Creative Destruction: Evidence?

Can Iceland's success be replicated? Its people are known for their resilience on this harsh isle.

Iceland has gone against the orthodoxy and weathered the financial storm arguably better than those who saved their banks. But is this one example enough to convince that Iceland’s measures are a one size fits all?

Iceland is a much smaller country than many others who experienced the brunt of the financial crisis; Ireland’s population is 14 times that of Iceland’s. However, “relative to the size of its economy, Iceland’s systematic banking collapse is the largest experienced by any country in economic history” (The Economist, 2008). This point takes some of the integrity away from arguments that Iceland’s crisis was more easily absorbed by its population given its relevant size.

A fundamental difference between Iceland and other crisis stricken countries in the EU such as Ireland was the autonomy of macroeconomic policy making. While Ireland bailed out its banks, it was unable to use monetary policy to aid in recovery. In contrast, Iceland was able to inflate its money supply to pay for debts incurred in addition to enacting capital controls to prevent capital flight. Additionally, although both countries have huge debt, Iceland’s is not being repaid to promote a voracious banking system.

However, this came at some major costs for Iceland. Its savings and purchasing power have taken a substantial hit as inflation reached a high of 20% in 2009. Ireland on the other hand has given its citizens a lower cost of living and an increase in purchasing power. Furthermore, its capital controls have induced stagnant FDI levels.

OECD (2012)

Nevertheless, Iceland’s indicators are on the rise while Ireland and others remain uneasy; Iceland has recovered from 10 quarters of shrinking GDP to experience 7 quarters of growth . Yet there is not enough to promote Iceland’s policies just yet; some say Iceland's remarkable recovery is simply down to the hardiness of its people.

Overall, it seems apparent that it may be too unrealistic to think a solution to the banking crisis could come in such a simple way – through creative destruction. To allow this would be a victory of ideology over pragmatic common sense. That said it is important to acknowledge that this pragmatic position ignores externalities over time; the long-term costs of propping up large banks (Mayer, 1975).

“At a time when devotion to pragmatism is so much in the air it is useful to consider also the benefits of sticking to one's principles even in hard cases.” (Mayer, 1975)

In general, the scale of the 2007/08 crisis is much too large. “…the flawed incentive structure, including the flaw resulting from too-big-to-fail--that have gotten us into this mess." (Stiglitz, 2009)

The next post will look at “too-big-to-fail” and how the bailout programs have arguably been misguided in really tackling the sector’s shortcomings. 

Bankruptcy: Creative Destruction?

Lehman, Iceland and Moral Hazard

We have previously examined how the banking system largely suppresses creative destruction. Governments have generally kept banks who are “too big to fail” alive when they face financial turmoil. Nevertheless, there are a few examples where banks were allowed to fail.

The Lehman Brothers is one of the most notable big bank failures. One of the world’s largest banks, it and its possible acquirers (Barclays) failed to receive financial aid to save the firm. However, this example does not represent some perfect free-market epiphany by the US government. Phillip Swagel details other problems with life support for Lehman which confirms this. In fact, Henry Paulson and the Treasury were actually pushing for Lehman to be saved, but British regulators inflicted the final blow by blocking such action.

Lessons from Iceland

Iceland is a prime proponent to some form of creative destruction. They refused to bailout the banks and furthermore, did not hold back on indicting those responsible of financial crime. Following the crisis, Iceland’s indicators were much more positive than fellow victims of the crisis, such as Ireland, who did bailout their banks.

“Why are the banks considered to be the holy churches of the modern economy? Why are private banks not like airlines and telecommunication companies and allowed to go bankrupt if they have been run in an irresponsible way?” Ólafur Ragnar Grímsson, President of Iceland

Iceland’s actions could have been viewed as madness but, evidently, there was some method behind this. Not only are bailouts a violation of free markets, they also create moral hazard. What is to stop banks from continuing to feed their appetite for risk if they know there is a safety net to catch them if they fail again? There is a catalogue of papers whose inferences indicate economically significant correlations between risk-taking and higher bailout belief; Kim, Y. (2013) and Dam, L. & Koetter, M. (2012) to name a few.

The Economist (2010)

The above graph is one such statistic that somewhat proves the worth of creative destruction. To verify this, we must ask what made Iceland so special, and why is this not a much more widely adopted method?

Failing Banks: A Question of Destruction

Danièle Nouy, Banks and Schumpeter

The global financial crisis has left governments, academics and the public with much consternation surrounding the economy, with particular concern on the banking industry. Many have voiced their angst that taxpayers’ money is being thrown at these banks who appear to have caused a great amount of destruction in our economy. However, we must remember that a strong financial system is a vital component of the modern world. That said, the banking system must address its shortcomings to regain credibility. This blog will take a look at what is being done to progress the system and assess whether – to exude real change – some creative destruction is required.

Let Weak Banks Fail

In the last week, Danièle Nouy, the new chief banking regulator of the ECB, stated that weak banks should be allowed to fail. The implication of this statement largely goes against government interventions of 2007/08 where many large banks that faced massive losses and/or imminent failure were subsequently bailed out.

The ECB’s statement shares some inferences with the theory of “Creative Destruction”, a term coined by the Austrian economist, Joseph Schumpeter, in his 1942 book, “Capitalism, Socialism and Democracy”. This phrase neatly describes a fundamental characteristic of capitalist economies: out with the old and in with the new. 

Abiding by pure Schumpeterian assessment of capitalist markets, these failing banks should be allowed to meet their demise. However, many would retort that this would be more likely to cause destructive destruction. Miss Nouy also conceded that “it’s not the best moment in the middle of the crisis to change the rules”. That said, the ECB and many others would agree that, in the long run, these rules must be changed; stricter regulations need to apply and more accountability must be incurred.

What Next?

The fact that banks are being bailed out so frequently suggests there needs to be major restructuring to the current model; there is capacity for creative destruction. So far, progress is centered on regulation and banking reform, but there is early evidence to suggest the answer lies in a greater form of change.