Why Iceland - Engilsaxneskir ritdómar

Why Iceland?: How One of the World's Smallest Countries Became the Meltdown's Biggest Casualty




Business Plus October 2009


Reykjavik on the Liffey

The banking systems in Iceland and Ireland collapsed as a result of madness and collective myopia. JOHN SWEENEY explores why sufficient agreement to take away the punch bowl did not develop in either country to support pre-emptive action Liffey Reykjavik

The Essay in pdf

There are significant doubts about the adequacy and effectiveness of Ireland’s cumulative efforts to dig itself out of its economic hole. Are we to lose a few years or a whole decade? A year on from the dramatic night when only a state guarantee kept the main Irish banks from failure, a year punctuated by further strong measures (the nationalisation of Anglo Irish Bank, state recapitalisation and state directors for the other main banks, the pensions levy, the incomes levy, public expenditure cuts etc), there is still no widespread confidence that either the banks or the state’s finances have been definitively rescued. The green shoots of recovery appear more evident in other countries. There is a fear that the Irish economy could become mired in a lost decade with businesses and consumers locked into risk-averse behaviours by high indebtedness and high unemployment.

The forthcoming Budget in December is being accorded a heroic role. Either it will confirm that a firm, fair and effective strategy for national recovery is finally being embraced. Or it will be an unconvincing and inclusive patchwork reflecting how the social partners, political parties and interest groups individually believe they are not to blame and fear being asked to contribute disproportionately to the economy’s rescue. When entitlements, gains and other fruits of the boom years are so evidently being eroded, perspective on what oneself and others are experiencing becomes all important. How we think about and interpret what is going on influences the experience itself. For example, are we ‘soft targets’ for public spending cuts or ‘doing our bit’? Which it is makes a huge difference to our mental health, how we perceive our prospects and what we are prepared to do to protect those prospects. This article wrestles with the broad perspective to be adopted on Ireland’s passage from boom to bust. It explores, on the one hand, the extent to which we are unique in how we blew the boom and, on the other, the degree to which the Irish case ‘conforms’ with the sorry experiences of other countries that also passed from boom to bust.

In particular this article feeds in perspectives from Iceland’s financial collapse, drawing on Ásgeir Jónsson’s book, Why Iceland?. Comparing Ireland with Iceland - a much smaller country and economy (population 310,000), that trades in a relatively small number of areas (marine products, aluminium, tourism, financial services) - might seem inappropriate. But Iceland is an OECD member and, since 1994, part of the European Economic Area and a full participant in the EU’s internal market. Until 2007, its GDP per capita was one of the highest in the OECD, widely ascribed to its strong work ethic, educated population, business friendly environment, and unusual blend of an egalitarian and entrepreneurial society. More supportive still of a comparison between the two countries, the manner of Iceland’s undoing has tantalising similarities and differences with Ireland’s property crash. In Iceland’s case, its banks sourced funds on international wholesale money markets to feed an export sector in its booming economy.

That this sector was investment banking and not construction only adds to Irish interest. Financial services, after all, are among the knowledge-intensive services exports considered to have significant potential for filling part of the void created by the collapse of Irish construction. If Ireland has a post-boom hangover like few other countries, it is partly because it had a boom that few others matched either. In retrospect, we grew more accustomed to Ireland’s outlier status on OECD and EU growth charts than we became curious about, or expert in, the consequences for assets of such a long boom and how they typically end.1 We did not notice or appreciate sufficiently the exceptional succession of factors that succeeded each other at the macro level to sustain an environment strongly supportive of high growth rates. For example, GDP growth was already averaging 9% (1994 to 1999) when Ireland joined EMU at an undervalued rate, only to then gain further in competitiveness from the euro’s initial decline against the dollar and sterling.

Along with Spain, Portugal and Greece, Ireland experienced a significant reduction in the risk premium it paid for borrowing overseas, while higher domestic inflation brought down the real interest rate more than elsewhere in the eurozone. Successive National Development Plans took advantage of the low costs of borrowing, buoyant government revenues and a declining debt/GDP ratio to increase the speed with which we sought to close historical infrastructural deficits. After 2004, high economic growth was further prolonged when educated labour from the new EU member states became available to Irish employers in large numbers. Due to the cumulative impact of these factors, the Irish economy’s potential growth path - the rate it can sustain in the long run with trend increases in factor availability and its utilisation - became exceptionally difficult to estimate. Rather than being arrived at ex ante with sufficient credibility to support cooling the economy, it was increasingly calculated ex post to, in effect, sanction what was anyway unfolding.

In all this, the principal long-term danger most consistently highlighted for the economy was the erosion of competitiveness. It was, and still is, a danger. Ireland’s price level relative to the EU 15 soared between 1998 and 2003 to become one of EU’s highest. By comparison, however, there was much less recognition that an equal or greater danger lay in asset markets than in rising business costs. Property prices and shares in Irish companies could only go one way in such a strongly growing economy - they rose. Soon, more people came to realise that their appreciation in value more than covered the long-term cost of borrowing to buy them. Price rises became a selffulfilling expectation as demand from investors anticipating price increases became the cause of the increases. In addition to this upward price-price spiral, rising asset prices fuelled faster economic growth. Owners of property and holders of equity felt better off and spent more (the wealth effect). Companies took advantage of their higher equity value to raise funds for investment and expansion. Credit soared as borrowers had more to offer by way of collateral (higher priced properties and equity holdings) and financial institutions assessed more individuals and companies as credit worthy.

