There were a lot of commentaries
regarding the Ireland and Iceland 2008–2012 financial crises. Most of
the commentaries were confined to the description of the events without
addressing the essential causes of the crises. We suggest that providing a
detailed description of events cannot be a substitute for economic analysis,
which should be based on the essential causes behind a crisis. The essential
cause is the primary driving force that gives rise to various events such as
reckless bank lending (blamed by most commentators as the key cause behind
the crisis) and a so-called overheated economy. Now, in terms of real GDP,
both Ireland and Iceland displayed strong performance prior to the onset of
the crisis in 2008. During 2000–2007, the average growth in Ireland
stood at 5.9 percent versus 4.6 percent in Iceland. So what triggered the
sudden collapse of these economies?
Policy the Key Trigger for Economic Boom
What set in motion the economic
boom (i.e., a strong real GDP rate of growth) in both Ireland and Iceland was
an aggressive lowering of interest rates by the respective central banks of
Ireland and Iceland. In Ireland, the policy rate was lowered from 13.75
percent in November 1992 to 2 percent by November 2005. In Iceland, the
policy rate was lowered from 10.8 percent in November 2000 to 5.2 percent by
In response to this, bank lending
showed a visible strengthening with the yearly rate of growth of Irish bank
assets rising from 7.4 percent in June 2002 to 31 percent by November 2005.
In Iceland, the yearly rate of growth of bank lending to residents climbed
from 26.5 percent in September 2004 to 57.8 percent by April 2006.
The growth momentum of the money
supply strengthened visibly in both Ireland and Iceland. The yearly rate of
growth of our measure of money supply (AMS) for Ireland jumped from minus 6.7
percent in March 2003 to 22 percent by March 2006. In Iceland, the yearly
rate of growth of AMS climbed from minus 1.6 percent in January 2003 to 61.6
percent by June 2004 before closing at 47.7 percent by July 2004.
The aggressive lowering of interest
rates, coupled with strong increases in the money-supply rate of growth, gave
rise to various bubble activities. (The central banks' loose monetary stance
set in motion the transfer of wealth from wealth-generating activities to
nonproductive bubble activities.)
Policies Trigger Economic Bust
Because of strong increases in the
money-supply rate of growth, a visible strengthening in price inflation took
place in Ireland and Iceland. In Ireland, the yearly rate of growth of the
consumer price index (CPI) rose from 2.9 percent in January 2006 to 5.1
percent by March 2007. In Iceland, the yearly rate of growth of the CPI
jumped from 1.4 percent in January 2003 to 18.6 percent by January 2009.
To counter the acceleration in
price inflation, the central banks of Ireland and Iceland subsequently
tightened their stance. The policy interest rate in Ireland rose from 2.25
percent in January 2006 to 4.25 percent by July 2008. In Iceland, the rate shot
up from 10.2 percent in January 2006 to 18 percent by February 2009.
Furthermore, the pace of money pumping by the central bank of Ireland fell to
minus 8.2 percent by July 2007 from 25 percent in January 2007. The pace of
pumping by the Iceland's central bank fell to 43 percent by February 2008
from 123 percent in July 2006.
The yearly rate of growth of AMS in
Ireland plunged from 32 percent in August 2009 to minus 30 percent by
November 2011. In Iceland, the yearly rate of growth of AMS fell from 96
percent in October 2007 to minus 18 percent by September 2009.
The sharp fall in the growth
momentum of the money supply, coupled with a tighter interest-rate stance,
put pressure on various bubble activities that emerged on the back of the
previous loose-monetary-policy stance.
Consequently, various key economic
indicators came under pressure. For instance, the unemployment rate in
Ireland rose from 4.4 percent in January 2006 to 14.9 percent by July 2012.
In Iceland, the unemployment rate climbed from 2 percent in January 2006 to
9.2 percent by September 2010. Year on year, the rate of growth of Irish real
retail sales fell from 3.8 percent in January 2008 to minus 25 percent by
September 2009. In Iceland, the yearly rate of growth of real retail sales
fell from 11.9 percent in Q1 2008 to minus 31 percent by Q1 2009.
Most commentators blame the crisis
on the conduct of banks that allowed the massive expansion of credit. It is
held that this was responsible for the massive property boom in Ireland and
overheated economic activity in Iceland.
