Free Market Capitalism
A free market is a market that is free from government interference, prices rising and falling in accordance with supply and demand. (Oxford Dictionary of Finance and Investment, 2005) In a free market individuals are free to make their own economic decisions. Consumers are free to decide what to buy with their incomes: free to make demand decisions. Firms are free to choose what to sell and what production methods to use: free to make supply decisions. The resulting demand and supply decisions of consumers and firms are transmitted to each other through their effect on prices, through the price mechanism. (Sloman & Hinde, 2007)
One of the most influential economists that adhered to the policy of free market capitalism was Milton Friedman (1912-2006). He was a United States economist, statistician and a public intellectual. He got the Nobel Memorial Prize in Economics Sciences in 1976 and is best known among scholars for his theoretical and empirical research, especially consumption analysis, monetary history and theory, and for his demonstration of the complexity of stabilization policy. (Nobelprize.org, 2009)
Milton Friedman came to visit Iceland in the 1980s. He, among others, influenced the president of the independence party and the Prime Minister of Iceland (1991-2004), Davíð Oddsson, and his co-workers to great extent. (Ólafsson, 2008) Under the control of Oddsson and his government the Icelandic banks were privatized. As with the free market capitalism of Oddsons´s government, the supervision and control was weak. This can be considered as financial deregulation, but it is widely understood to have important economic benefits for microeconomic reasons. Since Adam Smith, economists have argued that unfettered private markets yield outcomes are superior to public sector alternatives. But financial regulations, specific rules and overall structures are sometimes justified on macroeconomic grounds. (Goodhart & Illing, 2002)
The Central Bank
Goodhart & Illing (2002) have defined that a central bank serves two very different functions. First, central bank functions as monetary authorities, managing high-powered money to influence the price level and real activity. Second, central banks engage in regular and emergency lending to private banks and other financial institutions. Goodhart & Illing (2002), argue that just as private lenders must restrict and monitor individual borrowers, a central bank must regulate and supervise the institutions that borrow from it. In the case of the Icelandic banks, this was not working since the banks collapsed and the control of monetary policy with high interest rates was not impacting the high inflation as will be mentioned later on.
Oddsson was appointed the chairman of the central bank in Iceland in 2005, after having been the Prime Minister of Iceland for thirteen years and then Foreign Secretary. It is not common that a politician takes place as the chairman of a central bank‘s country, since the bank should be an independent institution. “This interplay between government ministers and central bankers is the heart of every national economic crisis. “ (Times Online, 2009b)
In 2001 the central bank presented its inflation target, 2.5%, as part of its monetary policy. Following the inflation target, the central bank started to raise interest rates. In 2003 the interest rate was 5.3% but in 2007 it was 15.25%. Today the interest rate is 18%.
The inflation targeting, failed in lowering inflation, but the resulting interest rate rise both motivated domestic households and firms in order to borrow in foreign currency and attracted foreign speculative capital, carry traders. The amount of hot money inflows is not publicly known, but it appears to have exceeded 50% of GDP. It is unclear why this did not raise concerns with the authorities. (Daníelsson & Zoega, 2009) This is better addressed and analysed with the IS/LM model in Appendix A.
The reasons for the failure of inflation targeting are not completely clear, but it seems to be that the massive currency inflows effectively became a part of the local money supply. As can be seen in figure 4, the money supply has increased dramatically in recent years.
Because of the central bank’s lack of credibility and firm’s willingness to borrow in foreign currencies, interest rate changes had a very limited effect on long-term interest rates and investment activity. About the only visible effect on inflation was that import prices were reduced when the exchange rate appreciated. (Daníelsson & Zoega, 2009)
The central bank in Iceland has remained weak, it had foreign exchange reserves of around 375 billion kronas just before the collapse of an economy with GDP around 1,300 billion kronas, just under 30% of GDP. This ratio, nonetheless, is very high; however the short-term liabilities of Icelandic banks in proportion to Iceland’s GDP were a staggering 211% at the beginning of 2008. (Daníelsson & Zoega, 2009)
Consequences
On 29th of September 2008 the first signs that the financial crisis was going to hit the country hard. The central bank came out with the fact that the smallest of the three big banks, Glitnir, had asked for a loan from the central bank, the lender of last resort. The central bank didn’t like the collateral behind the loan and decided to nationalize the bank, by buying 75% of its equity. The government expected by that action, the credit default swap would recover, but the contrary happened and it got a lot worse. The action of nationalizing Glitnir seems to have undermined the trust of the Icelandic banking system and Icelandic government. The government and the Icelandic banks had always claimed that the banks had no liquidity problems and were in no chance of defaulting. But, by nationalizing Glitnir, that undermined the ability for the central bank to deal with the situation. (Daníelsson & Zoega, 2009)
At 16:00 on Monday 6th of October were the first minutes of the breakdown of the Icelandic banking system and the economy. Prime Minister, Geir H. Haarde, had a live speech on the national television clarifying in how bad situation the banking system was, and therefore the economy as a whole. He said: “Dear Icelanders, there is a possibility, if the worst will happen, the nation will go bankrupt…”. That was the first time the public got to know that the situation of the banking system was not that good as had been indicated. The speech ended in these words: “God, bless Iceland”.
