Benn Steil


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Paul Krugman’s Baltic Bust—Part III

by Benn Steil and Dinah Walker
October 9, 2013

Does Paul Krugman Still Believe in “Icelandic Miracles”?
Photo Courtesy of Daniel Williams


Geo-Graphics posts in July 2010 and 2012 showed that Paul Krugman’s devaluation-driven “Icelandic Miracle” was nothing of the sort – a figment of his having chosen the most favorable possible starting date (Q4 2007) for his Baltic (and Irish) economic-performance comparisons.  Move it forward or back, and Krugman’s story collapses like a warming arctic ice shelf.

Our 2012 post particularly upset him – the poor thing being so weary of having to deal with benighted economic illiterates.  In suggesting that Krugman look not just at how his four chosen countries had performed relative to their pre-crisis peaks, but how they had performed since they hit bottom, we were apparently guilty of knowing nothing about business cycles – which to Krugman’s mind means believing that positive output gaps can actually exist.

Now that the IMF’s Olivier Blanchard, Mark Griffiths, and Bertrand Gruss have explained to him in a 39-page Brookings paper what we failed to get through to him in a simple sentence last year – that Latvia, whose inflation rate topped 15% in 2008, was producing well over its potential output at its pre-crisis GDP peak (undermining Krugman’s post-peak analysis) – Krugman has changed his tone on the Baltics abruptly.

(One can’t credibly call Olivier Blanchard an idiot, now, can one?)

Last year Krugman was peeved at having to defend his “Icelandic Miracle” claim against evidence that the competition had actually done as well or better, without devaluation; now, however, faced with more of the same evidence from a different source, he’s content just to quarantine Latvia as “a more or less unique case.”

But let’s not quibble about esoterica like output gaps.  Let’s address Krugman’s “Icelandic Miracle” claim on his own terms – that is, let’s just update his very own post-peak “Icelandic Miracle” figure.

Here it is, folks: Iceland, whose currency lost half its value against the euro in 2008, vs. Estonia, Latvia, and Ireland, all of which were euroized or pegged to the euro over the entire period . . .

Iceland v Latvia

In the updated figure, Estonia comes out on top, by a lot – well above Iceland, which performed no better than Latvia or Ireland, even using a starting date chosen by Krugman to make Iceland look as good as possible.

In short, Krugman credited Iceland’s post-crisis devaluation for an economic “miracle” that clearly never was. In fact, Iceland is now facing a new foreign-debt repayment crisis brought on by the capital controls Krugman extolled.

Hark, O ye Greeks: Beware pundits touting miracles.  The floating krona didn’t bring one to Iceland, and the drachma won’t bring you one either.


Financial Times: Dissatisfied Icelanders Question Myth of Post-Crash Success
VoxEU: The Collapse of Iceland’s Banks
Wall Street Journal: IMF Warns on Icelandic Economy


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Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”

Post a Comment 7 Comments

  • Posted by Kenneth Cukier

    To answer your photo caption: No, but he still believes in the iconic standard normal distribution…

  • Posted by Ray Lopez

    Well it seems Krugman is not really wrong, it’s that his Iceland remedy is no better (nor any worse) than Latvia’s austerity or Ireland’s EU bailout or whatever other remedies chosen by the other 3 countries. Flame on!

  • Posted by David Khoo

    Your graph actually shows Iceland to be a roaring success compared to the other countries. While the endpoints are the same, Iceland suffered the least over the period (the area under the axis is the smallest), with only Ireland being comparable. In terms of minimizing actual human suffering, Iceland’s policies came out far ahead. Remember, to Krugman, the purpose of economy policy is to maximize human welfare, not simply growth, so the less volatile path is better.

  • Posted by Benn Steil and Dinah Walker

    That was the whole point of our output-gap discussion. The starting point for Latvia (and Estonia) was output running significantly above potential. Declines from above-potential output represent corrections, not output failing to meet potential. Latvia (and Estonia) had a large positive output gap, and so suffered a large initial decline. Refer again to the bottom figure in our 2012 post ( Going back to 2000, what you see is that Latvia and Estonia had big booms, big busts, and big recoveries. Iceland and Ireland had small booms, small busts, and small recoveries. The point we were making this week is that regardless of how overheated the economies of Latvia and Estonia were in 2007, GDP has now recovered to the same extent in these countries as it has in Iceland. (Recall as well: the Q4 2007 starting date was chosen by Paul Krugman to flatter Iceland as much as possible.)

