Iceland's central bank raises interest rates to 18%

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We're going to be seeing a lot of this as the IMF swoops in with rescue money; raising interest rates and slashing government budgets are typically among the conditions that the IMF imposes.  These are inevitably rapidly followed by complaints that the IMF is making things worse, complaints that are generally vindicated by plummeting GDP and gross hardship due to the fiscal contraction.

But blaming the IMF may be cursing the cure rather than the disease.  Iceland is facing massive capital flight, for reasons that Felix Salmon points out:

The decision to raise rates is being painted as an attempt "to return to a market-based floating exchange rate regime". But the reason that regime fell apart was nothing to do with Iceland's monetary policy. Rather, it was a function of the fact that anybody looking to earn interest on Icelandic krona deposits would have to have that money on deposit with an Icelandic bank. Which, in turn, meant taking bank credit risk on top of FX risk. And if you wanted to take bank credit risk, you could make much more money by selling default protection.

So I suspect that this latest move by the central bank is largely symbolic. No liquid currency market can exist in a country without a functioning banking system. Unless and until Iceland gets solvent banks -- either new ones or restructured old ones -- the krona will continue to trade largely through newspaper classified ads.

This is a real problem, though the interest rates may help that recapitalization; they encourage saving and discourage consumption.  They may also compensate some outside investors for the bank/currency risk, which is huge; the Krona seems to have lost about 2/3 of its value since last year, though as far as I can tell, it still isn't really trading outside of Iceland.  At the very least, it will help control the inflation that will almost certainly result from the free-falling currency.

Of course, it won't be good for anyone who has to borrow money.  Opponents want the IMF to stop kicking countries when they're down.  But the conditions that force austerity aren't the making of the IMF; the IMF is there because of those conditions.  For example, when the price of oil fell in the 1980s, oil producing nations like Nigeria blamed IMF austerity measures for their plummeting standard of living.  But the IMF's job is not to insulate commodity-driven economies from falling prices; it's to prevent the resulting catastrophic financial collapse.  And if the government pursues inflationary policies and continues to run a giant deficit, capital will certainly flee. 

Witness Argentina recently nationalizing its private pension alternative, not because the pensioners were dissatisfied, but because the government needed the contributions to finance current spending.  In past years, the Argentinian government avoided austerity measures by massively defaulting on its foreign debts--but only at the price of systematically destroying investor willingness to lend it money.  Unless the world economy turns around in 2010, Argentina is going to end up with the austerity measures, and no recourse to outside help.

Ken Rogoff outlined the IMF's dilemma in a scathing response to Joseph Stiglitz's critique of the World Bank and the IMF:

Let's look at Stiglitzian prescriptions for helping a distressed emerging market debtor, the ideas you put forth as superior to existing practice. Governments typically come to the IMF for financial assistance when they are having trouble finding buyers for their debt and when the value of their money is falling. The Stiglitzian prescription is to raise the profile of fiscal deficits, that is, to issue more debt and to print more money. You seem to believe that if a distressed government issues more currency, its citizens will suddenly think it more valuable. You seem to believe that when investors are no longer willing to hold a government's debt, all that needs to be done is to increase the supply and it will sell like hot cakes. We at the IMF--no, make that we on the Planet Earth--have considerable experience suggesting otherwise. We earthlings have found that when a country in fiscal distress tries to escape by printing more money, inflation rises, often uncontrollably. Uncontrolled inflation strangles growth, hurting the entire populace but, especially the indigent. The laws of economics may be different in your part of the gamma quadrant, but around here we find that when an almost bankrupt government fails to credibly constrain the time profile of its fiscal deficits, things generally get worse instead of better.

Joe, throughout your book, you condemn the IMF because everywhere it seems to be, countries are in trouble. Isn't this a little like observing that where there are epidemics, one tends to find more doctors?

You cloak yourself in the mantle of John Maynard Keynes, saying that the aim of your policies is to maintain full employment. We at the IMF care a lot about employment. But if a government has come to us, it is often precisely because it is in an unsustainable position, and we have to look not just at the next two weeks, but at the next two years and beyond. We certainly believe in the lessons of Keynes, but in a modern, nuanced way. For example, the post-1975 macroeconomics literature--which you say we are tone deaf to--emphasizes the importance of budget constraints across time. It does no good to pile on IMF debt as a very short-run fix if it makes the not-so-distant future drastically worse. By the way, in blatant contradiction to your assertion, IMF programs frequently allow for deficits, indeed they did so in the Asia crisis. If its initial battlefield medicine was wrong, the IMF reacted, learning from its mistakes, quickly reversing course.

No, instead of Keynes, I would cloak your theories in the mantle of Arthur Laffer and other extreme expositors of 1980s Reagan-style supply-side economics. Laffer believed that if the government would only cut tax rates, people would work harder, and total government revenues would rise. The Stiglitz-Laffer theory of crisis management holds that countries need not worry about expanding deficits, as in so doing, they will increase their debt service capacity more than proportionately. George Bush, Sr. once labeled these ideas "voodoo economics." He was right.

Keynesian stimulus may work in a large domestic economy that borrows in its own currency.  But in small countries like Iceland, which imports nearly everything it eats and has a small domestic capital base, the government must quickly restore the credibility of its financial system, or watch its people starve. Expect to see austerity pressed on Hungary and Ukraine as well--and a resulting backlash against capitalism in those countries.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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