Recalculation in Iceland

As you know, I’ve been critical of “recalculation” models of the US recession.  I think it’s mostly demand-side, and some unknown part of the supply-side is government labor market interference.  Only a modest portion is recalculation.  But Arnold Kling’s model almost perfectly explains the current Icelandic recession:

Economy Minister Arnason wants more for Iceland than fishing and geothermal energy. He acknowledges that the nation got into banking without the right infrastructure or the know- how to do it well. Still, he doesn’t think Icelanders have to go back to fishing now that they’ve proven themselves inept at finance.

His government needs to find work for the 2,000 highly educated finance-sector employees who lost their jobs, he says. Otherwise, they’ll migrate, and a shrinking population is the biggest scourge for this small, isolated island nation.

“The choice isn’t between fishing and banking,” Arnason says. “The choice is building a healthy, diversified economy.”

Some Keynesians might object that it’s also a demand problem; after all, Iceland went through a severe financial collapse, one of the worse in world history.  All the major banks failed, with liabilities totaling 1200% of GDP.  The housing industry collapsed.  Surely that points to a decline in AD? 

Actually no.  Those Vikings wouldn’t have been able to survive in that harsh climate without having some smarts.  Unlike the foolish Irish, the Icelanders decided to let the big banks fail and have the creditors pick up the tab, not the taxpayers.  To prevent a fall in AD, they sharply depreciated the kroner.  I had trouble finding NGDP data, but if you look at the graph halfway down this link, you’ll see Icelandic NGDP rose continually through the worst of the 2008 crisis, and has continued to move gradually higher.  In contrast, Irish NGDP has plunged.  Ireland lacks the nominal income to repay its euro debts, and even to pay euro wages without steep wage cuts.  Ireland faces both recalculation and a severe demand shock.

The rise in NGDP did not prevent a fall in Icelandic RGDP; their financial collapse was a very severe real shock.  Those bankers can’t be immediately retrained as fisherman.  The reason Iceland fits Kling’s model so perfectly is:

1.  There was no demand shock

2.  It’s not even clear what the new patterns of specialization and trade should look like. Iceland is groping in the dark (literally, during these winter months) for new industries.

Paul Krugman also has a couple posts on Iceland.  In this one he points out that Icelandic RGDP fell about the same amount as in countries with much smaller financial crises, and that employment did considerably better.  I see those two arguments as being related.  Suppose Iceland had a real shock big enough to reduce RGDP by 15%, whereas Ireland and the Baltics merely had real shocks big enough to reduce RGDP by 8%.  But now assume that Ireland and the Baltics also had negative demand shocks, caused by their attachment to a euro that was way too strong for their economies (and indeed a bit too strong even for Germany.) 

In that case Ireland and the Baltics might see RGDP declines as big or bigger than Iceland, even though their real shocks were smaller.   And this is what happened.   This also explains why employment did better in Iceland.  Recall that their real shock was much bigger, so for equal drops in employment you’d expect a bigger drop in Iceland RGDP than in the other crisis countries.  But we know that the decline in RGDP in Iceland was actually a bit less than most of the others.  This is because the good AD policies allowed some fraction of unemployment bankers and real estate people to find jobs in other industries.  Those new jobs were at lower levels of (measured) productivity per worker, which explains why RGDP fell more than employment.) 

In other words, monetary policy did not slow the process of recalculation in Iceland.  In the other crisis countries monetary policy took a bad situation and made it even worse.   Unemployed workers in overbuilt sectors were not able to find jobs in other sectors, as total demand was falling.

PS:  How about some suggestions for Iceland:

1.  More tourism; most people don’t realize how awe-inspiring their volcanos are.

2.  Create more quirky pop groups

3.  Give banking another shot.  Don’t assume Icelanders are “inept” at banking; assume they’ve become “experienced.”

4.  Grow pineapples in greenhouses heated by geothermal power.

5.  Resume raping and pillaging northern Europe, as in the Viking days.  (Oops, that’s already been done to northern European creditors.)

6.  Become the 51st state, or rejoin Denmark.

What else do you guys suggest?  Where’s their comparative advantage?


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36 Responses to “Recalculation in Iceland”

  1. Gravatar of Indy Indy
    2. February 2011 at 09:14

    I’m for 51st state. But Iceland has a huge competitive advantage in cheap, clean, hydro-electricity. The question becomes “what valuable physical object can you export, the majority of the value of which is derived from electricity inputs?”

