Everyone thinks that we needed to bail out the failing U.S. banks lest they collapse and, in their collapse, take down both the U.S. economy and the international economy, plunging the world into a new Great Depression and (potentially) a new Dark Age.
As it turns out, maybe not. Ásgeir Jónsson explains that Iceland allowed their banks to collapse for the simple reason that they couldn’t afford to bail them out and no one else was interested in taking on the job. Today, Iceland’s economy is growing and Iceland’s banks are healthy once again.
Three years ago, Iceland forced its over-leveraged financial sector into a painful debt restructuring instead of bailing out its banks. The government had no other choice: Icelandic banks' assets totalled roughly 1,000% of GDP, and in the world's smallest currency area, no less. The central bank could not take on the role of lender of last resort without igniting a currency crisis.
Critics dubbed this response disastrous, and Iceland served as the cautionary tale of an "Icarus economy" whose banks had grown too big to save.
I remember this. I distinctly remember being in a doctor’s office, reading an article about the Icelandic economy, the massive levels of money in the banks, and the complete inability of the government to deal with the looming crisis. The tone of the article (probably in either Time or Newsweek) was apocalyptic.
Instead, we see now that Iceland and its banks both recovered. The medicine of bankruptcy didn’t taste good but it worked.
It is becoming clearer by the day that too many of Europe's banking crises were initially misdiagnosed as liquidity, rather than solvency, problems. For some countries, most notably Ireland, the policies prescribed for that misdiagnosis have transformed banking crises into sovereign-debt crises.
Europe's bailout path has only diverted ever-more resources to failing enterprises, postponing and deepening the problem. Iceland's restructuring was both painful and costly for the population, but the government did not throw good money after bad, and the taxpayers were spared a nationalization of private debts. Is it any wonder that forward-looking financial markets are now betting on the Icelandic recovery?
It’s hard not to think that we’d be in a better place if we’d done the same thing.