Saturday, May 25, 2013

Iceland’s Recovery: Hardly about Currency Devaluation

Alan Reynolds at the Cato Institute blog explains, (italics original, bold mine)
Iceland’s recent devaluation was highly orthodox policy condition for wards of the IMF (strings attached to a $2 bn. loan). Unfortunately, such devaluations often backfire by inflating commodity costs, interest rates and the burden of foreign debt. The Icelandic krona fell from 64 to the dollar in 2007 to 123.6 in 2009, before strengthening with the economy to nearly 116 in 2011.

Since oil, grains and metals are priced in dollars, the 2008-2009 devaluation inflated Iceland’s cost of production and cost of living.  Inflation rose from 5.1 percent in 2007 to 12 percent or more in 2008 and 2009; real GDP fell by 6.8 percent in 2009 and 4 percent in 2010.  Faced with a collapsing currency, the central bank interest rate was hiked to 18 percent by October 2008.  It could have been worse.  If Iceland’s Supreme Court had not nullified loans indexed to foreign currencies in June 2010, devaluation would have doubled the cost of repaying foreign debt.

Devaluation was supposed to boost GDP by making imports costly and exports cheap, thus narrowing the trade deficit. The current account deficit did fall after 2008, but that always happens when recessions slash imports. Ireland had a current account surplus from 2010 to 2012 without devaluation, even as Iceland’s current account deficit was still 7-8 percent of GDP.

Iceland’s economy grew by 3.1 percent in 2011 when the currency appreciated and the budget deficit was deeply cut to 4.4 percent of GDP.  Devaluation explains the previous spike in inflation and interest rates, but little else. 

Iceland’s statistical growth recovery following the 2008-2011 crisis.

Some notes from the above:

Devaluation policies serves the interests of political agents and their affiliates, allies or cronies than of the general economy.

The devaluation panacea oversimplifies a complex economy operating spontaneously on millions of independently moving parts. The natural result from such conflict: policy failure.

The devaluation snake oil therapy, which operates on the principle of getting something for nothing, also deals with solving short term quandaries that comes with larger long term costs.

Bottom line: Micro issues can hardly be resolved by using macro tools which mistakenly sees the economy as a mechanical machine. Individuals think and act on purpose. Macro economic policies assume otherwise.

Iceland’s recovery has largely been allowing for markets to clear (by not saving banks), and importantly, by the reversal of inflationist policies.

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