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Inflation Has Not Cured Iceland’s Economic Woes

mises.org / By David Howden / Monday, November 04, 2013

No two countries’ responses have polarized commentators over the past five years more than the contrasting post-crisis policies in Iceland and Ireland.

In a paper published in Economic Affairs (available here as a PDF) I contrast the policies enacted by Iceland and Ireland, perhaps the two countries most affected by the liquidity freeze of 2008. A common conclusion has been that one country did everything right and the other did everything wrong, however, I take a more pragmatic approach. There are some positive aspects in each case, and other aspects we can do without.

At the risk of over-simplifying their situations, the key policy differences are:

  1. Iceland allowed substantial swaths of its financial sector to collapse (mostly foreign-domiciled subsidiaries) while Ireland enacted blanket guarantees to keep its financial sector afloat.
  2. Iceland quickly inflated its krona in a bid to regain international competitiveness through depreciation. By being locked in the euro, Ireland was unable to pursue a similar path and instead had to become more attractive to foreigners by lowering its domestic prices (i.e., disinflation or outright deflation).
  3. Iceland stymied a capital flight by enacting monetary controls aimed at keeping investment within the country. By being part of the European Union, Ireland maintained its commitment to free capital markets, and investors were able to enter or exit as they pleased.

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