I usually write in this space about the economies of the Pacific Rim, and the lessons they hold for policymakers in the United States. But this year, Iceland, with its stunning beauty, is the place to go on vacation, and so I headed to the other side of the planet.

Settled by Vikings in the ninth century, Iceland was one of the first proto-democracies. Those Norse settlers held their rudimentary version of parliament, called the Alþing (Althing), at Thingviller, the rift where the North American and European plates are tearing apart.

From its inception, Iceland was part of a globalized world—first as a dominion in the far-flung lands of the Vikings, and later linked with European commerce. That linkage—essential for a country with fewer people than the city of Santa Ana, California—continues to this day, although the current prime minister’s Independence Party, now leading a coalition government, has serious questions about the value of European integration.

The trouble with globalized Iceland is that its connections to the outside world have been accompanied, and strained, by a relatively severe business cycle. Why? The causes are too many to name here, but two stand out: trade and finance.

Finance casts an especially long shadow. We in the United States thought the financial crisis of September 2008 was bad, and it was. But in Iceland it was much, much worse. Beginning in September 2008, Iceland suffered a financial crisis during which 90 percent of its financial system evaporated, all of the major banks defaulted and were nationalized, and the value of the Krona fell by 50 percent. It has been described as one of the worst financial crises of any economy in modern history.

In September and October of 2008, when the banking system exploded like so many Icelandic volcanoes, Icelanders faced the same choice that many countries, including the United States, confronted: backstop the banking system, or let it fail and start over again.

The Icelandic Independence Party was in power at the time of the crash (though it had not been in power during the preceding “banks-gone-wild” period). And so the party tried to reassure their countrymen that Iceland, like all other countries facing huge systemic debts, needed to step up to the plate and guarantee the private debt of the banking system. This is similar to what Ben Bernanke and the U.S. Federal Reserve decided to do in the fall of 2008.

But that was not to be. The Icelandic Independence Party’s coalition government, which (full disclosure) was led by my University of Minnesota classmate Geir Haarde, fell in February 2009. Eventually, Sigmundur David Gunnlaugsson’s Progressive Party came to power with a different point of view.

Gunnlaugsson, who rode a wave of anti-bailout sentiment, decided to default on Iceland’s international debts. His view was that foreign investors should have known the risks they were taking in exchange for the high returns they hoped to receive. Now that the risks had materialized, Gunnlaugsson asserted, they ought not look to others to help them.

“Icelanders, as descendants of the Vikings, are highly individualistic and have difficulty putting up with authorities, let alone oppression,” is how he colorfully put it after the election.

The results: Iceland’s banks went under, the bad debt was put into a resolution authority for sorting out, and a new, much more conservative banking system arose from the ashes.

The new banking system improved regulation, instituted higher bank equity requirements, and established strict stress tests, similar to what the U.S. implemented, but perhaps a little more restrictive.

And Iceland itself did not go under. In fact, the Icelandic economy has recovered quite nicely since then. That’s in part because taking decisive action was possible in a small, homogenous country. It’s also because the important parts of the real economy—agriculture, renewable energy, fisheries, and tourism—were still solid, despite a moribund banking sector.

As Geir Haarde put it, the hull of the Icelandic economic ship was strong, with only the superstructure being damaged. Fixing that superstructure by creating new banks with more restrictive regulation, and with bridge loans from the International Monetary Fund, engendered a return to prosperity.

Today, demand for fish is growing, tourism is hot, and economic activity has diversified into marine and renewable energy technology. From the Ocean Cluster House on the docks of Reykjavik to the large geothermal-heated greenhouses in Fliori, Iceland’s non-financial economic activity is booming.

The question is whether the new monetary system can meet its promise to smooth out fluctuations in the business cycle. History provides reason to worry. Iceland remains exposed to the world economy and, as a small player, is going to be buffeted by it in the future.

There is an Icelandic aphorism: to lay your head in water. It roughly means to think about what you are doing and perhaps come up with a new and better solution.

Economists from the Bank of Iceland are doing just that. They recently studied the past 150 years of Iceland’s economic history and found financial crises in Iceland are the rule not the exception. Of the 20 financial crises studied, five were quite similar to the 2008 implosion. The common thread is that they arose in conjunction with adverse global financial events.

