We are bringing you a comment to our post ‘Brown’s letter to Haarde‘ written by Richard Portes, the Professor of Economics at London Business School.
Published: October 12 2008 18:49 | Last updated: October 12 2008 18:49
The US authorities’ decision to let Lehman fail will be severely criticised by financial historians – the next generation of Bernankes. That precipitated the current acute financial crisis. The Bear Stearns operation had protected counterparties, but after Lehman all remaining trust vanished. Money markets and interbank lending froze completely. Spreads on credit default swaps rose to levels signalling both extreme fear and feverish speculation.
Iceland’s Glitnir Bank was among the first casualties. One of the many vicious circles in this crisis ensnared Iceland’s banks: they were deemed too risky because the country’s central bank seemed not to be a credible lender of last resort, while the government and central bank were deemed not credible because they might have to take over the banks.
The markets hit Glitnir first. Like fellow Icelandic banks Landsbanki and Kaupthing, Glitnir was solvent. All posted good first-half results, all had healthy capital adequacy ratios, and their dependence on market funding was no greater than their peers’. None held any toxic securities. These banks had been managed well since their “mini-crisis” in early 2006.
No matter – when foreign short-run credit lines closed, Glitnir had to request a short-term loan from the Central Bank of Iceland, which refused. Rather than taking Glitnir into administration, the CBI enforced nationalisation on punitive terms. The governor, David Oddsson, was prime minister for 13 years prior to moving to the CBI in 2005. His decision reflected politics, technical incompetence and ignorance of markets, and his comments thereafter were highly destabilising.
This triggered a sovereign debt downgrade and a sharp further fall in the already depreciated krona. Short-run funding for Glitnir and Landsbanki evaporated, margin calls came from the European Central Bank, loan covenants kicked in because of the downgrade. With the banks unable to meet commitments, Iceland’s financial regulators put them into administration.
Kaupthing still seemed viable. But last Tuesday, Mr Oddsson made public remarks that were interpreted to mean that Iceland would not meet its obligations to UK depositors. This was politics for home consumption. So was the UK’s retaliation, with an ill-considered invocation of anti-terror laws to seize the UK assets not only of Landsbanki, but also of Kaupthing. Gordon Brown’s highly aggressive statement was not his best moment of the financial crisis.
Kaupthing was collateral damage. Britain’s seizure of its Singer and Friedlander subsidiary destroyed the larger bank, as covenants on loan agreements were activated. The UK and Iceland appear now to have agreed on dealing with depositors, but too late for Kaupthing. Still, it would be foolish for the UK authorities to impair Kaupthing’s assets further.
Meanwhile the krona fell to ridiculous lows offshore, while domestic trading of the currency ceased. The CBI then made a further egregious error, the prime minister another. The CBI had mishandled its interest rate policy and the foreign exchange markets since early 2008. On Monday, it announced a currency peg at a rate well above the market. Without effective controls, this was unsustainable, and was abandoned by Tuesday. The prime minister prematurely announced a ?4bn ($5bn, £3bn) loan from Russia, but it emerged that negotiations would start only this week. What was meant to restore confidence did the opposite.
The Icelandic banks were highly leveraged and large relative to the domestic economy. So are those of the UK and Switzerland. None has been immune to the devastating effects of the crisis. And there may be significant contagion from Iceland to countries vulnerable to capital flow reversals.
There are further lessons. Politicians should not become central bank governors. Mr Oddsson is part of the problem, not of any solution, and should resign immediately. Allowing partial “euroisation” was a recipe for instability. And Iceland was unable or unwilling to arrange early international support, nor did it wish to call in the International Monetary Fund.
Iceland could now negotiate an IMF programme with conditionality and lending from the Fund. But letting the currency float is likely to be disastrous, even with (or because of) much higher interest rates. They could peg the currency with capital controls. Or they could announce they are entering into negotiations to join the European Union, with a commitment to join the euro. If they do, the eurozone authorities should agree to support a reasonable exchange-rate band.
