“Ice” & “Ire” – Supply & Demand Shocks

Back at the comment section of this Scott Sumner post, TravisV recalls a 25 month old Scott post on Iceland:

Some Keynesians might object that it’s also a demand problem; after all, Iceland went through a severe financial collapse, one of the worse in world history.  All the major banks failed, with liabilities totaling 1200% of GDP.  The housing industry collapsed.  Surely that points to a decline in AD?

Actually no.  Those Vikings wouldn’t have been able to survive in that harsh climate without having some smarts.  Unlike the foolish Irish, the Icelanders decided to let the big banks fail and have the creditors pick up the tab, not the taxpayers.  To prevent a fall in AD, they sharply depreciated the kroner.  I had trouble finding NGDP data, but if you look at the graph halfway down this link, you’ll see Icelandic NGDP rose continually through the worst of the 2008 crisis, and has continued to move gradually higher.  In contrast, Irish NGDP has plunged.  Ireland lacks the nominal income to repay its euro debts, and even to pay euro wages without steep wage cuts.  Ireland faces both recalculation and a severe demand shock.

The rise in NGDP did not prevent a fall in Icelandic RGDP; their financial collapse was a very severe real shock.  Those bankers can’t be immediately retrained as fisherman.  The reason Iceland fits Kling’s model so perfectly is:

1.  There was no demand shock

2.  It’s not even clear what the new patterns of specialization and trade should look like. Iceland is groping in the dark (literally, during these winter months) for new industries.

Paul Krugman also has a couple posts on Iceland.  In this one he points out that Icelandic RGDP fell about the same amount as in countries with much smaller financial crises, and that employment did considerably better.  I see those two arguments as being related.  Suppose Iceland had a real shock big enough to reduce RGDP by 15%, whereas Ireland and the Baltics merely had real shocks big enough to reduce RGDP by 8%.  But now assume that Ireland and the Baltics also had negative demand shocks, caused by their attachment to a euro that was way too strong for their economies (and indeed a bit too strong even for Germany.)

In that case Ireland and the Baltics might see RGDP declines as big or bigger than Iceland, even though their real shocks were smaller.   And this is what happened.

In other words, monetary policy did not slow the process of recalculation in Iceland.  In the other crisis countries monetary policy took a bad situation and made it even worse.   Unemployed workers in overbuilt sectors were not able to find jobs in other sectors, as total demand was falling.

Below, the argument in pictures.

Real output growth fell by about as much in both countries:

Ice-Ire_1

The behavior of inflation (viewed together with RGDP growth) is a good indicator of a (mostly) supply shock in Iceland and a (mostly) demand shock in Ireland:

Ice-Ire_2

Unemployment is less affected in Iceland:

Ice-Ire_3

All in all, the outcome is a reflection of the fact that nominal spending in Iceland never dropped below trend, converging on it from above (in which case spending growth just slows down for a while). In a sense, Iceland was ‘lucky’ because just prior to the onset of the crisis monetary policy had been “too easy”. But not being in the euro ‘straightjacket’ allowed Iceland to depreciate when the crisis hit, facilitating the adjustment.

Ice-Ire_4

Update: This older post describes Iceland´s “fiscal cliff” (the consequences of which never “materialized”)

Update: Scott Sumner does an encore on Ireland-Iceland

6 thoughts on ““Ice” & “Ire” – Supply & Demand Shocks

  1. “In other words, monetary policy did not slow the process of recalculation in Iceland.”

    This is a non sequitur. Nothing that was said prior justifies the use of “In other words” here.

    Slowing the process of recalculation cannot be observed through temporal trends in output. Recalculation is a counter-factual concept. The proper use of this concept would be to ask whether or not and to what extent did monetary policy in Iceland prevent unsound businesses from being liquidated. This of course would mean we should see a smaller output decline in Iceland, during and after the crisis. And that’s just what we saw. Output did indeed fall by less in Iceland, which is perfectly consistent with the theory that inflation hampers recalculation.

  2. Pingback: “Ice” & “Ire” – Supply & Demand Shocks | Fifth Estate

  3. Pingback: TheMoneyIllusion » What Britain could learn from Iceland

  4. Ireland vs Iceland is maybe the ultimate test case for the euro project. If such a small, isolated land can soldier through a historically rough financial crisis, with nothing but a high omega-3 diet and monetary sovereignty, why does the euro exist at all? Why on earth would the Baltic states want to join the Euro Zone?

  5. Pingback: Assorted Links | azmytheconomics

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