Free Market Capitalism
A free market is a market that is free from government interference, prices rising and falling in accordance with supply and demand. (Oxford Dictionary of Finance and Investment, 2005) In a free market individuals are free to make their own economic decisions. Consumers are free to decide what to buy with their incomes: free to make demand decisions. Firms are free to choose what to sell and what production methods to use: free to make supply decisions. The resulting demand and supply decisions of consumers and firms are transmitted to each other through their effect on prices, through the price mechanism.
(Sloman & Hinde, 2007) One of the most influential economists that adhered to the policy of free market capitalism was Milton Friedman (1912-2006). He was a United States economist, statistician and a public intellectual. He got the Nobel Memorial Prize in Economics Sciences in 1976 and is best known among scholars for his theoretical and empirical research, especially consumption analysis, monetary history and theory, and for his demonstration of the complexity of stabilization policy. (Nobelprize. org, 2009) Milton Friedman came to visit Iceland in the 1980s.
He, among others, influenced the president of the independence party and the Prime Minister of Iceland (1991-2004), Davi?? i?? Oddsson, and his co-workers to great extent. (i?? lafsson, 2008) Under the control of Oddsson and his government the Icelandic banks were privatized. As with the free market capitalism of Oddsonsi?? s government, the supervision and control was weak. This can be considered as financial deregulation, but it is widely understood to have important economic benefits for microeconomic reasons.
Since Adam Smith, economists have argued that unfettered private markets yield outcomes are superior to public sector alternatives. But financial regulations, specific rules and overall structures are sometimes justified on macroeconomic grounds. (Goodhart & Illing, 2002) The Central Bank Goodhart & Illing (2002) have defined that a central bank serves two very different functions. First, central bank functions as monetary authorities, managing high-powered money to influence the price level and real activity. Second, central banks engage in regular and emergency lending to private banks and other financial institutions.
Goodhart & Illing (2002), argue that just as private lenders must restrict and monitor individual borrowers, a central bank must regulate and supervise the institutions that borrow from it. In the case of the Icelandic banks, this was not working since the banks collapsed and the control of monetary policy with high interest rates was not impacting the high inflation as will be mentioned later on. Oddsson was appointed the chairman of the central bank in Iceland in 2005, after having been the Prime Minister of Iceland for thirteen years and then Foreign Secretary.
It is not common that a politician takes place as the chairman of a central bank’s country, since the bank should be an independent institution. “This interplay between government ministers and central bankers is the heart of every national economic crisis. ” (Times Online, 2009b) In 2001 the central bank presented its inflation target, 2. 5%, as part of its monetary policy. Following the inflation target, the central bank started to raise interest rates. In 2003 the interest rate was 5. 3% but in 2007 it was 15. 25%. Today the interest rate is 18%.
Figure 3: Interest rates 1994 – 2008. Source: Central Bank of Iceland, 2009 The inflation targeting, failed in lowering inflation, but the resulting interest rate rise both motivated domestic households and firms in order to borrow in foreign currency and attracted foreign speculative capital, carry traders. The amount of hot money inflows is not publicly known, but it appears to have exceeded 50% of GDP. It is unclear why this did not raise concerns with the authorities. (Dani?? elsson ; Zoega, 2009) This is better addressed and analysed with the IS/LM model in Appendix A.
The reasons for the failure of inflation targeting are not completely clear, but it seems to be that the massive currency inflows effectively became a part of the local money supply. As can be seen in figure 4, the money supply has increased dramatically in recent years. Figure 4: Increase in money supply in the Icelandic economy from 1994 – 2007. Source: Hagstofa i?? slands, 2009 Because of the central bank’s lack of credibility and firm’s willingness to borrow in foreign currencies, interest rate changes had a very limited effect on long-term interest rates and investment activity.