The option of isolating the economy from the rest of the world exists, but this is not very palatable for a small trading country. Another more radical solution was proposed in a government-commissioned study by Frosti Sigurjónsson: establishing a sovereign monetary system.

The basic idea is to eliminate fractional reserve banking; that’s the system whereby banks can leverage depositors’ funds through loans to others. By eliminating such leveraging, banks can be sure that they have enough funds to cover customers’ deposits during a financial crisis.

In a sovereign monetary system, banks play a transactions-only role. They take in deposits, charge a fee for storing and processing them, and facilitate transactions. Effectively, the banks become a big mattress for putting one’s money under. A bank cannot be insolvent because it always has on hand 100 percent of customers’ deposits. More risky investments may be made via investment banks similar to mutual funds in the U.S. For these, the customer is not guaranteed a return nor guaranteed the ability to withdraw their investment.

There are some technical issues about monetary policy in this system, but they can be resolved relatively easily. The real cost of a sovereign money system is that the deposits are now idle. In Western banking, deposits are put to work as loans that generate new economic activity. That doesn’t happen under the Icelandic bank mattress; the money just sleeps until the customer is ready to withdraw it.

If Iceland were to implement such a system, it would be an instructive experiment in monetary economics. Whether successful or not, we would learn something about how to better manage the systemic risks of the banking system. However, it would be very difficult for the United States to adopt such a policy.

Be that as it may, can we in the United States learn something from the Icelandic financial experience? After all, major financial panics with significant impacts on the U.S. economy occurred in 1819, 1837, 1873, 1893, 1907, 1929, and 2008.

In the wake of the Panic of 1929, significant banking reform in the United States was instituted, including the Glass-Steagall Act of 1933. Eventually, through subsequent regulatory changes and the Gramm-Leach-Bliley Act of 1999 (signed by President Bill Clinton), some restrictions on bank activity were repealed. That the longest episode without a major financial panic occurred during the time Glass-Steagall restrictions were in place may be significant, or it may be a coincidence. Economists who study this period have not settled the question definitively.

But we don’t have to know the answer to this question to take a lesson from Iceland’s Vikings. For countries with recurrent financial crises, there may be a real danger in rushing to return to the old banking system, as some of current efforts to repeal important sections of the Dodd-Frank financial regulation bill seek to do. Rather, taking your time is vital. There are complex interactions in the globalized banking system that should be analyzed with methodical care, considerable thought, and an eye towards economic history.

While that all seems very reasonable, I am reminded of a line from one of Icelandic musical superstar Björk’s hits, “There’s definitely, definitely, no logic to human behavior.” When one believes that financial markets are always and everywhere self-correcting, they may indeed be living in a Björk song.

The post How Iceland’s Rugged Viking Heritage Helped Salvage Its Economy appeared first on Zócalo Public Square.

Now it looks like Prop 30 might have an even longer life. Last month, the California Teacher’s Association—the union representing more than 300,000 teachers—filed an initiative to extend Prop 30’s temporary income tax surcharges until the year 2030. The rationale according to Gale Kaufman, strategist for the initiative, is to “keep our state budget balanced, and prevent devastating cuts to programs affecting students, seniors, working families, and health care.”

Unfortunately, economics and the available empirical evidence suggest there is a very large risk that Prop 30 will produce the exact opposite outcome from that suggested by Kaufman.

There are two issues that voters must consider before deciding whether to accept this risk. The first is the difference in incentives between a temporary and a permanent increase in income taxes. The second is the different impact a tax may have at different points in the business cycle.

When Prop 30 was proposed, it was billed as a temporary tax increase to bail the state and its schools out of a recession-induced financial crisis. In the political campaign, Gov. Jerry Brown said: “It’s about putting money into California’s schools or taking money out of it … there is no third way.”

At the time, opponents warned of a mass exodus of high-income earners from the state were Prop 30 to be enacted, since the income tax hikes were restricted to those who earned at least $250,000 a year. California has become increasingly dependent on such high-income earners for tax revenues. Income taxes paid by the top 1 percent of income earners grew from 33 percent of the total in 1994 to over 50 percent in 2012, the first year of the Prop 30 tax surcharges. But the exodus did not happen. Most high-earners stayed, more came, and they and the Golden State have prospered.

