Two thorns of experience: financialisation in Iceland and Ireland

Abstract

We explain the 2008 crisis in Iceland and Ireland with an emphasis on the role financialisation played in destabilising these countries’ economies. The two small open economies share similarities in that both countries had capital inflows before the crisis, ending with a sudden stop. However, the mechanisms of the crisis, which induced the capital flows, the factors that influenced them and their effects on the real economy differed due to differences in currency regimes and the response to the crises. We investigate the link between financialisation and the transmission channels of financialisation on the macroeconomy, using ARDL methodology. Finally, we suggest policy prescriptions to limit the scale and scope of similar crises in the future while highlighting the institutional differences between the two economies.

Keywords:

• Capital flows
• financialisation
• sudden stops
• small open economies
• currency regime

JEL Classifications:

• G01
• F32
• F38

Acknowledgements

The support of RANNIS, Iceland, and the Institute of New Economic Thinking (INET) is gratefully acknowledged in funding this research.

Notes

No potential conflict of interest was reported by the authors.

1 The countries belonging to the European Economic Area and not to the European Union are part of the Single Market (goods, labour and capital markets) and are obliged to adopt the European Union’s regulatory and legal framework that applies to the Single Market but are not members of the European Union—do not share a common agricultural policy and neither do they have the right or the obligation to aim at euro membership. The EEA countries are Iceland, Lichtenstein and Norway.

2 The separate treatment of domestic currency and foreign currency deposits was the source of conflict between the Icelandic authorities, on the one hand, and the British and Dutch authorities, on the other hand.

3 The total gross fiscal outlays were 44.2% in Iceland and 40.7% in Ireland, while the net outlays, once account is taken of recoveries, were 20.5% in Iceland and 40.7% in Ireland. These two numbers dwarf those for the Netherlands (12.7% gross and 5.6% net) and the UK (8.8% gross and 2.1% net). See Laeven and Valencia (2012).

4 See Gudmundsson (2015) for an extended review on the process of financialisation in Iceland.

5 Due to data limitations, we were not able to compute any other proxies for financilisation in this paper.

6 For Iceland, quarterly data for the compensation of employees is not available, therefore we use the quadratic-sum method to compute quarterly time series from the annual observations.

7 For Iceland, quarterly data for the compensation of employees is not available, therefore we use the quadratic-sum method to compute quarterly time series from the annual observations.

8 In the case of Iceland, we estimate Model 1 using unadjusted wage share due to data constraints, while in Model 2 and Model 3, we use the adjusted wage share. For Ireland, we use adjusted wage share in all the models.

9 Dummy takes the value of 1 during the last three quarters of 2008 since we find a structural break in the proxies of financialisation, using Zivot and Andrews (1992) methodology. However in the case of Iceland, the structural break in FDL series occurred in 2011 therefore the dummy takes the value of 1 in 2011Q3.

10 Although the fourthth lag of trade openness is negatively associated with the deposit liabilities to GDP, the cumulative dynamics indicate an overall strong positive effect (see Table A3 in the Appendix).

11 In 2006, there were large investment projects in aluminium smelting but due to sudden stop in 2008, these projects did not reach their completion.

Additional information

Funding

This work was supported by the Institute for New Economic Thinking [grant number INO1300030]; RANNIS [grant number 130551-052].