Friday, 4 April 2014

Money Supply and Iceland's Banking Collapse in 2008

A couple of weeks ago I started expanding my money supply database by adding a few new countries. One of those countries was Iceland. 

I remember Baugur Group, an Icelandic investment company, marching onto the London high street some ten years ago taking over some major UK clothing retailers. I remember even more clearly however the spectacular collapse of the group in early 2009 following the collapse of the major Icelandic banks in September and October 2008, some of which helped finance the group. According to The Economist back then, Iceland's banking collapse was "the biggest, relative to the size of an economy, that any country has ever suffered".

Back to the money supply, how can the growth rate in the money supply help explain the rise and fall of Iceland's banking sector and economy? 

Here's the money supply growth rate (year on year basis) from January 2000 to March 2008:

And here's the money supply growth rate ever since (March 2008 to December 2013): 

Lesson? Rapid monetary expansion will eventually lead to a collapse of any banking sector and hence of a country's economy. This is exactly what happened in the U.S., the UK and the Euro Area as well in 2008 (though on a smaller scale compared to the size of the economies). Undue expansion of the money supply is always the culprit of so-called financial and economic crisis which is nothing other than a classic bank run (which comes in many "disguises") caused by lending unbacked by prior savings - the act of creating money out of thin air.

Taking one step further back, this expansion of the money supply is made possible in the first place by fractional reserve banking backed by a central bank. Without this banking/monetary system, such spectacular booms and busts simply would be impossible. Regulation and the promotion of high moral standards are not the solutions to contain the damage this system can cause. Curing symptoms instead of removing the cause of those symptoms is rarely a sound solution to any problem. Instead, the solution is to remove banks ability to create money ex nihilo and to end central banks role as lenders of last resort. Implementing the latter would arguable solve most of this problem of undue monetary expansion.

In local currency