Why were the doomsayers wrong? It’s not easy to say. There are no data on this; nor are there data on the difference between a temporary Prop 30-like tax increase and a permanent one.

However, we do know that people react differently when presented with the same policy if they think there is a crisis (let’s all pitch in and solve this) or if they think it is business as usual (why am I contributing this amount?). These questions of context and timing must inform how we think about extending Prop 30.

For example, will there be a significant move of Californians to Seattle—where there are no income taxes—if Prop 30 income tax surcharges are made effectively permanent? If the answer is yes, then it could well be the case that state tax revenues would decline as high-income earners and their employees depart, offsetting gains from the higher taxes on those who stay put. This is a difficult but essential forecasting problem facing the voters as they consider the extension of Prop 30.

Another forecasting problem involves the fact that income taxes apply to earned income, and in a recession income declines. A recession is coming. When? We do not know, but it is coming and tax revenues will necessarily decline when that occurs. Importantly, when it does, California’s high-income earners will once again take a greater hit to their income than the balance of the state. The heavier the reliance on them to fund state government, the greater the cuts will be to the same programs that Kaufman cited.

But then shouldn’t the state extend Prop 30 income taxes to cover this impending shortfall? The unfortunate answer is no. Income that does not exist because of a recession yields the same revenue regardless of the marginal tax rate—zero.

In fact, an extension of Prop 30 could make the situation worse than it was during the Schwarzenegger and Davis budget crises. Our current greater dependence on high-income earners to balance the state budget makes us more not less vulnerable. It is one key reason why the three bond rating agencies, Fitch, S&P, and Moody’s, rate California bonds as relatively high-risk investments compared to those of other states.

The close and deleterious relationship between the unstable incomes of high-income earners and California’s public finances dates back to Governor Ronald Reagan’s progressive tax law, which itself was supposed to be temporary. Ever since then, when rich people have done badly, so has the state. The impact was not pronounced in the early years (1967 through 1990) because the California economy was dominated by large manufacturing firms, which paid middle-class wages to their workers. As innovation, technology, and their concomitant entrepreneurial activity replaced large-scale manufacturing, the importance of high-income earners soared.

The income of the new entrepreneurial class is quite different than their high-income predecessors. In good times, these entrepreneurs and their team rake in profits. Their companies issue IPOs, they exercise stock options, and they receive generous bonuses. But when the economy tanks, so do their incomes. It is just not the same as, for example, a 15 percent reduction in the workforce at the GM plant in Van Nuys hitting revenues. It is a virtual wipeout of a major source of revenue.

And so actual deficits—that is, an excess of general fund spending over general fund revenues (not counting savings from previous years)—have, even adjusting for inflation, grown dramatically. There is nothing in the revenue structure to suggest today is any different from the recent past.

*Data from California Department of Finance, BEA.gov, UCLA Anderson Forecast

One counterargument is that the state now has a “rainy day” fund thanks to Prop 2, approved by voters in 2014. The current budget projects between $3 billion and $4 billion in the rainy day fund at the end of the fiscal year. It cannot be more because of Prop 98’s education-funding requirements and because of budgets that dedicate some of the increased income to restoring expenditures cut at the time of the previous recession.

The important question then becomes: When compared to previous deficits, is this rainy day fund sufficient? A dispassionate reading would suggest it is not even close. Do we remember the $26 billion deficit of 2009? One estimate, using data from the 1991 recession, found that states need rainy day funds equal to about one-third of their budgets. For California, that would mean a rainy day fund of roughly $40 billion—10 times as large as today’s rainy day fund. A much milder recession than the last one, with heavier reliance on high-income earners, wipes the rainy day fund out and then some.

There are two questions any discussion of an extension to Prop 30 must address. First, will permanent increases in taxes on entrepreneurs, the source of California’s rapid recovery from the last recession, leave the state bereft of many of them for the next recovery? Second, will increasing volatility in state tax revenues over the business cycle be a harbinger of what will happen in the next recession?

