wages’ and deters them from taking low-paying jobs with poor working conditions, although whether this is a bad thing is a matter of opinion (personally I think the existence of a large number of ‘working poor’, as in the US, is as much of a problem as the generally higher unemployment rates we see in Europe). However, if it is well designed, with a view to giving workers a second chance, as it is in Scandinavian countries, it can encourage economic growth by making people be more open to changes and thus making industrial restructuring easier.
We can drive our cars fast only because we have brakes. If cars had no brakes, even the most skilful drivers would not dare to drive at more than 20–30 miles per hour for fear of fatal accidents. In the same way, people can accept the risk of unemployment and the need for occasional re-tooling of their skills more willingly when they know that those experiences are not going to destroy their lives. This is why a bigger government can make people more open to change and thus make the economy more dynamic.
Thing 22
Financial markets need to become
less, not more, efficient
The rapid development of the financial markets has enabled us to allocate and reallocate resources swiftly. This is why the US, the UK, Ireland and some other capitalist economies that have liberalized and opened up their financial markets have done so well in the last three decades. Liberal financial markets give an economy the ability to respond quickly to changing opportunities, thereby allowing it to grow faster. True, some of the excesses of the recent period have given finance a bad name, not least in the above-mentioned countries. However, we should not rush into restraining financial markets simply because of this once-in-a-century financial crisis that no one could have predicted, however big it may be, as the efficiency of its financial market is the key to a nation’s prosperity.
The problem with financial markets today is that they are too efficient. With recent financial ‘innovations’ that have produced so many new financial instruments, the financial sector has become more efficient in generating profits for itself in the short run. However, as seen in the 2008 global crisis, these new financial assets have made the overall economy, as well as the financial system itself, much more unstable. Moreover, given the liquidity of their assets, the holders of financial assets are too quick to respond to change, which makes it difficult for real- sector companies to secure the ‘patient capital’ that they need for long-term development. The speed gap between the financial sector and the real sector needs to be reduced, which means that the financial market needs to be deliberately made less efficient.
Visitors to Iceland in the 1990s reported that the official tourist guide handed out at Reykjavik airport had, like all other such guides, a ‘useful phrases’ section. Unlike them, I was told, the Icelandic guide also had a ‘useless phrases’ section. Apparently it contained three phrases, which were, in English: ‘Where is the railway station?’, ‘It’s a nice day today’, and ‘Is there anything cheaper?’
The railways thing is, surprising though it may be, true – Iceland does not have any railways. About the weather, the guide was perhaps being overly harsh. I haven’t lived there, but by all accounts Iceland does seem to have at least a few sunny days a year. As for everything being so expensive, this was also pretty accurate and a consequence of the country’s economic success. Labour services are expensive in high-income countries (unless they have a constant supply of low-wage immigrants, as the US or Australia), making everything more expensive than what the official exchange rate should suggest (
Rich as it already was, the Icelandic economy got a turbo-charged boost in the late 1990s, thanks to the then government’s decision to privatize and liberalize the financial sector. Between 1998 and 2003, the country privatized state-owned banks and investment funds, while abolishing even the most basic regulations on their activities, such as reserve requirements for the banks. Following this, the Icelandic banks expanded at an astonishing speed, seeking customers abroad as well. Their internet banking facilities made big inroads in Britain, the Netherlands and Germany. And Icelandic investors took advantage of the aggressive lending by their banks and went on corporate shopping sprees, especially in Britain, its former adversary in the famous ‘Cod Wars’ of the 1950s to 1970s. These investors, dubbed the ‘Viking raiders’, were best represented by Baugur, the investment company owned by Jon Johanneson, the young business tycoon. Bursting on to the scene only in the early 2000s, by 2007 Baugur had become a major force in the British retail industry, with major stakes in businesses employing about 65,000 people, turning over ?10 billion across 3,800 stores, including Hamleys, Debenhams, Oasis and Iceland (the temptingly named British frozen-food chain).
For a while, the financial expansion seemed to work wonders for Iceland. Once a financial backwater with a reputation for excessive regulation (its stock market was only set up in 1985), the country was transformed into a vibrant new hub in the emerging global financial system. From the late 1990s, Iceland grew at an extraordinary rate and became the fifth richest country in the world by 2007 (after Norway, Luxemburg, Switzerland and Denmark). The sky seemed to be the limit.
Unfortunately, after the global financial crisis of 2008, the Icelandic economy went into meltdown. That summer, all three of its biggest banks went bankrupt and had to be taken over by the government. Things got so bad that, in October 2009, McDonald’s decided to withdraw from Iceland, relegating it to the borderland of globalization. At the time of writing (early 2010), the IMF estimate was that its economy shrank at the rate of 8.5 per cent in 2009, the fastest rate of contraction among the rich countries.
The risky nature of Iceland’s financial drive since the late 1990s is increasingly coming to light. Banking assets had reached the equivalent of 1,000 per cent of GDP in 2007, which was double that of the UK, a country with one of the most developed banking sectors in the world. Moreover, Iceland’s financial expansion had been fuelled by foreign borrowing. By 2007, net foreign debt (foreign debts minus foreign lending) reached nearly 250 per cent of GDP, up from 50 per cent of GDP in 1997. Countries have gone to pieces with far less exposure – foreign debts were equivalent to 25 per cent of GDP in Korea and 35 per cent of GDP in Indonesia on the eve of the Asian financial crisis in 1997. On top of that, the shady nature of the financial deals behind the Icelandic economic miracle was revealed – very often the main borrowers from the banks were key shareholders of those same banks.
Why am I spending so much time talking about a small island with just over 300,000 people that does not even have a train station or a McDonald’s, however dramatic its rise and fall may have been? It is because Iceland epitomizes what is wrong with the dominant view of finance today.
Extraordinary though Iceland’s story may sound, it was not alone in fuelling growth by privatizing, liberalizing and opening up the financial sector during the last three decades. Ireland tried to become another financial hub through the same strategy, with its financial assets reaching the equivalent of 900 per cent of GDP in 2007. Like Iceland, Ireland also had a bad fall in the 2008 global financial crisis. At the time of writing, the IMF estimate was that its economy contracted by 7.5 per cent in 2009. Latvia, another aspiring financial hub, has had it even worse. Following the collapse of its finance-driven boom, its economy was estimated by the IMF to have shrunk by 16 per cent in 2009. Dubai, the self-appointed financial hub of the Middle East, seemed to hold on a bit longer than its European rivals, but threw in the towel by declaring a debt moratorium for its main state-owned conglomerate in November 2009.
Before their recent falls from grace, these economies were touted as examples of a new finance-led business model for countries that want to get ahead in the era of globalization. As late as November 2007, when the storm clouds were rapidly gathering in the international financial markets, Richard Portes, a prominent British policy economist, and Fridrik Baldursson, an Icelandic professor, solemnly declared in a report for the Iceland Chamber of Commerce that ‘[o]verall, the internationalisation of the Icelandic financial sector is a remarkable success story that the markets should better acknowledge’.[1] For some, even the recent collapses of Iceland, Ireland and Latvia have not been enough reason to abandon a finance-led
