Wednesday, July 02, 2008

Mitchell's miracle in Iceland

Last August, Dan Mitchell of the Cato Institute and the Center for Freedom and Prosperity Foundation issued a press release about the virtues of Iceland's low-tax, flat-tax economic model. The authors gushed:

The reforms in Iceland have yielded big dividends. Iceland is a rich and successful nation. Lower tax rates and supply-side policies have boosted growth, increased efficiency, and made the country more competitive. The three biggest reforms are the low corporate tax rate, the low-rate flat tax on capital income, and the intermediate-rate flat tax on labor income. The authors find considerable evidence that the first two reforms have been very successful. Indeed, they also find it is quite likely that the lower rates have generated significant Laffer Curve effects – meaning the government collects more revenue at a lower tax rate.

How is Iceland doing now? Let's take a look at an article about Iceland in today's Financial Times:

Gross domestic product shrank by almost 4 per cent in the first quarter of 2008 compared with the final quarter of last year, when growth was barely positive. The stock market and the currency have both fallen by about a third since the start of this year. The size of the accumulated macroeconomic imbalances beggars belief. The external deficit was 25 per cent of GDP in 2006 and 17 per cent in 2007. Gross short-term foreign debt amounted to 15 times the value of the central bank’s foreign exchange reserves at the end of 2007, or roughly 200 per cent of GDP. Gross long-term foreign debt amounted to another 350 per cent of GDP. Bank assets swelled to 10 times GDP by the end of 2007.

How did this happen? The FT tells an interesting tale, which is worth reading: it ends with this:

The “great unwind” currently under way is the result of the excesses built up in this framework of light regulation – itself the product of hasty, though overdue, privatisation. Now the new coalition government itself is in deep trouble. . . . That could signal a welcome change of direction in Iceland’s economic policy towards a more Scandinavian model, where finance does not rule the economy and macroeconomic imbalances are taken seriously.
Dan Mitchell, it should be noted, had earlier accused TJN's Richard Murphy of cowardice for declining to debate with him in a biased forum - then came off rather badly when a more neutral forum was found - and Richard was judged to have won hands down. Mitchell has been rather quiet about Iceland of late.

But it's unfair to fixate only on him. A mass delusion has been underway for years, and Iceland was just the "canary in the mine" for dangerous excesses that were building up for the global economy. A new report from the Bank for International Settlements said this:

How could a huge shadow banking system emerge without provoking clear statements of official concern? Perhaps, as with processes for internal governance, it is simply that no one saw any pressing need to ask hard questions about the sources of profits when things were going so well.

And the report continued:

“The current market turmoil in the world’s main financial centres is without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point. These fears are not groundless.”

The FT's chief economics commentator Martin Wolf observed:

How big are the risks now? The answer is: very large . . . nobody can credibly claim to know what lies ahead.

One of the features of the crisis is how widely distributed securitised loans turned out to be. The resulting uncertainty about who owns them, along with parallel uncertainty about what they are worth, has blighted money markets for almost a year.

One of the most important long-term answers to such uncertainty is better transparency in international finance. We have outlined several answers elsewhere: country-by-country reporting is one of our recent ones. Cracking down on tax havens is another (that is why we named our recent submission to the UK Treasury on tax havens "Creating Turmoil". There are several other approaches.

Icelanders seem to be cooking up some interesting wheezes to get out of the mess their financial wizards seem to have got them into. Richard Murphy takes a look at one of them here. Let's hope these aren't the best answers they, or the UK, can come up with.

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