Banks on Ice
by Fred E. Foldvary, Senior Editor, 23 May 2011
The people of Iceland said “no” to bailing out the country’s banks. And Iceland is still here.The Icelandic banks were not able to service and pay back their debts. The banks had borrowed funds in order to buy up foreign financial firms. The people were then told that the country’s banks were too big to fail. That there would be an economic catastrophe if the banks were not rescued. But they said “no” to austerity to pay off the bank debts. And Iceland abides.
The people of Iceland refused to bail out the international banks and the European Union. The governments of the UK and Netherlands had covered the losses of British and Dutch speculators, who had lost $5.8 billion in the Iceland in 2008. The British and Dutch governments said that repayment by Iceland was required for Iceland to join the European Union.
On April 9, 2011, the government of Iceland put the issue of the bailout to a referendum. The answer was, no. There had been a previous vote in 2009 in which 93 percent of the voters in Iceland rejected a guarantee for the foreign deposits in Iceland’s banks.
The losses of the banks of Iceland were several times the annual income of Iceland, far too great for its taxpayers to bear. But the banks of Iceland were not too big to fail; rather, they were too big to succeed.
When the big banks fail, credit is no longer available to enterprises, yet the country did not ice up. The credit rating of Iceland was downgraded, but business goes on. The growth rate of Iceland is expected to be 2.5 percent. In contrast, Ireland has sought to impose its bank debt on the taxpayers, replacing bank debt with government debt, and its economy is doing worse than in Iceland. The government of Ireland is draining the country of resources so it can bail out its banks, while Iceland, free of debt, is recovering well.
When the US financial system crashed in 2008, many of the failed mortgage-backed securities were held by foreigners. The US government depends on foreigners to buy up over half of its annual deficit, and it feared that foreigners would not buy US Treasury bonds if they lost their holdings of American mortgage derivatives, especially those of Fannie Mae and Freddie Mac. So the US bailout of its banks, government-sponsored enterprises, brokerage firms, and insurers such as AIG were to a great degree a desire to maintain the foreign purchase of government bonds.
Financial players had a hint of the troubles to come when the bonds of Iceland were paying high interest, around 12 percent, prior to the crash. The big lenders should have been sophisticated enough to see the crash coming. They speculated that Iceland’s government would cover the bank’s losses. Money poured into Iceland to get the high interest. The inflow of money overvalued Iceland’s currency, the krona.
Iceland has since then benefited from the devaluation of the krona, relative to the US dollar and the euro. Iceland did go into a recession in 2008, and obtained a loan from the IMF to stabilize the falling krona. Now the economy is recovering. The foreign lenders will get back a small fraction of what they loaned.
A loan is a contract, and borrowers have the moral obligation to pay back their debts, unless there is a clause in the contract, or a governmental law, enabling the borrower to walk away, in which case the lender should understand that risk. The contract should only bind the borrower, not others. When a government guarantees the bank deposits or the loans, then the government becomes a party to the loan, and that creates “moral hazard,” the incentive by the lender to take on greater risk. Banks would not make such risky loans and speculations if they knew that government would not bail them out.
The US government should learn a lesson from its own experience and that of Iceland. The GSEs Fannie Mae and Freddie Mac should be completely privatized. The US government should cease to insure bank deposits -- let the banks get private insurance. The US government should stop subsidizing and providing backing and guarantees for mortgages.
Economists learned the wrong lessons from the trauma of the Great Depression. The superficial remedy for bank failures is for government to step in an guarantee the deposits. But the better policy is to prevent the depression, and also to prevent the moral hazard that induces banks to take on excessive risk.
The great cause of depressions is massive subsidies to real estate. The monetary subsidy can be eliminated with free-market banking, letting the money supply and interest rates be set by the market. The fiscal subsidy can be prevented with land-value taxation, by which landowners would repay to government the gains they receive from public works and civic services. With free banking and land-value taxation, the boom-bust cycle would cease to exist. Banks could still make bad loans, but speculator would know that they, not the taxpayers, will bear any losses, and random bad loans would not bring down the economy.
The voters of Iceland have defied authority, and perhaps that will inspire others to make speculators responsible for their own losses.
-- Fred Foldvary
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Copyright 2010 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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Also see: The Resource Curse has been Broken by some
Bank failures in 3 months = all of 2008
Why Pay the Privileged our Public Money? |
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