10.01.2012 1

Should Spain follow Iceland in letting banks fail?

By Bill Wilson — One almost feels bad for Paul Krugman, who in recent days appears like the brilliant student in class who spots meaningful relationships between different sets of data, but then fails to fully apply the concepts.

Of late, the New York Times columnist and economist has been fond of noting that Spain did not get into budget trouble because of over-inflated government sectors per se, as in Greece, but because it suffered through a major housing bubble popping.

Here, Krugman is actually right — in part.

In a recent blog post, he writes, “Spain is suffering the hangover from a huge housing bubble, which caused both an economic boom and a period of inflation that left Spanish industry uncompetitive with the rest of Europe. When the bubble burst, Spain was left with the difficult problem of regaining competitiveness, a painful process that will take years.”

That’s true, but the part he leaves out is that after the bubble popped Spain then bailed its banks out, throwing its public finances into chaos. Spain’s deficits today come almost entirely as a result of guaranteeing its insolvent banks against failure.

Ironically, Krugman has had no trouble pointing to bank bailouts as the reason for Ireland’s own budget problems.  In contrast, he has frequently heralded the example of Iceland in 2008 as an alternative model to Ireland of how to work out of a financial crisis.

Iceland let its banks fail and told foreign creditors to take a hike. And now it is on the path to recovery.  While its unemployment rate ticked upward in the recession, it peaked at about 9.2 percent in Sept. 2010 and is now down to 6.3 percent.

Spain and Ireland, on the other hand, followed the examples of the U.S. and UK and bailed their banks out.  Unsurprisingly, they overcommitted their treasuries and now cannot fund the resulting deficits.

They never came back economically either. Both Spain and Ireland face untenable unemployment situations of 25 percent and 15 percent, respectively, and rising.

The Spanish and Irish bailouts prevented major deleveraging — the necessary correction to credit bubbles — from occurring rapidly, which has only prolonged the recession. Labor conditions continue to deteriorate.

In contrast, because Iceland ate all of its losses right up front, restructured its financial system and debts, the bottom of its recession was quickly hit. Now, its labor market is in recovery.

Perhaps that is why Spanish protestors wave Icelandic flags and chant, “We are all Icelanders now” in the streets of Madrid.

In the U.S., are we more like Iceland, which is seeing labor market conditions improving, or are we more like Spain and the rest of Europe, which is in decline? With 23 million who cannot find full-time work and another 5 million who have simply given up since 2009, plus a rapidly shrinking labor force, we are unquestionably in a depression.

Yet, Krugman would not recommend an Icelandic solution of letting banks fail in advanced economies like the U.S. He supported the Troubled Asset Relief Program (TARP) at the time.  Since then, despite seeing the benefits of the Icelandic success story, he has not yet changed his tune on bailouts of too-big-to-fail institutions in the U.S.

For him, the mistake is merely one of academic consequence. It does not change anything. He’s just a pundit. But for government officials that insist on this suicidal course of propping up insolvent banks, they risk much more than constructive criticism.

The situation bears striking similarity to the Credit Anstalt crisis of Austria in 1931. Then, the price of bailing out too-big-to-fail banks was a complete collapse of the Austrian schilling linked to gold.

In Spain, Ireland, and elsewhere, the price of bailing out the banks will be a collapse of the euro as we know it.

A step Krugman openly acknowledges: “Unless Spain leaves the euro — a step nobody wants to take — it is condemned to years of high unemployment.” One might note that a Spanish departure from the eurozone might also entail letting its banks — whose debts are denominated in euros — fail.

So why not in the U.S.? Here, banks got the $700 billion TARP, then another $1.25 trillion from the Federal Reserve to purchase back shoddy mortgage-backed securities, and now have been guaranteed another $480 billion a year in printed money in QE3.

What have the American people got to show for it so far? 11 percent real unemployment, more debt than ever, and flat wages.

Nobody has ever gone to jail for their role in blowing up the credit bubble in the U.S.  Nobody at Fannie Mae or Freddie Mac was really held accountable, like Franklin Raines, who oversaw Fannie as its CEO during the critical bubble years of 1999 through 2004 and walked away with millions despite the company’s catastrophic failure.

Perhaps too-big-to-fail institutions do not pose an economic problem at all, but saving them does. This is and always was a political problem for elected and unelected officials of whether or not to bail out their buddies on Wall Street. Now, because of their decision, everyone else is suffering.

The economics of defaulting banks could have been handled through real bankruptcy proceedings. If we had just followed an Icelandic policy twist of allowing creative destruction to take place in the markets, perhaps we’d already be out of this mess.

For now, it could be time for both Spain and the U.S. to say hasta la vista, baby, to the too-big-to-fail banks that cannot stand on their own feet.

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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