The debacle is due to the unexpected severity of the financial crisis and shocking policy errors. But Iceland has excellent institutions and human capital, as well as sophisticated service enterprises. Its people will have to absorb a temporary fall in their high living standards. Its banks will be revived as much smaller institutions, still with highly capable managers. It will ultimately prosper again.
Copyright The Financial Times Limited 2008
[…] É fácil usar muletas argumentativas em vez de procurar as causas efectivas dos problemas. Neste artigo, Richard Portes identifica algumas das desastrosas intervenções políticas (governamentais e […]
something that surprised me is the huge drop in oil prices. Seems like the day traders left the oil market so what we are seeing now is the “real” price of oil. Hopefully authorities in scandinavia will do something about Nordpool too, so we can get electricity at market price instead of speculative prices.
Energy is a plenty, and rationing will not be happening what instead could happen is that people simply can’t afford these luxuries in the future.
GreatDane: doesn’t matter what he said and when he said it it, but was a fair warning. However I doubt we are going to be anywhere near the 1970’s when we had IMF loan, a 3 day week, petrol rationing and nightly power cuts. and the 1950’s .. rationing.. please..
FT are reporting a 6Billion load to Iceland with fewer strings attached than Korea’s loan.
What will hit Britain the hardest in the comming years is that, it doesn’t really seem like young people in the UK are getting into universities at the rate they should. And many universities, for example University of Liverpool, I get spammed from these tossers trying to convince me to take an “online” degree with them. Basically quality in education is low in comparison to other north european countries.
Hmm. Didn’t Darling state, “The outlook for Britain’s economy is the bleakest since the days when the country was rebuilding from the Blitz”
Basically that translate into something like the worst economic prospects in 60 years? And he said that before things went from bad to worse.
I can tell none of you have any idea what is about to happen. Take a look at recent history, Argentina, Russia. No one will provide credit to any Iceland company because no one knows what it’s status is to the banks and any failed loans. Anyone providing credit to an Icelandic company to provide imports is at risk of another creditor coming in and attaching the assets of the company as payment for a failed loan somewhere else down the line. Since no one knows the interrelationships between the banks, debts, and Iclandic companies, Iceland will have to pay cash for all imports. That puts a freeze on imports because usually importers get their stuff on credit and buy in bulk and then pay back the loans as they repackage the stuff and make small individual sales. You don’t have the money for any imports. You are going to feel what’s it’s like to agree to IMF terms. No welfare, no socialized medicine. Cutbacks on retirement benefits. Roads that don’t get repaired. Sewers that overflow and don’t get fixed. The IMF will demand everything be turned over to them in repayment of the loan except the bare essentials of government. The bare essentials of government don’t usually include typical european socialist policies.
No, I’m well aware of the UK’s serious issues and so are the markets. However, its not about to default. We are going to have a recession, big deal. If the power, water, transport and gas keep going it will be better than the 1970’s.
Survived that, no problem.
Have you dared to read what they have to say about the UK?
Nothing in that IMF report disagrees with anything posted here. Its says, in couched terms, that Iceland is heading for disaster.
E.g.
6. Uncertainties surrounding the outlook are unusually large, with significant downside risks dominated by external considerations. External liquidity risks remain a key concern, given the high foreign debt of the private sector, chiefly related to the banking system. If the outflow of capital continues, the króna could depreciate more (moving ever further below its equilibrium level), leading to tighter domestic credit conditions. Domestic risks (related to inflation, house and equity prices, and household and corporate indebtedness) are also substantial, although they are more likely to be triggered by external factors.
Well the IMF disagrees with you.
read’n’weep
http://www.imf.org/external/np/ms/2008/070408.htm
The lesson learned here is that having banks heavily intertwined with politics and that vastly dwarf host economies is a recipe for disaster.
At our bank we were shocked and terrified to see how fast a solvent bank could have it’s assets seized, and those assets fore-closed not to the highest bidder but to the first bidder! And that loss caused the mother company to become insolvent, and put under administration.