    The answer, so far, is aluminum. I think there’s also potential for being the home of giant google-like server farms, since Iceland also has a competitive advantage in cold, and server farms need both cheap electricity and cooling.

    The again, Canada’s got similar advantages, and they’re closer to the US Market.

  2. Gravatar of Marcin Marcin
    2. February 2011 at 09:18

    They’re a quite well-favoured people, so perhaps television presenters, english-language broadcasts, both entertainment and news.

    Summer holidays for northern europe.

    English teaching.

    They could also increase tourism by legalising and regulating soft drugs.

  3. Gravatar of scott sumner scott sumner
    2. February 2011 at 10:25

    Indy and Marcin, I like those ideas. I drove by an aluminum smelter when I visited Iceland in May of last year.

  4. Gravatar of Mrs. Davis Mrs. Davis
    2. February 2011 at 10:50

    They’ve got a lot of ocean around them. Sea bed mining and refining.

  5. Gravatar of Benjamin Cole Benjamin Cole
    2. February 2011 at 10:58

    Well, there is always gambling, prostitution, drugs. I doubt they can manufacture anything competitively, due to location and size of domestic market.

    I suppose they could try to create an “authentic” Icelandic art form, that other people will buy. Banking makes sense, if they are good at it. Software can be sold globally.
    Unusual tinned food items.

    Some services, such as architecture, can be sold globally.

    I suppose they can be the “flag of Liberia” for something, like insurance companies.

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. February 2011 at 11:03

    Scott,
    I hate to rain on your parade but there’s something seriously wrong with John Mauldin’s data.

    Both Eurostat and the OECD have Icelandic NGDP, and their numbers are identical (and different from his).

    Icelandic NGDP
    Millions of króna seasonally adjusted, current prices at a quarterly rate:
    2007:Q4-329,615.0
    2008:Q1-341,110.9
    2008:Q2-358,119.7
    2008:Q3-381,091.8
    2008:Q4-397,616.2
    2009:Q1-364,184.9
    2009:Q2-381,092.1
    2009:Q3-361,180.8
    2009:Q4-394,307.8
    2010:Q1-384,487.1
    2010:Q2-380,631.3
    2010:Q3-378,559.0

    Note Iceland’s NDP plunged 8.4% in 2009Q1 after peaking the previous quarter and eventually bottomed out at 10.2% below peak in 2009Q3. It was still 4.8% below peak as of 2010Q3.

    In contrast Ireland has done much worse. Ireland’s NGDP peaked in 2007Q4 and fell 20.2% before bottoming in 2009Q4. It was still 16.8% below peak as of 2010Q3.

    So there *was* a demand shock in Iceland, but it was only half as great measured peak to trough.

    I wonder where Mauldin’s numbers are coming from? If they are official Icelandic figures then why are they so different from Eurostat and the OECD?

    P.S. On the bright side this means we’re still looking for a real example of Kling’s “recalculation”.

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. February 2011 at 11:06

    Obviously 10.2% should read 9.2%.

  8. Gravatar of Britmouse Britmouse
    2. February 2011 at 12:45

    Iceland! First, they stole our fish. Then they corrupted our children with LazyTown. To cap it all, they gave us Icesave. Please, no more. Stick to the tourism. We will come and visit. We get the message.

    /- Britmouse

  9. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. February 2011 at 13:33

    Did somebody say Viking recalculation?

    http://www.youtube.com/watch?v=el0RFkSPk-o&feature=player_embedded

  10. Gravatar of dWj dWj
    2. February 2011 at 13:43

    High-frequency arbitrage of discrepancies between prices in the US and those in Europe.

    I think doing some finance would make sense; just don’t get carried away again. It’s one of those things where the downside can be superlinear.

  11. Gravatar of scott sumner scott sumner
    2. February 2011 at 14:32

    Mrs. Davis, Maybe, but no one has been able to make a profit doing that.

    Benjamin, The club scene there is already supposed to be pretty good.

    Mark, Thanks for that data. Oddly, it’s called seasonably adjusted, but it doesn’t look seasonably adjusted (big spikes in each Q4.)

    Still, Ireland has trended sharply lower since 2007:4 and Iceland has trended sharply higher. Maybe he used annual averages, because you’re right his graph doesn’t show those high frequency fluctuations.

    Britmouse, I’m still amazed that no one knew who was responsible for all those deposits.

    Mark, Yes, that video does show the difficulty of recalculation.

    dWj, I think they’ve learned their lesson.

