Ireland vs Iceland: deflation vs devaluation

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BCA Research has just published a short note, highlighting the stark difference in policy response followed by Iceland and Ireland to remedy their debt malaise, in the absence of the Emerald Isle being able to devalue its currency. Their summary follows below.

“Iceland and Ireland experienced similar economic illnesses prior to their respective crises: both economies had too much private-sector debt and the banking system was massively overleveraged. Iceland’s total external debt reached close to 1,000% of its GDP in 2008. By the end of the year, Iceland’s entire banking system was crushed and the stock market dropped by more than 95% from its 2007 highs.

“Since then, Iceland has followed the classic adjustment path of a debt crisis-stricken economy: the krona was devalued by more than 60% against the euro and the government was forced to implement draconian austerity programs.

“In Ireland, the boom in real estate prices triggered a massive borrowing binge, driving total private non-financial sector debt to almost 200% of GDP, among the highest in the euro area economy. In stark contrast to the Icelandic situation, however, the Irish economy has become stuck in a debt-deflation spiral. The government has no other options but to accept the €85 billion bailout package from the EU and the IMF.

“The big problem for Ireland is that fiscal austerity without a large currency devaluation is like committing economic suicide – without a cheapened currency to re-create nominal growth, fiscal austerity can only serve to crush aggregate demand and precipitate an economic downward spiral. The sad reality is that unlike Iceland, Ireland does not have the option of devaluing its own currency, implying that further harsh economic adjustment is likely.” [Emphasis added by PduP.]

Source: BCA Research, December 2, 2010.

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