset the impact of fiscal austerity and this in my view clearly shows that monetary policy is far from impotent. Hence, you can easily undertake sizable budget consolidation without causing a recession if you have the right monetary policy regime in place.

PS Today it 10 years ago that the “Geyser Crisis”-report, which forecasted doom-and-gloom was published. I of course co-authored that report. It is fair to say the report changed my life.

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