  12. Gravatar of Andri Andri
    2. February 2011 at 16:45

    I’m not sure exactly sure how so many smart people can get this so wrong. Iceland’s favorable jobs numbers are mostly due to thousands of locals taking jobs in Scandinavia, and migrant workers being kicked out and sent back to Eastern Europe. Combine that with a very large number of people employed in the winding up efforts of the collapsed banks, and you account for most of the short term balance.

    As for measuring no fall in nominal GDP. Well, considering that more than 50% of all basic necessities are imported and the currency fell by 60% from it height, you would expect that there would be an increase in kronur denominated nominal GDP. I mean people have to eat. It would be interesting to see what is happening to household savings and credit card debt. My understanding is that both are going up.

    So while it may seem that aggregate demand has not fallen, it actually has — it’s just that the local population has to pay more for imports, while a few exporting industries are doing well. Cold comfort to the already freezing people on the ground.

  13. Gravatar of Patrick Patrick
    2. February 2011 at 16:48

    I live in Seattle and in late ’09 the Iceland Tourism Board was hitting option 1 hard in conjuction with Iceland Air direct flights from SeaTac. I got really close to being tempted to take a devaluation vacation.

  14. Gravatar of scott sumner scott sumner
    2. February 2011 at 17:07

    Andri, Here’s how so many “smart people” can get it so wrong:

    1. Smart people know that Icelanders going to Denmark and migrants leaving Iceland have no bearing on the fact that employment fell much less than in other countries. (Those effects would reduce unemployment.)

    2. Smart people know that aggregate demand is a nominal concept. If prices rise rapidly, that means AD is usually going up. You are confusing the real quantity of goods purchased (Qd) with the AD curve itself.

    3. Smart people know that imported goods aren’t part of GDP.

    You are right that there is plenty of suffering, but no one denied that.

    Patrick, Check out the link for that option, it shows pictures from my short vacation in Iceland (in May 2010.) It was unforgettable.

  15. Gravatar of Benjamin Cole Benjamin Cole
    2. February 2011 at 17:49

    BTW, the lead words of Krugman’s latest blog are…Scott Sumner.
    And he actually says something nice.

    Sumner has changed the nature of discourse on modern day economics. Just in time too. Bernanke is roughy doing the right thing (too slowly, too timidly), but getting increasing recognition thanks to the groundwork laid by Sumner.

    In a few months, the consensus will be, “Well, why didn’t Bernanke go to QE harder and earlier, like we said?”

  16. Gravatar of Andri Andri
    2. February 2011 at 22:00

    Scott-

    According to the Icelandic Bureau of Statistics the size of the labor force shrank by 2% between 2008 and 2009. The number of people employed full-time fell by 11.3% between 2008 and 2010.

    As for imports not being part of GDP. Yes, but that wasn’t the point. There was massive inflation in the cost basis of the whole economy (except labor prices) because of devaluation; wouldn’t that show up in nominal aggregate demand?

    But I will leave the economics to the experts.

    On what Iceland should do for it’s economic future. Does it have to do very much? Just stop pissing away the massive riches it produces on tunnels between empty fjords, a bloated bureaucracy, and dabbling in the rigged game of international finance.

  17. Gravatar of Oli Oli
    3. February 2011 at 01:28

    Consider this: Pension funds own roughly 50% of all securities in the Iceland Stock Exchange. They control funds that are roughly 120% of GDP.

    They must, due to law and regulation, get 3.5% REAL interest rates on the funds they invest on behalf of upcoming pensioners.

    Fancy thinking about what happens to the real interest rate in such an economy? Here is where you can see up-to-date data on securities that are registered in the stock exchange: http://www.keldan.com/

  18. Gravatar of Stefan Stefan
    3. February 2011 at 05:08

    I believe the real reason why AD in Iceland has not fallen as sharply as in Ireland, is because the government has frozen the payment on all the JPY, EUR and CHF mortgages that are spread all over the island. They have atificially kept the icelandic consumer running on credit from the government. Once they unfreze this arrangement, I would be very surprised to see the Vikings keep up their spending.

    /Stefan

  19. Gravatar of Mark A. Sadowski Mark A. Sadowski
    3. February 2011 at 07:16

    Scott,
    You wrote:
    “Mark, Thanks for that data. Oddly, it’s called seasonably adjusted, but it doesn’t look seasonably adjusted (big spikes in each Q4.)”