It was clear; the financial crisis had hit Iceland severely and, in fact, was turning into a major economic crisis. The Icelandic government agreed on a new law which allowed the government to take over any financial institution in the country. That was done in order to keep the domestic banking sector functioning in these turbulent times. The law allowed the government to create “new banks” on the ruins of the “old ones”, which had domestic deposits and loans. The international activity was left over in the “old banks” and they were heading into technical bankruptcy.
A common definition of a systemic crisis is when the payment system fails. That is what happened to the Icelandic payment system following the collapse of the Icelandic banking system. International part of the payment system shut down and part of the domestic system had difficulties. (Daníelsson & Zoega, 2009) For an economy as dependent on import and export it had major influences. Firms had difficulties in paying for their imported goods and there was a major threat of a shortage of necessities, like food and fuel, but it never reached that far.
Within a week after the collapse of the banks, the Icelandic currency, krona, had dropped by more than 70% in value. With the firms, as well as the households in Iceland with so much foreign debts it made things a lot worse than they already were. The households as well as the firms in Iceland are heading into very difficult times which will eventually lead to bankruptcy for many of them. In a recent press release from European Small Business Alliances (ESBA) it is stated that up to 80% of firms in Iceland have gone technically bankrupt following the British government using anti-terrorist law in order to take over Icelandic assets. For any economy it’s a major shock and it will take a long time for Iceland to recapture trust from governments and investors around the world. (Vísir, 2009)
In the following weeks Iceland was the first Western country to have approached the International Monetary Fund (IMF) for aid since 1976. (BBC News, 2008) The agreement with IMF is to restore confidence in the Icelandic banking system and stabilise the Icelandic krona. External pressures to unwind krona positions were mounting, and there were significance risk that domestic depositors and investors could lose confidence in the krona, despite the government’s guarantee on domestic deposits. These pressures, coupled with low level of reserves, meant that a fixed foreign exchange regime would not be credible, so IMF opted for a combination of interest rate policy, liquidity management, foreign exchange intervention and restriction on capital flows. (International Monetary Fund, 2008)
On top of the aid from the IMF, few nations have agreed to lend Icelandic government in order to fulfil foreign debts of the collapsed banks. This dramatically increase in debt burden has already lead to cutback in government spending in order to meet its obligation.
Model of Financial Crisis – Iceland Comparison
The model that will be used to compare to the financial crisis in Iceland is a model that has been set out by host of classical economist including John Stuart Mill, Alfred Marshall, Knut Wicksell, and Irving Fisher, and many economist have later set out with personal variations. Kindleberger (1978) covers it in his book Manias, Panics and Crashes.
Events leading up to a crisis start with a “displacement”, some exogenous, outside shock to the macroeconomic system. The nature of this displacement varies from one speculative boom to another. It may be the outbreak or end of a war, a bumper harvest or crop failure, the widespread adoption of an invention with pervasive effects - canals, railroads, the automobile – some political event or surprising financial success. But whatever the source of the displacement, if it is sufficiently large and pervasive, it will alter the economic outlook by changing profit opportunities in at least one important sector of the economy. As a result, business firms and individuals with savings or credit seek to take advantage of the former and retreat from the latter. If the new opportunities dominate those that lose, investment and production pick up. A boom is underway.
