Bond Market Blackmail

Like probably most people, I have not been following the saga of Iceland and its banks’ foreign depositors, so I was grateful for Planet Money’s podcast last week on the topic.

The background, as I understand it, is something like this:

  1. Iceland’s banks offered high-rate savings accounts to depositors in other countries, notably the United Kingdom and the Netherlands. These accounts did not have an explicit government guarantee.
  2. In 2008, the global financial system nearly collapsed, Iceland’s banks failed, and depositors got more or less wiped out.
  3. Iceland, unlike Ireland, did not guarantee its banks’ liabilities. It did, however, choose to bail out domestic depositors in those banks — but not foreign depositors.
  4. The U.K. and the Netherlands both chose to bail out their citizens who had deposited money in Iceland’s banks.
  5. The U.K. and the Netherlands then tried to get the Icelandic government to pay them back. They negotiated a settlement, but that was rejected by a popular referendum in Iceland. Then they negotiated another settlement (which would have cost Iceland about $6,000 per person), but that was also rejected.

Now, there is a legal question about whether or not Iceland has an obligation to bail out foreign depositors in its banks. Remember, there was no explicit government guarantee. The question is whether bailing out domestic but not foreign depositors is illegal discrimination under international law.* Apparently that’s a close question, but it’s not relevant for my purposes.

The economic question, as the podcast framed it, is whether paying off the U.K. and Dutch governments will help Iceland attract foreign investment in the future. They had a bond investor from Vanguard — ordinarily just about my favorite financial institution — saying that a vote against the settlement would make investors less likely to lend money to the Icelandic economy in the future.

Now, this may be true (although I doubt it). But think about what this is really saying.

Some people — largely retail investors — lent money to Iceland’s banks, either deciding that the high interest rates made up for the lack of a government guarantee or not bothering to check if there was a government guarantee. They lost their money (or they would have, if their home governments hadn’t bailed them out). The lesson I think people should learn from this is: MAKE SURE THERE’S A GOVERNMENT GUARANTEE!!!!! In other words, lenders should be smarter in the future.

Vanguard Bond Guy is saying something different, however. He’s essentially saying that foreign investors will only lend money to some country’s private institutions if that country promises to bail out foreign investors should those private institutions fail. That’s the only light in which his statement makes any sense. In the future, lenders to Icelandic institutions will only care about the chances of their future loans being paid back. Whether Iceland pays off the U.K. and the Netherlands now can only matter as a signal about Iceland’s future behavior. And the only signal it could possibly send is that Iceland recognizes some hitherto nonexistent obligation to bail out its private institutions whenever they default.

This is both obnoxious and crazy. It’s obnoxious for the same reason the campaign against strategic homeowner defaults is obnoxious. If you made a zero-money-down loan to someone and he walks away, it’s your fault. The lesson you should learn is that you shouldn’t make zero-money-down loans; you shouldn’t suddenly invent some principle that people should pay debts they no longer owe when it’s not in their own interests.

And it’s crazy because — what does it say about capitalism? The theory of the financial markets is that they allocate capital to the places where it will be used most efficiently. If Bond Guy is right, that’s not true: they allocate capital to the places where the government provides the strongest implicit guarantees. You want capital? Then your government has to bail foreign creditors out of their bad decisions. How is that good?

Now, maybe the credit markets will refuse to lend money to Icelandic companies, which would be bad for Iceland. I don’t know; I don’t have their phone number. But if so, then the credit markets are not doing what they are supposed to be doing, at least according to their most ardent defenders. Instead, they will be punishing Iceland for lenders’ failure to read the terms of their contracts carefully.

* What international law? you may ask, especially since Iceland isn’t (yet) a member of the EU. I don’t know.

This post is originally appeared on Baseline Scenario and is reproduced here with permission.