Iceland’s austerity; second to one

Matt Yglesias recently did a post on Iceland’s surprisingly strong recovery.  In a post at Econlog I agreed with much of what he had to say, but was doubtful about Matt’s claim that Iceland rejected austerity.  Paul Krugman did a post criticizing austerity, and cited Yglesias’s post as supporting evidence for the heterodox policy approach. Now Mark Sadowski has a post over at Marcus Nunes’s blog, which provides much more comprehensive information on Iceland’s fiscal policy:

Scott is looking at the “net operating balance” which excludes the “net acquisition of nonfinancial assets”. Including this item results in “net lending”, which is what Europeans call “the deficit”. The net lending of Iceland’s general government fell from 9.7% of GDP in calendar year 2009 to 1.7% of GDP in calendar year 2013, a change of 8.0% of GDP.

Moreover, Iceland’s general government budget ran a surplus equal to 1.8% of GDP in 2014, or a change in fiscal stance since 2009 equal to 11.5% of GDP. This can be found on Table A1 of the April 2015 IMF fiscal Monitor.

And, according to IMF estimates, Iceland’s output gap was actually somewhat larger in 2014 than in 2009.  .  .  .  Table A3 shows that Iceland’s general government cyclically adjusted balance rose from a deficit of 10.0% of potential GDP in 2009 to a surplus of 2.7% of potential GDP in 2014, or a change of 12.7% of potential GDP.

But even this tends to understate the amount of fiscal austerity that Iceland has engaged in. This is because it includes the increase in spending attributable to rising interest payments on the national debt. To get a proper idea of the amount of fiscal austerity that Iceland has engaged in (i.e. cuts in direct spending and increases in taxes) one has to look at the general government cyclically adjusted primary balance which can be found in Table A4.  Iceland’s general government cyclically adjusted primary balance rose from a deficit of 6.9% of potential GDP in 2009 to a surplus of 6.2% of potential GDP in 2014, or a change of 13.1% of potential GDP.

Mark also constructed this graph, showing Iceland’s austerity relative to other countries:

Screen Shot 2015-06-12 at 9.28.37 PM

 

Mark continues:

By this standard Iceland has done about 30% more austerity than Ireland, over double that of the UK, roughly two three and a half times as much as the US, and approximately five and a half times as much as Latvia. The only country that has done more fiscal austerity is Greece.

None of this should come as a surprise. When nearly all the other OECD members were busy implementing fiscal stimuli in early 2009, Iceland (joined only by Ireland) was engaged in a massive fiscal consolidation (see Figure 3.2 and Table 3.1).

In 2012 the Icelandic Finance Ministry, in front of an audience of fellow OECD senior budget officials, patted itself on the back for a job well done.

The scope and scale of Iceland’s fiscal consolidation was truly mind boggling. Real primary expenditures were estimated to fall by 12.7% between 2009 and 2012 (Slide 16). This was accomplished by slashing current expenditures, transfers, and maintenance and investment, and by freezing public sector wages and benefits for a period of four years (Slide 13), during a time when inflation soared due to the 50% depreciation of the króna.

On the revenue side the VAT was raised to 25.5%, which at that time was the highest in the world (Slide 14). The top personal income tax rate was increased from 35.7% to 46.2% (Table 2):

The capital income tax rate was doubled from 10% to 20%, the corporate income tax was increased from 15% to 20%, the social security contribution (SSC) was increased from 5.34% to 8.65% and fishing levies (important in Iceland) were increased. In addition a whole slew of new taxes were imposed (e.g. a net wealth tax, an inheritance tax, a financial activities tax (FAT) etc. etc.)

The bottom line is that Krugman’s implied poster child for anti-fiscal austerity is in reality the advanced world’s second leading practitioner of it. If Iceland’s economy is doing as well as Krugman claims (I have my doubts), then the only real reason it is doing so well (we have yet to see what happens after capital controls are lifted) is relatively steady NGDP growth as demonstrated in Scott’s post.

Thus it seems to me that Krugman’s recent posts extolling the relative economic performance of Iceland are inadvertently strengthening the argument for the ability of monetary policy to wholly offset fiscal policy.

Note that Iceland’s various income tax rates were surprisingly low before the crisis, especially for a Nordic country.

 


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26 Responses to “Iceland’s austerity; second to one”

  1. Gravatar of Morgan Warstler Morgan Warstler
    13. June 2015 at 06:24

    The worm turns.

  2. Gravatar of benjamin cole benjamin cole
    13. June 2015 at 06:47

    If is this chart is true, then Greece has gone through a historic and heroic restructuring.

    Should the IMF and ECB continue to suffocate Greece?

    Or, is Greece justified at this point in quitting the Euro, reneging on its debt, and printing drachmas to the moon?

  3. Gravatar of Ray Lopez Ray Lopez
    13. June 2015 at 06:55

    As B. Cole implies upstream, the stats are bogus if you are to believe Greece is practicing austerity. I live there, and I can assure you nothing is further from the truth. Another giveaway that the stats are bogus is the mention of “potential GDP”, which is a fudge factor. If in fact structural changes induced by the Great Recession cause a permanent drop in GDP, then ‘potential’ GDP is a lot less than pre-Great Recession projections, and hence the data is skewed.