In the case of the Icelandic financial crisis we can say that the “displacement” in the economy has started in 1994 when Iceland entered the EEA. Other factor that leads to the financial crisis is the privatization of the banks. That’s not a bad thing in itself but in our opinion a stricter rules had to be set on the ownership of the banks. Government should have set a limit on proportional ownership for each investor and require foreign investors to be part owners of the banks. We think those two factors are the main outside shock to the macroeconomic system, though it happens over a number of years.
The boom is fed by an expansion of bank credit which enlarges the total money supply and for a given banking system at a given time, monetary means of payment may be expanded not only within the existing system of banks, but also by the formation of new banks, the development of new credit instruments, and the expansion of personal credit outside of banks. Crucial questions of policy turn on how to control all these avenues of monetary expansion.
Number of financial institutions, and their businesses, increased dramatically in Iceland from 2000 and proportion of income tax coming from financial institutions has increased from being 15% in 2004 to 43% in 2006. (Icelandic Financial Services Association, 2008) With the ever growing financial sector and access to cheap capital on foreign capital markets, the increase in money supply was enormous, like can be seen in figure 4.
The increase in the money supply in the Icelandic economy ignited for expansion in transactions and consumption which increased asset price dramatically, mainly on housing prices and securities. The large amount of the increase in money supply coming from abroad did nothing but increase the asset price, even more, and the exchange rate of the krona was way above what could be regarded as normal.
Let’s assume that the urge to speculate is present, and is transmuted into effective demand for goods or financial assets. After a time, increased demand presses against the capacity to produce goods or the supply of existing financial assets. Prices increase, giving rise to new profit opportunities and attracting still further firms and investors. Positive feedback develops, as new investments leads to increases in income that stimulate further investment and further income increases. This stage is called “euphoria”. Excessive gearing arises from cash requirements which are low relative both to the prevailing price of a good or asset and to possible changes in its price. As firms and households see others making profits from speculative purchases and re-sales, they tend to follow. When the number of firms and households indulging in these practices grows large, bringing in segments of the population that are normally aloof from such ventures, speculation for profits lead away from normal, rational behaviour to what have been described as “manias” or “bubbles”. The word “mania” emphasizes the irrationality; “bubble” foreshadows the bursting. At a late stage, speculation tends to detach itself from really valuable objects and turn to delusive ones. A larger and larger group of people seeks to become rich without a real understanding of the processes involved.
We think that the “euphoria” and the “mania” mentioned above is a good description of Iceland for last few years. Everything has been spinning around money and profit. The households have been building and buying new houses. Buying expensive luxury cars from abroad and the Icelandic nation hitting the news world wide for spending highest amount of money in the first day of opening of a global chain stores, like Toys “R” Us. (Icelandic Review, 2007) Meanwhile, Icelandic investors, usually referenced as “investor Vikings” have been gearing themselves heavily and investing all around the world, mainly in the Nordics and in UK, where they have been buying a good proportion of the high street. While the “investor Vikings” have been striking new deals around the world, politicians, the president and other people have been touting them as geniuses. So the “euphoria” and the “mania” haven’t just been by the households and firms but by virtually the whole nation, except some scholars and few sceptics. (Times Online, 2009a)
As the speculative boom continues, interest rates, velocity of circulation, and prices all continue to mount. At some stage, a few insiders decide to take their profits and sell out. At the top of the market there is hesitation, as new recruits to speculation are balanced by insiders who withdraw. Prices begin to level off. There may then ensue an uneasy period of “financial distress”. A considerable segment of the speculating community that a rush for liquidity – to get out of other assets and into money – may develop, with disastrous consequences for the prices of goods and securities, and leaving some speculative borrowers unable to pay off their loans. As distress persists, speculators realize, gradually or suddenly, that the market cannot go higher. It is time to withdraw. The race out of real or long-term financial assets and into money turns into a stampede.
The specific signal that precipitates the crisis may be the failure of a bank or firm stretched too light or a fall in the price of the primary object of speculation as it, at first alone, is seen to be overpriced. In any case, the rush is on. Prices decline. Bankruptcies increase. Liquidation sometimes is orderly, but more frequently degenerates into panic as the realization spreads that there is only so much money, and not enough to enable everyone to sell out at the top. The word for this stage is “revulsion”.