A final twist in this upward spiral was when banks realised that funds for lending were available overseas at low rates and in almost unlimited supply and that their funds for lending long-term did not have to be confined to growth in the domestic pool of long-term savings. This skeletal or ‘bloodless’ account of how Ireland’s property bubble developed does no justice of course to the knaves and knights, villains and prophets who displayed their true colours during it. Three-D accounts are needed that include the self-delusion, opportunism, greed and corruption that also thrive in asset booms. In fact, it is interesting to ask whether exceptional booms need exceptional villains to proceed as far as they do. Integral to the Irish property boom that has so spectacularly collapsed are not just technical issues such as poor land management and a tax system overly kind to property, but sociopolitical factors. For example, the emergence of Anglo Irish Bank as an aggressive property lender, the final capitulation of previously conservative managements in AIB and Bank of Ireland to ‘evidence’ that huge profits from property-related lending were being foregone, the traditional sensitivity of Fianna Fáil to construction interests, and much more.

Ásgeir Jónsson provides just such a rich socio-political account of Iceland’s boom and collapse and of the entrepreneurs, regulators and politicians caught up and finally overwhelmed by it. As the same time, as a professor of banking and international finance, and former chief economist in one of the three big Icelandic banks that crashed, Jónsson has the technical background to steer through the complex financial engineering of the three investment banks that were at the heart of it. What were the Icelandic banks doing? At home, they were lending funds for long-term projects, principally in the aluminium and construction industries, far in excess of the pool of long-term domestic savings. They made up the shortfall by borrowing short-term overseas, believing international interest rates would remain low and the option also remain open of rolling over the loans at these low rates.

There is an evident similarity here with Ireland’s banks, who also borrowed short overseas to lend long domestically. In fairness to Iceland, their lending for domestic purposes was, arguably, less concentrated on property than in Ireland, for as diversified a spread of investments as its small economy and relatively successful. The degree of success allowed a significant carry trade to develop, based on Iceland’s high interest rates (compensating domestic depositors for inflation) and confidence that the fundamentals of its economy supported its currency, the krona. In the carry trade, banks borrowed foreign currency at low interest rates overseas for relending as kronur at the higher domestic interest rates. It is what three major Icelandic banks began to do overseas that proved the country’s undoing. They built up extensive business as investment banks in Scandinavia, the UK and elsewhere.

At first, they were widely considered to be savvy investors running well-managed banks that acquired good quality assets outside Iceland that matched their growing overseas liabilities. They regularly garnered good credit ratings. But success was addictive. At the end of 2008, the total assets of the three Icelandic banks were eleven times the country’s GDP and about 80% of them were in foreign currency. The domestic financial system became vulnerable to a major liquidity crisis independently of the quality of the individual banks. Their foreign assets were long term; it was precisely their potential to appreciate in value over time that was considered to justify large shortterm borrowing to finance their purchase in the first place. When the wholesale money markets seized up in autumn 2008, the Icelandic banks faced an enormous need for instant foreign currency to repay short-term loans and simply could not realise enough from quick sales of their ‘good’ assets to generate the foreign currency needed. And there was nowhere for them to turn.

Iceland’s Central Bank simply did not have the resources - in foreign exchange reserves or through credit lines with other central banks - to function as a lender of last resort on the scale that could rescue the three private banks, while the tax base of the Icelandic government was too small for it to be able to inject capital into the banks on anything like the scale needed. In effect, an international financial sector was exposed as simply ‘too large to bail’ with neither a central bank nor a sovereign government with the capacity to rescue it. The fundamental response of the Icelandic authorities to the collapse of its three giant banks has been to ‘look after their own’ i.e. restrict taxpayer resources to protecting domestic deposits and domestic banking operations only. Foreign deposits and foreign bondholders will be paid back from the liquidation of foreign assets, and what they cannot be paid they will lose. The fundamental argument in support of this drastic approach is that the debt burden otherwise placed in Icelanders would bleed the country for a generation. For example, there was almost one UK deposit with the online bank, Icesave, for each Icelander, and their cumulative total amounted to between 60% and 80% of Iceland’s GDP.

In this particular case, strong UK tactics have forced a partial Icelandic retreat and the two governments between them are to indemnify the UK account holders over a period of time. But the Icelandic authorities have assumed no responsibility towards foreign bondholders and the distinction between senior and subordinated debt has been irrelevant to their stance. It is a drastic measure taken in the imminence of a national catastrophe. Reading Jónsson, one can only appreciate how much the euro and Ireland’s position within the EU have kept our banking crisis from leading to a currency crisis, protected mortgage holders and businesses from hikes in interest rates, and brought extensive international support for solutions that do not entail economic nationalism. At least in Ireland, we can ask whether senior debt should be treated differently from subordinated debt, and whether the key to maintaining international confidence in the economy is the extent to which bondholders are protected or the extent to which the Irish taxpayer and tax system is protected from future liabilities arising from the rescue of private banks.

 Ireland has had time to find ways of sharing losses in its banks with those who invested in them that Iceland did not. What appears so clearly in retrospect as madness and collective myopia in both Iceland and Ireland begs the question as to why sufficient agreement that ‘the punch bowl must be taken from the party’ - there were always some who advocated it - did not develop in either country to support pre-emptive action. For Iceland, Jónsson paints a picture of investment banking developing as an enclave that political leaders and the regulatory authorities poorly understood. And they poorly understood it because they came from an older generation than the banking fraternity, were principally interested in domestic issues and drew on too few people with the international experience and academic backgrounds to grasp the significance of what the Icelandic investment banks were doing abroad. The head of their central bank throughout the crisis was a former prime minister who was not above carrying elements of his former domestic political agenda into his new position.

By contrast, the much less complex nature of the banking operations that fuelled Ireland’s asset bubble and the ‘in your face’ nature of the scramble for property make the blindness of the Irish authorities even more astounding. The Viking financial raiders responsible for Iceland’s bubble can be counted in tens, and appear in Jónsson’s account as not particularly political or social insiders. However a much larger group of people brought Irish banking to its knees - bank managers and directors, property developers, local authority planners, politicians, solicitors and multiple other individuals in a position to procure credit on a large scale - many of whom were social and political insiders. In retrospect, there seems to have been a predisposition on the part of Ireland’s authorities not to see, hear or think that property prices were out of control.

