Page last updated at 15:41 GMT, Tuesday, 28 October 2008

Why raising interest rates won't work

Jon Danielsson
Economist, Financial Markets Group, London School of Economics

The first industrialised country to request assistance from the International Monetary Fund (IMF) in over 30 years is Iceland.

The crisis will hurt ordinary Icelandic households.

The reason is that Iceland was hit by the deepest and most rapid financial crisis in peacetime history.

At the moment, the Icelandic economy has come to a standstill, it is almost impossible to transfer foreign currency between Iceland and abroad, which is a calamity for a country that is almost entirely dependent on imports and exports.

Exporters cannot bring export earnings into Iceland, and it is very difficult to obtain foreign currency to purchase necessities.

The key factor in Iceland's failure has been the monetary policy pursued by its central bank, in particular inflation targeting, similar to the UK.

This means the central bank targets inflation, raises interest rates if inflation is above the target, and lowers them if inflation is below target.

Such a policy has a sound foundation in economic theory and is often appropriate for large countries.

In the case of Iceland, it was disastrous.

Financial bubble

Throughout the period of inflation targeting, inflation was above its target rate, resulting in interest rates exceeding at times 15%.

In a small economy like Iceland high interest rates both encourage domestic firms and households to borrow in foreign currency, and also attract currency speculators.

Given the damaging role of high interest rates in events leading up to the crisis, it is very unfortunate that the IMF has insisted on a high interest policy

This brought large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth.

The speculators and borrowers profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation.

These effects encouraged economic growth and inflation, further leading the central bank to raise interest rates.

The end result is a bubble caused by the interaction between domestic interest rates and inflows of foreign currency.

The exchange rate was increasingly out of touch with economic fundamentals, with a rapid depreciation of the currency inevitable.

This should have been clear to the central bank, which wasted several good opportunities to prevent exchange rate appreciations and build up reserves.

Given the damaging role of high interest rates in events leading up to the crisis, it is very unfortunate that as a part of their conditions, the IMF has insisted on a high interest policy.

Indeed, it is the very same policy that has caused considerable damage in previous IMF rescues, such as in the Asian crisis.

Independent bank?

Adding to this is the peculiar governance structure of the Central Bank of Iceland. Uniquely, it does not have one but three governors.

The Icelandic authorities do not seem to have appreciated the seriousness of the situation, not communicated appropriately with their international counterparts, leading to an atmosphere of mistrust

One or more of those has generally been a former politician.

Consequently, the governance of the central bank has always been perceived to be closely tied to the central government, raising doubts about its independence.

Currently, the chairman of the board of governors is a former long-standing prime minister.

Such a governance structure carries with it unfortunate consequences that become especially visible in the financial crisis.

By choosing governors based on their political background rather than economic or financial expertise, the central bank may be perceived to be ill-equipped to deal with an economy in crisis.

Oversized banking sector

The second factor in the implosion of the Icelandic economy this week has been the size of its banking sector.

Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP, with debts to match.

Icelandic Prime Minister Geir Haarde
Iceland's prime minister Geir Haarde has been under the spotlight this week.

In normal economic circumstances this is not a cause for worry, so long as the banks are prudently run.

Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts.

In this crisis, the strength of a bank's balance sheet is of little consequence. What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity.

Therefore, the size of the state relative to the size of the banks becomes the crucial factor.

The relative size of the Icelandic banking system means that the government was in no position to guarantee the banks, unlike in other European countries.

This effect was further escalated and the collapse brought forward by the failure of the central bank to extend its foreign currency reserves.

'Pariah status'

The final collapse was brought on by the bankruptcy of the entire Icelandic banking system.

We may never know if the collapse of the banks was inevitable, but the manner in which they went into bankruptcy turned out to be extremely damaging to the Icelandic economy, and indeed damaging to the economy of the United Kingdom and other European countries.

The Icelandic authorities do not seem to have appreciated the seriousness of the situation, not communicated appropriately with their international counterparts, leading to an atmosphere of mistrust.

The UK authorities exasperated with responses from Iceland seem to have overreacted, using antiterrorist laws to take over Icelandic assets, and causing the bankruptcy of the remaining Icelandic bank.

Ultimately, this led to Iceland getting a pariah status in the financial system.

The original cause of the Icelandic crisis was a combination of inappropriate monetary policy and an outsized banking system.

Throughout this year, the Icelandic currency has been falling due to the currency speculators running for shelter.

This has caused doubts about the Icelandic economy and its banking sector.

What eventually tipped the balance was the current extreme global financial uncertainty, the mishandling of the crisis by the Icelandic authorities and the overreaction of the UK authorities.

The real tragedy in the crisis is the impact on Icelandic households; they are seeing payments on loans increased by up to 50%, and inflation which may reach 30% or more this year, with salaries frozen and mass layoffs.

Fortunately, the long-run macroeconomic potential is good.

Iceland is a natural resource-based economy, with plenty of untapped natural resources and well educated workforce.

The long-run economic outlook is therefore favourable.

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