Iceland shows that debt forgiveness under Swedish model leads to best recovery

Bloomberg ran an excellent article on Iceland confirming that adopting the Swedish model for handling a bank solvency led financial crisis results in recovery (as oppose to the Japanese model which results in prolonged economic decline).

Regular readers know that under the Swedish model banks absorb the losses on the excesses in the financial system today.  These excesses are the total of all the debt that excedes the borrower's capacity to repay.

By writing off all of this debt today, the banks protect the real economy.

Icelanders who pelted parliament with rocks in 2009 demanding their leaders and bankers answer for the country’s economic and financial collapse are reaping the benefits of their anger. 

Since the end of 2008, the island’s banks have forgiven loans equivalent to 13 percent of gross domestic product, easing the debt burdens of more than a quarter of the population, according to a report published this month by the Icelandic Financial Services Association. 

“You could safely say that Iceland holds the world record in household debt relief,” said Lars Christensen, chief emerging markets economist at Danske Bank A/S in Copenhagen. 

“Iceland followed the textbook example of what is required in a crisis. Any economist would agree with that.”

While your humble blogger agrees that Iceland is doing what is required in a crisis, I see very little evidence that 'any' economist would agree beyond Patrick Honohan and Joseph Stiglitz.

The island’s steps to resurrect itself since 2008, when its banks defaulted on $85 billion, are proving effective. 

Iceland’s economy will this year outgrow the euro area and the developed world on average, the Organization for Economic Cooperation and Development estimates. It costs about the same to insure against an Icelandic default as it does to guard against a credit event in Belgium. 

Most polls now show Icelanders don’t want to join the European Union, where the debt crisis is in its third year. 

Remember, the EU chose the Japanese model with its focus on protecting bank book capital levels.  As a result, the bad debt is still in the banking system and the real economy is spiraling down under the weight of the excess debt.

The island’s households were helped by an agreement between the government and the banks, which are still partly controlled by the state, to forgive debt exceeding 110 percent of home values. On top of that, a Supreme Court ruling in June 2010 found loans indexed to foreign currencies were illegal, meaning households no longer need to cover krona losses.

“The lesson to be learned from Iceland’s crisis is that if other countries think it’s necessary to write down debts, they should look at how successful the 110 percent agreement was here,” said Thorolfur Matthiasson, an economics professor at the University of Iceland in Reykjavik, in an interview. “It’s the broadest agreement that’s been undertaken.”  

Without the relief, homeowners would have buckled under the weight of their loans after the ratio of debt to incomes surged to 240 percent in 2008, Matthiasson said....

Please re-read the highlighted text as it confirms why the real economy must be protected from the excesses in the financial system.

Iceland’s approach to dealing with the meltdown has put the needs of its population ahead of the markets at every turn.

Once it became clear back in October 2008 that the island’s banks were beyond saving, the government stepped in, ring-fenced the domestic accounts, and left international creditors in the lurch. The central bank imposed capital controls to halt the ensuing sell-off of the krona and new state-controlled banks were created from the remnants of the lenders that failed. 

Activists say the banks should go even further in their debt relief. Andrea J. Olafsdottir, chairman of the Icelandic Homes Coalition, said she doubts the numbers provided by the banks are reliable. 

“There are indications that some of the financial institutions in question haven’t lost a penny with the measures that they’ve undertaken,” she said. 

According to Kristjan Kristjansson, a spokesman for Landsbankinn hf, the amount written off by the banks is probably larger than the 196.4 billion kronur ($1.6 billion) that the Financial Services Association estimates, since that figure only includes debt relief required by the courts or the government....

This demonstrates one of the reasons that banks must be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this disclosure, market participants could confirm that loans had been written down.

According to Christensen at Danske Bank, “the bottom line is that if households are insolvent, then the banks just have to go along with it, regardless of the interests of the banks.”

The real bottom line is the banks have to go along with absorbing the losses on the excesses in the financial system regardless of the interests of the bankers.