Why was there such a willingness to believe that fundamentals and not speculation continued to drive the Irish property market? The antennae of the Irish authorities can be seen to have been dulled in four significant ways. In the first place, the fundamentals them-selves were pretty impressive: a population growth rate far higher than elsewhere in the EU, shored up by high net migration and a high rate of natural increase; the fact that the fastest-growing cohorts in the population were those of an age at which households are formed; the rise in employment and higher disposable incomes; the still large average household size by EU standards and evidence of a growing trend towards independent living; and the demand for second homes and home extensions or improvements on the part of a wealthier population.

In addition, the buoyancy the property boom imparted to the public revenues was a strong narcotic. Stamp duty on housing transactions and VAT and capital gains tax on the value of house sales created a quite abnormal element to tax revenue buoyancy. In addition, the implications for normal revenue buoyancy of the shift from export-led growth to domestic demand driven growth was probably underestimated. Fiscal policymakers were tempted to believe in a structural increase in available resources and few of Ireland’s elected politicians or social partners had the far-sight to question that assumption, while many had the near-sight to spot and pursue opportunities for their own constituents and interest groups. At a time when the economy was de facto operating well above potential, tax reductions continued and current public expenditure plans were increased. A third factor dulling authorities’ sense that something could be drastically wrong was the fact that Ireland complied well with the

Stability and Growth Pact during most of the boom period. A booming GDP contributed to hauling down the debt/GDP ratio, and a current account surplus was comfortably recorded in most years, sufficient to finance a significant slice of a large investment programme. However, ECB analysis of the stability programmes submitted annually by eurozone states show that Ireland underestimated growth in its public expenditure more consistently than other states. Ireland also significantly and consistently underestimated growth in its tax revenues, which enabled the country to get generally good report cards, even though this revenue buoyancy was insufficiently analysed and a fundamental imbalance in Ireland’s public finances was in fact developing. The surveillance procedures of the SGP simply did not delve deep enough to identify additions to tax revenue that were temporary and due to an overheated economy, and the allocation of this temporary revenue to forms of higher public spending that were not discretionary and which would prove difficult and pro-cyclical to cut back in an economic downturn.

The fourth source of blindness was particular to Ireland’s monetary and financial regulatory authorities. They managed to ignore multiple warning lights coming from the housing market and domestic financial system. For example, house prices began to depart from their long-term relationship to incomes and rents in the late 1990s onwards. The sustainable level of residential investment (some 10% of GNP) was left behind in 2001. The net inflow of funds to the banks largely to fund property construction and acquisition jumped from 10% to 41% of GDP in the two years to the end of 2005, and 15% of the housing stock was found to be vacant in the 2006 census. The balance sheet of Anglo Irish Bank grew at an average annual rate of 36% between 1998 and 2007 (20% in one year is considered a warning). And so on. In many respects, quite traditional metrics and regulatory tools should have been sufficient to prevent the Irish banks from getting into deep trouble if they had been vigorously and rigorously used. But they were not.

Several reasons can be advanced as to why they were not. The espousal of a principle-led rather than rules-based approach to financial regulation fitted well with Ireland’s concerns to attract inward investment in financial services and assure these high-quality employers of the country’s friendly business environment. But the same approach was particularly ill-suited to the domestic networks that figured prominently in Ireland’s construction sector and linked developers, builders, financiers and politicians. These networks were vulnerable to abuse and familiarity, shared social interests, the mutual protection of reputation and even the trade of favours reduced the effectiveness of monitoring. If economists were not prominent in these networks, their views were, nevertheless, effectively filtered and those which supported inaction became the most widely known.

Beyond Ireland, intellectual reasons were advanced with authority that cautioned strongly against precipitate intervention by monetary and regulatory authorities when asset prices were surging. Each found some echo in Ireland particularly because they were entertained strongly by Alan Greenspan and associated with the strong economic performance of the US economy. They have subsequently been expertly dissected by European Central Bank president Jean-Claude Trichet and Henry Kaufman.2 First is the argument that there is no fool-proof method for identifying asset price bubbles in real time and, on the contrary, always some risk that the authorities will ‘lean against’ developments that are, in fact, justified by the ‘fundamentals’. Yes, says Trichet, but holding out for the perfect method and complete information is not good policy making either.

Monetary and credit indicators can and do provide early warnings that asset price developments are unsustainable. Indicators can always be improved and new data is always about to appear, but neither absolves policy makers from their fundamental obligation which is to assess and respond to the risks posed by excessive asset price developments on the basis of what information is available to them. Ireland provides the OECD world with one of its newest examples that the risks of acting too late hugely outweigh the risks of acting too soon. Second is the argument that the scale of the interest rate increases needed to contain surging asset prices can do more harm than good. Trichet believes this is simply wrong for the eurozone as whole. The profitability of banks, he argues, that systematically borrow short and lend long can be significantly affected by even a small change in policy interest rates, which can trigger the closingout of leveraged positions and the moderation of asset price growth. The Irish authorities might rue that the ECB did not adopt such a policy but they did not then go on to address the implications of their inability to set interest rates purely to Irish conditions. This would have entailed pursuing counter-cyclical fiscal developments much more vigorously.

The final way of thinking made popular by Greenspan is that it is better to wait until an asset bubble bursts and then ease monetary policy aggressively so as to contain the adverse effects on real activity and inflation. Trichet notes how this approach risks creating moral hazard on a large scale and, thus, can help to create a state of potential instability. By contrast, a central bank that leans against the wind is more likely to encourage responsible behaviour on the part of investors and reduce the risk of a crisis. But it is recent experience that has most comprehensively debunked the ‘easier to clear up after’ theory. Policy action unprecedented in its scale and coordination across the industrialised world failed to prevent a sharp fall in economic activity in the wake of the financial crisis of 2008. All this said, Trichet appears remarkably gentle towards central bankers and financial regulators who did not intervene more decisively to nip asset booms in the bud. Trichet writes: “Over the past few years, both experience and developments in the literature appear to support a shift in favour of the adoption of some form of leaning against the wind. However, having spent 16 years facing the successive challenges of operational central banking, I am doubtful that such a strategy can be implemented in a mechanical way.

