Why you should let banks fail

The Telegraph reports:

The crash of 2008 hit every country in the world. And yet none was quite so completely destroyed as . A tiny country, home to just 323,000 people, with cod fishing and tourism as its two major industries, it deregulated its finance sector and went on a wild lending spree. Its started bulking up in a way that might have made Royal Bank of Scotland’s Fred Goodwin start to wonder if his foot wasn’t pressed too hard on the accelerator. When confidence collapsed, those banks were done for.

In every other country in the world, the conventional wisdom dictated the financiers had to be bailed out. The alternative was catastrophe. Cash machines would stop working, trade would grind to a halt, and output would collapse. It would be the 1930s all over again. The state had no option but to dig deep, and pay whatever it took to keep the financial sector alive.

But Iceland did not have that option. Its banks had run up debts of $86bn, an impossible sum for an economy with a GDP of $13bn in 2009.

So the banks went under.

So what happened next? Iceland collapsed? For the next few years, the Icelanders were presumably shivering in their frosty homes, eating cod tails, and wondering where they could scratch together enough money for a packet of candles to see them through the winter?

Well, as it happens, not quite. Sure, there have been some very tough times. Interest rates went all the way up to 18pc to try to find some kind of floor for a currency that collapsed by more than 80pc. Strict controls on bringing money into and out of the country were imposed. Iceland’s GDP, not surprisingly, took an immediate hit falling by almost 7pc in one year.

Overall, four out of 10 Icelandic households were declared technically insolvent, mainly on account of the foreign currency mortgages they had taken out at the height of the boom. The International Monetary Fund had to step in with an emergency package of measures just to keep the country from sinking into the chilly depths of the North Atlantic.

It was about as bad as the mainstream economic consensus predicted it would be. The banks went down, and the economy went down with them. But there has been a twist in the tail. As it turned out, Iceland recovered relatively quickly.

Last year, its economy expanded by an impressive 7.2pc. Unemployment has dropped all the way down to 3pc, a level which means virtually everyone who wants a job has one. The krona was up by 18pc in the past year against a basket of rival currencies as global investors started to buy into its rapid recovery. Interest rates have been steadily reduced from emergency levels to 5pc, a sustainable long-term rate that rewards savers and yet makes it affordable to borrow and invest. Its debt to GDP ratio by 2015 was down to 68pc: significantly less than ours.

Contrast this to Greece which keeps getting bailouts, and because it has not had to adjust, its economy remains wrecked.

There is surely a lesson in that. The consensus insisted we had to bail out the banks. If we did not, the economy would be taken back to the Stone Age. But there was an alternative. In fact, governments could only protect domestic deposits. After that, they could simply say, very sorry, but there wasn’t enough money left to pay back all the debts the bankers had run up.

Bad debts would get written off immediately, rather than remaining a millstone around the neck of the country for years to come. More importantly, it would be better morally. Reckless, irresponsibly behaviour would not be rewarded. Bankers would have to think a lot harder about what risks they were taking, and what their consequences might be. Depositors would have to be a lot more careful about where they put their money, rather than just lazily assuming the government would pick up the tab for any losses. True, the collapse was a terrible shock for Iceland.

But it was short-lived, and the bounce back has been very strong. Next time a bank collapses, we should remember that – and perhaps follow its example.

Wise words indeed.

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