Thursday, November 01, 2012

Errata for "A note on the Icelandic crash from an amateur Austrian perspective".

After receiving some comments on my previous post, I've decided to update it with some errata, and just leave the post as it currently is. The following is verbatim from a comment by user herbert_spencer on reddit.com:

>busts are mainly caused by low interest rates.

It may be more accurate to say that they are caused by unsustainable investments because of *artificially* low interest rates.

> Due to the large size of the Icelandic banks (among other things), the belief in Icelandic Krona was high, causing it to be seemingly overvalued.

The fact that that the CBI said it would act as a lender of last resort and that the IMF was believed to have the capability to provide stability seems more important than the size of the banking system (which was albeit probably oversized) to the proliferation of currency mismatching.

>Central Bank of Iceland, through the Floating exchange rate policy raised the exchange rate.

The CBI does not determine the exchange rate directly. The fact that the krona had a floating rate means that it can fluctuate on the market. There is the issue of foreign currencies having lower interest rates than the krona and the consequent currency mismatching because of the implicit guarantee of bailout from the IMF.

> They might have tried to offer the krona undervalued, and then foreign currency would have flowed into the Central Banks stash, as always happens between good money and bad money, for all would have wanted to get their hands on the krona instead of the foreign currency, seeing as it was seen as being better.

Again, a floating exchange rate does not allow the legal undervaluing or overvaluing of currencies. The state may however, as Iceland did following the crash of the krona, limit the use of foreign exchange.

> This enabled Icelanders to get pretty cheap loans

Its not so much the value of the currency that allowed this as the easy monetary policy pursued by the ICB along with the low worldwide interest rates. Short term borrowing expanded as those rates remained low, which, in conjunction with increased long term investment created maturity mismatching (classic Austrian malinvestment) during the boom period.

> for various items, and was used to buy cars etc.

It is also important to remember, and perhaps mention that the credit expansion was not limited to loans for purchases of consumer goods but also in industry and capital goods (and international business). This is where the malinvestment comes into play.

>The price of housing was also artificially high

It may be good to explain the causal relation between the monetary policy and housing prices.

>Then, when the Icelandic banks fell, due to being in a "liquidity trap"

The Keynesian notion of a liquidity trap is questionable and not exactly the cause of the bank crash. It is important to note the difference between the liquidity crisis we saw, where the ICB had lent to insolvent banks (and to the government, which was insolvent). This is where the currency mismatching came back to haunt the ICB. Since debt was owed in foreign currency, there could be no bailout.


>this of course raised the cost of capital to even higher levels than it should have been.

The bust merely reveals the malinvestment.

>The belief in the Icelandic Krona fell, and thus the exchange rate set by the Central Bank was too high, causing an outflow of foreign currency, as it was now determined as being overvalued, and now no one wanted the Icelandic Krona. They then lowered the exchange rate, and thus the foreign currency loans which so many thought were so cheap turned out to be not so cheap at all, merely a fluke.

Again, the exchange rate is not set but is determined by the foreign exchange market. When the bust reared its ugly head in Iceland, and bankruptcy ensued, faith in the krona collapsed, people tried to sell kronur for foreign currency, and its exchange rate naturally collapsed in consequence.

>How could the banks grow so large?
Also, it is important to ask how the banks could make such bad loans.

>We could start by going onto a gold standard, or some other standard in which the value of the currency is based on some commodity.

While it would definitely be an improvement, a denationalized currency may be even better from an Austrian perspective.

>It is a hassle to dig up more gold (certainly more than just to print more money/issue government bonds)

If gold money is mined (on the market. If done by governments, then yes, there is still a problem but the state would probably rather resort to debasing the currency than to mine) to make money, then it is not even inherently a problem. The mining entrepreneur is acting as an arbitrageur since he realized people value gold more than anything else those miners (and the mining equipment) could be doing.

End verbatim.

As I've previously stated, I'm still studying Austrian economics, and many of these points highlight some of my misunderstandings. I believe that reading the book Deep Freeze by Phillip Bagus will further clarify this, and I hope to make another post after having read said book.

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