The uncertainties remain too great, and perhaps always will. What is required is a significant degree of judgment, embedded in a rule-based framework for policy making, which encapsulates the essence of leaning against the wind without suggesting that central banks are in a position to manage closely - much less target - developments in asset prices.” The tone of Trichet’s observation sets the tone for this article’s conclusion. The search for culprits in the Irish economy’s dramatic fall from grace is necessary to win popular support for the breadth, depth and duration of the fiscal retrenchment that is still necessary. It is also a requirement of social justice given the scale and likely duration of the unemployment that can be directly attributed to the collapse of the housing bubble. But identifying culprits and ensuring they do not keep their gains from the bubble is quite secondary to the need to press on with coordinated and decisive action in four areas:

● One way or another, bank balance sheets must be cleaned so that they are able to resume extending credit to worthy (if stressed) businesses and attract funding from international markets.
● Ensuring that the restructured Central Bank Commission develops the competence, confidence and conviction to monitor and regulate financial institutions operating in and from Ireland, and doing this with and through the ECB and the new regulatory infrastructure at EU level.
● Ensuring that the management of the public finances is protected more effectively from electoral politics and future asset cycles, and that the Stability and Growth Pact is also strengthened in this way.
● Achieving the inescapable imperative of further fiscal retrenchment in the short term in as transparent and inclusive a way as possible.

John Sweeney is a Senior Policy Analyst with the National Economic and Social Council since 2002 and associate lecturer in Trinity College Dublin and St Patrick’s College (DCU). He holds a PhD in economics from Leuven University.





 City Journal.

17 September 2009

Global Warning: Iceland’s failed banks offer the West a lesson.


Nicole Gelinas


Why Iceland?: How One of the World’s Smallest Countries Became the Meltdown’s Biggest Casualty, by Asgeir Jonsson (McGraw-Hill, 224 pp., $22.95)

Nearly a year ago, tiny Iceland’s financial institutions collapsed, just as banks and investment firms did all over the West last autumn. But Iceland differed from the rest of the developed world in forcing its insolvent financial institutions’ bondholders to take their losses. Alone among the world’s nations, Iceland has efficiently taken the principle of “too big to fail,” which governs taxpayer rescues of large or complex financial institutions, to its inevitable end: failure. Other nations, including the United States, risk eventually following Iceland, unless they understand its lesson.

As Asgeir Jonsson, chief economist at one of the banks at the center of the crisis, observes in Why Iceland?, Iceland had a tense relationship with finance long before 2008. A century ago, the island nation benefited from creative financial growth, with a foreign-owned bank supporting the modernization of its fishing industry. But when the Depression came, that bank failed, and Icelanders opposed spending money to benefit the overseas speculators who owned it. Rather than create regulations to support a healthier private-sector financial industry, as much of the West did, Iceland nationalized its banks, causing a “50-year pause in Iceland’s financial development,” writes Jonsson.

Iceland gave little thought to banking again until the 1980s, when a severe recession soured its citizens on postwar statism and pushed them to embrace the Thatcherite reforms taking hold in Britain. The Nordic country slashed taxes, broke inflation, gradually sold off its banks (completing that process in 2003), and signed an agreement to gain access to European markets.

The previous decades of government dominance continued to haunt finance, though. A “lack of institutional memory” in the industry “allowed all participants, bankers and government officials alike, fundamentally to underestimate systemic risk,” Jonsson writes, while private firms, until 2003, had to compete against the remaining state firms, which retained the advantage of government backing. (Similarly, in America, few financiers or regulators after the 1980s remembered the lessons of the Depression five decades earlier, and America, too, had its fair share of government distortion of finance, especially in the Washington-dominated mortgage markets.) In Iceland, this government shadow helped define one upstart private-sector bank, Kaupthing. Kaupthing made up for its disadvantages against state-owned competitors with what seemed at the time like smart aggression. Eventually, the rest of Iceland’s banking system followed suit, with Iceland’s two big banks matching the growing Kaupthing risk for risk.

In the decade leading up to the 2008 crisis, Iceland’s banks, along with the rest of the world’s financial economy, became short-lived beneficiaries of the global debt and derivatives bubble. They could attract tens of billions of dollars from global investors partly because Iceland had no public-sector debt, but largely because international banks desired the Icelandic banks’ bonds, folding them into AAA-rated securities and selling them to other international banks. Absent this global hunger for debt, Iceland’s banks couldn’t have grown so quickly, as Icelanders’ savings were tiny compared with the size of their banks’ ambition. Much of the debt was in dollars—a tremendous risk, since if the local currency fell against the dollar, the banks would owe much more. But the bankers didn’t let this concern slow them down. The derivatives they used would hedge that risk, they thought, just as financial institutions around the world convinced themselves that they had solved similarly irresolvable problems.

But the fundamental reason for Icelandic banks’ growth—and financial growth around the world—was the universal faith that because finance had grown so complex and interconnected, no Western nation would allow any of its big, complex financial institutions to fail. As Jonsson writes, “Banks in the western world have operated for decades under the assumption that both bondholders and depositors have a government guarantee against their loss. . . . This assumption of state support unquestionably helped to fuel the Western banking bubble, and it also helped the Icelandic banks to shine.” By 2007, Iceland’s banks had amassed assets ten times the nation’s annual GDP—tenfold growth in a decade. But even as foreign investors grew nervous in 2006, bond analysts at Moody’s assuaged their worry, determining that each of Iceland’s banks was “too important to fail” and declaring that if the need for government support arose, “access to finance will always be available.”

