Saturday, August 25, 2012

Top economists agree that Iceland's choice of Swedish model is right way to deal with bank solvency led financial crisis

In a post on ZeroHedge, blogger George Washington documents how top economists agree that the Swedish model is the right choice for handling a bank solvency led financial crisis.

As regular readers know, since the beginning of the financial crisis your humble blogger has been pushing for adoption of the Swedish model.

Under the Swedish model banks are required to recognize and absorb the losses on the excess debt in the financial system today.  Subsequently, they can rebuild their book capital levels through retention of 100% of pre-banker bonus earnings and the sale of stock.

Having the banks absorb the losses on the excess debt protects the real economy.

If the losses were not absorbed by the banks, then the real economy would have to support the excess debt.  This diverts capital from being used to rebuild and expand the real economy to debt service.  The result of this diversion of capital is to put the real economy into a downward spiral.

The EU, UK and US have chosen not to require the banks to absorb the losses on the excess debt and, predictably, their economies are suffering accordingly.

Finally, in my posts on the Swedish model, I have written extensively about Iceland referencing the same articles as used by Mr. Washington.  I present most of his post as it is a nice summary of what I have been saying.

Nobel prize winning economist Joe Stiglitz notes:
What Iceland did was right. It would have been wrong to burden future generations with the mistakes of the financial system. 
Nobel prize winning economist Paul Krugman writes:
What [Iceland's recovery] demonstrated was the … case for letting creditors of private banks gone wild eat the losses. 
Krugman also says:
A funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver. 
Actually, since the Swedish model was first used by the US to break the back of the Great Depression in the 1930s, the rules have been to let the banks absorb the losses.
Krugman is right.  Letting the banks go bust – instead of perpetually bailing them out – is the right way to go. 
We’ve previously noted:
Iceland told the banks to pound sand. And Iceland’s economy is doing much better than virtually all of the countries which have let the banks push them around. 
Your humble blogger has been making this observation and explaining how the putting the burden of the excess debt on the real economy creates a downward economic spiral.
Bloomberg reports:
Iceland holds some key lessons for nations trying to survive bailouts after the island’s approach to its rescue led to a “surprisingly” strong recovery, the International Monetary Fund’s mission chief to the country said.

Iceland’s commitment to its program, a decision to push losses on to bondholders instead of taxpayers and the safeguarding of a welfare system that shielded the unemployed from penury helped propel the nation from collapse toward recovery, according to the Washington-based fund....


Iceland refused to protect creditors in its banks, which failed in 2008 after their debts bloated to 10 times the size of the economy. 
The IMF’s point about bondholders is an important one:  the failure to force a haircut on the bondholders is dooming the U.S. and Europe to economic doldrums. 
The IMF notes:
[The] decision not to make taxpayers liable for bank losses was right, economists say. 
In other words, as IMF put it:
Key to Iceland’s recovery was [a] program [which] sought to ensure that the restructuring of the banks would not require Icelandic taxpayers to shoulder excessive private sector losses. 
Icenews points out:
Experts continue to praise Iceland’s recovery success after the country’s bank bailouts of 2008.

Unlike the US and several countries in the eurozone, Iceland allowed its banking system to fail in the global economic downturn and put the burden on the industry’s creditors rather than taxpayers.


The rebound continues to wow officials, including International Monetary Fund chief Christine Lagarde, who recently referred to the Icelandic recovery as “impressive”. And experts continue to reiterate that European officials should look to Iceland for lessons regarding austerity measures and similar issues. 
Barry Ritholtz noted last year:
Rather than bailout the banks — Iceland could not have done so even if they wanted to — they guaranteed deposits (the way our FDIC does), and let the normal capitalistic process of failure run its course.

They are now much much better for it than the countries like the US and Ireland who did not....

“Iceland did the right thing … creditors, not the taxpayers, shouldered the losses of banks,” says Nobel laureate Joseph Stiglitz, an economics professor at Columbia University in New York. “Ireland’s done all the wrong things, on the other hand. That’s probably the worst model.”

Ireland guaranteed all the liabilities of its banks when they ran into trouble and has been injecting capital — 46 billion euros ($64 billion) so far — to prop them up. That brought the country to the brink of ruin, forcing it to accept a rescue package from the European Union in December.


Countries with larger banking systems can follow Iceland’s example, says Adriaan van der Knaap, a managing director at UBS AG.

“It wouldn’t upset the financial system,” says Van der Knaap, who has advised Iceland’s bank resolution committees.
In fact, the modern banking/financial system is designed so that the banks can absorb the losses on the excess debt in the financial system without upsetting the system.

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