Iceland’s borrowing in international credit markets during the period 2003-2007 propelled a macroeconomic expansion as well as the very rapid expansion of the banking sector.1 Borrowing was also undertaken to fund leveraged buy-outs of foreign companies as well as the buying of domestic assets. There developed the biggest stock market bubble in the OECD while house prices doubled.
The banking development was ominous. No visible measures were taken to limit the banks’ growth during the expansionary phase. The size of the banking sector at the end of this period was such that it dwarfed the capacity of the central bank to act as a lender of last resort2 as well as the state’s ability to replenish its capital. The banking system was also vulnerable because of its rapid expansion and the bursting of the domestic asset price bubble.
The end came quickly. In the otherwise quiet city of Reykjavik, suspicious movements of government ministers and central bank governors were detected on Saturday morning, 27 September. On Monday it was explained that Glitnir, the smallest of the three larger banks, had approached the central bank for help because of an anticipated liquidity problem in the middle of October. Lacking confidence in the collateral offered, the central bank had decided to buy 75% of its shares at a very low price.
Like the banks themselves, the government had claimed for months that all three banks were liquid as well as solvent, yet when push came to shove it tackled a pending liquidity squeeze by wiping out the shareholders of Glitnir. Credit lines were now withdrawn from the two remaining banks. There followed an old-fashioned bank run on the Icesave branch of the Landsbanki in the UK The Landsbanki fell when it was unable to make payments to creditors.
The responses were chaotic. The governors of the central bank announced a 4 billion euros loan from Russia but then had to retract the story within hours. They also decided to fix the exchange rate but without the requisite foreign currency reserves this was an impossible task so the bank gave up within two days. One of the governors appeared on television and stated that the Icelandic state would not honour the foreign debt of the banks without distinguishing deposits from loans. Telephone conversations between government ministers in Iceland and the UK appear not to have clarified the situation.3 The British government then seized the British operations of both the Landsbanki and Kaupthing in London. The seizure of Kaupthing’s Singer and Friedlander automatically brought Kaupthing into default. All three banks were now in receivership.
The foreign exchange market collapsed on October 8th. Following a period of sporadic trading the central bank started to auction off foreign currency on October 15th. There are plans to let it float again.
The real economy is currently responding to the turmoil; unemployment is rising and there have been several bankruptcies and many more are imminent. There is the realisation that not just the banks but a significant fraction of non-financial firms are heavily leveraged; have used borrowing, mostly in foreign currency, to fund investment and acquisitions. The Icelandic business model appears to have involved transforming firms into investment funds, be they shipping companies such as Eimskip (established 1914), airlines such as Icelandair (established in 1943), or fish-exporting companies, to name just a few examples. Exporting firms, however, are benefiting from lower exchange rates. The future belongs to them.
The proximate cause of the economic meltdown in Iceland is the rapid emergence of an oversized banking sector and the accompanying domestic credit creation, asset price bubbles and high levels of indebtedness. At this point it is important to consider the reasons why this was allowed to happen.
Monetary policy technically flawed
A sequence of interest rate rises, bringing the central bank interest rate up from 5.3% in 2003 to 15.25% in 2007 did not prevent the boom and the bubbles that preceded the current crash. On the contrary, they appear to have fuelled the bubble economy.
But surely it was apparent to anyone in the latter stages of the boom that it was driven by unsustainable borrowing and that a financial crisis was fast becoming inevitable. Iceland would have faced the music soon even in the absence of turmoil in international credit markets. However, in spite of many observers pointing this out 4 (including the central bank itself!5), the course of economic policy was not changed. There were clearly other, more profound, reasons for this inertia and passivity in the face of peril.
Belief in own abilities and good luck
History is full of examples of nations gripped by euphoria when experiencing rapidly rising asset prices. During the economic boom it was tempting to come up with stories to explain the apparent success, such as the notion of superior business acumen. However, this is a normally distributed variable and its mean does not differ much between nations. The ability to govern a modern economy is unfortunately also a normally distributed.
The normal distribution and the division of labour
When there are not too many people to choose from, it becomes doubly important to pick the best candidate for every job. While the private sector has, as if led by an invisible hand, a strong incentive to pick the most competent people for every position, the same can not be said of certain areas within the public sector. The appointment of former politicians to the position of central bank governor, to take just one example, reduces the bank’s effectiveness and credibility. The danger is that the individual in question has interests and policies that exceed those fitting a central bank governor in addition to lacking many job-specific skills. And this one example is just the tip of the iceberg!