This happy thought proved ephemeral. When, starting in 2007, the world’s lenders lost confidence in the main technique behind all that global debt—securitization—they also lost confidence that financial firms’ assets could hold their values without the easy debt that securitization had provided. As exuberance turned to pessimism, the financial world used unregulated credit derivatives to bet against the Bear Stearns and Lehman Brothers investment banks—and against Iceland’s banks, too. With cheap debt gone and with unregulated financial instruments monetizing and magnifying fear, the banks faced the prospect of selling into a plummeting market, forcing more distressed sales as prices fell.

After the U.S. government bailed out Bear Stearns’s bondholders and trading partners in March 2008, investors stopped pretending to trust financial institutions and looked instead to the strength of national governments. In June, Iceland had an opportunity to shore up its banks with public money, but that would have required extensive borrowing, and it saw the interest rate, while affordable, as unfairly high. Iceland’s central bank also sought help from the world’s central banks, including the Federal Reserve, attempting to secure access to dollars and euros in an emergency. But Iceland failed to get the help it needed, partly because Icelanders “seemed not at all ready to abandon their aggressive international banking model, an impossible dream made real,” Jonsson writes. In this stubbornness, Iceland was like Lehman Brothers, which, during the spring and summer of 2008, balked at selling out to a stronger outside investor at what seemed like an unfair price.

After Lehman’s September 15 bankruptcy, each nation protected its own, but by now, Iceland couldn’t borrow to save its banks at any price. Officials tried, assuming that the impossibly high interest rates that the market was demanding to hold its banks’ debt would come down and meet the lower rates that bondholders had required to buy government debt, since the banks would now have government support. That was what happened in America and much of Western Europe. But in Iceland, the opposite occurred, and borrowing costs for the government skyrocketed out of reach. The world started to understand that Iceland’s financial sector was, not too big to fail, but too big to save. So Iceland—out of necessity, not ideology—did what no other Western nation has done: it let two of its three financial giants go under, nationalizing them and forcing losses on bondholders.

As the banks failed, Iceland, too, did what it could to protect its own. It pledged to expand coverage to all domestic deposits under its version of FDIC insurance. But the strategy had a weak spot. One Icelandic bank, Landesbanki, had marketed its “Icesave” accounts over the Internet to British customers, and it had used its own branches to do so, not a separate British company. That meant that Iceland’s deposit insurance applied to the Britons, too, and European regulations forbade Iceland from saving domestic depositors at the expense of equally insured foreign ones. This put Iceland in a fiscally untenable position, since Icesave had amassed foreign deposits worth 70 percent of the country’s GDP.

As Iceland dithered over whether it could make good on a liability that would take its debt from zero to levels that would have been considered high at the time even in the rest of the indebted West, British depositors panicked, and so did the British government, which feared that the public wouldn’t differentiate between Britain’s banks and Icesave. To maintain confidence in its banks, Britain offered Icesave account holders its own government protection. Then, using powers granted under antiterrorism law, the government seized the British assets of Landesbanki, by now Iceland’s last remaining big bank. The bank then collapsed back home, bringing 95 percent of Iceland’s financial system into bankruptcy and under state control. “Most ordinary Icelandic citizens felt as if they had been expelled from Europe,” Jonsson writes, with Icelanders abroad cut off from international credit-card and ATM systems.

So that its citizens and businesses could import necessities as its currency cratered, Iceland went to the International Monetary Fund, borrowing money on terms that included budget cuts and a promise to repay the British and the Dutch (whose government had also stepped in to protect its Icesave customers). In addition to the $2 billion IMF loan (with more likely to follow), Iceland now owes $5 billion because of Landesbanki’s Icesave obligations—roughly one foreign Icesave account for every Icelandic citizen.

It’s comforting to think, as Tufts professor Daniel W. Drezner wrote in the Wall Street Journal, that “what happened in Iceland will probably stay in Iceland.” Yet we ignore Iceland at our peril. “The biggest difference between the Icelandic banks and the banks abroad was first and foremost the level of assistance their government would be able to grant in times of crisis,” Jonsson correctly notes. But Iceland’s financial sector outgrew the nation’s ability to rescue it because global investors thought that the nation could rescue it—and unless the rest of the West credibly rejects its too-big-to-fail approach, the same thing, someday, could happen here. Thirty-five years ago, financial-sector debt in America was 17 percent of GDP; today, it’s 18 percent greater than GDP. We don’t know how big is too big for the government to rescue, but without adequate regulations, we risk finding out.

Yes, the U.S. and significant parts of Europe have obvious protections against an Iceland-style capital runoff. America borrows in dollars, the world’s reserve currency; Europe, too, has strength in the euro. America and Europe have more diverse economies than Iceland’s. But the first advantage can slowly erode the second. America’s access to debt could allow it to keep underwriting an unsustainable financial system. The government has already used its credit to bail out banks instead of financing modern infrastructure. Private capital could continue to find a home in a profitable, government-protected financial industry—at the expense of healthier growth in other industries and a robust economy maintained and refined through fair competition. Perversely, Iceland’s demise may accelerate concentration of financial services in seemingly stronger nations, crowding out other businesses, because nobody will recklessly lend money to a bank headquartered in a country that can’t back up its banks.

What’s next for Iceland—its economy sunk, its self-esteem ruined, its government slashing spending, and its citizens angry at becoming “Iceslaves” to reimburse foreign depositors? University of Missouri econ professor Michael Hudson wonders if Iceland will “be plunged into austerity in an attempt to squeeze out an economic surplus to avoid default.” Some observers believe that Icelanders will end up like the Germans after World War I, resentful at the world and tempted to spite global lenders. For now, Iceland’s economy depends partly on Western creditors’ giving it some slack; Britain and the Netherlands have agreed to delay the country’s repayment of the Icesave obligation and then limit it to 6 percent of future GDP per year. But Iceland can’t avoid cutting public spending as it weans itself from unsustainable financial services’ illusory wealth.

