Douglas French: When a country goes bankrupt

What’s it look like when a country goes bankrupt? Store shelves are suddenly empty. Individual stock portfolios are decimated. Homes and cars are encumbered by loans totaling three times what the assets are worth, and the nation’s debt reaches 850 percent of Gross Domestic Product (America’s debt to GDP ratio is 370 percent).

For example, Iceland went from a forgotten country of 320,000 people who mainly fished, to being a giant hedge fund. Fishermen traded their nets for three-piece suits and HP12C calculators. With the Icelandic krona interest rates at 15.5 percent and the krona getting stronger, the sensible ex-fishermen borrowed money in Japanese yen or Swiss francs not only for their expensive toys but to play the carry trade: borrow at 3 percent and earn 15.5 percent a no-brainer until your native currency collapses.

But when U.S. investment bank Lehman Brothers hit the ditch last fall, so did Iceland, and Icelanders were forced to horde foreign currency and groceries, and a lot of overleveraged luxury cars mysteriously caught fire.

The usual not-enough-regulation explanation is being trotted out to explain the mushrooming of Iceland’s banking sector and its subsequent crash. But Phillip Bagus and David Howden, from the Universidad Rey Juan Carlos, Madrid, both of whom have studied at the Ludwig von Mises Institute here in Auburn, argue that it was government guarantees, artificially low interest rates and central-bank-created liquidity that are the culprits.

Bagus and Howden point to a maturity mismatching policy employed by the three large Icelandic banks that ultimately proved lethal. When these liabilities couldn’t be rolled over, the Icelandic financial system collapsed. The banks engaged in this risky financial maneuver because the government stood ready to bail them out if their speculations didn’t work out. But when the banks grew to 1,400 percent of Iceland’s GDP, the banks had become too big to bail, instead of too big to fail.

“The ultimate problem with maturity mismatching is that there are insufficient savings available to finish the artificially high number of projects undertaken,” Bagus and Howden explained. “In the Icelandic case, the malinvestments were made mainly in the aluminum and construction industries” both of which are long-term investments that were funded with short-term funds created through the Icelandic banking system with the help of that country’s and other foreign central banks.

The explosion in employment in the financial sector drew people away from producing real goods to pushing paper assets.

So in the aftermath, Iceland has few skilled fishermen and the infrastructure of its once primary industry has withered away.

The lesson is that government guarantees and central bank’s monetary pumping create artificial booms that misdirect and ultimately waste valuable resources, harming normal working people for the benefit of high-living bankers, until the cleansing of a crash brings the bankers back down to earth.

Douglas E. French is President of the Ludwig von Mises Institute in Auburn.