    There is no currency story here, let alone an “Icelandic Miracle.” Ireland was euroized and could not devalue; Iceland had its own currency, which fell spectacularly in 2008. Yet they followed the same growth trajectory. And where are they now? Icelanders, who had the global purchasing power of their savings decimated by the krona collapse, are on the verge of another foreign-debt crisis.

  • Posted by Jeffrey Sommers

    Overall, Krugman has been a lot more right than wrong. He might have viewed the devaluation issue with Latvia too simplistically, given his lack of familiarity with the Baltics when he began writing about them. That said, the authors of this piece misrepresent Blanchard’s (et a.) latest Brookings article which actually states that Latvia came through the crisis by taking its people to the woodshed on social policy–although they say it much more politely.

    What’s interesting about the CFR’s own chart is that is shows that Iceland’s strategy led to a LOT less pain. Latvia and Lithuania (according to their own GDP graph) lost massive GDP in the crisis compared to Iceland. By 2013 they may have returned to the same place as Iceland, but the huge GDP losses suffered by L&L during the crisis led to massive emigration from which it is possible they may never recover, and even if they do, represents a terrible, and unnecessary suffering imposed on their own people to keep the Scandinavian banks happy, and the vanity and egos of Latvia’s policymaking “elite” intact.

    Part of Latvia’s “success” is convergence. Latvia is a middle income country. Iceland is a high-income country. So, Latvia should grow much faster than Iceland (though it both have only caught up a the same rate, but with Iceland having avoided Latvian levels of pain.

    Second, note that the chart goes to Q1 2013. Latvia had 2 great wheat harvests when prices were high (2011 and even better for 2012). Note that for Q1 2013 Latvia’s growth has stalled. If the chart showed Q2 2013 it would show an even greater slow down. Manufacturing has slowed, wheat prices are down and the harvest is down.

    What is sustaining Latvia’s economy? We’re back to the highly volatile offshore banking and tax dumping along with clear-cut logging.

    This is not to say that there are no positive developments in transit and some in manufacturing, but EU austerity is now beginning to undermine those too.

  • Posted by Benn Steil and Dinah Walker

    The data presented in the chart above do cover Q2 2013. The axis labels are only every 3 quarters, so there isn’t a label for Q2 2013, but the data do go through the second quarter.

  • Posted by AEggerz

    Thanks for the interesting post being critical of Mr. Krugman’s world view. In fact the Icelandic recovery miracle is none – growth is missing – as could be explained in length. I allow myself to link to the full analysis here for a background reading on the following arguments.
    With the glasses of a practitioner I think Krugman and others are missing two points:
    The first one is that currency devaluation in my opinion can have to facets: productivity adjustment (numéraire function of the currency) or (asset price/debt) imbalance clearing mechanism (commodity function of currency) in the sense of overshooting. Of course most of the time both facets are in place, but there are differences also regarding the “intent of actors” of a devaluation. With respect to GPD growth the overall economic setup (e.g. export share, total debt in own currency) decides of net effects.
    Iceland’s devaluation was not managed, but a sell-off of assets to rescue capital stopped by currency controls. On the contrary one might argue that if Italy could devalue today very roughly speaking the effect on exports could outweigh other costs. Greece? Mm, tourism becomes cheaper …, but it is cheap already. Greece is not allowed to exit (=devaluation) to protect bank balance sheets since we live in a debt crisis world not in an industrial or productivity shock world.
    Exactly this is the second point: The magnitude of debt fueled distortion prior. The 50% devaluation in my point of view brought Iceland close to normal with an internal sector shift. Thus as you write it did not bring about a “miracle” that clearly never was.
    In response to the comment by Mr. Khoo: Krugman hailed the Icelandic miracle besides devaluation for being able to maintain or increase (I do not remember the exact wording from his NYT blog) the social security net. It left Iceland with two imbalances gov debt and the currency control to clear. Let’s then take a look on the chart. It does not necessarily mean the other countries here are better off.

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