Icelanders may in time understand that they have bought something quite valuable with all of this debt, which now exceeds 100 percent of GDP: freedom from a too-big-to-fail financial system. Iceland’s taxpayers may owe a lot, but they’ve cut the tab off. “Iceland now enjoys the dubious distinction of being the only Western nation to have ‘solved’ its banking problem,” writes Jonsson. The rest of the West is still racking up charges.

As Iceland recovers, it should even think about returning to global finance. In a few years’ time, if Iceland reprivatizes its financial industry and improves regulation to limit borrowing, it could credibly argue that its rebuilt industry offers the West’s only real measure of financial risks, absent government guarantees. It might get few takers. That would say a lot about investors’ confidence in an industry upon which the West has become dangerously dependent for economic growth.

Nicole Gelinas, a City Journal contributing editor, is author of the forthcoming After the Fall: Saving Capitalism from Wall Street—and Washington.



The New York Times


August 16, 2009
Off the Shelf

The Little Economy That Couldn’t

THERE is a relatively new expression in global financial circles: “going Iceland.”

It’s not an invitation to foreign tourists to enjoy a vacation on the island known for its geysers, glaciers and legendary Viking heritage. Rather, as Asgeir Jonsson explains, it denotes the sudden economic collapse of an entire country, a tale that larger nations might do well to heed.

Mr. Jonsson details Iceland’s extraordinary roller-coaster ride from rags to riches and back to rags in his fascinating, if often frustratingly arcane, book, “Why Iceland? How One of the World’s Smallest Countries Became the Meltdown’s Biggest Casualty” (McGraw-Hill, $22.95).

Mr. Jonsson says Iceland’s plunge was not caused by criminality or bad luck, and he makes his case with a store of insider knowledge. A native Icelander and the author of several books about Icelandic history and economics, he is head of research and chief economist at Kaupthing Bank, which as the largest bank in Iceland was a central figure in the crisis.

Mr. Jonsson devotes the first half of the book to a recounting of the nation’s history and its rapid-fire evolution into a modern banking power. The main theme is a recurrent swing between an extreme geographic, cultural and geopolitical isolation and an apparently contradictory, equally extreme openness.

“Iceland was the creation of cosmopolitans, Norse chieftains who roamed through the Atlantic and even into the Mediterranean,” Mr. Jonsson notes. “These were confident, risk-taking adventurists that conducted daring raids on hostile territories. On the other hand, they were also refugees, and deeply suspicious of any foreign authority.”

For more than 1,000 years, Iceland remained, as Mr. Jonsson puts it, “frozen in time,” having a land mass the size of Kentucky, an economy based on farming and fishing, and a language all its own.

But the author says Icelanders “refuse to acknowledge that the small size of their nation could ever be a hindrance to their ambition.” He describes them as full of “unbounded confidence and zealous drive” but hobbled by “a lack of critical thinking and precaution.”

All of these traits came starkly into play during the 1990s, when a generation of Icelanders born between 1966 and 1976 set their sights on transforming their country into a global financial center. Mr. Jonsson’s own Kaupthing Bank was among a handful of major players in this game; it was a commercial bank, an investment bank, a private equity firm and a hedge fund.

In order to grow, Kaupthing bankers had to find opportunities overseas. Iceland’s central bank didn’t have the regulatory authority of the Federal Reserve of the United States. And lacking a “lender of last resort,” Mr. Jonsson says, Icelandic banks had to rely on international wholesale credit markets for financing.

Before everything fell apart, Kaupthing and rival institutions like Landsbanki and Glitnir built a financial empire worth — at least on paper — 10 times their country’s gross domestic product. The wealth of the average Icelandic family also increased.

In October 2008, just days after the fall of Lehman Brothers, the Icelandic house of cards toppled. The collapse was caused by a sudden loss of confidence by foreign financial institutions and hedge funds. Investors stampeded to sell their stakes and/or short the Icelandic krona.

Mr. Jonsson says the Federal Reserve, the European Central Bank and the Bank of England refused to rescue the Icelandic banks with emergency loans. Kaupthing, Glitnir and Landsbanki went into receivership, many nonbank Icelandic companies were effectively bankrupted and thousands of average citizens lost their life savings.

The humiliated Icelandic government ultimately accepted a $6 billion bailout package from the International Monetary Fund.

According to Mr. Jonsson, about 95 percent of the Icelandic banking system, including his employer, Kaupthing, is now under state control.

He says the nation, which has a population of about 300,000, is torn between trying to recapture “ephemeral international glory” by joining the European Union and returning “to the old Iceland, contained in a natural, resource-based economy.”

Mr. Jonsson warns that in the meantime, Britain and Switzerland may be setting themselves up for financial crisis. He says that both have relatively small populations, “large internationally exposed banking sectors,” “a currency that is not a global reserve currency” and “limited fiscal capacities.”

“WHY ICELAND?” is a provocative, urgently important case study in international finance, but it is marred by the fact that the prose sometimes degenerates into macroeconomic-speak that may be incomprehensible to the general reader.

“The quotas were maintained for assets with risk that ran idiosyncratic to the international financial market,” the book says at one point, “and thus incrementally decreased the total risk of their portfolio adjusted for return.”

Mr. Jonsson also stops short of applying the lessons of Icelandic banking to the United States — which, of course, has a large population, the Fed and a global reserve currency. But our government has lately become a major stakeholder in some of our biggest banks and corporations. If the rest of the world suddenly loses confidence in our faith and credit, will America still be fiscally strong enough to avoid “going Iceland?”




 The Wall Street Journal

The Making Of a Meltdown

The sage of Iceland's boom and bust.

AUGUST 18, 2009, 7:23 P.M. ET


It is an odd question but a fitting one: Why Iceland? It's boom-to-bust saga—one of the wilder stories of the Great Financial Crash of 2008—is almost as dramatic as a tale from Norse mythology.

