ē Philipp Bagus and David Howden, Deep Freeze Ė Icelandís Economic Collapse, Auburn, Ala Ludwig von Mises Institute, 2011, 125 pages, $12.00.
In this relatively short but highly illuminating book, economics professors Philipp Bagus and David Howden (both of whom are schooled in Austrian theory) explain the collapse of Icelandís economy in 2008. Why bother with the difficulties of that little nation (population 313,000) in the remote North Atlantic? The reason is that the Icelandic debacle stemmed from exactly the same governmental blunders that have caused so many other boom and bust cycles around the globe. Icelandís horrible recent experience has important lessons for Americans ó indeed for people everywhere.
The key insight of Ludwig von Mises was that artificial credit expansion initially will lead to a boom in certain sectors of the economy, but the boom cannot be sustained indefinitely. Once the artificial stimulus of cheap credit ends, the overexpanded sectors must contract. Workers must be released and overextended firms must go bankrupt. Government policies set this train of economic mistakes in motion and once itís going, they often propel it faster and faster. Bagus and Howden demonstrate that Icelandís collapse fits the Austrian theory of the business cycle perfectly.
Icelandís boom was rooted in a decision by the countryís central bank (the CBI) in 2001, proclaiming that it would act as lender of last resort for all Icelandic banks. That let loose the problem of moral hazard. Knowing that they could depend on the CBI to come to their rescue, commercial banks began to operate without much concern for the level of risk.
Making matters worse, the CBI also lowered reserve requirements for commercial banks, enabling them to make more loans from the same deposit base, and it drove down interest rates. Icelandic banks found that in order to compete among themselves, they had to undertake increasingly risky loans. Icelandic banks engaged in massive short-term borrowing around the world in order to finance long-term investments.
Much of that investment went into housing, just as was the case in America, aided by the governmentís Housing Finance Fund. The HFF was even worse than our atrocious mortgage twins, Fannie Mae and Freddie Mac. Bagus and Howden observe that while Fannie and Freddie had low mortgage standards, HFF had none at all. Everyone could get a low-cost mortgage. Residents splurged on luxury cars.
The prosperity bubble had other effects too, in particular, changes in the financial sector and the labor force. During the boom, many young people were drawn into banking and finance, which were ďhotĒ fields, and away from Icelandís traditional productive industries, especially fishing and related commerce. Bagus and Howden do an excellent job of driving home the vital point: Cheap credit distorts a nation in many ways.
In 2008, the air went out of the bubble, when foreigners realized that Icelandís currency was overvalued terribly. The inflow of cheap funds that the banks were hooked on stopped. The CBI tried to keep the party going, but that was (and should have been known to be) hopeless. The economic crash swept over the country like a tidal wave: defaults, foreclosures, abandoned projects, unemployment. At one point, hunger was even a real prospect until several Scandinavian governments made an emergency loan to Iceland so that food importers could pay for shipments.
By now, Icelandís severe turmoil has subsided and it is slowly adjusting back to normalcy, putting labor and capital back to profitable use. Many housing projects stand uncompleted; many of those luxury cars have been shipped off to bargain hunters elsewhere. The situation is akin to a once hard working individual who wagered his wealth on a big gamble, lived it up for a while on early winnings, but has now been wiped out and has to start over.
The authors end by explaining how nations can avoid the boom and bust cycle that did so much damage to Iceland: sound money and banking. Money needs to be based on gold. Banks must never be led to think that the government will cover their losses. The boom and bust cycle is not an inherent feature of laissez-faire, but instead is a bug planted by government bungling.