Iceland serves as an interesting comparison with Ireland. Both had severe banking collapse but each was handled in a very different way. This a good experiment of policy differences. Bail-out in Ireland versus no bail-out in Iceland. Devaluation in Iceland versus deflation in Ireland.
In the case of Iceland, the banks were allowed to fail, the currency depreciated, and the economy took a major hit. Debt-holders of Iceland banks were left with nothing as expected in a bankruptcy. Ireland, on the other hand, decided to enlist help and bail-out the banks so that debt was shifted to the taxpayers. The debt burden was not decreased. Hence savings would have to be increased and growth would be cut in order to pay-down debt. The results has been a debt deflation spiral in Ireland versus a devaluation and cleaning of the balance sheet in Iceland.
Of course, the decline in Iceland was severe and painful, but it seems that they have been able to get on with its economic life with a better balance sheet and a trade surplus. Iceland GDP fell by 15% while Ireland fell by 14%; however, Iceland has seen interest rates fall from 18 to 4.5% but the exchange rate has fall by 50%. The inflation rate is falling and unemployment is declining so the misery index of inflation plus unemployment is actually declining and less than Ireland.
Devaluation is tough medicine but has advantages going forward versus switching private debt to public debt and fixing the exchange rate.
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