Iceland and Ireland Models Help to Guide Greece’s Path

Opinion has polarized on what the best path is for Greece to take as it struggles out of its debt burden. European politicians are pressing for the country to follow Ireland’s example of austerity and debt repayment. But Keynesian economists, led by Nobel Laureate Paul Krugman, argue that austerity merely paves the way to semi-permanent depression. A more humane and economically sensible approach, they maintain, is to allow Greece to default on its obligations and to devalue its way back to competitiveness by leaving the euro.

This debate, though, has been complicated by the Irish economy’s rebound—it is managing to grow its way through austerity, and at a surprisingly strong clip.

It might, then, be worth comparing Iceland and Ireland’s experiences of their respective paths out of crisis, albeit with a couple of major caveats. Ireland’s population is more than 14 times the size of Iceland’s—4.6 million against 318,000. And both countries are far from fully recovered.

Both economies peaked in the second half of 2007; Ireland in the fourth quarter, Iceland in the third. Both were hit hard by financial-sector crises, and, in both, banking-sector assets were more than five times the size of national output. The difference was how the two countries dealt with their banks. Iceland allowed them to go bust and initially even refused to honor its guarantee obligations to depositors. Ireland stood behind the industry’s liabilities, offering a blanket guarantee.

Iceland allowed its currency to depreciate dramatically in order to absorb some of the impact of the crisis. Between October 2007 and when it bottomed in August 2009, the krona fell more than 40% on a trade-weighted basis. By contrast, the euro appreciated through 2008 and is now hardly changed on where it was in late 2007.

The respective impacts on Irish and Icelandic inflation was profound. Toward the end of 2007, Ireland’s year-on-year inflation rate was 3%. Iceland’s was a bit lower, at 2.3%. By early 2009, Icelanders were suffering a near-22% inflation rate. By contrast, Ireland was weighed down by deflation during most of 2009 and the whole of 2010.

So what were the impacts on the Irish and Icelandic economies of their respective choices of deflation and inflation? Iceland’s GDP is 12.6% smaller than it was at its peak, while Ireland’s has shrunk 9.8%. Iceland started growing again in the second quarter of 2010 and then relapsed at the end of the year and the start of this year. Ireland bottomed at the end of 2009. It, too, had a reversal, albeit shorter and milder than Iceland’s.

Nor is Iceland’s drop bigger because it had a bigger run-up in the preceding years, either. In fact, Ireland’s GDP had expanded by about three percentage points more than Iceland’s between the start of 2000 and its peak in 2007, though it could be that using the GDP series—which includes income belonging to foreign firms based in Ireland for tax reasons—exaggerates how well the Irish are really doing.

If the GDP data are equivocal, the unemployment numbers certainly seem to tilt in Iceland’s favor. Joblessness there peaked at 9.3% at the start of 2010 and has since come back down to 6.6%. By contrast, Irish unemployment remains near its peak of 14.5%. The actual differences aren’t quite as stark as those numbers suggest. At the end of 2007, unemployment in Iceland was 0.8% while Ireland’s was around 4.5%. So the trough-to-peak increases were roughly equivalent, though Iceland has clearly been doing better since.

When Argentina defaulted and devalued a decade ago, the situation was considerably messier. Its currency lost 80% of its value and the unemployment rate hit some 25%. Large numbers of people were thrown into catastrophic poverty, while savings were all but wiped out.

And despite the fact that Iceland devalued its currency while Ireland couldn’t, Ireland has done a better job of pulling its current account into surplus, while Iceland continues to register deficits of more than 10% of GDP. In part, Ireland’s improving balance of trade is down to its low corporate-tax rate, which is half that elsewhere in the euro zone, but it also has a lot to do with the improved competitiveness of its work force.

But export performance won’t be a saving grace if, as recent data suggest, global demand slows. A weakening of Irish growth because exports stall could yet force Irish banks to recognize lurking bad debts that haven’t yet been fully acknowledged. Iceland, meanwhile, faces being forced to honor some of its guarantees by international courts.

Neither country has fully swallowed all the pain of the crisis.

As for Greece, it’s in no position to choose the one path over the other. Rather, it needs to adopt parts of both. It needs to default on at least half of the national debt while deflating internally, cutting salaries by a third across the board.

As for a Greek exit from the euro; well, that’s still a political no-go. As British Foreign Minister William Hague pithily put it, the euro is a burning building with no exits.

But even if it could leave, Iceland and Argentina have shown that the alternative to austerity is not pain free.

Alen Mattich / WSJ

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