What eventually un-winded the collapse of the Icelandic banks, and therefore the whole Icelandic economy, was the global financial crisis. Banks around the world hadn’t the same access to capital as before and because of the structure the Icelandic banking system, the credit lines for the Icelandic banks were the first to be shut closed which resulted in a collapse. We are pretty sure that the same would have happened sooner rather than later though there wasn’t the global financial crisis. Because of the size of the banking system and the excessive gearing of the banks as a proportion of GDP the central bank couldn’t serve its role as a lender of last resort.
Conclusion
Ahead is probably the deepest recession that Icelandic economy has gone through in years. Households and firms fight for their lives because of high interest rates, inflation and weak krona. The interest rates are today 18% and inflation 18.6 %. It has been more difficult to restructure the financial system for the Icelandic government than was predicted. GDP is expected to be -8.3% 2009 and -2% 2010 and get to positive number after that. Unemployment rate is expected to be over 10% 2009 to 2011. We think these estimations are a bit optimistic but it really depends on how successfully Icelandic government and IMF will stabilize the krona and also how well and soon they can restructure the financial system in order to get confidence back in the system. (Central Bank of Iceland, 2009)
We think it was a positive step to enter the EEA to open up the economy because that led to easier access to capital, easier to do business across borders among other things. However, we think that by entering the EEA we should have set stricter rules for institution, especially financial institutions. Supervision of the financial system should have been better as can be seen on the enormous size of the banking system in proportion of GDP. The central bank should have increased the reserve requirement for banks, but that will probably be part of discussions about changing of financial regulation all over the world in continuation of the global financial crisis.
We think that the privatization can easily be criticised. In our opinion stricter rules should have been set for the ownership of the banks and foreign investors should have been participants in the ownership. It was part of the agreement, but it was never followed.
It’s our opinion that the directors and the owners of the banks are responsible for the collapse of the banks by gearing the banks excessively and investing rashly all over the world. However, we think that government, mainly the independence party, should take huge proportion of the responsibility. They privatized the banks and have been setting the regulations on the market. As can be seen from the background and causes of the collapse of the Icelandic banking system the regulations and supervision have been heavily lacking.
It’s obvious that the Icelandic central bank has failed in his role of being monetary authorities and managing high-powered money to influence the price level and real activity. In order to tackle the inflation target, interest rates were raised but without any success because of the inflow of foreign capital which increased the money supply which leads to higher inflation. We think that interest rates should have been lowered some years ago in order to prevent the increase in money supply.
Next thing to do for the Icelandic government and the nation is to decide whether to join the European Union (EU) and entering in to the European Monetary Union. Although, we are not sure if Iceland should join EU because of the enormous natural resource the country has, but we think that the country needs new currency.
References
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Appendix A
The IS-LM model is a model that determines the short-run equilibrium of an economy as the intersection of two individual market equilibrium curves, called IS and LM. The IS curve is the schedule of nominal interest rates and output levels at which the output and foreign exchange markets are in equilibrium, while the LM curve shows points at which the money market is in equilibrium. The IS curve reflects the goods market; I stands for investment and S for savings. The LM curve on the other hand reflects the asset market where L stands for liquidity and M for money supply.
The IS-LM model assumes that investment, and some forms of consumer purchases are negatively related to the expected real interest rate. When the expected real interest rates are low, firms find it profitable to borrow and undertake investment plans. Figure 5 shows a shift in the LM-curve to the right, when the money supply increases temporary. As in the case of the money supply in Iceland, as can be seen in figure 4, money supply was increasing but still interest rates were high. The massive capital inflow effectively became a part of the local money supply and the increase in interest rates further stimulated the growth of currency inflows by encouraging speculative inflows of currency and motivating households and firms to borrow in foreign currency. According to the IS/LM model the inflation targeting by the central bank, by raising interest rates, has failed in recent years. When looking at the IS/LM it has to be considered that the model only uses nominal interest rates, i.e. it excludes inflation. IS/LM model is perhaps not exhaustive when analysing the combination of increase in money supply and interest rates in Iceland because of the influence of the high inflation rate on the Icelandic economy. (Krugman & Obstfeld, 1997)
With the increase in the money supply the output has been increasing like is indicated in the model and as is shown in Appendix B. The GDP in Iceland has been increasing year by year from 2000 to 2007.
Appendix B
Data on the macroeconomic development preceding the collapse.
GDP = Gross Domestic Product
C = Consumption
I = Gross investment
CA = Current account surplus
e = Real exchange rate
P = Employment participation rate
U = Unemployment rate
