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The Icelandic banking collapse - was the optimal policy path chosen?

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  • Thorsteinn Thorgeirsson
  • Paul van den Noord

Abstract

This study examines the economic policies of the Icelandic government in the wake of the banking collapse of 2008 in terms of counter-factual policy options. The path chosen was important for the recovery but policy makers faced alternative policy options for handling the many difficult situations that arose, with potential implications for government finances and economic growth. We utilize two complementary macroeconomic models to assess the decisions taken and the recovery and on that basis develop counter-factual scenarios of how the crisis could have played out if the decisions had been different. Four alternative scenarios are considered involving different ways to deal with the collapse: i) adopt a more pro-cyclical fiscal policy, ii) allow the ISK exchange rate to drop without imposing capital controls, iii) pay the interest expense on the initial Icesave agreement, or iv) rescue the banks as Ireland did. Macroeconomic model simulations are performed to assess the impact of different decisions involving public finances on economic growth, unemployment and other macroeconomic variables over the period 2008-2025. The results are compared to the actual path taken. Addressing this question is potentially interesting in its own right and also from the point of view of other countries that have experienced similar crises but have responded differently.

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Bibliographic Info

Paper provided by Department of Economics, Central bank of Iceland in its series Economics with number wp62.

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Date of creation: Mar 2013
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Handle: RePEc:ice:wpaper:wp62

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  1. Weymes, Laura & Bermingham, Colin, 2012. "Fiscal Compact - Implications for Ireland," Economic Letters 09/EL/12, Central Bank of Ireland.
  2. Pier Carlo Padoan & Urban Sila & Paul van den Noord, 2012. "Avoiding debt traps: Fiscal consolidation, financial backstops and structural reforms," OECD Journal: Economic Studies, OECD Publishing, vol. 2012(1), pages 151-177.
  3. Már Gudmundsson & Thorsteinn Thorgeirsson, 2010. "The fault lines in cross-border banking: lessons from the Icelandic case," Chapters in SUERF Studies, SUERF - The European Money and Finance Forum.
  4. Ethan Ilzetzki & Enrique G. Mendoza & Carlos A. Végh, 2010. "How Big (Small?) are Fiscal Multipliers?," CEP Discussion Papers dp1016, Centre for Economic Performance, LSE.
  5. DiTella, Rafael & MacCulloch, Robert & Oswald, Andrew J., 2001. "Preferences over inflation and unemployment: Evidence from surveys of happiness," ZEI Working Papers B 03-2001, ZEI - Center for European Integration Studies, University of Bonn.
  6. Peter S. Heller, 2005. "Understanding Fiscal Space," IMF Policy Discussion Papers 05/4, International Monetary Fund.
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