Icelandic lessons for the eurozone

Iceland is doing much better, if you ignore the volcanoes

Greece is not Iceland; the differences between the two countries extend well beyond the average temperature and contrasting attitudes to herring.

But watching the Greek crisis grind toward its umpteenth "crunch point", you can't help wondering why we hear so much about the country that's been desperately trying to win the markets' confidence for nearly two years, but so little about the country that, at the height of the crisis, basically told international investors to shut up and wait their turn.

So naturally, I opened this week's OECD survey of Iceland with interest. The contents are surprising on two fronts. The first surprise is that Iceland is doing pretty well, all things considered; rather better than Ireland or Greece.

The second surprise is that the OECD thinks the lesson of the past few years is that Iceland ought to join the euro.

I promise you I am not joking, but before we go on, let me give you some vital statistics.

Steep recession

As the report makes clear, there are still enormous challenges ahead for Iceland. One of the largest is how it will dismantle the capital controls it imposed in 2008 to prevent foreign creditors departing the country with a large chunk of Iceland's GDP.

But in basic economic terms, Iceland appears to have come out of the crisis better than the other two European countries who came into it with clearly unsustainable amounts of private or public debt: the Irish Republic and Greece.

Iceland had a steep recession, one of the steepest, with a peak to trough decline of around 11% of GDP. That's in the same ballpark as the other two problem cases. The figure for Ireland is just over 12% and the figure for Greece, if you include the further decline expected this year, is likely to be around 10%.

But there you have the big contrast between them: the Irish Republic and Greece will have had three successive years of decline, and are looking at a flat or falling economy in 2011, whereas the OECD is predicting more than 2% growth for Iceland this year and in 2012.

Budget surplus

Using OECD figures, the Icelandic economy will have shrunk by an average of 0.75% a year over the five years from 2008 to 2012. The average decline in Greece will have been 1.6% a year, with an average decline of just under 2% a year for the Irish Republic.

Iceland's long-term interest rate is just over 8%, compared with over 13% for Greece. It is true that unemployment is high by Icelandic standards at 5.8%, but Greek joblessness stands at more than 16%.

Oh yes, and despite a financial crisis that has cost the government around 20% of GDP, Iceland is expected to have a budget surplus by by 2013.

Iceland still has junk bond status in the eyes of the ratings agencies. But, in the words of the IMF mission chief earlier this month, "the most adverse effects (of the country's sweeping capital controls) have not materialised".

The OECD does not have much to say on that pleasant surprise. It draws no conclusions about that aspect of Iceland's experience, which I for one find pretty interesting and that the IMF essentially endorsed by approving a standby arrangement for Iceland. Though, like the IMF, the OECD report has plenty to say about when and how these controls might be removed.

Instead, the OECD's economists focus on that surprising conclusion I mentioned at the start: that Iceland should now rush to join the single European currency.

Join the club

Here is the reasoning:

"While Iceland does not appear to be part of the optimal euro currency area, the costs of losing exchange rate flexibility in response to idiosyncratic shocks should nevertheless remain limited, owing to Iceland's having a very flexible labour market, though adjusting the real exchange rate through the labour market is slower and possibly more costly than adjusting it through the nomination exchange rate."

In other words, Iceland, because it is such a small and vulnerable economy, should join the euro, even though its economy is not strictly in sync with the core eurozone economies, and even though it is likely to be more costly for it to respond to shocks from inside the zone than outside it.

I am sure there are good arguments for Iceland to join the euro, but that doesn't sound much like one.

To avoid any doubt, I don't think the Iceland example holds enormous relevance to Greece, because Iceland came into this crisis with no public debt at all. As we know, that was not the case for Athens. In fact, it turned out they had a lot more debt than they had let on.

As I've said before, the more telling comparison is with the Irish Republic, which, like Iceland, had handled its public finances well but its financial system disastrously badly.

Financial wall

Unlike Greece, the Irish Republic is now looking at a tolerable recovery and has a competitive economy, so perhaps the jury on that one is still out. The private debt restructuring that Icelandic households and companies are now going through is pretty horrendous.

But it is strange that the OECD is so uninterested in the lessons from Iceland's decision to call time on a chunk of its foreign liabilities, and put a financial wall around its economy to stop investors getting out.

These were pretty drastic steps, with complicated consequences, but they do not seem to have caused the heavens to open up over Iceland, to wipe the country from the face of the earth (unless you're counting all those erupting volcanoes).

The OECD does not go in for alternative histories, but presumably the authors of the report think things would have gone better for Iceland if it had been in the single currency.

Certainly, it would have been spared a shocking devaluation of its national assets, and probably it would have been prevented from putting up capital controls.

But, as I said earlier this week on the subject of Greece, reacting to financial crises comes down to choosing between the available alternatives. In the dire circumstances the Icelanders found themselves in, it is not yet obvious that they made the wrong choice.

To repeat, the differences between Greece and Iceland are many and various, but reading the report there was one other phrase that leapt out at me.

In all, the authors reckon that the total public cost of the crisis in the financial system will come to 20% of GDP, which is more than any other country except the Irish Republic. But, the report notes, relatively little of this was incurred winding up the country's bankrupt financial institutions.

Most of the cost "was incurred in the months before the banks failed, when the central bank of Iceland lent to them against collateral of dubious quality... in what appears with hindsight to have been a strategy of gambling for resurrection". Losses on those loans have since amounted to 13% of GDP.

That doesn't remind me of the European governments' approach to Greece at all. Not one bit.