V, U og L kreppur

Jón Daníelsson hagfræðingur við London School of Economics skrifar grein um kreppur sem eru eins og V í laginu, eða U eða L.

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V, U and L shape crises

Jon Danielsson

March 24, 2010

An extensive body of research exists on categorizing economic and financial crisis. As the risk of oversimplifying, one can broadly classify them into one of three categories: V, U and L.

In a V shape crisis, the economy collapses sharply and recovers quickly. This is typical of the Asian crisis where countries such as South Korea, Thailand and Malaysia suffered perhaps a 10% drop in GDP in short order, but mostly recovered within a year or so. A key reason for the crisis was a dry-up of liquidity. These countries were dependent on short-term external borrowing, which eventually dried up in 1997, resulting in widespread bankruptcies and sharply depreciating exchange rates. However, there was limited destruction of economic capacity and the following exchange rate depreciation helped making the economies more competitive. The Asian economies returned to almost full production within a year or two. Significantly, the crisis did not result in excessive government debt or any serious realignment of what the countries produce.

In a U crisis recovery takes a lot longer, perhaps five years. This is typical of Finland. In such a crisis the banking system collapses along with the exchange rate, where the country also looses significant parts of the economy. In the case of Finland, it was the export industry to Soviet Union. So long as the government does not lose control of its finances, the country recovers eventually.

Finally, in a L crisis recovery may never happen. This is typical of Japan and Argentina. In these cases the government debt following the crisis is very high. It could be because prior to the crisis government debt was already high and the crisis just adds to that, or the crisis just imposes large costs on the government. Because government debt may be in foreign currency in some cases, the exchange rate depreciation makes the debt increase, counterbalancing the benefits from the depreciation. Also, the contraction in GDP will make domestic debt to GDP increase. Furthermore, the contraction in GNP may be even larger. The problem here is that the government gets into a vicious cycle. High levels of debt mean high cost of servicing the debt. The crisis means demand for government services increases but tax revenues decrease. As the government raises taxes, eventually it will start damaging the real economy, slowing economic growth and hence future tax revenues. But the increased taxes never catch up with the budget deficit, and the country never recovers.

Of the European countries in serious crises, most seem to be heading for a U shaped crisis. For the worst affected, Lithuania this seems to be the case, and similarly to Ireland. Greece is a special case because its crisis has little to do with the global crisis; it is just the result of living beyond its means for many years. It is quite possible it may end up in the L.

So what about Iceland? It is clearly not a V, as some optimistic commentators have claimed. But its not a L, yet. Government debt is very high but still manageable, but questions remain about future economic activity. The country became quite dependent on banking and something will have to replace that. The question is what. While the government finances are still under control, there are doubts about the governments willingness to sufficiently cut its budget and fears persist that it intends to tax its way out of the budget hole. International capital markets indicate that they think it is going to be L, as witnessed by both the CDS spreads and credit ratings. To recover, the government needs to have a credible plan for reduction in government expenditures, avoid excessive taxation, resist micromanaging the economy, abolish capital controls, and settle Icesave. Without this, Iceland may well be heading for the L.