If we remember back to the days of the global financial crisis, one of the earliest and hardest hit countries in the European area was Iceland. Iceland was also the only country which made the fateful decision to not bailout the three largest banks in their country. This was not because they simply said ‘no’ like they did afterwards to the demands of the creditors of these banks in the UK and the Netherlands, but they simply could not afford to bailout these banks which held 10 times GDP worth of assets. By choosing not to bailout the banks it didn’t mean the domestic financial payments system collapsed as well, and without good reason detailed further in the article.The country of course fell into a heavy recession much like the rest of Europe afterwards, unemployment rate surged from pre bubble 2.2% to 9.3% in 2010 (Figure 1), GDP growth plunged in the troubling years cumulating to around 45% GDP lost by 2011 (Figure 2). The stock market plunged by 90% from its peak in the bubble, the Krona lost around half its value (Figure 3), foreign currency transactions were suspended for weeks to stop the haemorrhaging of capital outflows, Inflation rose to 18% at one point in time (Figure 4), the Current account and the Capital Flows was also heavily in deficit (Figure 5).
Have a look at Iceland now, the numbers are quite encouraging compared to other European countries where most are still in recession, have elevated unemployment rates and are having troubles containing debts and budget priorities. That’s not to say Iceland has a wonderful debt position now, with Debt to GDP at 100%, but because there isn’t much turmoil in the markets, much of the attention has been drawn towards potential euro exiting countries like Greece, Spain, Italy etc. The interesting question people frequently ask is how Iceland, who didn’t bailout the banks, is doing better than most of Europe who did.
Firstly the most obvious difference between Iceland and Europe is the currency, having lost half its value, the krona has made exports from Iceland relatively more competitive in foreign markets. This is without actual effort to become more competitive by businesses, and the lower krona also substantially boosted its Tourism, Fishing and Aluminium industries. The drawback is that for a small country heavily dependent on imports, a weaker currency means higher prices for imports, thus a much higher than otherwise cost of living. Another troubling area of concern is that the housing market is heavily filled with Inflation indexed mortgages, perhaps due to lower risk for the banker thus lower interest. A loan worth twelve and a half years ago 6m Krona (£28,850) would now cost 9.7m Krona (£46,642), with many homeowners in negative equity as the debts are now worth more than the value of their homes. An additional problem is if people took out a loan in foreign currency, with the same principle of negative equity applying due to the much weaker krona increasing the debt owed. In order to prevent an additional housing meltdown in Iceland, the government put in special protection to home-owners threatened by banks foreclosing. Contrast this with the non-recourse loans in the US; it could have been much worse for both homeowners and the retail banking arms in Iceland.
Now to the banks, to say that the Iceland government let the banks completely fail is a complete misstatement. This is because the domestic financial payments system (essentially why we need banking in the first place, to make financial transactions) did not collapse. Iceland actually nationalised the domestic parts of its banks, guaranteed local depositors money and allowed the international arms of the bank to collapse, in the process infuriating foreign creditors and but saving domestic retail banking. The international parts of the banks are where foreign savers who invest in Iceland’s banks, investment funds, borrowing from foreign banks, and the division itself also invest in foreign assets. Iceland of course needed bailout funds from the IMF and other countries to actually achieve this and also implement fiscal stimulus required to fight the recession. Iceland also became an outcast in the international financial community having been downgraded to “junk” status, but that seems to have returned to normal with their credit rating back to BBB-. The financial sector shrunk from 10 times of GDP back to 2 times GDP with massive layoffs accompanying and of course the jailing of bankers. However the silver lining was that it allowed Iceland to rebalance their economy from an island of banks back to a ‘nation of farmers and fisherman’ phrased by President Grimsson. Iceland’s physical economy now has access to the brainpower of skilled graduates such as engineers, scientists, computer science and business students which would’ve found their way into the high salary bonus-paying banks in the past.
One of the problems with understanding Iceland’s economic recovery is that the lessons learnt aren’t exactly applicable in the many situations we might come upon. This is because Iceland’s situation was unique as it was a small economy, with insignificant influence over the global markets. Its economy was also particularly dominated by the financial sector during the bubble. If the countries like the US, Japan or even countries like Spain decided to let the international parts of their banks fail, it would’ve caused massive financial losses on creditor nations, but with the trade off of saving domestic banking. Also the massive depreciation of their currencies (except Spain would most likely suffer internal devaluation) would most likely cause a messy situation in terms of global trade and misallocation of resources. Finally the quick lessons that are applicable from this are as follows: 1. Don’t take out an inflation indexed mortgage, don’t issue non-recourse loans (like the US) 2. Don’t let the financial sector grow too big to rescue, also attempt to ring fence domestic banking arms or provide more regulations and oversight in investment banking (reduce trading loss risk, investment bubble risk)/international banking arms (reduce contagion risk) and 3. Don’t let the domestic financial payments systems fail. Not everything went smoothly for Iceland, they still have a high debt-to-GDP, and the double edged krona devaluation caused high inflation which also increased household debt. However, Iceland was able to recover because of its own unique economic situation and the decisions it made.