Is Iceland Krugman’s Inadvertent Case for the Monetary Policy Offset of Fiscal Policy?

A Mark Sadowski post

On May 28, Paul Krugman exclaimed:

 “Back in 2013, when Olivier Blanchard presented a paper on Latvia at the Brookings Panel, many of the participants were bemused: why was the august panel devoting so much time to a country with the population of Brooklyn? But Latvia was, for a time, the great poster child for austerity….And now, as Frances Coppola notes, the era of rapid bounce back has stalled out.”

Krugman proceeds to compare the Real GDP performance of Latvia with that of Iceland. If one clicks on through to Coppola’s post, they learn that Latvia “embarked on a brutal front-loaded fiscal consolidation in 2009, sacking public sector workers, slashing public sector salaries, cutting benefits and raising taxes.”

Then on June 9, Krugman states:

 “I was, I think, one of the first commentators to notice that a funny thing was happening in Iceland: the nation that was supposed to be Ground Zero for financial disaster was actually having a milder crisis than many others, thanks to heterodox policies — debt repudiation, capital controls, and massive devaluation. Now, as Matthew Yglesias points out, Iceland is getting ready to lift the controls, and its experience still looks remarkably good considering the circumstances.

And as Yglesias says, the interesting contrast is with Ireland, now being hailed as a success story for austerity because things eventually stopped getting worse and have lately been getting a bit better. Talk about lowering the bar.”

If one reads the post by Yglesias, they find out that one of the things that Iceland did to achieve this was to “[r]eject [fiscal] austerity.”

Anyone who came away from reading Krugman’s posts, and the posts to which he links, might be forgiven for concluding that Krugman thinks that Iceland, unlike Latvia and Ireland, did not do any fiscal austerity at all.

But Scott knows something is fishy in the state of Iceland, and looks into Krugman’s implied claim.

 “Sorry, but I don’t see it. The crisis caused the debt to balloon, presumably due to the big cost of paying off depositors of failed banks, and the effects of the recession itself. But then Iceland started reducing debt as a share of GDP, from 101% to 86.4% in just three years. That’s much better than the US and UK, which supposedly had austerity. The budget deficit in Iceland was 7.8% of GDP in 2009, but only 0.9% of GDP in 2013–better than the US and far better than the UK. So if the US and UK practiced austerity, what’s so different about Iceland?”

As often is the case, in my opinion Scott is somewhat understating things.

Scott is looking at the “net operating balance” which excludes the “net acquisition of nonfinancial assets”. Including this item results in “net lending”, which is what Europeans call “the deficit”. The net lending of Iceland’s general government fell from 9.7% of GDP in calendar year 2009 to 1.7% of GDP in calendar year 2013, a change of 8.0% of GDP.

Moreover, Iceland’s general government budget ran a surplus equal to 1.8% of GDP in 2014, or a change in fiscal stance since 2009 equal to 11.5% of GDP. This can be found on Table A1 of the April 2015 IMF fiscal Monitor.

And, according to IMF estimates, Iceland’s output gap was actually somewhat larger in 2014 than in 2009. When an economy becomes more depressed it usually results in falling revenues and rising expenditures as a percent of GDP. Not taking this into account might tend to understate the amount of fiscal austerity a country has engaged in (e.g. Greece). Table A3 shows that Iceland’s general government cyclically adjusted balance rose from a deficit of 10.0% of potential GDP in 2009 to a surplus of 2.7% of potential GDP in 2014, or a change of 12.7% of potential GDP.

But even this tends to understate the amount of fiscal austerity that Iceland has engaged in. This is because it includes the increase in spending attributable to rising interest payments on the national debt. To get a proper idea of the amount of fiscal austerity that Iceland has engaged in (i.e. cuts in direct spending and increases in taxes) one has to look at the general government cyclically adjusted primary balance which can be found in Table A4.  Iceland’s general government cyclically adjusted primary balance rose from a deficit of 6.9% of potential GDP in 2009 to a surplus of 6.2% of potential GDP in 2014, or a change of 13.1% of potential GDP.

How does this compare with other countries? The following graph shows the change in general government cyclically adjusted primary balance between 2009 and 2014 for 33 advanced nations, plus the Euro Area as a whole, and the four emerging economies of Croatia, Hungary, Poland and Romania that also happen to be EU members. (It turns out that 2009 is a good base year since the cyclically adjusted primary deficits of most advanced nations peaked that year.)

Sadowski Iceland

By this standard Iceland has done about 30% more austerity than Ireland, over double that of the UK, roughly three and a half times as much as the US, and approximately five and a half times as much as Latvia. The only country that has done more fiscal austerity is Greece.

None of this should come as a surprise. When nearly all the other OECD members were busy implementing fiscal stimuli in early 2009, Iceland (joined only by Ireland) was engaged in a massive fiscal consolidation (see Figure 3.2 and Table 3.1).

In 2012 the Icelandic Finance Ministry, in front of an audience of fellow OECD senior budget officials, patted itself on the back for a job well done.