    The OECD and Eurostat both have quarterly NGDP for Iceland from 1997 onward. If there was a pattern of big spikes in the fourth quarter you would probably see a decline in NGDP in the first quarter each following year. Out of the 13 quarters you only see that happen three times :2002, 2009 and 2010. So I think its just a coincidence, that there have been spikes in the fourth quarter recently.

    Still not convinced? Just graph it (a picture is worth a thousand pieces of data). I personally don’t see a seasonal pattern over 1997-2008.

    True, Iceland’s NGDP rose throughout 2008 unlike Ireland’s, but it’s NGDP has never exceeded 2008Q4 after nearly two years of additional data. It’s clearly below trend. By your own standards that’s a negative shock to AD.

  20. Gravatar of JoshK JoshK
    3. February 2011 at 07:38

    Now that Iceland said FU to creditors they may have the balls to stand on their own as a private banking center that can replace Switzerland in terms of confidentiality.

  21. Gravatar of Mark A. Sadowski Mark A. Sadowski
    3. February 2011 at 15:11

    Icelander protesting the economic situation (comedy).

    Warning, profane language (in Icelandic):

    http://www.youtube.com/watch?v=d-3kgALcnkE

  22. Gravatar of Mark A. Sadowski Mark A. Sadowski
    3. February 2011 at 18:16

    Iceland Travel Tip #22

    “Dating Viking Women”

    P.S. For better or worse, she reminds me a lot of my mother.

    http://www.youtube.com/watch?v=t1l9r60oH8g&NR=1

  23. Gravatar of Rien Huizer Rien Huizer
    4. February 2011 at 01:47

    Scott,

    You write faster than normal people can read.. There is no question that Ireland’s bailing out of bank creditors and Iceland’s lack of regulatory oversight (the Icelandic regulators were supposed to look for trouble under the Basle accords, not the local ones, although those local ones were asleep at the wheel) are both very expensive mistakes. To what extent Iceland* is more likely to bounce back (and recalculate) than Ireland is a bit harder and I believe that Ireland’s debt burden from the bank bail out is much more bearable than you suggest. Normally gvt debt equals required future taxation, but in this case there is of course the asset base of the banks (highly dependent on future gorth, OK) and Ireland’s relatively strong demographic and fiscal fundamentals. Ireland should not have joined the EUR without the UK, I think (and so did a quite a few Irish at the time, but that was not for public consumption).

    Iceland became independent during WWII for Allied strategic reasons (Denmark was occupied by Germany). Are you suggesting we turn back the clock? While the Greenlanders are getting greater autonomy! Annexation by the US would be abetter idea, but preferably after Canada.

    * Travelling Iceland and especially visiting some of those fjords, one gets te feeling that there are too many people, especially bankers. They should model themselves on the fishermen of Isafjordur, who spent the winters from 1000 to 1900 catching and processing (mainly in the dark, using the same technology and rowboats and the same trading post) cod from their Fjord for the Hanseatic League, until the successors of the German merchants told them that there was no longer a demand for their product.

  24. Gravatar of reason reason
    4. February 2011 at 05:31

    Surely,
    Canada would be a better match for Iceland than the USA (BOTH in terms of political culture AND geography).

  25. Gravatar of scott sumner scott sumner
    4. February 2011 at 18:27

    Benjamin, Yes, Krugman’s suddenly saying nice things about this blog–three times in a month, after 23 months of bad reviews.

    Andri. The employment numbers don’t contradict my argument. When I say aggregate demand I mean demand for Icelandic products, i.e. NGDP.

    Oli, I’m not sure I see how it relates to real interest rates.

    Stefan, When will they unfreeze that arrangement?

    Mark, You said;

    “True, Iceland’s NGDP rose throughout 2008 unlike Ireland’s, but it’s NGDP has never exceeded 2008Q4 after nearly two years of additional data. It’s clearly below trend. By your own standards that’s a negative shock to AD.”

    Maybe if it was the US, but for Iceland I just don’t see much of a negative AD shock. NGDP growth averaged just over 5% a year during the 2.75 year period you provided. I’d say that’s very normal. In contrast, the US grew only slightly, maybe 1% a year, and Ireland fell dramatically. You can point to the fact that the average 5% growth saw some sharp quarter to quarter fluctuations, but that’s normal in an ultra-small economy. A good fish catching season can probably throw things off.

    In level targeting terms they were pretty much on target in the long run, and as long as that’s true I don’t see a big problem from quarter to quarter fluctuations.

