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.