    More lies, damn lies, and statistics, of which economists are famous for.

  4. Gravatar of chris arnade chris arnade
    13. June 2015 at 07:37

    Sure
    You can be austere following a devaluation and cap controls.

    If absence of those two, austerity is just piling on an untenable situation.

  5. Gravatar of ThomasH ThomasH
    13. June 2015 at 09:18

    To know whether or not Iceland’s government indulged in “austerity,” we need to know both the government effective borrowing rate and the amount of expenditures with NPV greater than zero when discounted at that rate. Since it seems likely that the borrowing rate increased (and if anything expenditures with positive NPV might have decreased) a lower deficit would not be “austerity” but rater prudent fiscal management.

  6. Gravatar of ThomasH ThomasH
    13. June 2015 at 09:31

    To know whether or Ray Lopez is correct about Greece’s government not applying “austerity,” we need to know both the government’s effective borrowing rate and the amount of expenditures with NPV greater than zero when discounted at that rate.

    Without and independent monetary authority that keeps NGDP on a steady trend it’s impossible to tell how by much if any actual real GDP is below its potential (how much inflation would be below the historic trend portion of NGDP). I suspect the Troika program resulted in a fall in NGDP growth, which, with sticky prices, one would expect to result in a fall in real GDP below its potential.

  7. Gravatar of collin collin
    13. June 2015 at 10:15

    Isn’t Kevin Drum/Tyler Cowen point on Iceland the simplest here? It is a small nation with the size of Bakersfield and it is an interesting case study to think about. So was it the austerity or simply a massive devalueing the currency or just a small island that can still be a ‘local economy’? They suffered with high inflation but with 300K people they can suffer together.

    One has to wonder if Ireland or Greece simply rejected the Euro, told creditors to pound sand and deal with a couple of years of ~15% that would be in better shape.

  8. Gravatar of Did Iceland reject fiscal austerity? Did Iceland reject fiscal austerity?
    13. June 2015 at 11:30

    […] Sumner serves up the appropriate links.  He cites Mark Sadowski, who tells […]

  9. Gravatar of Jerry Brown Jerry Brown
    13. June 2015 at 11:55

    Thanks for posting this. I have missed Mark Sadowski’s always intelligent (and stat laden) writing. Glad to hear from him again.

  10. Gravatar of ssumner ssumner
    13. June 2015 at 13:14

    Ben, At this point supply-side reforms would be better than either leaving or doing more austerity. But the government opposes supply-side reforms.

    Ray, The stats may be bogus, but these are the sorts of stats that Keynesians use to justify fiscal stimulus. So if the data is bogus, doesn’t Keynesian economics collapse?

    Chris, Fine, but if monetary stimulus allows for austerity, then Krugman’s argument for fiscal stimulus collapses. His argument is based on cross-sectional studies containing of eurozone members, which break down when you exclude countries with their own currencies.

    Thomas, Fine but then if you are right then the standard Keynesian arguments for fiscal stimulus that we’ve all been reading over the past 5 years are worthless.

    Collin, Monetary stimulus would also work in large countries, but your point about Greece is a good one—it’s not easy to leave the eurozone. In that sense, Iceland had better options.

  11. Gravatar of bill bill
    13. June 2015 at 13:15

    Krugman is trying to use these examples to show that the US government should spend more. The key fallacy (and it’s hard to believe that he doesn’t see it because he is very intelligent) of this comparison is that he purposely glides over the fact that Iceland succeeds because it has its own currency and monetary policy while Greece suffers because it doesn’t have its own currency. To paraphrase Clinton/Carville, it’s the monetary policy stupid.

  12. Gravatar of BigEd BigEd
    13. June 2015 at 17:46

    So what was the change in the value of Iceland’s fish exports between 2009 and 2014??

  13. Gravatar of Steve Steve
    13. June 2015 at 17:48

    “and it’s hard to believe that he doesn’t see it because he is very intelligent”

    Kroogman sees what he wants to see and disregards the rest

  14. Gravatar of Steve Steve
    13. June 2015 at 17:53

    Did Hillary just support a wage subsidy?

    “I will give new incentives to companies that give their employees a fair share of the profits their hard work earns,” Clinton said.

    http://money.cnn.com/2015/06/13/news/economy/clinton-campaign-speech-wall-street-hedge-funds/

    It’s not an “incentive” if companies are forced to pay it out of their own pockets…only if the government is chipping in for employment costs.

    I suppose Hillary’s campaigning is just an odd rhetorical fusion of Obama class warfare and 1990s centrism.

  15. Gravatar of Morgan Warstler Morgan Warstler
    13. June 2015 at 18:05

    If I’m not mistaken the point, and the ONLY point is that govt, after it stopped paying it’s debts, wasn’t able to borrow and the country was forced to live on tax receipts.

