What happened to the global economy and what we can do about it
with 36 comments
By James Kwak
Like probably most people, I have not been following the saga of Iceland and its banksâ?? foreign depositors, so I was grateful for Planet Moneyâ??s podcast last week on the topic. The background, as I understand it, is something like this:
Now, there is a legal question about whether or not Iceland has an obligation to bail out foreign depositors in its banks. Remember, there was no explicit government guarantee. The question is whether bailing out domestic but not foreign depositors is illegal discrimination under international law.* Apparently thatâ??s a close question, but itâ??s not relevant for my purposes.
The economic question, as the podcast framed it, is whether paying off the U.K. and Dutch governments will help Iceland attract foreign investment in the future. They had a bond investor from Vanguard â?? ordinarily just about my favorite financial institution â?? saying that a vote against the settlement would make investors less likely to lend money to the Icelandic economy in the future.
Now, this may be true (although I doubt it). But think about what this is really saying.
Some people â?? largely retail investors â?? lent money to Icelandâ??s banks, either deciding that the high interest rates made up for the lack of a government guarantee or not bothering to check if there was a government guarantee. They lost their money (or they would have, if their home governments hadnâ??t bailed them out). The lesson I think people should learn from this is: MAKE SURE THEREâ??S A GOVERNMENT GUARANTEE!!!!! In other words, lenders should be smarter in the future.
Vanguard Bond Guy is saying something different, however. Heâ??s essentially saying that foreign investors will only lend money to some countryâ??s private institutions if that country promises to bail out foreign investors should those private institutions fail. Thatâ??s the only light in which his statement makes any sense. In the future, lenders to Icelandic institutions will only care about the chances of their future loans being paid back. Whether Iceland pays off the U.K. and the Netherlands now can only matter as a signal about Icelandâ??s future behavior. And the only signal it could possibly send is that Iceland recognizes some hitherto nonexistent obligation to bail out its private institutions whenever they default.
This is both obnoxious and crazy. Itâ??s obnoxious for the same reason the campaign against strategic homeowner defaults is obnoxious. If you made a zero-money-down loan to someone and he walks away, itâ??s your fault. The lesson you should learn is that you shouldnâ??t make zero-money-down loans; you shouldnâ??t suddenly invent some principle that people should pay debts they no longer owe when itâ??s not in their own interests.
And itâ??s crazy because â?? what does it say about capitalism? The theory of the financial markets is that they allocate capital to the places where it will be used most efficiently. If Bond Guy is right, thatâ??s not true: they allocate capital to the places where the government provides the strongest implicit guarantees. You want capital? Then your government has to bail foreign creditors out of their bad decisions. How is that good?
Now, maybe the credit markets will refuse to lend money to Icelandic companies, which would be bad for Iceland. I donâ??t know; I donâ??t have their phone number. But if so, then the credit markets are not doing what they are supposed to be doing, at least according to their most ardent defenders. Instead, they will be punishing Iceland for lendersâ?? failure to read the terms of their contracts carefully.
* What international law? you may ask, especially since Iceland isnâ??t (yet) a member of the EU. I donâ??t know. Share this: Email Facebook Print Share Digg Reddit StumbleUpon
Written by James Kwak
April 26, 2011 at 11:19 am
Posted in Commentary
Tagged with Iceland
By definition, â??lawsâ? must be written by somebody and interpreted by somebody.
Who are those somebodies for â??international lawâ?, and how are they chosen?
â?¦
Nice post. Not sure why you decided to focus on Iceland refusing to bail out retail investors in the U.K. rather than Ireland agreeing to bail out megabanks in Germanyâ?¦ But still, nice post.
Nemo
April 26, 2011 at 11:26 am
I believe itâ??s the EEA directive 94/19/EC. Act 98/1999 formally adopted the EEA regulation into Icelandic law.
Martinghoul
April 26, 2011 at 11:44 am
The issue is a bit more complicated as the Icelandic authorities did nothing when the branch (not subsidiary) advertised its deposit scheme as being insured.
There was also no indication from the Icelandic government beforehand that the deposit insurance fund wouldnâ??t back up the banks. They also spouted the same mantra of a sound system that would be backed up if needed as every other country. They also had many meetings with investors and UK and Dutch authorities where they never once hinted that they wouldnâ??t pay the 20k Euro minimum.
They basically wanted to enjoy the fruits of investorsâ?? expectation of an implied bailout but not bear the cost if it actually happened.
I think the podcast gets it right in the end as investors would question the intentions of Icelandic authorities and not believe their rhetoric. It would be a different issue if it had been clearly stated all along that the authorities wouldnâ??t back the scheme, but thatâ??s clearly not the case.
Bagofhot
April 26, 2011 at 11:54 am
> They basically wanted to enjoy the fruits of investors' expectation of an implied bailout but not bear the cost if it actually happened.
And â??investorsâ? (i.e. depositors) expected an 8% return from a savings account with zero risk. Cry me a river.
Nemo
April 26, 2011 at 12:16 pm
Nemo,
That may well be, but those were the rules of the time. If you think deposit insurances are morally wrong or whatever then thatâ??s fine, lobby for a reformed system in the future. But you donâ??t change the rules retroactively.
Bagofhot
April 26, 2011 at 12:23 pm
Nice post.
These so called â??capitalistsâ? are revealing their true nature with the Icelandic and Irish banking collapses. They are revealing to us that they are little more than economic predators, siphoning off a nationâ??s wealth by paying off different governments.
The bad news, of course, is that some of these same financial institutions are in the upper echelons of the US government and the privately-held Federal Reserve Bank.
The scales are falling off James. Good work!
Jerry
April 26, 2011 at 12:26 pm
But if the purpose of government is to maintain the wealth and power of the wealthy and powerful then the Icelandic government has to compensate the wealthy and powerful people who have been affect by this.
marc sobel
April 26, 2011 at 1:59 pm
@Bagofhot: â??But you don't change the rules retroactively.â? Really. Isnâ??t that what some municipal and state governments are threatening to do to the pensions of certain public employees? Please tell me if I am mistaken.
Carla
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