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.