I would suggest that the answer to both questions is yes and the initiative to extend Prop 30 taxes, rather than solving a problem, creates a worse one.

A better alternative would be to change the tax system such that it generates a smoother revenue stream available to the general fund over the business cycle and prevents the kinds of drastic cuts we have become accustomed to. There are many ways of doing this that preserve progressivity in the tax structure, but the extension of Prop 30 is not one of them.

The post The Unintended Consequences of Extending Proposition 30 appeared first on Zócalo Public Square.

“In order to save, you need to have income from which to save,” he said. If every nation tries to save at once, no nation generates any income, no one buys any products, GDPs shrink all around, and debt grows. Austerity only sinks economies deeper into their economic troubles—and places an undue burden on the most vulnerable.

In Europe, said Blyth, “Every single country that has gone on an austerity program has gone into more debt, not less.” Unemployment is rampant throughout the E.U.; In Greece, youth unemployment has hit 60 percent. The policy of the European Commission is for nations to lower wages and prices in order to become globally competitive with their exports. But the nations of the E.U can’t all run a trade surplus at once. “There’s only one country that can make and sell BMWs,” said Blyth. Everyone else needs to buy them. The entire E.U. can’t become a giant Germany.

Unlike the United States, Europe can’t solve its crisis through bailouts, because the European Central Bank isn’t allowed to bail out banks. Also, because individual nations gave away their printing presses to join the Eurozone, they can’t inflate their currencies. So austerity is the only policy left for Europe—the only way the E.U. can prevent a run on the banks. “That’s why you keep your foot on the Greeks and squeeze as hard as you can,” said Blyth. “God forbid the banks have to pay for their own mistakes.”

The American economic crisis might be over, he said, but Europe’s is just beginning. And why do policymakers think austerity is a good idea? It goes all the way back to John Locke, David Hume, and Adam Smith. Private property creates inequalities, explained Locke, and a stronger state is the only way to protect the people at the top of the heap. But that state has to be paid for—and so Hume came up with the idea of the government buying debt in order to pay for itself. Morally, said Blyth, this policy perverts normal parsimonious behaviors. People buy and sell debt. And Hume and Smith both predicted that by the end of the 1700s, Britain would be bankrupt as a result. Instead, Britain built an empire to pay for its government.

Yet we persist in cutting back. Blyth explained that people are convinced that cutting public expenditures solves the problem of national debt, while keeping taxes low convinces people to start spending. But in reality, for every dollar that was cut in Southern Europe, the IMF estimates that $1.50 was lost.

“We’re not in this mess because of spending but because of cutting,” said Blyth. Why, he asked, when we talk about “government intervention” is it always about spending rather than cutting? And, why is public spending bad and private spending good? Blyth presented one scenario that’s considered “bad” spending: a government-bought computer goes to a public university to process a form for an NIH grant; the grant funds the invention of a product that revolutionizes the biotechnology industry and creates 100,000 jobs 10 years down the line. Yet we consider someone buying a computer at a Mac store “good” spending.

So why do we keep cutting? Quipped Blyth, “Because mere facts are never enough to get in front of a good ideology, particularly one that’s 400 years in the making.”

One audience member asked Blyth how much austerity is driven by public perception. A lot, he said—and yet there’s a very simple story that can end arguments about austerity’s efficacy.

People like to say that the government’s like a family—if it spends too much, it just has to stop spending. But, said Blyth, families don’t issue their own, internationally tradable paper. Families don’t get to import other people into their families and tax them to pay for paper issued. Families don’t issue the global reserve currency everyone needs to conduct international trade. The idea that a country’s budget is like a family budget “is complete nonsense,” said Blyth. “A family can’t stimulate its way to prosperity by going shopping.” But a government can.

Another audience member asked Blyth how he thinks the government should spend its money. Blyth said he thinks spending must be “calibrated and nuanced”; he doesn’t share Paul Krugman’s bullishness on it. Public spending must enhance productivity or otherwise pay off as a long-term investment; infrastructure is a good example. “It’s not about consumption or passing the hat, but being smart about your public investment,” he said.

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