Iceland’s Crash and Stunning Recovery: Lessons for Greece?

July 22, 2015 Topic: Economics Region: Europe Tags: IcelandGreeceBanking

Iceland’s Crash and Stunning Recovery: Lessons for Greece?

"Iceland’s leaders defied the austerity orthodoxy, and to good effect....[but] alas, the Icelandic remedy won’t revive Greece."

In Independent People, the best-known work of Iceland’s Nobel Prize-winning writer Halldór Laxness, the protagonist, Bjartur of Summerhouses, a hardscrabble sheep farmer, embodies self-reliance, thrift, and attachment to the land and to nature. Bjartur’s disdain for the wealthy and powerful doubtless reflects Laxness’s own antipathy toward the materialism and power hierarchies produced by capitalism.

In reality, during the inflation-marked years following Iceland’s independence in 1944 (the island had been ruled by Norway and then Denmark), Icelanders spent money in the moment, fearing that to defer spending to later would be to pay more. Still, until the late 1990s, Iceland  was a socialist economy; the state’s role was extensive, and the commitment to social welfare through publicly financed programs was robust.

The economy’s mainstays were sheep farming (family-run farms still dot this bucolic island of 360,000 people, and free-roaming sheep are ubiquitous in the countryside), fishing, tourism, and the American military base at Keflavik, which at its height employed several thousand Icelanders. Apart from aluminum smelting, a bauxite-based energy-intensive process made economical by Iceland’s abundant thermal power, there was no industry to speak of. So it was not until the 1990s when an economic revolution got underway. The catalyst was Davíð Oddsson, leader of the rightist Independence Party, who became prime minister in 1991 and served until 2004, longer than anyone had before, or has since. Oddsson imbibed the free-market theories of Friedrich Hayek and Milton Friedman, whose 1984 lecture at the University of Iceland he attended, and was a devotee of Margaret Thatcher’s and Ronald Reagan’s economic policies.

Oddsson believed that bold privatization and deregulation would liberate Icelanders’ creative spirit, which the state’s extravagant economic role, myriad regulations and steep taxes had suppressed. Once its economy was unshackled and entrenched socialistic policies jettisoned, Iceland would become a private enterprise dynamo propelled by high finance, hi-tech, and a state-of-the-art service sector. Iceland would be remade into a globalized 21st-century economy on par with Europe’s best. The leveler-like nostrums of Laxness and his ilk would become relics.

Such was the dream. Reality proved rather different, and the privatization of banking, begun in 1998, had particularly disastrous consequences. It culminated in the rise of three private banking giants, Kaupthing, Landsbanki, and Glitnir, each of which also established foreign branches and affiliates: brick-and-mortar and online. The triad effectively comprised Iceland’s entire banking sector. Operating alongside it was a Byzantine network of interlocking holding companies created expressly for purchasing shares in companies, with the aim of taking them over.  

The holding companies’ owners also tended to control the largest shares in the banking triumvirate, or to sit on its boards. They were also its principal borrowers. This arrangement guaranteed Iceland’s tycoons the lavish bank loans that they relied on to amass real estate, retail chains, banks, telecommunications companies, and newspapers, television networks, and radio stations. This unrestrained leveraged buying was not limited to Iceland. The moguls bought assets in Europe (Britain was a favored venue) and, albeit to a much smaller extent, the United States.

The largest of the holding companies was the Baugur Group, owned by the swashbuckling, hard-partying, free-spending Jón Ásgeir Jóhannesson, who typified the big-risk, borrow-and-buy ethos of the times. Icelandic financial barons like him were smart, brash, and self-confident in the extreme, akin to the cardboard characters in Ayn Rand novels. That proved to be big a part of the problem: those same qualities blinded them to their hubris. They were convinced that they had the savvy to play indefinitely what was essentially a ponzi game—albeit a complicated one that in the aftermath of the crisis would confuse the best investigators—and that their economic empires and wealth would keep expanding.

