Iceland’s seven meagre years

Thorvaldur Gylfason

26 November 2015

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Seven years after its spectacular fall from grace in 2008, Iceland has staged an economic recovery. The current economic situation is a mixed bag, however.

  • The rescue operation mounted by the IMF after the bank failures of 2008 was well designed and produced good results.

While real output contracted by 8% during 2008-2010 in terms of local currency, not 10% as originally envisaged, unemployment peaked at 8% of the labour force before dropping to 4% in 2015.

  • By 2013, the purchasing power of per capita GNI measured in dollars had been restored to its 2007 level (Figure 1).

Figure 1. GNI per capita 1990-2014 (US$, ppp)

Source: World Bank, World Development Indicators.

Comparison with Ireland

In Ireland, the 2007 level of the purchasing power of per capita GNI was restored a year later than in Iceland, in 2014.

  • It is, therefore, not true that having its own currency (which lost a third of its value in real terms during the crash) saved Iceland from the sorry fate that Ireland would have to suffer because Ireland is anchored to the euro.

Ireland adjusted by other means. Iceland, had it used the euro, could have done the same. The Icelandic króna has lost 99.95% of its value vis-à-vis the Danish krone since 1939 when the two currencies were equivalent, convincing many local observers that Iceland is ripe for the adoption of the euro.

Iceland remains a low-wage country

Recent months have seen labour unrest resulting in part from an uprising by the have-nots against the haves (Ólafsson and Kristjánsson 2013, Gylfason 2015). Following strikes and double-digit wage hikes in some cases, inflation is expected to be back on its way up. Economic inefficiency caused, inter alia, by insufficient competition in a number of areas, including agriculture, banking, and fisheries, keeps real wages lower than in the rest of the Nordic countries as well as in Ireland, inducing workers to put in longer hours and stay longer in the labour force than they might otherwise do. GNI per hour worked in 2013 was US$30 in Iceland compared with $51 dollars in Denmark (Figure 2). National income per hour worked takes into account the work effort required to generate a certain level of income, and is therefore a better measure of economic performance than income per person.

Figure 2. GNI per hour worked 1990-2013 (US$, ppp)

Source: World Bank, World Development Indicators, and Groningen Data Base for hours.
Note: GNI per hour worked is defined as Y/H = (Y/Q)/[(H/E)(E/L)(L/Q)] where Y = GNI, H = hours, Q = population, E = employment, L = labour force, and E/L = 1 – u/100 where u is the unemployment rate in %.

Emptied from within

The government in office in Iceland since 2013 appears not to have learned enough from the crash of 2008. This is a coalition government comprising of the two political parties widely held chiefly responsible for the crash. The Independence Party and the Progressives privatised the banks in 1998-2003 by selling them at modest prices to their cronies, who took only a few short years to crash them.

The banks were emptied from within by, among other things, granting loans with little prospect of repayment, a classic recipe (Black 2005, Gylfason 2010, Johnsen 2014). According to the Parliament´s Special Investigation Commission (SIC 2010, vol. 2, 2), “The largest owners of all the big banks had abnormally easy access to credit at the banks they owned, apparently in their capacity as owners. ... in all of the banks, their principal owners were among the largest borrowers.”

The current Minister of Finance who – according to the Special Investigation Commission (SIC 2010, vol. 2, 200) – owed the failed banks nearly €2 million at the time of the crash (his official salary would not have sufficed to pay interest on the loan) has recently directed financial support from his ministry to a team of academics whose mandate is to investigate the role of foreign governments in the home-made crash. The current Minister of the Interior owed the banks more than €1 million before the crash. The two were backbenchers in Parliament at the time, and are now leader and deputy leader of the Independence Party, the larger of the two coalition partners back in office. Their government is now preparing for a new round of bank privatisation.

The bankers treated several other politicians with similar generosity. How the bank loans to politicians – including loans to ten MPs of more than €1 million each (SIC 2010, vol. 2, 200) – were handled after the crash while thousands of families were being evicted from their homes, on paper if not always in practice, has not been disclosed. According to opinion polls, the government – two and a half years after winning the 2013 parliamentary election with 51% of the vote – enjoys the support of only a third of the electorate, less support than the new Pirates party, an apparent icon of innocence.

Deal with the creditors

Iceland´s economic recovery from the crash of 2008 is not surprising. If bankers, aided and abetted by politicians, crash their country by running away with other people´s money to the tune of five times the country’s GDP, the country could expect to prosper unless the whole lot went up in smoke. Five times GDP is the IMF’s original estimate of the economic cost inflicted by the collapse on creditors, shareholders, and some depositors. Greater-than-expected asset recovery may have reduced the ratio to three or four.