About the only visible effect on inflation was that import prices were reduced when the exchange rate appreciated. (Dani?? elsson ; Zoega, 2009) The central bank in Iceland has remained weak, it had foreign exchange reserves of around 375 billion kronas just before the collapse of an economy with GDP around 1,300 billion kronas, just under 30% of GDP. This ratio, nonetheless, is very high; however the short-term liabilities of Icelandic banks in proportion to Iceland’s GDP were a staggering 211% at the beginning of 2008. (Dani??
elsson & Zoega, 2009) Consequences On 29th of September 2008 the first signs that the financial crisis was going to hit the country hard. The central bank came out with the fact that the smallest of the three big banks, Glitnir, had asked for a loan from the central bank, the lender of last resort. The central bank didn’t like the collateral behind the loan and decided to nationalize the bank, by buying 75% of its equity. The government expected by that action, the credit default swap would recover, but the contrary happened and it got a lot worse.
The action of nationalizing Glitnir seems to have undermined the trust of the Icelandic banking system and Icelandic government. The government and the Icelandic banks had always claimed that the banks had no liquidity problems and were in no chance of defaulting. But, by nationalizing Glitnir, that undermined the ability for the central bank to deal with the situation. (Dani?? elsson ; Zoega, 2009) At 16:00 on Monday 6th of October were the first minutes of the breakdown of the Icelandic banking system and the economy. Prime Minister, Geir H.
Haarde, had a live speech on the national television clarifying in how bad situation the banking system was, and therefore the economy as a whole. He said: “Dear Icelanders, there is a possibility, if the worst will happen, the nation will go bankrupt… “. That was the first time the public got to know that the situation of the banking system was not that good as had been indicated. The speech ended in these words: “God, bless Iceland”. It was clear; the financial crisis had hit Iceland severely and, in fact, was turning into a major economic crisis.
The Icelandic government agreed on a new law which allowed the government to take over any financial institution in the country. That was done in order to keep the domestic banking sector functioning in these turbulent times. The law allowed the government to create “new banks” on the ruins of the “old ones”, which had domestic deposits and loans. The international activity was left over in the “old banks” and they were heading into technical bankruptcy. A common definition of a systemic crisis is when the payment system fails. That is what happened to the Icelandic payment system following the collapse of the Icelandic banking system.
International part of the payment system shut down and part of the domestic system had difficulties. (Dani?? elsson ; Zoega, 2009) For an economy as dependent on import and export it had major influences. Firms had difficulties in paying for their imported goods and there was a major threat of a shortage of necessities, like food and fuel, but it never reached that far. Within a week after the collapse of the banks, the Icelandic currency, krona, had dropped by more than 70% in value. With the firms, as well as the households in Iceland with so much foreign debts it made things a lot worse than they already were.
The households as well as the firms in Iceland are heading into very difficult times which will eventually lead to bankruptcy for many of them. In a recent press release from European Small Business Alliances (ESBA) it is stated that up to 80% of firms in Iceland have gone technically bankrupt following the British government using anti-terrorist law in order to take over Icelandic assets. For any economy it’s a major shock and it will take a long time for Iceland to recapture trust from governments and investors around the world.
(Vi?? sir, 2009) In the following weeks Iceland was the first Western country to have approached the International Monetary Fund (IMF) for aid since 1976. (BBC News, 2008) The agreement with IMF is to restore confidence in the Icelandic banking system and stabilise the Icelandic krona. External pressures to unwind krona positions were mounting, and there were significance risk that domestic depositors and investors could lose confidence in the krona, despite the government’s guarantee on domestic deposits.
These pressures, coupled with low level of reserves, meant that a fixed foreign exchange regime would not be credible, so IMF opted for a combination of interest rate policy, liquidity management, foreign exchange intervention and restriction on capital flows. (International Monetary Fund, 2008) On top of the aid from the IMF, few nations have agreed to lend Icelandic government in order to fulfil foreign debts of the collapsed banks. This dramatically increase in debt burden has already lead to cutback in government spending in order to meet its obligation.
