An Icelandic post-mortem

The Economist does a very good post-mortem on Iceland and its spectacular collapse with a number of lessons for other countries, especially those with oversized financial sectors like Ireland, Switzerland and the U.K.  Below is a snippet from their article which I highlight because it also demonstrates the real risk of social unrest due to economic collapse.

Atop a hill near Reykjavik’s old harbour is a bronze statue of Ingolfur Arnarson, the first Nordic settler of inhospitable Iceland. It overlooks a bunker-like building: the central bank, headed by David Oddsson, a man who more than 1,100 years later has shown similar survival skills. Before chairing the central bank’s board of governors, Mr Oddsson was prime minister for more than 13 years, a record, during which time Iceland became one of the richest countries in the world. For years he was Iceland’s most popular politician, privatising most of the banking system with a Thatcherite zeal and floating the currency, the krona.

But the collapse of the krona and nationalisation of the country’s three largest banks in early October, which forced the country to secure help from the IMF, have left Iceland’s economic miracle and Mr Oddsson’s reputation in tatters. For weeks, protesters have gathered in Reykjavik’s main square each Saturday calling for his removal from office. On the chilly afternoon of December 1st a few hundred of them, shouting “David out, David out”, gathered at the Arnarson statue and marched down the hill to the central bank. In the lobby, they were met by riot police, who eventually defused the situation.

Such protests are almost unheard of: the only previous mass demonstrations to shake the country, against NATO membership, took place in 1949. But the economic crisis has exposed deep fissures in the nation of 300,000 people. In the same building the next day, Mr Oddsson barely smiles when he tells The Economist, “They say that the only way to get to paradise without dying is to be governor of a central bank. This has not been true in Iceland.”

So far, such protests are the most tangible evidence of the troubles besetting Icelandic society. The landscape bears scars too. From the central bank, the view of snow-dusted Mount Esja across the estuary is blocked by a half-finished grey edifice, sprawled like a dead whale across the harbour-front. This was to have been Iceland’s most spectacular building, crowning 15 years of economic growth: a concert hall facing out to the North Atlantic, covered in glass prisms imported from China meant to resemble glaciers and lava. But since the collapse of the bank that led the funding, construction has almost ground to a halt.

Likewise, blocks of half-built luxury flats stand half-finished along the waterfront. Instead of glass prisms, Icelanders are looking forward to a different Chinese cargo in the dying weeks of the year: fireworks. They set off more per person each new year than any other country in the world. Such is the demand that the Chinese manufacturers are making a special loan to Icelanders to buy them, according to a local newspaper.

Almost no other private creditor is lending them anything; Iceland has turned instead to the IMF. In November the fund agreed to a $2.1 billion two-year standby programme, which was supplemented by promises from Nordic countries and Poland, as well as Britain, the Netherlands and Germany. The package will be worth $10.2 billion in total—more than half of Iceland’s GDP.

The IMF calls the collapse of the banks the biggest banking failure in history relative to the size of an economy. In 2007 Iceland’s three main banks made loans equivalent to about nine times the size of the booming economy, up from about 200% of GDP after privatisation in 2003 (see chart 1). Only about one-fifth of those loans were in kronur; interest rates on these were punitively high. Ordinary citizens instead borrowed from their banks in cheaper currencies such as yen and Swiss francs to buy even the most modest homes and cars.

I think you know how this one ends. The full article is much longer. I highly recommend reading it, especially as it pertains to the UK economy. The link is below.

Source Cracks in the crust – The Economist

  1. hbl says

    What are your thoughts on the inflationary or deflationary future of Iceland? I haven’t seen this discussed much yet but it seems important given how many other countries may face similar problems. I know price inflation is high now — but I assume most of that is the continuing effect of monetary expansion in past years as well as imported inflation from the currency collapse.

    Given that credit-to-GDP is around 530% of GDP in Iceland versus 350% in the US, will money supply begin a deflationary contraction that eventually overpowers the price inflation? If so it could be even more dramatic than in the US. (It seems especially relevant that domestic mortgage payments rise with inflation, as this makes the debt harder to inflate away!!!)

  2. Edward Harrison says

    long time, no hear. good questions about iceland. I would say that iceland is case quite different from the U.S. for several reasons. Two are particularly important. First, they had a huge amount of foreign currency debt. Second, they have a small country and an insignificant currency that is vulnerable to capital flight. So, this means their demise has been felt mostly in a currency depreciation. As they have few natural resources, and they must import nearly everything, that makes inflation skyrocket. at the same time, the currency depreciation makes the the foreign currency debt burden crushing.

    So they are getting local currency deflation because of the debt but real inflation because of the currency fall. In the U.S., this would occur if the dollar dropped vis-a-vis commodity prices, the euro, and the yen. But, as the Dollar is the world’s reserve currency, the U.S. is less vulnerable than iceland to hot money flows. And the U.S. issues debt in local currency, so the debt load would not increase in the case of a devaluation of the dollar. That puts the U.S., in relative terms, in a better position.

    I hope that makes sense.

  3. hbl says

    Yes, that does make sense, thanks. I do understand that the root of their recent crisis to date is largely a result of the large external debt (700-900% of Iceland’s GDP or something?) However, at some point the Icelandic kroner will stop falling (right?) at which point price import inflation will cease… Regardless of what happens with external debt they also have the huge unsustainable internal debt which should be susceptible to debt deflation (cascading defaults etc) with contraction of the Icelandic broad money supply (base money plus credit). I just wonder what happens when those two massive forces (price inflation due to falling currency, domestic deflation) are juxtaposed on this scale and what the future might hold.

    Since capital flight doesn’t actually reduce domestic money supply (right?) it seems it would have less impact on domestic broad money supply inflation/deflation, despite the large impact it has on currency value.

    Hopefully what I’m after makes sense…

  4. Edward Harrison says

    you’re right. The kroner has stopped falling. The last I saw it was actually rising a bit against the Euro. So, I too would expect that deflation would take over as the initial inflation goes away.

    Argentina is a good test case of what happens there. Usually what happens though is that the central bank continues to print money and this means that inflation resumes and the currency falls further. And capital flight does not mean there are fewer krona in circulation, just that no one outside of Iceland wants them. What you would expect is that this means a net increase in the volume of money domestically also abetting inflation.

    So, inflation has a bit of stickiness to it despite the deflationary forces of a contracting money multiplier and asset deflation. Over the longer term, it seems it’s a matter of whether or not the central bank inflates or not as to whether deflation takes hold.

    One other thing, I would expect a country like Iceland or its citizens/businesses to default on foreign currency debt obligations as the Argentines did. This reduces the real burden of debt and in conjunction with quantitative easing makes inflation still a possibility.

    In Asia, after the bubble in the 1990s, countries taking IMF money did not have these options available so deflation was the result.

  5. hbl says

    Thanks for the further details. The reason I think the Iceland inflation/deflation scenario is so important to understand is I think it can shed light on the odds of success of other countries beating deflation in its early stages versus after deleveraging has run its course. Iceland’s crisis this year seems like a supercharged version of the slower decline of the dollar over the last 5 years (with added factor of massive external debt). If the country veers into deflation despite huge currency debasement, inflationary expectations, and even possibly QE, then we’ll have an even stronger case study of the impossibility of defeating the initial deflationary unwind of unsustainble credit bubbles — a lesson applicable to the US, UK, etc etc. It would be further evidence that policy makers in the US (Great Depression) and Japan had no way to “fix” things once the bubble was there.

    “In Asia, after the bubble in the 1990s, countries taking IMF money did not have these options available so deflation was the result.”

    I had not heard that, only about inflation and raised interest rates… it has seemed to me one problem with recent “banana republic” comparisons to countries in the Asian financial crisis is they [most? all?] had pegged currencies, and that seemed to worsen certain problems in a way that may not apply to the US and other free floating currencies.

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