    That’s basically god’s law, no?

  16. Gravatar of Blair Blair
    13. June 2015 at 18:37

    Scott,

    I’m not sure if you subscribe to Matt’s newsletter but in it he says:

    “I wrote about Iceland’s handling of the financial crisis recently. Something that I think is interesting about this is that it’s almost invariably left-of-center people who you see talking about Iceland. But in many ways what they did is what you would think of as a conservative response to a banking crisis. What they did, basically, was rely overwhelmingly on monetary and exchange rate policy to stabilize employment simply because the costs of relying on bank bailouts and fiscal policy would have been inconceivable for such a small country. It was, in other words, more or less like an application of Milton Friedman’s ideas to the circumstances of a tiny island country.

    They departed in a serious way from free markets in imposing capital controls, but all the mainstream countries also departed in a serious way from free markets through very heavy government intervention in the banking system. It’s not clear to me why a free marketer would prefer the US or European approach to the Icelandic one, even as the Icelandic way clearly appeals to left-wing people’s sensibilities.

    For me, though, the most important lesson is that even though people legitimately dislike it when they have to live through a few years of high inflation this is much less socially destructive than living through an equal number of years of sky-high unemployment. When bad things happen, you need to pick your poison. And the inflation poison is much milder.”

  17. Gravatar of Ray Lopez Ray Lopez
    13. June 2015 at 18:49

    OT: http://www.bbc.com/news/business-33092732 – a story by the BBC on Brazilian inflation. Of interest is that banks made money during high inflation more so than now (competition was such that the spreads were higher then), the 1997 Plano Real which lowered inflation involved bank bailouts, criticized at the time by the West, and jawboning by the 2011+ Brazilian president Rousseff was effective to keep rates low (apparently a couple of banks are her favorites and collude with her when she speaks). Also note that despite high inflation of 14%/yr, #1 in the world, Brazil is slipping back into recession. I’m sure our host could give some nuanced reason why high inflation does not mean high money creation (perhaps he believes there’s a bottleneck in supply? Or some crazy IS-LM interpretation?) but Brazil’s high inflation but coming recession seems to undercut the argument that printing money will stave off recession.

    Short story even shorter: quantity theory of money does not work as a policy tool with non-constant velocity.

  18. Gravatar of Postkey Postkey
    14. June 2015 at 01:49

    “The implications of the observed velocity decline and breakdown in the money demand function for macroeconomics were devastating. This empirical failure not only discredited monetarism, but posed a major obstacle to all the other schools of
    thought as well, most of which had previously relied on the quantity equation in one way or another. ”
    http://eprints.soton.ac.uk/339271/1/Werner_IRFA_QTC_2012.pdf

  19. Gravatar of benjamin cole benjamin cole
    14. June 2015 at 03:58

    I have to say I agree with the thrust of BigEd, s comment above; in a country the size of Iceland could we see a recovery due to some good fishing and a new geothermal plant?

  20. Gravatar of Ray Lopez Ray Lopez
    14. June 2015 at 07:08

    @Postkey – bravo, good find. The author of the paper you cite, Richard A. Werner, is a hero and writes good on heterodox economics. He also has the distinction of coining the phrase “QE” (Quantitative Easing).

  21. Gravatar of ssumner ssumner
    14. June 2015 at 08:04

    Morgan, It’s amazing how many people don’t get that simple point. If you are broke, austerity is your only option.

    BigEd, I don’t know. Is it relevant to Iceland’s fiscal austerity?

    Thanks Blair.

    Ray, Brazil’s problems are clearly supply-side, as I’ve stated in previous posts. Printing money won’t help them.

    Postkey, How is that relevant to anything here? Unless your claim is that it supports market monetarism over old time monetarism.

  22. Gravatar of Postkey Postkey
    14. June 2015 at 10:12

    Do market monetarists distinguish between the type of
    credit that boosts GDP and credit that is associated with asset prices and banking crises?

  23. Gravatar of ssumner ssumner
    15. June 2015 at 07:57

    Postkey, I pay no attention to credit. I focus on money, NGDP and jobs.

  24. Gravatar of The miraculous story of Iceland – The Washington Post The miraculous story of Iceland - The Washington Post
    17. June 2015 at 03:14

    […] Portugal or Spain or Britain or even supposed budget-cutting superhero Latvia did, as economist Scott Sumner points out. Only Greece has done more. Not only that, but Iceland also increased interest rates […]

  25. Gravatar of Morgan Warstler Morgan Warstler
    17. June 2015 at 03:36

    test

    Argh!

    Sender computer program receiver

    This is Scott’s old economy:

    Nature Scott

    What we have right now is this:

    Natural reality -> computer program Scott

    Eventually it becomes this:

    computer program Scott

  26. Gravatar of The miraculous story of Iceland The miraculous story of Iceland
    27. May 2016 at 12:03

    […] Portugal or Spain or Britain or even supposed budget-cutting superhero Latvia did, as economist Scott Sumner points out. Only Greece has done more. Not only that, but Iceland also increased interest rates […]

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