In addition, Adam Smith’s dictum that the scale of the division of labour is determined by the size of the market also applies to the government. There are scale economies when it comes to running the state and small nations might benefit from the sharing of a government, as well as the central bank!
We now come to an equally profound problem, which is that the small size of the population makes it inevitable that personal relationships matter more than elsewhere.
One of the keys to success for an individual starting and sustaining his or her career in Icelandic society has been to pledge allegiance to one of the political parties – more recently business empires – and act in accordance with its interests. It follows that society rewards conformity and subservience instead of independent, critical thinking. Many players in the banking saga have interwoven personal histories going back many decades. The privatisation of the banks, not so many years ago, appears also to have been driven by personal affections and relationships rather than an attempt to find competent, responsible owners.
Mancur Olson’s The Logic of Collective Action, first published in 1965,6 describes the difficulties of inducing members of large groups to behave in the group’s interests. Clearly, political parties need to reward their members in order to motivate them and ensure their loyalty. The same applies to labour unions and business empires. But the smaller the country, the smaller the total surplus income that can be used in this way, while the amount needed to guarantee the loyalty of any given individual may not be any smaller. It follows from Olson’s analysis that the smaller the nation, the more likely it is that society will be uni-polar. As a matter of fact, powerful individuals or parties that often rule small nations. Such a society usually does not encourage dissent or critical thinking.
It follows that one individual’s criticism – be that of banks or the political or economic situation – may put him in a precarious position vis-à-vis the dominant group. The private marginal benefit of voicing your concerns and criticising is in this case negative and much smaller than the social marginal benefit.
The same logic explains why the media may not criticise the ruling powers. During the boom years, the media, different commentators and even some academics lavished praise on the Icelandic bankers and other capitalists who profited from the asset bubble. This then is the root of the problem; a cosy relationship between businesses, politics and the media and limited checks and balances. Everybody knows everything but no one does anything about anything!
Relations with Europe
Membership of the European Economic Areas, involving market integration and the free mobility of factors without the participation in a common currency and joint decision-making, made economic policy in Iceland difficult, even impossible, to implement. The local central bank was no match for the vast flows of funds that came into the country.
Membership of the EU might help remedy many of the problems described above. The sharing of certain areas of government may improve the quality of decision-making. Having greater contact with decision makers in Europe may provide stimulus, criticism and points of comparison that may improve the quality of decisions. The rule of law may be strengthened. The adoption of the euro will provide monetary stability and lower interest rates.7
Iceland either has to move backwards to the time of capital controls or forwards into the EU. It needs to choose the latter option if it wants to stand a chance at keeping its well-educated young people from emigrating.
1 See Gylfi Zoega (2008), “Icelandic turbulence: A spending spree ends,” VoxEU, 9 April.
2 See Willem Buiter and Anne Sibert (2008), “The Icelandic banking crisis and what to do about it,” CEPR Policy Insight No. 26; and “The collapse of Iceland’s banks: the predictable end of a non-viable business model,” VoxEU, 30 October; also Jon Danielsson, (2008), “The first casualty of the crisis: Iceland,” VoxEU, 12 November.
3 See report by David Ibison in the Financial Times, 24 October 2008, titled “Transcript challenges Darling's claim over Iceland compensation.”
4 See, amongst others, Robert Wade, “Iceland pays price for financial excess,” Financial Times, 1 July 2008; Robert Wade, “IMF reports uncertain outlook for Iceland,” Financial Times, 15 July 2008; Thorvaldur Gylfason, “Events in Iceland: Skating on thin ice?” VoxEU, 7 April 2008; Gylfi Zoega, “A spending spree,” VoxEU 9 April 2008; Robert Aliber, “ Monetary turbulence and the Icelandic economy”, lecture, University of Iceland, 5 May 2008; Thorvaldur Gylfason, “Hvernig finnst þér Ísland?”, Herdubreid, 27 July 2007; Gylfi Zoega (2007), “Stofnanaumhverfi, frumkvöðlakraftur og vægi grundvallaratvinnuvega,” in Endurmótun íslenskrar utanríkisstefnu 1991-2007, ed. Valur Ingimundarson.
5 See Central Bank of Iceland, Monetary Bulletin, years 2005-2007 (http://www.sedlabanki.is/?PageID=234).
6 Mancur Olson (1971), The Logic of Collective Action: Public Goods and the Theory of Groups, Harvard University Press.
7 See Philip Lane (2008), “Iceland: The future is in the EU,” VoxEU, 6 November.