The scope and scale of Iceland’s fiscal consolidation was truly mind boggling. Real primary expenditures were estimated to fall by 12.7% between 2009 and 2012 (Slide 16). This was accomplished by slashing current expenditures, transfers, and maintenance and investment, and by freezing public sector wages and benefits for a period of four years (Slide 13), during a time when inflation soared due to the 50% depreciation of the króna.

On the revenue side the VAT was raised to 25.5%, which at that time was the highest in the world (Slide 14). The top personal income tax rate was increased from 35.7% to 46.2% (Table 2):

The capital income tax rate was doubled from 10% to 20%, the corporate income tax was increased from 15% to 20%, the social security contribution (SSC) was increased from 5.34% to 8.65% and fishing levies (important in Iceland) were increased. In addition a whole slew of new taxes were imposed (e.g. a net wealth tax, an inheritance tax, a financial activities tax (FAT) etc. etc.)

The bottom line is that Krugman’s implied poster child for anti-fiscal austerity is in reality the advanced world’s second leading practitioner of it. If Iceland’s economy is doing as well as Krugman claims (I have my doubts), then the only real reason it is doing so well (we have yet to see what happens after capital controls are lifted) is relatively steady NGDP growth as demonstrated in Scott’s post.

Thus it seems to me that Krugman’s recent posts extolling the relative economic performance of Iceland are inadvertently strengthening the argument for the ability of monetary policy to wholly offset fiscal policy.

21 thoughts on “Is Iceland Krugman’s Inadvertent Case for the Monetary Policy Offset of Fiscal Policy?

  1. Hi Mark. It’s been a while. Interesting post.

    I’m curious, can you give a concrete example or two of what future empirical data sets might look like that would convince you that you’re wrong about monetary policy offsetting fiscal policy? In other words, what are some examples of things that might happen in the future that would be compelling evidence against your current position? Not necessarily just for Iceland, but for any country. Thanks.

    • Hi Tom.

      If we ever saw a statistically significant correlation between changes in cyclically adjusted balances and changes in GDP (either nominal or real) in a cross section of nations that have independent monetary policies, that might be sufficient to make me skeptical. (But I’m not holding my breath.) You might remember this post for example:

      • Mark, thanks. I do remember that post actually. I just looked at it a few days ago.
        If you were going to rate your confidence on a scale of 0% to 100%, where do you think you’d be on this?

      • Tom, I’m probably as close to 100% on this as an inductive thinker can claim to be.

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  7. Hello Mark,

    I have been an admirer of yours for years and I would like to congratulate you on having been chosen by SS as a research assistant. This is quite a feather in your cap , heartily deserved.

    My question today involves this statement:
    (…..during a time when inflation soared due to the 50% depreciation of the króna.)

    I have seen many iterations of this phrase in the financial press over the last few years and it never sits well with me.
    I see the logic: As a provider of goods/services to the local economy in Reykjavik an instantaneous doubling of my input costs must be passed on to consumers ergo prices rise/inflation. I am assuming you are relying on this assumption.

    For John Q. Public in Reykjavik, the higher cost of say, gasoline, would strip him of liquidity which would then prevent him from bidding up prices in the local economy. From this perspective the radical Krona devaluation would seem highly deflationary. Add to this higher taxes and one would assume even more downward pressure on prices.

    If , by external shock, the seller must raise prices and because of this same external shock the buyer has even less liquidity than he did at the old equilibrium level, how can this new market clear at the higher level?

    I am aware that Icelandic CPI has risen 50% since the onset of the financial crisis ( 280 in 2008 —- 429 today)
    Clearly my thinking is wrong, I was hoping you could show me where I am wrong.
    Thank You

    • Thanks Paco,
      With respect to your question, If John Q. Public spends krona at the same rate as before, then by definition his demand remains exactly the same, although the real quantity of goods he can buy has declined since the price level has risen.Moreover, after the devaluation, the price of imported goods probably rose more than the price of domestic goods, because the price of the most important input of domestic goods is probably the labor of John Q. Public, which has not changed. It’s likely that John Q. Public will substitute away from imported goods to domestic goods. Thus the effect of the devaluation on John Q. Public’s nominal spending on domestic goods will be ambiguous, although the real quantity he buys will probably fall.

      However, domestically produced goods are now more competitive on the global marketplace. Thus it’s almost certain that a larger quantity of goods will be exported, and at a higher price in terms of krona. It’s also very likely that the increased quantity exported will be far more important than the decrease in the real quantity sold to John Q. Public. So much so that, John Q. Public’s employer, Generic Reykjavik Firm, Inc., will be moved to rehire his brother James R. Public, who was laid off during the financial crisis.

      And so both the price level and aggregate real output increase, as is telltale of an increase in aggregate demand. (The addition of a government sector to this scenario adds a further layer of complexity, but doesn’t change the outcome much, if at all.)

      • Mark, thank you so much for the detailed reply. I know you are busy and really appreciate your time.

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