The more assets these magnates acquired, the more they coveted, never mind that each new acquisition inflated further their already-huge debts. Why worry? Iceland’s banks provided a steady stream of credit; and what they could not provide, foreign banks and bond-purchasers would.

Iceland’s oligarchs were not the only ones caught up in this credit-fueled excess; so was Icelandic society more generally. The boom years swelled the ranks of young, inexperienced, bankers. Newly rich, they wanted to drive swanky cars, to live in plush apartments, and to dine in fine restaurants. When their earnings—padded by big bonuses—could not finance their tastes, they turned, as befitted the times, to loans. Their lifestyles, in turn, shaped other Icelanders’ conception of success, which in essence amounted to a shopping spree funded by borrowed money.

At the time, many, including well-known economists, hailed Iceland as grand success.  Economic growth averaged 4.96 percent from 2000-2007. Per capita income reached $70,000 and was surpassed by only four other countries.

But appearances proved deceptive. The good times were enabled by a binge of credit—and mounting debts.

The banks raised their money partly from depositors and shareholders’ equity but mainly through serial, multi billion dollar international bond issues. Much of the borrowing occurred in low interest locales. The loans, denominated in the currency of the originating country, were then lent out at higher rates. By 2007, the big banks’ assets exceeded GDP fourteen-fold. The pace of lending vastly exceeded the rate of economic growth. Novice bankers approved loans feverishly. Their bonuses, lush lifestyles, and ability to service their own debts, depended on financial hyperactivity.

In short, soaring credit inflated asset prices (and the debt of banks, companies, and consumers), producing a bubble.

What passed for the vetting of borrowers was slipshod at best. The wealthier and more politically connected the borrower, the more likely that the already-lax loan making processes would be relaxed further. Besides, how do you turn down a prospective borrower who owns your bank? Often, there was no investigation of credit histories or borrowers’ ability to repay. Not a few loans were unsecured or provided on the strength of questionable collateral or backed by assets that had already been fully pledged to other creditors. Loan-to-value mortgages became commonplace. When the banking giants needed more cash, they manipulated the stock market by deliberating making loans that were recycled to buy their own stocks so as to drive up the share price and entice investors.

The state’s monitoring of this credit orgy and its accompanying shenanigans proved utterly inadequate. The government’s faith in privatization was unbounded. In what was a small country, there was a mismatch between the volume of lending and the number of official overseers. Banks and plutocrats contributed money to the ruling party. Politicians who sat on the boards of banks received favored loans. All of this made for a marriage between incompetence and corruption.

As the 2008 American financial crisis demonstrated (many of the sleazy, irresponsible practices that produced it were replicated in Iceland), this sort of party, exhilarating while it lasts, ends badly. The solvency of Iceland’s banks had started worrying some rating agencies and international financiers as early as 2007. But the dam burst once Lehman Brothers collapsed in September 2008 and global credit markets froze. Shell-shocked lenders and investors steered clear of Iceland’s banks and holding companies. The credit crunch made it impossible for them to pay off the mega loans that were fast coming due, especially once international creditors started making margin calls.  

Bank runs accelerated. Iceland’s exchange controls having been lifted in 1994, international creditors rushed to spirit their money out of the country. Most loans were denominated in foreign currencies and couldn’t be paid because Iceland’s central bank lacked the necessary reserves. Iceland’s banks began looking to their foreign branches for help. To ensure that British depositors wouldn’t be left holding the bag, in October 2008 the British government froze the funds of the UK affiliates of Landsbanki and Kaupthing, including assets of the Icelandic government. Adding insult to injury, Downing Street invoked a post-9/11 anti-terrorism act to do so.

