Working with Real Things
By Nicole Foss
Countries caught in the grip of financial crisis, with austerity measures
compounding their problems, are continually being told to follow Iceland’s
example. The assumption is that if a state can disregard the claims of the
banking sector, it can address the threat of financial crisis relatively
painlessly and get back to ‘normal’ quite quickly. Iceland is held up as an
example, but the situation is actually far more complex. As such, it is worth
exploring the situation in Iceland in all its complexity. It is an example in
some sense, but not necessarily in ways which are transferable. It does,
however, illustrate a number of lessons for post-bubble economies, and there
will be many of those over the next few years.
Iceland, which achieved independence from Denmark in 1944, was once a
relatively poor country of primary producers – fishermen and farmers – but it
reinvented itself in the era of globalization under its longest serving Prime
Minister, Davíd
Oddsson:
It was Oddsson who
engineered Iceland’s biggest move since NATO: its 1994 membership in a
free-trade zone called the European Economic Area. Oddsson then put in place a
comprehensive economic-transformation program that included tax cuts,
large-scale privatization, and a big leap into international finance. He
deregulated the state-dominated banking sector in the mid-1990s, and in 2001 he
changed currency policy to allow the króna to float freely rather than have it
fixed against a basket of currencies including the dollar. In 2002 he
privatized the banks. When he stepped down as Prime Minister in 2004, he did a
stint as Foreign Minister before becoming governor of the central bank in 2005.
The economy expanded and diversified in many ways, attracting ecotourists,
moving into new technologies, taking advantage of its abundance of renewable to
expand manufacturing and developing a more comprehensive service sector. It
became a highly internationalized economy, with the means to import goods from
all over the world thanks to a strong currency. With GDP growth running at 4-6%
for a number of years, the average family’s wealth increased markedly, with
much of it invested in property. As a result, house prices in Iceland saw
greater than 10% annual price appreciation from 2003-2007.
The financial sector took
off following privatization:
But the principal
fuel for Iceland’s boom was finance and, above all, leverage. The country
became a giant hedge fund, and once-restrained Icelandic households amassed
debts exceeding 220% of disposable income – almost twice the proportion of
American consumers.
Very large amounts of money were loaned were to the public, allowing them
to further bid up the price of property. The fact that many of these loans were
denominated in foreign currency (Japanese yen, Swiss francs etc) added currency
risk to the resulting speculative mania. Three large banks – Glitnir, Landsbanki
and Kaupthing – grew to dwarf the size of the island’s real economy in a
financial bubble of unprecedented size (in comparison with a host economy based
on only 320,000 people). Total debt to GDP peaked at over 1200%, reflecting the
grossly disproportionate nature of the financial sector. This had been a cause
for concernat the central
bank as far back as 2005, but nothing was done to reign in credit expansion. At
the peak of this period of great affluence, the Icelandic population was lauded
as the richest people in the world, but it
was not to last:
A visitor seeking
a sense of how Iceland’s clique of powerful financiers saw themselves before
their empire came tumbling down need look no further than Reykjavik’s Harpa
concert hall. The extravagant steel and glass structure, which has more seats
than London’s Royal Opera House, looks like a futuristic beehive glowing above
the grey buildings that make up most of the capital. It was commissioned by
Bjorgolfur Gudmundsson, one of the “Icelandic oligarchs” who exploited cheap
credit following the aggressive financial deregulation of the early 2000s to
create a billion-dollar empire. He set out in 2007 to build a cultural venue to
match the country’s new found wealth – but when the global financial crisis hit
the next year, and Iceland’s over-leveraged banks collapsed, he went bankrupt,
leaving the state to complete the project.
The structural instabilities upon which the illusion of prosperity was
based proved fatal in late 2008. Maturity mismatching (issuing short-term debt
in order to invest in long term assets) was rife, requiring that short term
liabilities be continually rolled over until long term assets matured. Reserve
requirements were reduced, increasing the money multiplier. The huge increase
in the effective money supply, much of the credit denominated in foreign
currencies, combined with a 35% fall in the value of the Icelandic króna
relative to the euro, led to substantial price increases – 14% in the year
before the system reached its limit. As mortgage principle is typically indexed
to CPI in Iceland, this price inflation was compounding the effect of a housing
bubble.
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