Surviving Too Much Debt – Short Version
My wife has to listen to me simply because we occupy the same house. She’s heard me say that Iceland is the blueprint for countries to regain prosperity after finding themselves overwhelmed by excessive debt. Last night she asked me to give her a really short version of how they did it that even she could understand.
Here it is:
Iceland’s entire banking system failed in 2008’s due to world-wide real estate and financial melt-downs. Iceland owed foreigners about 8x their entire GDP. They needed to figure out how to recover from what was essentially a national bankruptcy.
So they did. Icelandic citizens rejected the idea of fiscally killing themselves simply to make good on debt to non-Icelandic counterparties. They told the rest of the world they weren’t going to pay them what was owed (translation: they defaulted on their debt).
Iceland was lucky enough not to be part of the Euro currency group. Icelandic citizens were protected from the bank failures by their version of our FDIC. Domestic households which had 1 MM kronur in their account still had the same nominal balance post-crisis.
So, why would the people of Reykjavik even care? Once Iceland was no longer credit worthy their currency’s exchange rate plummeted from around 60 to the $US (at the start of 2008) to an all-time low of 148.33 per $US in December 2008. At that moment it took 2.47x more kronur to buy anything imported than it did at the start of the year.
Gasoline, automobiles, non-locally grown foods etc. all shot up in price very dramatically. 1 MM kronur went from being worth $16,667 to only $6,742. The banking crisis had devastated the buying power of ordinary citizens despite leaving their nominal net worths unchanged in local currency.
The good news was that Iceland became a bargain destination for tourists where their dollars or euros now received tremendous value. Likewise, Icelandic exports became much more competitive on world markets.
Without the need for external debt service tax money could be channeled back to internal uses. Less total revenue was needed to fund government.
Iceland’s recovery required an initial period of pain due to currency devaluation and the lack of international credit availability. Pure economics forced people to limit spending on imported goods. It improved the prospects for exports. It fostered the ability to attract foreign tourism which brought in much needed hard currencies.
Iceland is now one of the fastest growing economies in Europe.
Greece, Spain, Cyprus, Portugal and others need to exit the euro and go through the same cleansing process. There’s no way to avoid the initial pain because the devaluation of your local currency is what makes recovery possible. This can never happen in the world order we have today. No pain no gain.
Dr. Paul Price of RealMoneyPro@TheStreet.com July 20, 2012