Iceland’s financial sector collapsed. Bankruptcies soared, unemployment spiked, the economy contracted. The government was forced to prop up the central bank and to reinstitute capital controls. A country once feted as the Nordic Tiger looked more like a cowering kitten. In his October 6, 2008, address to the nation, Prime Minister Geir Haarde, finance minister from 1998-2005 (Oddsson was by then running Iceland’s central bank) provided a bleak assessment, ending with “God Bless Iceland.” Leaders’ appeals to the divine, standard in the United States, were unheard of in Iceland. Haarde’s closing merely aggravated public anxiety.

Fast forward to 2015.

What a difference seven years make. Iceland, though chastened, has recovered, thanks to some bold, against-the-grain policies.

The Icelandic government refused to bail out the banks. It let them fail and then nationalized them—at a discount. It guaranteed Icelanders’ savings and pensions. It reinstated capital controls to prevent an exodus of funds. It forgave home mortgage debts, funding the move by increasing taxes on the financial sector to the tune of $1.4 billion (9 percent of GDP). It refused to slash social services. It indicted and jailed crooked financiers. Jón Ásgeir Jóhannesson was among the lucky ones: he was acquitted in 2014 but only after a series of investigations and two prior convictions for tax evasion and accounting irregularities.

In short, Iceland’s leaders defied the austerity orthodoxy, and to good effect.

According to a 2015 IMF report, all of Iceland’s key economic indicators are trending in the right direction. Economic growth was projected at 3 percent for 2015. The inflation rate, below 1 percent, was expected to inch up to 2.5 percent, averting the risk of deflation. The 2014 budget surplus was 1.8 percent of GDP, the current account 4.7 percent. Real wages increased by 5.8 percent during that year and unemployment, which peaked at 8.3 percent in 2010, had fallen to 4.1 percent. Non-performing loans, 40 percent of GDP in 2009, had dropped below 10 percent. The IMF’s assessment contained caveats and warnings to be sure, but it depicted a remarkable comeback, which was underscored by the government’s announcement in June that it planned to lift capital controls.

Iceland’s revival comes up these days because of the Greek mess. Alas, the Icelandic remedy won’t revive Greece.  

First, Iceland’s was a financial crisis, not a fiscal one. Iceland’s taxation and budget policies and figures were fundamentally sound; there was no evidence of profligacy or recklessness on the part of the state. (The government failed to supervise the financial picture, but that’s another story.)

Second, though corruption certainly marked Iceland’s years of excess, it has never been the deeply rooted, omnipresent problem that it has long been in Greece. Nor is tax evasion chronic and pervasive. Transparency International, which ranks countries from least to most corrupt, places Iceland 12th, and Greece 69th in a list of 150 countries.

Third, though Iceland did require a $2.1 billion loan from the IMF in 2001, that sum is paltry compared to what Greece owes the IMF, the European Central Bank, and the Eurozone countries: $271 billion.

Finally, Iceland has its own currency and hence an independent monetary policy. The European Central Bank and the euro decide Greece’s, and that makes devaluation impossible. Icelanders were certainly pinched by the krona’s fall after the crisis. The exchange rate plunged from 1:55 against the dollar in 2006-2007 to about 1:225 in late 2008, before recovering and stabilizing at around 1:130 after 2009. Imports became pricier, as did euro-denominated mortgages. But exports, tourism, and foreign investment were boosted. The positive effects will be apparent to anyone who visits Iceland today.

Iceland’s brush with economic disaster offers salutary lessons about the hazards of casino capitalism, greed, and arrogance. And it vindicates the values of Laxness and Bjartur. Alas, it does not offer solutions that Greeks can use so long as they are tied to the euro.

Rajan Menon is Anne and Bernard Spitzer Professor of Political Science at the Colin Powell School of the City College of New York/City University of New York and a Senior Research Scholar at the Saltzman Institute of War and Peace at Columbia University. His most recent book (coauthored with Eugene B. Rumer) is Conflict in Ukraine: The Unwinding of the Post-Cold War Order (MIT Press, 2015); his next book, The Conceit of Humanitarian Intervention, will be published by Oxford University Press in 2016.

Image: Flickr/manumilou