On Iceland: Defending Professor Mishkin

by Guinandra Jatikusumo

Iceland

Many people assail Professor Mishkin of Columbia University for his inconsistent stance on Iceland’s economy before 2008. Especially those who have watched the widely-acclaimed documentary, ‘Inside Job’, in which Professor Mishkin was interviewed regarding his opinions on the 2008 financial crisis and how it was similar to that of Iceland’s. The shrewd interviewer found that Professor Mishkin changed the title of his report, from ‘Financial Stability in Iceland’ to ‘Financial Instability in Iceland,’ as the crisis ensued. The narrator further said that Professor Mishkin had a conflict of interest; that he published his report under the direction of the Icelandic government, to stabilize the market after Fitch downgraded Iceland banks from ‘stable’ to ‘negative.’ I read the report, and as expected, the tone was optimistic. Indeed, in the end, history disproved Professor Mishkin’s claim that “[Iceland’s] financial system remained strong.” (In the report, he did not expect, or mention the potential of, a Lehman’s collapse in 2008, which subsequently led to illiquidity in interbank lending. Which economists correctly predicted the 2008 crisis anyway? There were only a few of them).

He wasn’t completely incorrect, however, and here’s why. In addition to his exceptional analyses of Iceland’s competitive advantage, governmental and educational system, he did implicitly illustrate a hypothetical case of the Icelandic banks failing to finance their liabilities. After skimming the report, I found a chart demonstrating the relationship between CDS (Credit Default Swaps) spreads and the probability of an Icelandic financial instability. (For those not acquainted with the term CDS, Investopedia has a great description of it). CDS is basically an insurance that protects the CDS owner/speculator against a probable default or ‘failure’ of an asset. As commonly known, larger CDS spreads imply that the market perceives the Icelandic banks as having a high probability of possessing bad assets, defaulting, or becoming insolvent. Professor Mishkin did his calculation, and he found that when the spreads reach 500 basis points, there is a 100% probability that Iceland inevitably would experience a financial turmoil.

CDS Spread vs. Probability of Financial Crisis1

The paper was written in 2006. That time, CDS spreads were clearly below 500…

CDS Spreads1

… but as shown in the graph above, CDS spreads soared rapidly until 2008. It even reached above 1000 basis points. Under Professor Mishkin’s calculation, it means that a financial crisis would occur, unavoidably. And it did; the banks were insolvent, capital inflows sharply declined, the Icelandic Krona depreciated, the banks restructured, public debt increased, foreign assets frozen, and unemployment tripled. All of these were triggered by the U.S. subprime mortgage crisis in 2008, which rendered interbank lending freeze. Professor Mishkin was therefore not completely incorrect. His graph shows that he did ‘predict’ a financial instability in Iceland. He didn’t simply change the word ‘stability’ to ‘instability’ out of thin air; he had a basis for doing so.

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