Devaluing
Oneself to Prosperity Proves Harder than Expected
by Pater
Tenebrarum
Readers may
recall that we have always argued that the mere fact that a number of countries
in the euro area use a common medium of exchange is not the region's major
problem. It should be easy to see why this cannot be the case. For a very long
time almost the whole world used a common medium exchange, namely gold. During
that time both the world's economies and trade between them were growing at
very high rates (today such growth rates are but a distant dream).
The euro
area's problem is rather that the euro is a centrally planned fiat currency and
that the central bank aided and abetted a credit bubble of stunning proportions.
The European cocktail of socialism and easy money proved unsustainable and the
boom has undoubtedly caused capital consumption on a grand scale. The reaction
to this discovery was that ways were sought to cover this fact up by engaging
in a raft of interventionist measures that will eventually come back to haunt
Europe.
Anyway, the
purveyors of the idea that the best way back to riches was to impoverish
oneself by devaluation have often held Iceland up as a shining example of the
miracles this strategy would produce. It turns out that things are not that
easy, as many Icelandic companies now find themselves with their backs to the
wall as they are unable to service their foreign currency denominated
debts:
“Iceland’s private sector is
running out of cash to repay its foreign currency debt, according to the
nation’s central bank.
Non-krona debt owed by
entities besides the Treasury and the central bank due through 2018 totals
about 700 billion kronur ($5.8 billion), the bank said yesterday. The projected
current account surpluses over the next five years aren’t estimated to reach even
half of that and will equal a shortfall of about 20 percent of gross domestic
product.
The nation faces a “repayment
risk of foreign debt by private entities in the economy, who don’t have access
to foreign financial markets,” Sigridur Benediktsdottir, head of
financial stability at the Reykjavik-based central bank, said yesterday in an
interview. “We view this as being exacerbated or made worse by the fact that
our current account is actually declining.”
(Emphasis
added)
'Access to
foreign financial markets' means access to debt rollovers in the same
currencies the debts were incurred in. This access is lacking precisely because
Iceland has adopted capital controls. Iceland is certainly a good example for
the utter ruination a credit boom can bring. There is one additional reason
foreign creditors have no interest in rolling over loans: they simply no longer
believe that Iceland's wealth creation ability will suffice to service or repay
them – too much wealth has been decimated by the boom. Unless there's a sudden
jump in the price of codfish, that is likely to remain the case for a while
yet, as it will take time to rebuild the wealth that was lost.
The Icelandic krona vs. the US
dollar. Iceland's currency has thus far failed to recover from the large
devaluation during the crisis – click to enlarge.
Trapped
Foreign Investors
Iceland's
government has also managed to lose the confidence of foreign investors as it
has practically confiscated their funds by instituting the above mentioned
'temporary' capital controls, which remain in place to this day. Who wants to
lend to a country that has capital controls in place and may be tempted to
tighten them if another emergency arises?
“Foreign creditors hold about
$7.2 billion that are trapped behind the controls Iceland designed to protect
the $14 billion economy from capital flight in 2008. Gunnlaugsson has said he
wants offshore bank creditors to accept writedowns on 461 billion kronur in
claims to avoid a sell-off as soon as the restrictions are eased.
Iceland’s plight in dealing
with the unintended consequences of its capital restrictions shows how
difficult it is to exit such a regime without putting an economy at risk. The central bank said
yesterday that while the controls are still needed to protect the nation, their
long-term effect risks distorting asset prices.”
(emphasis
added)
The worries
about distorted asset prices seem not especially pertinent at this juncture, as
a look at the Icelandic Stock Exchange Index shows (see further below). The
problem that under these conditions, Icelandic private companies are unable to
access foreign capital is undoubtedly the far bigger one. They are certainly
expected to pay their debts however, and cannot hide behind the capital
controls in this context.
As Mises
noted regarding the alleged benefits of devaluation:
“The much talked about advantages
which devaluation secures in foreign trade and tourism, are entirely due to the
fact that the adjustment of domestic prices and wage rates to the state of
affairs created by devaluation requires some time. As long as this adjustment
process is not yet completed, exporting is encouraged and importing is
discouraged. However, this merely means that in this interval the citizens of
the devaluing country are getting less for what they are selling abroad and
paying more for what they are buying abroad; concomitantly they must restrict
their consumption. This effect may appear as a boon in the opinion of those for
whom the balance of trade is the yardstick of a nation's welfare.”
It should be
pointed out that a restriction of consumption would have been unavoidable even
if Iceland had not devalued – after all it would still have had to work off the
excesses of the boom. Since booms are characterized by both capital
malinvestment and overconsumption, the means to continue consuming at the rate
Icelanders had become accustomed to were certainly lacking once the artificial
boom collapsed. However, devaluation has no doubt made this particular problem
worse. Note that Iceland needs to import a great many goods that can simply not
be produced on this island with 320,000 inhabitants. Its biggest exports are
fish, fish products, aluminum and packaged medicines.
There is one
major reason to be optimistic about Iceland's longer term future if it decides
to finally ditch the capital controls, and that is the fact that it has very
low taxes and a far less developed welfare state than the rest of Europe. As an
aside, we believe the fears surrounding the rescission of capital controls are
very much misguided; for a short while there may be a surge in outflows, but
the fact that capital would once again be able to move in and out freely would
be an attraction for new capital that is currently sorely lacking.
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