A government should only nationalise a bank (let alone most of its banking sector) if it has the fiscal strength to support the bank (or its banking sector). If it does not have the fiscal resources, now and in the future, to restore the banks to solvency, a private sector insolvency problem is transformed into a government insolvency problem. On the whole, the consequences of state default are more serious for the residents of a country than the consequences of a private bank default.
If the banks in question have a large amount of foreign currency debt, maintaining government solvency when the government tries to make all the banks’ creditors whole, requires two distinct resource transfers: an internal fiscal transfer, through spending cuts or tax increases from the domestic private sector to the government, and an external transfer through a larger primary surplus in the balance of payments accounts. Such an external transfer generally requires a depreciation of the real exchange rate and a worsening of the country’s external terms of trade.
Iceland is a rich country, but it has just 300,000 inhabitants (like Coventry in the UK). It does not have the fiscal resource base to support a credible nationalisation of its banking sector, unless it is willing and able to securitise the future revenues from its hydro- and geo-thermal power resources (something Anne Sibert and I recommended last April). Apparently, the government is not willing to do that.
The acquisition by the government of a 75 percent stake in Glitnir and the recent nationalisation of Landsbanki were therefore a mistake. Rather than hammering its tax payers and the beneficiaries of its public spending programmes, rather than squeezing the living standards of its households through a sustained masstive real exchange rate depreciation and terms of trade deterioration, and rather than creating a massive domestic recession/depression to try and keep its banks afloat, it should now let Glitnir, Landsbanki and Kaupthing float or swim on their own. The interests of domestic tax payers and workers should weigh more heavily than the interests of the creditors of these banks.
It is likely that, without further official support, these banks will fail, and that the banks’ creditors will not recoup the full value of their investments in the banks. Domestic retail deposit holders of kroner deposits will presumably be protected, but all other creditors will have to wait and see. The failure of Iceland’s three main internationally active banks would be most unfortunate, indeed a tragedy; it will be very costly to the country. But not as costly as would be an attempt to keep these banks afloat by putting all of the country’s foreign exchange resources and all its fiscal resources at risk in support of the survival of the banks. I assume the government can let a nationalised bank fail without this counting as a sovereign default. If this is not the case, the nationalised banks should again be privatized (pro forma) and then left to fend for themselves.
Iceland should now conserve its remaining foreign exchange reserves and other foreign assets to prepare for the post-default disruptions of its international trade and its international financial relations.
I am surprised that Iceland’s Scandinavian partners (Norway, Sweden, Denmark) could not be convinced to do more than create the rather miserly €500mn swap lines with the Central Bank of Iceland that they agreed to last summer. The EU, the Eurosystem and the governments of the larger European countries (the UK, Germany, France, Italy, Spain) also don’t come out of this covered with glory. Neither does the government of the USA. And where was the IMF in all this?
Apart from unhelpful, the aforementioned parties were also not smart. According to estimates by Anne Sibert and myself made during the spring of this year, it would not have taken much more than $10 bn to see the Icelandic banks into 2009. Now the authorities of the US, the UK, Germany, France, Italy, Spain and the rest of the EU will be able to test the strength of the contagion effects that follow from some more high-profile bank failures. Faced with the choice of hanging together or hanging separately, they chose the second alternative. They will probably regret it before long.