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The European Financial Crisis Is Going Global – and We're Along for the Ride

Economics / Eurozone Debt Crisis Oct 08, 2014 - 04:12 PM GMT

By: Money_Morning


Peter Krauth writes: After printing $4 trillion since 2008, we've little to show for it.

Endless debates about the effectiveness of QE, or its lack thereof, haven't spawned better decisions, especially in Europe. Think periphery nations like Greece, Spain, Portugal, and Italy.

Better yet, take a look at the stock market, where worries about Europe's economy rattled investors. It's certainly not a pretty picture...

Recently one European national leader offered a somewhat unique response for dealing with the financial crisis and debt bubble.

It appears an unorthodox, yet sound, approach on the surface. But when you scratch beneath, it turns out just the opposite is true.

Developed economies would do well to consider the true state of this country's example of a "model" recovery before an even more catastrophic, debt-ridden future arrives, and erupts...

Iceland Isn't Greece... It's Worse

The country I'm talking about is Iceland. 

With a population of just under 320,000, its economy lacks diversity, with fishing, aluminum, and energy as its dominant sectors.

Something it does have is the world's oldest functioning legislative assembly, the Alþingi, established in the year 930. That's a long time to have practiced democracy.

You'd expect that experience could have saved this tiny country's economy, but as it turns out Iceland has a lot more in common with the birthplace of democracy: Greece.

And unfortunately, the parallels are eerily similar.

Greek households, it's estimated, have lost $215 billion of wealth in the last seven years.  Unemployment still runs near 27% with 44% of incomes below the poverty line.

Debt to GDP currently sits at 175% (EU's highest) and its latest annual deficit is 12.7%. 

Bailed out by $332 billion in "rescue" loans from the European Union and International Monetary Fund, Greece is now saddled with a national debt of $470 billion. That's nearly half a trillion dollars, for a nation whose economy represents 1.4% of the entire EU.  

Most of that money, by the way, goes to repay mainly German and French banks that were highly invested in Greek debt. The country's output has shrunk by a staggering 25% in the last six years.

This didn't have to happen to Greece. So why did it?

When Greece over-borrowed and over-spent in the past, it had its own currency, the drachma.  So, floating exchange rates with other currencies effectively devalued the drachma, which decreased domestic demand for pricier imports. It also lowered the costs of Greek labor and exports, spurring foreign investment in the country, as well as tourism.

It was the free market at work - Adam Smith's classic "invisible hand," as it were. But now Greece is handcuffed with the euro as its currency. That's a large reason things went south in Greece; devaluing its currency is no longer an option.   

So the Greeks will instead suffer under austerity for years, perhaps generations, along with a shrinking economy and soaring unemployment.

The "Opposite" Road to Recovery for the Icelandic Economy

Iceland, however, took the opposite route... sort of.

In 2008, overextended Icelandic banks also collapsed under the weight of their inflated mortgage "assets." Its financial sector shrank to a mere fifth of its former self. 

The country let its banks fail and imposed capital controls. Deposits held in Iceland by foreigners are stuck. Foreign-held bank debt was sacrificed.

Some bankers were investigated and then charged with fraud; at least one went to jail.

Iceland was able to take a different route because it has sovereignty and could decide its own future. 

The Icelandic krona dropped in value by half, its people accepted agonizing reforms, and the economy has posted better than 3% growth. There's even a risk the economy is overheating, with forecasts for 2014 and 2015 of 3.1% and 3.4% growth respectively.

Not being part of the EU and having its own currency allowed Iceland to make its own rules and decisions.

On the surface, Iceland appeared to do what Greece had done in the past when it used the drachma - default and devalue.

Or so it seemed...

Instead of austerity, Icelandic politicians resorted to capital controls.

The nation's central bank took on a massive IMF bailout in order to help (somewhat) prop up the krona. That's why Iceland's "recovery" from the crisis looks so impressive, for now.

But the bailout has caused national debt to triple, with currently over 17% of taxes going to pay its interest alone. Unemployment is low, but so are living standards, while prices have skyrocketed with inflation. And the now much weaker currency makes for costly imports, a needed lifeline for this tiny - and remote - nation.

Real estate prices have been devastated thanks to vanishing demand and high mortgage rates, leaving homeowners to deal with negative amortization loans. Remember those?

The IMF would like us to believe Iceland's debt-to-GDP is at a manageable 84%.

At the Clinton Global Initiative Symposium in New York, Iceland's President Ólafur Ragnar Grímsson said "When you look at Iceland and how we have recovered in six years, we have recovered more than any other European country that suffered from the financial crisis."

Things looked so good, Iceland lost its appetite to join EU, even withdrawing its negotiating team from discussions. But Grímsson failed to mention that debt-to-GDP is 221% when you count outstanding bank liabilities. On that basis, only one country is worse: Japan at 227%.  Even Greece is better at 175%.

The Nordic nation's top central banker has raised the idea of relaxing capital controls. But foreigners hold some $7.4 billion in Icelandic accounts, and many would want to leave, exposing banks to serious risks.

This "Volcanic" Eruption Will Rip Through Markets

Iceland has already endured difficult economic times, but its massively inflated debt has only softened the blow for the time being. The country is still running annual budget deficits, so odds are increasing they'll have to eventually default on a crushing debt load.

What lessons can we learn from all of this? 

What Jim Rickards said about Iceland in The Death of Money holds true for the United States: "...They should have accepted considerable short-term pain and administered real structural reform rather than just paper over with still more debt." 

That would have led to a true and robust recovery with capital properly allocated, instead of being misdirected thanks to artificially low rates.

As it turns out, despite a somewhat different approach, Iceland is actually no better off than anywhere else. And it's only a matter of time before its economy erupts like the country's second-highest peak: the volcano Bárðarbunga.  

Here's the thing... we're now all sitting under a similar "volcano."

Source :

Money Morning/The Money Map Report

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