Iceland vs Ireland

Both Iceland and Ireland had a very damaging banking crisis. In both countries, the banking system looked insolvent, rather than just liquidity issues (see: Insolvency and Liquidity) But, they are responding in different ways.

Iceland looks as if it has been able to survive its banking crisis by

• Devaluing the currency
• Letting a proportion of private bank debt fail.

In Ireland, the decision to underwrite all banking debt, led to a huge rise in government borrowing which has precipitated the bond crisis and necessity for harsh spending cuts. The Irish will be asking with much justification why the taxpayer is offering a blanket guarantee to bank investors, when a fairer and potentially less damaging solution would be to make bank investors accept certain losses.

Though this does raise another difference between Iceland and Ireland. Iceland could default on private bank debt without causing a ripple through the European banking system. If Irish banks defaulted on bank debt it would impact on many other European banks.

External vs Internal Devaluation

Whilst Iceland benefited from an external devaluation, Ireland - being a member of the Euro - is having to rely on the more painful process of internal devaluation. Internal devaluation relies on cutting wages and spending to try and regain competitiveness. Unfortunately, the experience of Latvia is not promising. In a nutshell, Latvia tried to retain their currency peg against the Euro, and relied on wage cuts and deflationary fiscal policy to try and regain competitiveness. The result is one of the biggest falls in GDP (-25%) on record. Yet, despite all the pain, unemployment and lower GDP, the real exchange rate has only fallen by 8%.

Related

• Problems of Internal devaluation
• Iceland vs Ireland at Guardian
• Saving and Austerity

Punishing the Banks

There is a great piece here by Kevin O'Rourke in a 'Letter from Ireland'

It is a heartfelt account of the tragedy of the Irish economic situation. It highlights the injustice of the seemingly unlimited bank bailout for those who precipitated the crisis. Yet, no matter how much we explain the cause of the crisis, it is the ordinary Irish voter who is facing the consequences of high unemployment, spending cuts and a fragile economy.

In France, Eric Cantona suggests a mass withdrawal of cash from French banks on December 7th. This will be about as helpful as asking Nicolas Sarkozy to play for the French football team, or asking Silvio Berlusconi to head an EU wide Ethics and morality committee.

The irony is that a mass withdrawal of cash could create a liquidity shortage, and the French government offering a bailout to the banks. I guess this would come from taxpayers who withdrew the cash. It certainly wouldn't hurt the bankers.

Economics is more concerned with the optimal distribution of resources that dealing with injustice. But, given the nature of the crisis, a rescue package should have, at least, shared the burden between taxpayer and banks. To offer an unlimited bailout for a banking system that is not just illiquid, but broke is wrong. The government could have made bond holders pay some of the cost.

The best way to learn from this banking crisis would be to put in place reforms which reduce the incentive for banks to get carried away with lending in a boom. Easier said than done, but there are some policies which would help. Bank Reforms

Related

• Bank Bonuses

German Exit of Euro?

Back in May, I wrote about the possible exit of Germany from the Euro. At one time, the idea of Germany leaving the Euro seemed far-fetched, but now many are weighing up the pros and cons (including the German Chancellor, Angela Merkel (according to Guardian article)

In 2011, Euro growth is forecast to be 1.5%. But, this growth is uneven. Boosted by soaring exports (15% growth in 2010) and investment, the German economy is looking robust. The peripheral areas, Greece, Spain, Ireland and Italy are all looking at a period of stagnant growth. I worry that even the feeble growth forecasts for Spain and Ireland may prove optimistic, given the policies that are being currently implemented.

I doubt Germany will leave the Euro because it would be an act of great political courage, that I can't see the EU having. But if, next year, Germany is required to bailout Spain's banks and government, it could prove to the last straw after Greece and Ireland.

If Germany leaves, (and it could possibly take some Benelux countries with it), it would be a visible two speed Europe, which many don't like the idea of. But, from all perspectives, we already have a two speed Europe. Trying to squeeze the whole of this Eurozone into a single monetary / fiscal policy will lead to continued difficulties.

• Consequences of leaving the Euro - BBC, Stephany Flanders

Amidst all the gloom of this bleak winter, it is reassuring to see some good news - a boost for British manufacturing - helped by Sterling devaluation and strong demand from oversees. A good example, of the time lags involved in depreciation.