On The Road To Recovery

The ultimate question on everyone’s lips is did Iceland make the right choice by allowing the banks to fail? Jon Danielsson (2011) argued that “Iceland’s IMF programme has been unsuccessful”. Nonetheless I believe the answer is absolutely. Iceland’s economy has grown by 3% over the last year and considering the crisis is still growing elsewhere; it can be said that Iceland is doing pretty well for itself.

What were the benefits of defaulting? The most obvious reason for this happy ending was Iceland’s independence with the Krona. Remaining to stay as a strong fishing society has also benefitted as it has allowed Iceland to become gifted with natural resources. There has also been a decline in unemployment as new jobs are being created from the increase in recent tourism in the country. This boost in the economy has given employers faith and self-assurance and as a result they are now willing to employ people once more. Iceland was greatly affected by the recent crisis but with its supplies and intellectual labour force Iceland is willing to overcome the current difficulties it is facing.

How is Iceland ensuring a similar banking crisis never occurs again? Iceland is now working closely with the IMF and better bank supervision, as well as regulation, has been put in place to prevent another crisis arising in the future. Finally Iceland is fighting back and if the worldwide financial system fully recovers from the present crisis Iceland will be completely back to normal. To conclude it would be as if nothing ever happened to the country, apart from a few extra fish and an erupting volcano.

For an overview of Iceland's crisis see: Iceland's Journey

"Every Cloud Has A Silver Lining"

As Iceland’s economy was struggling to cope, the Krona was getting worse and worse. Hence it was suggested that Iceland should become part of the European Union so that the currency would be converted to the Euro, instead of the Krona. However if Iceland joined the EU it would have to adhere to EU policies, including the policy on fishing rights. Since Iceland is such a great fishing community, Icelanders were against this change and refused to become a member of the EU. 

Nonetheless Iceland's debts were still not reimbursed so something had to be done immediately to fix this. Who could Iceland turn to for help in these dark and depressing times? The International Monetary Fund (IMF) was the answer to Iceland’s problems. On the 24^th October 2008 the IMF granted Iceland $2.1 billion. Iceland also received loans from other countries, including Sweden and Russia. In total Iceland received $5 billion to help repair its financial requirements.

How did the IMF step in to deal with Iceland’s crisis? With the Krona declining, debt service was getting costly so the IMF focused on making the Krona stable to stop further damage and defaults occurring. To bring the Krona nearer to its true value the IMF increased interest rates for a short period of time using fiscal policy. In 2011 the IMF deal was officially completed on the 26^th August. Professor Joseph Stiglitz from Columbia University believes that Iceland defaulting was the correct thing to do as he assumed “it would have been wrong to burden future generations with the mistakes of the financial system”.

The Big Freeze

Governors for the Central Bank of Iceland are selected mainly for their political background, hence Jon Danielsson (2008) highlighted that “the Central Bank may be perceived to be ill-equipped to deal with an economy in crisis”. As a result the Central Bank of Iceland failed to help the Icelandic economy during the recent crisis. 

Michael Bordo (1990) describes the role of the lender of last resort (LLR) as “under the classical doctrine, the need for a lender of last resort arises in a fractional reserve banking system when a banking panic threatens the money stock and, hence, the level of economic activity”.So why did the LLR not step in to save the Icelandic banks? Should the Central Bank not have had enough reserves to bail out all three banks?  The simple reason was that the three banks were all involved in foreign currencies hence the Central Bank could not print enough money to rescue them. This resulted in a banking panic where a sequence of failures caused unstoppable bank runs jeopardizing all Icelandic banks. 

Iceland’s crisis was notorious with massive bankruptcies occurring at the beginning of the crisis. Other issues resulting from the catastrophe were a decrease in disposable income, a high rise in unemployment, and there were collapses in house prices. The Government stepped in and tried to reduce these problems by dividing the three banks into two separate banks. These two banks were distinguished as the “old” bank (consisting of liabilities and foreign assets) and the “new” bank (which held loans and reserves). The Government also cut the exchange value of the Krona in half by introducing rigorous foreign exchange.

Why then did the Icelandic crisis also have a major effect on economies in different countries? Some people from the UK and Netherlands had savings in Icesave, which was set up by Landsbanki. The assets were regulated in Iceland so once the Icelandic banks failed the assets were no longer covered, thus their total value was lost completely. What was the reaction from the British and Dutch nations? Obviously they were furious that their savings were gone so they requested help from their Governments to sue Iceland for refusing to pay back their arrears. However, compared to Iceland’s GDP, the overall losses from Icesave were greatly extensive so Iceland could not afford to give back the money without facing severe difficulties. Consequently Icelandic voters elected against the repayment of money to the UK and Netherlands, which further angered the British and Dutch communities.

For having once being a flourishing country with plenty of opportunities Iceland had now hit rock bottom.

Domino Effect

Why was Iceland the first country to be affected by the recent financial crisis? The main Icelandic bank, Kaupthing, collapsed on October 9^th 2008 just shortly after Lehman’s Brothers went bust. Just a few days prior to this Iceland’s other two major banks, Landsbanki and Glitnir, had been nationalized. So why did the closure of Lehman’s Brothers have such an impact on Iceland’s three central banks? 

Well, similar to Lehman’s, these three banks invested heavily in mortgage backed securities and inter-bank lending. Jir Hr et al (2011) believe that “the explosive growth of the private, non-government-sponsored enterprise (GSE) backed mortgage-backed securities (MBS) market lies at the heart of the 2007-2009 global financial crisis”. The MBS market was stimulated by the housing boom along with an increase in sub-prime capital, and vice versa.Hence when home-owners initiated non-payment on sub-prime mortgage loans it wasn't long before the capital markets, which the three banks depended on for financial support, crashed. For this reason the Krona plummeted in value and was no longer idolised as an international currency.

Fishing For A Crisis

As it has been known for centuries Iceland was a country that revolved around fish; people ate, procreated, and most of all traded fish. So how did this once small fishing economy suddenly progress into a highly sophisticated society with strong financial growth? The answer lies in Iceland’s currency, the Krona. 

Over the years Icelandic banks grew at an extraordinary rate and so the Krona became extremely valuable. This resulted in an economic boom and Iceland became one of the wealthiest places in the world. Olafur Arnarson (April 2008) commented on Iceland’s unexpected transformation in his book, “Sofandi and Feigdarosi” by remarking that everything had changed so much, so quickly. 

However sometimes success comes at a cost. Financial organisations started to enquire about Iceland’s increasing wealth and thus began raising interest rates to try and control inflation. What was the outcome of this? Not surprisingly of course, a financial crisis. As debt began to rise, Icelandic banks began to borrow money from foreign banks and by October 2008 they had borrowed over six times the amount of capital the country produced in a year. This caused the Icelandic banks to become insolvent, which in return triggered off the recent Icelandic crisis.