To help liberalize its financial sector, Iceland ­privatized its largest banks roughly six years ago and then allowed them to go on a leveraged-buyout spree across ­Scandinavia and Britain. When Iceland's central bank raised interest rates, the country became an ­epicenter of the carry trade, in which money managers borrow from one country with a low interest rate and place deposits in a country with a higher one. The ­purchasing-power effects were extraordinary. In the span of three years, Iceland's per-capita income tripled, and its stock market capitalization increased by a ­factor of eight.

Then the credit bubble burst. ­Iceland's overvalued ­currency plummeted, and there was a run on the country's banks. As bad as the ­crisis was in the U.S., in Iceland it was worse. By ­October 2008, the financial sector had racked up debts equivalent to eight times the country's gross ­domestic product. The government had no choice but to seek financing from the International Monetary Fund.

Meanwhile, Iceland's politicians seemed almost ­clueless. After a weekend in October 2008 when the entire economy seemed ready to implode, Prime ­Minister Geir Haarde held a press conference at which he made anodyne, soothing comments, trying to ­reassure reporters that all was well. When it became clear that his claims were anything but persuasive, he responded by explaining: "I haven't really had a decent breakfast yet." It will not surprise anyone that the ­governor of Iceland's central bank during the ­crisis—with the strangely appropriate name of David Oddsson—was trained in poetry rather than finance.

After a particularly disastrous phone call between the British and Icelandic finance ministers, also in ­October, Britain decided to take over the U.K. ­operations of one Icelandic bank by invoking, for ­expediency, an antiterrorism law. By doing so, it put Iceland—the country with the best performance on the United Nations 2008 Human Development Index—in a category with the likes of North Korea and Burma.

All of this is excellent material for a narrative rich with mayhem, misjudgment and moral lessons—and even some farce. As the chief economist at Kaupthing, the biggest bank in Iceland before the meltdown, ­Ásgeir Jónsson was certainly well placed to tell the ­inside story of exactly what happened. Unfortunately, he doesn't offer much that is new in "Why Iceland?"

Long stretches of Mr. Jónsson's story read like ­summaries of investment-analyst reports and news transcripts. He provides vignettes from Kaupthing, but they are not especially piquant: "Work and fun were to be synonyms at Kaupthing, and workmates became best friends. Being a spouse to a Kaupthing employee was also a testing role at times. Not only were the ­employees expected to turn in long hours of work but the bank would also encourage all kinds of extracurricular activities." The only insider-like anecdote is the ­description of a January 2008 trip to Reykjavik by four American hedge-fund managers. During a night of drunken revelry, they were overheard claiming that they intended to short Icelandic assets. But the night's events were widely reported in the financial press soon after they occurred. The closest Mr. Jónsson comes to a fresh insight is his observation that the vicissitudes of Iceland's fishing sector—over the course of ­centuries—had left Icelanders well prepared to ­navigate the turbulence of financial markets.

Mr. Jónsson often likens Iceland to America, even observing at one point that "the Icelandic dream is similar in character to the American dream." The ­differences are many, however. Although blessed with sound fundamentals, Iceland's size—its population (320,000) is roughly equivalent to Cincinnati's—helps to make its economy more volatile than America's, and its ­financial liberalization included greater risks. Kaupthing alone held a book value equal to 2½ times Iceland's GDP—thus the country's central bank did not have the capacity to act as a credible lender of last ­resort in the way the Federal Reserve did in the U.S. By the peak of the bubble, 85% of Iceland's equivalent of the Dow Jones Industrial Average came from the ­financial sector alone. Mr. Jónsson eventually ­acknowledges that "Iceland's bubble had its own way of doing things."

Later, Mr. Jónsson advances a "canary in the coal mine" argument, saying that Iceland is a harbinger of bigger countries being brought low. But, again, the country's size and the incompetence of its political leadership—watching obliviously as things grew out of control and then fell apart—made it especially ­vulnerable to global shocks. It is telling that, by the end of 2008, Iceland was the only country in Western Europe that failed to secure a currency swap line from the U.S. Federal Reserve, guaranteeing official access to hard currency. What happened in Iceland will probably stay in Iceland.

The greatest value of "Why Iceland?" is the window it may open on the country's mind-set. Mr. Jónsson ­devotes page after page to the international culprits that allegedly helped to scupper the economy. In one chapter it is hedge funds. In another, rating agencies, aiming their malice at Iceland in ­particular. Finally, it is a cabal of central bankers who, it is claimed, froze Iceland out of the help they could offer and forced it into the arms of the IMF. None of this is convincing. In the end, Icelanders who want to find someone to blame for their woes may want to look at themselves.

Mr. Drezner is professor of international politics at the Fletcher School at Tufts University.



The day after the review was published in WSJ Mr. Drezners put the following log into his blog page



Iceland redux

Wed, 08/19/2009 - 12:54pm

I have a book review in today's Wall Street Journal of Why Iceland? by Ásgeir Jónsson.  The closing paragraph: 

The greatest value of "Why Iceland?" is the window it may open on the country's mind-set. Mr. Jónsson ­devotes page after page to the international culprits that allegedly helped to scupper the economy. In one chapter it is hedge funds. In another, rating agencies, aiming their malice at Iceland in ­particular. Finally, it is a cabal of central bankers who, it is claimed, froze Iceland out of the help they could offer and forced it into the arms of the IMF. None of this is convincing. In the end, Icelanders who want to find someone to blame for their woes may want to look at themselves.

That's a bit harsher than I intended -- Iceland is not solely responsible for theire predicament.  Still, the lack of self-reflection about what happened is quite extraordinary. 

I'm not a big fan of this book, but a great book on this case is dying to be written. 


The geothermal superpower strikes back!

Thu, 08/20/2009 - 2:15pm

OK, so by my calculations, your humble blogger has heard from at least .001% of the Icelandic population in response to my latest book review.  By an eerie -- and not conspiratorial!! -- coincidence -- they have been unable to post responses using FP's f***ed-up somewhat dysfunctional comment software.  Sooo... as a special courtesy to Icelandic Friends of Drezner's Blog (IFDB), here are the responses: 

1) From Petur Henry Peterson: 

You seem, rather naively, to think that this book was written by the Nation of Iceland. You would be better to "follow the money" and realize that its author is one of the people hired and payed handsomely,  for what at the best, appears to be to deceive and manipulate Icelanders about the real state of their banking system. Is he going to identify himself and his friends as the culprits, I dont think so. Strangely, the people who were the best and the brightest, now claim to have been totally clueless
(well some of them were and still are ;).

