Iceland's debt-relief lessons for eurozone

In a Guardian column, Thorolfur Matthiasson wrote about how Iceland adopted the Swedish model for handling a bank solvency led financial crisis and required the banks to absorb the losses on the excess debt in the financial system.

He focused on how Iceland approached debt-relief.

As recession deepens across southern Europe, stories abound of indebted firms and households being forced to hand over ownership of their assets to their creditors. 

For example, a recent report in Der Spiegel tells of a Spanish bank that evicted from his home a now unemployed man, previously earning less than €1,000 a month. The bank had happily lent him €240,000.  

Mass foreclosures of this kind ricochet through the economy, grinding down economic activity and compounding the "social recession".

Your humble blogger has spent a considerable amount of time focused on how protecting bank book capital levels transfers the burden of the excess debt to the real economy and grinds down economic activity by redirecting capital from reinvestment in the real economy to debt repayment.

Mr. Matthiasson adds an additional element to the burden placed on the real economy.  This is the social recession.

Iceland shows how to do things differently, with creditors bearing more of the direct cost upfront.  

Southern European governments – and even the creditors to southern European firms and households – would be wise to study its example. 

Iceland was hit by a perfect financial storm in October 2008 ..... By early 2009 it was clear that some 80% or 90% of Icelandic companies should have declared bankruptcy, including some of the biggest firms in the economy.  The central bank estimated that 25% to 30% of households were in a similar position. 

In normal times, the occasional bankruptcy is evidence of a well-functioning economy.  Mass bankruptcy in hard times is another matter entirely. 

For one thing, the legal system is painfully slow in clearing up even one bankruptcy, let alone thousands at a time. 

For another, it cannot be the case that 80% or 90% of all private activity becomes genuinely unproductive overnight. The question is how to keep firms with temporary balance-sheet problems going and at least partly covering their losses until demand improves....  

After much heated debate,  the government, the financial sector, and the federation of businesses agreed on a comprehensive debt-relief programme. 

The main components were as follows: 

• For the household sector, debt in excess of 110% of the fair value of each property was written off.  Specific relief measures (administrated by a bank or a new debtors ombudsman) applied for those that could not service a reduced loan. 

• Low-income, asset-poor  households with high-interest mortgage payment got a temporary subsidy from the government. 

• Small to medium sized firms could apply for debt relief if they could credibly document positive cash flow from future activities.  

The firm had to be willing to re-engineer its operation so as to make best use of its assets. Given those conditions, the firm could expect its debt to be written down to equal the discounted value of future earnings; or alternatively, written down to the amount that the bank or other financial firm could expect, in the best of circumstances, to gain from taking the assets over and realizing their monetary value.  

Hence the debt relief programmes did not create new equity on the balance sheets of firms or households....

The bottom line is that the government, the financial sector and the business sector collectively created a situation that leaves the financial sector with as good a result in terms of total debt collection as possible without the pain of sending most of the firms and many families into bankruptcy, unemployment and dispossession. 

Compare and contrast this with the Japanese model for handling a bank solvency led financial crisis that was adopted by the EU, UK and US.  Here the emphasis is on protecting the bank book capital levels and 'foaming the runway' so that banks can work through all the bad debt over the course of years.

Instead of avoiding putting society through pain like Iceland did, the EU, UK and US policy makers chose the most painful route.  A route that President Obama confirms will not be quick or easy.

Thanks in good part to this tempered approach to debt write-down Iceland's economy is now growing faster than most countries in Europe, and unemployment is less than 5% (having hit 9.3% in early 2010). 

This is the most important aspect of the Swedish model and Iceland's experience.  Pursuing the Swedish model and requiring the banks to absorb all the losses that they would otherwise experience through a multi-year process of debt collection protects the real economy by avoiding the associated bankruptcy, unemployment and dispossession.

Japan has recently admitted after 2+ decades that going through the multi-year process of debt collection and all the associated policies (including bank bailouts, fiscal stimulus, regulatory forbearance that allows banks to engage in 'extend and pretend' on zombie loans, zero interest rates and quantitative easing) does't work.

Of course, many Icelanders are still angry at the government and the banks, like their southern European counterparts. But at least they have a job, they pay property and income taxes, they service their reduced debt, and they can make plans for a vacation or a new car in two years' time.