Wednesday, December 8, 2010

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%.


No comments: