Gone With the (Arctic) Wind

It was beautiful while it lasted: Impressive growth rates, speedy development, and a strong and diversified financial services industry put miniscule Iceland on the economic map. But it wouldn’t last forever. In the past month, all three major Icelandic banks have been effectively nationalized, the stock market has crashed, and the International Monetary Fund (IMF) has been called in to calm international investors and prevent the country’s bankruptcy. As the global financial crisis claims its first sovereign victim, it is important to understand that every party involved would have benefited from more coordinated international regulation.

The crisis affecting Iceland has its roots in the catastrophic consequences of an oversized banking industry in a country without the financial muscle to become a lender of last resort amidst a liquidity crisis. Although the country had been known for generations as an isolated fishing outpost off Europe, in the last few decades the national economy veered from fish to finance. According to official figures, the fishing industry shrunk from 16 percent to 6 percent of GDP between 1986 and 2006. Banking, insurance, and property, meanwhile, came to represent 26 percent of GDP by 2006.

At the core of this transformation was the spectacular growth of Iceland’s three main banks, Glitnir, Landsbanki, and Kaupthing, all of which grew at impressive rates following their deregulation in 2000. Much of the borrowing for these banks and Icelandic society more generally came from the continent, where rates were especially low. The money would then be converted into the local currency, the krona, and invested for a higher return in real estate and business both in and beyond Iceland. The result is what economists call “carry trade”—currency arbitrage and speculative investment highly susceptible to liquidity crises. Whereas banking sector assets accounted for 96 percent of GDP in 2000, they were over 10 times GDP this year. Furthermore, external debt in the form of foreign deposits in Icelandic banks was over 20 times the government’s debt. Effectively, the banks had become too big for the government to protect.

Despite the fact that countries like Switzerland and Britain have survived for centuries with a similar discrepancy between banking assets and GDP, the miniscule size of the Icelandic economy as well as its fragility contributed to the deepening of the crisis. Earlier this year, while Icelandic banking executives offered interviews to calm investors, the Financial Times published an influential story revealing an ongoing investigation into hedge funds trying to destabilize the country. Last month, the liquidity freeze made it impossible for Glitnir to roll over its short-term debt, as the krona suddenly depreciated and interest rates soared.

Fear rapidly spread to the United Kingdom and the rest of Europe, where residents had deposited billions in the other two Icelandic banks attracted by their high interest rates. Amidst the banking run that immediately followed, the British government transferred authority over an Icelandic subsidiary in the UK, and then sold it to the Dutch firm ING. Because Landsbanki had over 300,000 British depositors through its Icebank subsidiary, Prime Minister Gordon Brown’s government used anti-terrorist legislation to freeze Icelandic assets in the UK, including property of the Icelandic Central Bank. Just a few days later, Chancellor of the Exchequer Alistair Darling added fuel to the fire when he said on BBC Radio that the Icelandic Finance minister had told him that the Icelandic government did not plan to honor British deposits after nationalization, an allegation later found to be utterly false from the conversation transcripts.

Amidst these incredible circumstances, the Icelandic government chose to effectively nationalize all three main banks, and investors began to worry about a national default on debt given the size of the debts the government had to absorb. Despite the harsh criticism it has endured in the last decade, it was the IMF that stepped in to provide a highly symbolic $2 billion loan to Iceland, which was followed by support from a consortium of Nordic central banks. This has finally eased some pressure on the unfortunate island, but it has left many wondering how this chaos might have been averted.

The Icelandic financial services bubble was a ticking time bomb, and the Brown administration in the U.K. behaved amateurishly given the circumstances. but perhaps more importantly, the lesson is that Iceland’s banks should not be so heavily invested in Europe if the country as a whole is not better integrated into continental regulatory structures. Specifically, its banking behemoths should not have been allowed to take on so much debt and currency risk without effective safeguards by the Icelandic government and agreed upon by the European Union. Hopefully, this financial meltdown will move the Nordic island closer to Europe and away from unsustainable growth philosophies. Along with the Nordic winter, Icelanders will now face a frozen economy: Those who shifted from fishing to finance will most likely have to return to the ancestral occupation.



Pierpaolo Barbieri ’09, a former Crimson associate editorial chair, is a history concentrator in Eliot House. His column appears on alternate Thursdays.