Thorvaldur Gylfason

1929: Wall Street collapse Compounded by massive public policy failure

Monetary contraction (Friedman-Schwartz story) Protectionism (Smoot-Hawley tariff)

1987: Wall Street, again Corrected through monetary expansion

(Volcker) 1997: Asian crisis

Preceded by construction boom in Thailand 2000: Dotcom collapse, limited impact 2008: Subprime loan debacle in US

Where will it lead? Repeat from 1929? No.

Exposes a fundamental asymmetry of information, leading to grave moral hazard Selling mortgage loans to people with no jobs,

no incomes, no money to put down, no means of paying back

Bankers convinced subprime customers that they could pay higher interest on their mortgages after a short grace period because house prices would rise, but prices fell

Dealers have a vested private interest in making socially destructive deals The most they stand to lose is their jobs The most they can win is astronomical wealth You figure out the average of those two

options

Need legal protection against predatory Need legal protection against predatory lendinglendingLike laws against quack doctors, same logic

Patients know less about health problems than doctors, so we have legal protection against medical malpractice

Same applies to some bank customers vs. bankers, especially in connection with complex financial deals

Subprime assets of dubious value were packaged into complex financial instruments of equally dubious value that not even some of the bankers themselves understood …

… and were given top ratings by rating agencies paid by the banks that pushed these instruments

Do not allow rating agencies to be paid Do not allow rating agencies to be paid by the banksby the banksFundamental conflict of interestFurther, regulation was weak In US, laws from 1930s (Glass-Steagall Act)

separating commercial banking from investment banking were deliberately weakened around 1990, permitting banks again to blend the two types of banking Consider merging an electric utility providing a

steady stream of electricity to rate-paying customers and a casino, making it possible for the casino, if it goes bust, to bring down the utility

But this is controversial because, in good times, the casino can support the utility

Need more and better regulation of Need more and better regulation of banks and other financial institutions, banks and other financial institutions, but exactly how needs to be worked outbut exactly how needs to be worked outWork in progress

Read the warning signalsRead the warning signalsThree rules, or stories

The Aliber RuleCount the cranes

The Giudotti-Greenspan RuleNever allow gross foreign reserves held by the

Central Bank to fall below the short-term foreign debts of commercial banks

Failure to respect the Giudotti-Greenspan Rule amounts to an open invitation to speculators to stage an attack on the currency

The Overvaluation RuleSooner or later, an overvalued currency will

fall

Read the warning signalsRead the warning signals First story

Professor Aliber in Iceland 2007: Count the cranes!Bangkok 1996: Many cranes, yes, but no clue

Second story Thailand 1996: Ratio of foreign reserves to short-

term foreign debt had fallen below the critical number 1Speculators took notice, and attacked the bahtLike others, IMF was caught off guard

Iceland took longer: Central Bank foreign reserves dropped from 100% of short-term debt in the 1990s to 6% in 2008 while bank assets rose to 9 times GDP

Mid-2008

Three-Month Rule

Giudotti-Greenspan Rule

Mid-2008

Read the warning signalsRead the warning signals Third story

Overvaluation: Like many African countries, Iceland has a long history of an overvalued currency

2007: Iceland’s per capita GDP had risen to 50% above US per capita GDP Clear sign that correction was due Even so, many households and firms borrowed in cheap

foreign currencies at low interest even if their entire earnings were in domestic currency

Even senior bankers and ministers did this An indication of wide-spread euphoria

Other unmistakable signs Large current account deficits, mounting foreign debts Creeping inflation Pervasive farm support, including fisheries High domestic prices of tradable goods (Big Mac index) Recently, also, carry trade

Mid-2008

Beyond our means, yes, big time:

Investment (housing, hydro-

projects) Consumption (jeeps, jets, Elton

John)

Mid-2008International Investment Position (% of GDP)International Investment Position (% of GDP)

Do not let banks outgrow Central Bank’s Do not let banks outgrow Central Bank’s ability to stand behind them as lender – ability to stand behind them as lender – or borrower – of last resortor borrower – of last resort

Do not allow banks to operate branches Do not allow banks to operate branches abroad rather than subsidiaries, thus abroad rather than subsidiaries, thus exposing domestic deposit insurance exposing domestic deposit insurance schemes to foreign obligationsschemes to foreign obligations Without having been informed about it,

Iceland (population 300.000) suddenly found itself to be held responsible for the moneys kept in an Icelandic bank by 300.000 British depositors, and more in the Netherlands and Germany

Barclays: 100% of Britain’s GDP

Deutsche Bank: 80% of

Germany’s GDP

Source: Union Bank of Switzerland.

Mid-2008

“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.”

J.M. Keynes

Icelandic banks copied each other’s business model

This can be good when the going is good, but not so good when the sea gets rough

Erect firewalls between banking and politicsErect firewalls between banking and politics Iceland’s privatization of its state banks 1998-

2003 was mismanaged in ways that contributed to collapse and to weak restraints on bank growth GovernmentGovernment ought to have constrained the banks

through taxes Central Bank Central Bank ought to have constrained them

through reserve requirements Financial Supervision Authority Financial Supervision Authority ought to have applied

more stringent stress tests, appropriate to local conditions

Besides, several earlier episodes of bank problems when banks were state-owned were covered up No accountability

When things go wrong, hold those When things go wrong, hold those responsible accountable by law, or at responsible accountable by law, or at least try to uncover the truth: Do not least try to uncover the truth: Do not cover upcover up In Iceland, there are now vocal demands for

an International Commission of Enquiry, a Truth and Reconciliation Committee of sorts

If history is not correctly recorded if only for learning purposes, it is more likely to repeat itself with dire consequences

When banks collapse and assets are wiped When banks collapse and assets are wiped out, protect the real economy by a out, protect the real economy by a massive monetary or fiscal stimulusmassive monetary or fiscal stimulus Think outside the box: put old religion about

monetary restraint and fiscal prudence on ice Always remember: a financial crisis, painful

though it may be, typically wipes out only a small fraction of national wealth Physical capital (typically 3 or 4 times GDP) and

human capital (typically 5 or 6 times physical capital) dwarf financial capital (typically less than GDP)

So, financial capital typically constitutes one fifteenth or one twenty-fifth of total national wealth or less

Source: World Bank, World Development Indicators 2008.

Do not jump to conclusions and do not Do not jump to conclusions and do not throw out the baby with the bathwaterthrow out the baby with the bathwater Since the collapse of communism, a mixed

market economy has been the only game in town

To many, the current financial crisis has dealt a severe blow to the prestige of free markets and liberalism, with banks having to be propped up temporarily by governments, even nationalized

Even so, it remains true that governments are not well suited to own and operate banks, so banks will in due course need to be re-privatized

Banking and politics are not a good mix Even so, private banks clearly need proper

regulation because of their ability to inflict severe damage on innocent bystanders

From the IMF Data Mapper, October 2008

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