    Mark, My favorite video is still the comedian who ran for mayor, and won.

    http://www.youtube.com/watch?v=xxBW4mPzv6E

    And remember, Reykjavik has a big chunk of the entire country’s population.

    Rien, Thanks for that interesting info. I’m not suggesting the Icelanders will do much better than Ireland, I’m suggesting they will do better given the fact that their financial crisis was far worse. I agree that Ireland made a big mistake joining the euro. The biggest mistake of course was the highly corrupt regulation of their banking system–with lots of sweetheart deals involving political insiders.

    Reason, I agree.

  26. Gravatar of Mark A. Sadowski Mark A. Sadowski
    4. February 2011 at 19:21

    Scott,

    Helvittis Fokk!

    You’ve trumped me.

  27. Gravatar of Mark A. Sadowski Mark A. Sadowski
    4. February 2011 at 20:17

    Scott,
    You wrote:

    “Maybe if it was the US, but for Iceland I just don’t see much of a negative AD shock. NGDP growth averaged just over 5% a year during the 2.75 year period you provided. I’d say that’s very normal. In contrast, the US grew only slightly, maybe 1% a year, and Ireland fell dramatically. You can point to the fact that the average 5% growth saw some sharp quarter to quarter fluctuations, but that’s normal in an ultra-small economy. A good fish catching season can probably throw things off.

    In level targeting terms they were pretty much on target in the long run, and as long as that’s true I don’t see a big problem from quarter to quarter fluctuations.”

    That’s a huge load of bull dung to take from you. I expected much better.

    NGDP averaged 9.8% from 1997 through 2008 on an annual basis. How do you explain a below 17%+ NGDP below trend in 2010?

    The variance in cod catch! RUBBISH!

  28. Gravatar of Mark A. Sadowski Mark A. Sadowski
    4. February 2011 at 20:34

    I take back my Helvittis Fokk!

    Instead make that a Helvittis Fokking Fokk!

  29. Gravatar of Mark A. Sadowski Mark A. Sadowski
    4. February 2011 at 21:03

    When I wake up tomorrow I don’t want to hear any BS about 5% targets. It’s all about previous etablished trends as you’ve made it clear previously. A sharp and sudden reduction in the rate of NGDP growth can have real consequences, right? Or no? Save my faith in you.

  30. Gravatar of Brent Royal-Gordon Brent Royal-Gordon
    5. February 2011 at 01:36

    You can use all that geothermal energy to generate electricity, but there’s no way to export it. However, if you then use that electricity to electrolyze water (perhaps purified sea water), you can produce hydrogen gas, which can be exported and used as fuel.

    Of course, hydrogen is highly explosive, but I think we can now safely say that Iceland is pretty much fearless.

  31. Gravatar of scott sumner scott sumner
    5. February 2011 at 16:21

    Mark, I didn’t know the trend rate was that high. But still, it’s undeniably much better than Ireland, which was my main point. Perhaps there was an AD shock, but you need to be very careful with extrapolations. You can do another plausible extrapolation that has the 2008 peak be above trend, and get a different result.

    You said;

    “Instead make that a Helvittis Fokking Fokk!”

    And the same to you! :)

    You said;

    “When I wake up tomorrow I don’t want to hear any BS about 5% targets. It’s all about previous established trends as you’ve made it clear previously. A sharp and sudden reduction in the rate of NGDP growth can have real consequences, right? Or no? Save my faith in you.”

    OK, reductio ad absurdum, Say a country like Turkey or Brazil slows from 35% NGDP trend growth to 30% NGDP trend growth. Do you predict a recession as bad as what the US went through? I don’t. A higher trend makes a difference, so does Iceland’s very small population. I grant your point, there was an adverse demand shock, but I think you are overstating its importance a little bit.

    Oh, and sorry to ruin your breakfast.

    Brent, interesting idea. What they’ve actually done is build aluminum smelters, which is an indirect war of exporting electricity.

  32. Gravatar of Stefan Stefan
    7. February 2011 at 02:39

    They actually lifted the freeze in october 2010 and they are now in the process of restructuring the debt. It seems that mortgage debt will be converted to icelandic currency and recieve a haircut of around 25-50% accourding to a recent statement from the central bank.

    Estimates show that roughly 20-40.000 households will be effected.

  33. Gravatar of ssumner ssumner
    7. February 2011 at 17:00

    Stefan, Thanks for the info. It’s always dangerous to make mortgage loans in other currencies. The Swiss also had a problem in Eastern Europe.

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