After the crash, many creditors sold their impaired assets to hedge funds for pennies on the dollar. With time, the Icelandic asset holdings of the hedge funds appreciated. The government felt it necessary to prevent the creditors from taking their foreign-exchange holdings out of Iceland, which would have weakened the króna further still, jeopardising living standards and balance sheets of households and firms due to widespread indexation of financial obligations.

This is why strict capital controls are still in force with the IMF’s approval seven years after they were installed. Recently, in preparation for the relaxation of the controls, the government announced that the creditors either had to reach an agreement with the winding-up committees of the estates of the failed banks or face a special exit tax equivalent to about 40% of Iceland´s GDP, i.e. about US$6.5 billion. The creditors settled for a deal by which they will accept a haircut equivalent to about 20% of GDP and promise not to sue the government. Whether this deal, designed to enable the creditors to take the equivalent of 20% of Iceland´s GDP in foreign currency out of the country, will keep the króna on an even keel and free Iceland fully from the risk of litigation remains to be seen.

Banks don’t break laws, bankers do

Iceland’s economic recovery has been accompanied by an effort to bring to justice some of those who broke the law while breaking the banks. To date, the Supreme Court of Iceland has sentenced 16 individuals, including several bankers, to a total of more than 40 years in prison for violations of the law in connection with the crash, especially insider trading, breach of trust, and market manipulation. Among those sentenced thus far are the former Chairman of the Board and the CEO of Kaupthing (4 years and 5½ years, respectively) and the former CEO of Landsbanki (3½ years). Further bank-related cases remain to be heard by the Supreme Court, including district-court verdicts sentencing 17 individuals to a total of 37 years in prison. It will take the Supreme Court at least until 2018 to finish the job. The former Chairman of the Board of Landsbanki has been charged by French authorities.

If the failed banks were basically all alike (a widely held view) and if all bankers are equal before the law, it seems likely that the number of prison years will rise further, especially because the Supreme Court seems to take a stricter view of breach of trust than the Reykjavík district court has done. In one case, the district court issued an acquittal on the grounds that no one was hurt, an acquittal that was changed on appeal to a guilty sentence by the Supreme Court on the grounds that what matters by law is the risk that the bankers in question exposed their unsuspecting clients to, not whether the clients ultimately emerged unscathed.

This aspect of Iceland’s coming to terms with the crash differs from developments in the US and Europe where the authorities have for the most part let it suffice to impose fines on banks, including all the major Wall Street firms, for legal violations – the practical equivalent of fining Route 66 for speeding. In effect, Iceland preferred to take its cue from Black (2005), Galbraith (2010), Stiglitz (2015), and others who advocate penalties for the perpetrators of financial fraud in the name of justice as well as deterrence. Recent advocates of individual accountability for financial fraud include former Fed Chairman Ben Bernanke, Fed Vice Chairman Stanley Fischer, and IMF Managing Director Christine Lagarde.

References

Black, W K (2005), The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry, University of Texas Press, Austin, Texas.

Galbraith, J K (2010), “Why the 'Experts' Failed to See How Financial Fraud Collapsed the Economy”, Written statement to members of the Senate Judiciary Committee.

Gylfason, T (2010), “Mel Brooks and the Bankers,” VoxEU.org, 18 August.

Gylfason, T (2015), “Social Capital, Inequality, and Economic Crisis,” Challenge 58 (4), August, 326-342.

Johnsen, G (2014), Bringing Down the Banking System: Lessons from Iceland, Palgrave MacMillan, New York.

Ólafsson, S, and A Sölvi Kristjánsson (2013), “Income Inequality in Boom and Bust:  A Tale from Iceland’s Bubble Economy,” in Gornick, Janet C., and Markus Jäntti (eds.), Income Inequality Economic Disparities and the Middle Class in Affluent Countries, Stanford University Press, Palo Alto, 416-438.

Special Investigation Commission (SIC) (2010), “Report of the Special Investigation Commission (SIC)”, report delivered to the Icelandic Parliament 12 April.

Stiglitz, J E (2015), The Great Divide: Unequal Societies and What We Can Do About Them, W.W. Norton, New York and London. 

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Topics:  Europe's nations and regions

Tags:  Iceland, Icelandic crisis, creditors, bankers’ fraud

Thorvaldur Gylfason

Professor of Economics, University of Iceland; Research Fellow, CESifo and CEPR Research Fellow