We hold that the key factor in the
economic crisis was the boom-bust policies of the central banks of Ireland
and Iceland. Loose monetary policy had significantly weakened the economies'
abilities in both Ireland and Iceland to generate wealth. This resulted in
the weakening of various marginal activities. Consequently, a fall in these
activities, followed by a decline in the pace of lending by banks — and
this, in turn, coupled with a tighter stance by central banks — set in
motion an economic bust. With the emergence of a recession, banks' bad assets
started to pile up and this in turn posed a threat to their solvency.
From May 2007, the banks' stock
prices on the Irish stock market declined markedly — they had halved by
May 2008. This had an inevitable effect on banks' capital-adequacy ratios and
therefore their ability to lend the ever-higher amounts that were necessary
to support property prices.
As a result, housing loans as
percentage of GDP plunged from 70.5 percent in Q2 2009 to 49.2 percent by Q2
this year. At the height of the boom, a fifth of Irish workers were in the
construction industry. The average price of a house in Ireland in 1997 was
€102,491. In Q1 2007 the price stood at €350,242 — an
increase of 242 percent. The average price of a home in Dublin had increased
500 percent from 1994 to 2006.
Now, in Iceland, at the end of Q2
2008, external debt was €50 billion, more than 80 percent of which was
held by the banking sector — this value compares with Iceland's 2007
GDP of €8.5 billion. The liabilities of the three main banks were
almost 10 times the size of the island's GDP.
With the emergence of the bust,
Icelandic authorities allowed its banks to go belly up, while the Irish
government decided to support the banks. According to estimates, the cost to
the taxpayers of providing support to Irish banks stood at €63 billion.
(The private debt of the failed banks was nationalized.) In Iceland, the
government, by allowing Icelandic banks to fail, made foreign creditors, not
Icelandic taxpayers, largely responsible for covering losses.
The fact that Iceland allowed the
banks to go bankrupt was a positive step in healing the economy.
Unfortunately Iceland introduced a program of safeguarding the welfare of the
unemployed. Also, the collapse of the Icelandic krona was a hard hit to
homeowners who borrowed in foreign currency. In response to this, the
authorities orchestrated mortgage-relief schemes. Iceland has also imposed
draconian capital controls. Obviously, all this curtailed the benefits of
allowing the banks to go belly up.
Whether the Icelandic economy will
show a healthy revival, as suggested by some experts, hinges on the monetary
policy of Iceland's central bank. We suggest the same applies to Ireland.
(What is required is to seal off all the loopholes for the growth of the
However, it is clear that Iceland's
economic situation is less bad than Ireland's, and that is largely due
to the Iceland's allowing its banks to go bankrupt.
Are Coming Back
For the time being in Iceland, the
yearly rate of growth of AMS jumped from minus 11.3 percent in May 2010 to 34
percent by May 2012. Also, in Ireland, the growth momentum of AMS is showing
strengthening with the yearly rate of growth rising from minus 30.3 percent
in November last year to 4.7 percent in September 2012.
The rising growth momentum of money
supply is a major threat to sound economic recovery in both Ireland and
Also note that the policy interest
rate in Ireland fell from 1.5 percent in October 2011 to 0.75 percent at
present. In Iceland, the policy rate was lowered from 18 percent in February
2009 to 4.25 percent by July 2011. All this again sets in motion a
misallocation of resources and new bubble activities — and, in turn,
Summary and Conclusion
Many commentators blame reckless
bank lending as the key cause behind the 2008–2012 financial crises in
Ireland and Iceland. Our analysis, however, suggests that it was not the
banks as such that caused the crisis but rather the boom-bust policies of the
central banks of Ireland and Iceland. It is these institutions that set in
motion the false economic boom and the consequent economic bust. While
Iceland allowed its banks to go bankrupt, the Irish government chose to bail
out its banks. So, in this sense, the Icelandic authorities did the right
thing, and Iceland has consequently outperformed Ireland economically. We
hold that despite this positive step, Iceland's authorities have introduced
various welfare schemes that have curtailed the benefits of having let banks
go belly up. Furthermore, both Ireland and Iceland have resumed aggressive
money pumping, thereby setting in motion the menace of boom-bust cycles.