Milton and the Meltdown in Iceland
I was intrigued by what is happening in Iceland, so the following is a piece I’ve written on it.Â It has some introductory macro-economics in it,Â which I think it is good to keep in perspective as we consider the frantic attempts being made to prevent an economic depression.
The economic and financial collapse of 2008 is shaping up to be a real life testing ground for the two titanic theories of 20th century economics: those of John Maynard Keynes on one hand and Milton Friedman on the other and their respective followers.
Keynes’s real analysis was more complicated and nuanced, but his main work, the General Theory of Employment, Interest and Money, provided a theoretical basisÂ for the New Deal policies of deficit spending and investments in public works that helped countries recover from the Great Depression.
While Keynes certainly didn’t dismiss the role of monetary policy in countering an economic downturn, some of his followers (notably 2008 Nobel Economics prize winner Paul Krugman in relation to Japan) highlighted the possibility of a “liquidity trap” making reliance on traditional monetary policies, such as cutting interest rates, ineffective.
Milton Friedman, in his Monetary History of the United States, argued that the Great Depression was primarily caused by negligence on the part of monetary authorities such as the U.S. federal reserve, who didn’t do enough to counter an ordinary financial shock and bank failures by expanding the money supply.
Keynes’s theories, though often misapplied, provided the foudnation for much macroeconomic theory and policies in the capitalist world from the 1930s until the late 1970s when the oil-price shock and stagflation hit.
Friedman’s economic views about restricting the role of government, cutting taxes, low inflation, deregulation, privatization and the benefits of free markets spearheaded a reaction against Keynesianism and have considerably defined economic policy since the 1980s.Â While his narrow form of money supply monetarism was quickly abandoned in the early 1980s, most governments have relied primarily on monetary tools instead of fiscal toolsÂ for their macroeconomic policiesÂ over theÂ past few decades.Â Â
Alan Greenspan, former head of the U.S. federal reserve, had no particular expertise in economics, but was a disciple of libertarian Ayn Rand and an advocate of Friedman’s economic policies, including tax cuts and deregulation.Â He is widely considered to share the blame for creating the conditions that resulted in the current economic collapse.
Greenspan’s successor as chair of the federal reserve, Ben Bernanke, is also a follower of Friedman, but is an accomplished economist and interestingly enough an expert in the economics of the Great Depression.Â Although his focus has been on other issues, such as the importance of credit markets, he has stated that the federal reserve was responsible for causing the Great Depression and making banking panics during it “much more severe and widespread.”Â
Bernanke is now one of the people in charge of what is probably the most expensive experiment in human history, with a cost of well-over $1 trillion to the U.S. Treasury alone and rising.Â (This leaves the cost of the $6 billion CERN large hadron collider far behind in the microscopic dust).
Although we are in the midst of them, it appears that these experiments inspired by Friedmanite economics are not meeting with much success.Â Â Each action taken by the U.S. Treasury and federal reserve until mid-October was metÂ with a further decline in stock prices.Â Stock markets did not start to recover until much more aggressive action was taken by European nations, including effective nationalization of major banks, and then followed by the U.S.Â Â This is far beyond what Friedman and his followers would have advocated.
What does this all have to do with tiny Iceland, one of the most physically isolated countries in the world with a population of only 320,000?
Iceland–better known for its geothermal hot springs, abundant fish, all-night raves, and eclectic musicians suchÂ as BjÃ¶rk and Sigur RÃ³s–quickly became the first and foremost casualty of this economic and financial meltdown.Â The country is now essentially bankrupt after taking over its three major banks to prevent them from failing.Â These banks owe more than $60 billion overseas, about six times the value of Iceland’s annual economic output.Â As a professor at London School of Economics said, “No western country in peacetime has crashed so quickly and so badly.”Â
This made me wonder: what on earth happened to get Iceland and its banking sector into such a state?
It turns out that Iceland, despite its coalition governments and Nordic social mores, became a poster child for Friedmanite economic policies from the 1990s on.Â Friedman himself visited Iceland in 1984 and participated in a lively television debate with leading Socialists.Â He inspired a generation of young conservative intellectuals in Iceland who came to power in 1991 through the Independence party and have run the government through different coalitions since then.
Under Prime Minister David Oddsson and explicitly inspired by Friedman, they implement a radical (but now familiar) program of privatization, tax cuts, reductions in spending and deficits, inflation control and targeting, central bank independence, free trade and exchange rate flexibility.Â Corporate taxes were cut from aÂ rate of 50% down to 18%.Â Privatization and deregulation were driven directly through the Prime Minister’s office and the major banks were privatized early this decade.Â
At first, the policies seemed to be very successful.Â The economy grew at a strong pace, rising until Iceland achieved one of the highest per capita GDPs in the world.Â In 2007Â it also topped the score for the UN’s Human Development Index.
IcelandÂ rocketed up to the top ten rank in the indexes of economic freedom designed by the Fraser Instittue and the Heritage Foundation.Â It was lauded by the conservative Cato Institute for its flat taxes, privtaization and economic freedoms–and Naomi Klein was criticized forÂ not mentioning itÂ (along with Ireland, Estonia and Australia) as an example of the success of Friedmanite economic policies.Â
Icelandic banks and businesses, with the support of their government, expanded aggressively overseas, particularly into the U.K. and the Netherlands. The banking industry and private businesses flourished and created a number of billionaires on theÂ island.
Â Then it all came crashing down.
Short-term interest rates and inflation have both hit 14% and the country’s currency has lost half of its value.Â As a result of its economic and financial meltdown, iceland now has an external debt equivalent to about $200,000 per person with virtually no prospect of repaying it.
This wasn’t caused by the U.S. subprime crisis or by what is happening at the former centre of free market capitalism on Wall Street, but instead by the same Friedmanite free market policies being applied in one of the smallest countries in the world.
What is somewhat incredible is the apparent lack of remorse or self-reflection and doubt being expressed by the ideologues who put these policies in place and caused this economic and financial meltdown.Â Amazingly, many neo-cons continue to argue that this was caused by regulations that were too strong, or by a confluence of unlikley events, including a rise in “leftist attitudes“.
There seems to be a belief among many that a financial market bailout will soon relieve the credit crunch caused by the subprime fiasco and then we can go back to business-as-usual.Â We don’t need to look too far back in time or too far abroad to see how misguided that view is.