Most Icelanders realize all too well the cause of the meltdown in lax regulations and cronyisms between right wing politicians (and their supporters, the farmers party) and the financial sector, plus a dash or two of nepotism, stupidity, greed, lack of active democracy and a national minority complex.

I think that's supposed to be "inferiority complex" rather than "minority complex," but you get the idea. 

2)  This one comes from Audur Ingolfsdottir:

I have not read the book myself, and thus have no comments on your analysis on the book itself. However, I must agree with your own second thoughts, on if the last part of the review is perhaps a bit harsh. Not so much because I think Icelanders should not look within to find explanations for the crash last October, but rather you assumption, after having read a book by a single individual, that his analysis are reflective of the "country´s mindset".

The Icelandic public went out to streets, outraged, pounding their pots and pans, which resulted in the government resigning and early elections were called. The director of the financial serveillance authority resigned after huge public pressure. The central bank managers were forced to leave theirs seats, also after great pressure by the public. Hardly any of the people that were in power during and before the collapse are still holding their positions.

Currently the government is going through the very painful process of cutting down costs in the public sector. At the same time, considerable amount of money is being spent in order to investigate the banks, and what went wrong.

So I would say that although there were of course some strong international forces influencing the chain of events, most Icelanders are acutely aware of that a number of things went wrong in our own country, and a lot of work is aheaad to clean up the mess. 

These are fair comments, and it would certainly be unfair to say that Jonsson's worldview represents all Icelanders.

That said, I'm not the only one who's picked up on this meme.  Both Michael Lewis and Ian Parker sussed out the same vibe when they visited Reykjavik -- and it comes out a little bit in the newest Icelandic PM's recent public statements.  Furthermore, the Financial Times recently noted that, "Iceland has a tendency to imagine a British or Dutch conspiracy behind any bad news." 

The problem with this kind of label is that it's hard to shake, so maybe this is dogpiling on a small country.  I'll merely point out, with respect, that this statement in my book review was not based only on Jonsson's book -- rather, it is emblematic of everything I have read to date about Iceland. 




Business Books: Economist answers question 'Why Iceland?'

Thu Aug 13, 2009 8:40am EDT


By Jack Reerink

NEW YORK, Aug 13 (Reuters) - Brashness, self-assurance and an entrepreneurial spirit -- those traits transformed Iceland from a tiny fishing nation into an outsized investment fund that blew up and briefly became the epicenter of the global financial crisis.

Asgeir Jonsson, chief economist of top bank Icelandic bank Kaupthing, details what happened in "Why Iceland?" (McGraw-Hill, $22.95), a very readable account that explains the financial engineering that led to Iceland's boom and bust.

Iceland, an island the size of Kentucky with 300,000 people, laid the groundwork for its financial miracle in the 1990s, when the government enacted reforms like tax cuts, a flexible labor market and privatizations.

Cheap money abroad helped do the rest, as did top-notch credit ratings, hedge funds' appetite for Iceland's high-yielding krona currency, an ever-rising stock market and flamboyant entrepreneurs like Jon Asgeir Johannesson, who installed a 10-foot Viking statue with a sword and electric guitar at his London office.

Banks and entrepreneurs went on shopping sprees and created an ever-wider net of companies that bought stakes in each other at ever-higher prices. In the end, the nation itself had become a highly leveraged fund that borrowed foreign money to buy stuff at inflated prices.


A warning signal came with the "Geyser crisis," named after the Iceland hot spring known for its violent eruptions.

Hedge funds had long borrowed cheap Japanese yen to invest in high-yielding currencies like the krona. They reversed this so-called carry trade in early 2006 when it became clear the krona had become overvalued.

A joint intervention by the central bank and private banks beat back the attack on the krona, and Iceland again went on its merry way. With regulators and politicians asleep at the wheel, the confidence of Iceland's entrepreneurs turned to arrogance.

Where was Jonsson in all this? Did he see and warn of the coming crisis? The book doesn't say.

"In hindsight, one can easily see I was too naive," Jonsson told Reuters, adding that he did not appreciate how cross-shareholdings had created a house of cards. "Our main problem was over-ambition, wanting to be too big for a nation so small." 


The house came crashing down in 2008, after the fateful weekend of Lehman Brothers' bankruptcy. Banks shut off the island's credit lines; the UK confiscated Icelandic Internet savings accounts using anti-terrorist laws; and the government let its three main banks go bust and appealed -- in vain -- for Russian financial aid.

A former assistant professor of finance, Jonsson describes the sequence of events well, but provides almost none of the behind-the-scenes drama.

He does have plenty to offer: He was head-hunted from academia by Kaupthing's CEO, a university buddy, to become "the only guy in the bank with a beard," he said in the interview. His own father, now minister of fisheries and agriculture, agitated against "corporate greed" during the boom years.

Jonsson says he left out his personal experiences to follow Iceland's tradition of writing history in a fair and detached way.

So when the crisis peaked in early October and Iceland's leadership was holed up in a historical government villa for days, Jonsson doesn't take us to the negotiating table.

He does summarize the government's paralysis brilliantly when he recounts former Prime Minister Geir Haarde's press statement after days of deliberations: "'I haven't really had a decent breakfast yet,' he claimed, delivering an anti-climax for the ages."

The only personal anecdote involves partying with a group of increasingly boisterous U.S. hedge fund managers in Reykjavik's trendy 101 Hotel in early 2008. One of them -- "Joe," who looks like a New York City cop -- sounds a prescient warning: Iceland will "be the place for the second coming of Christ, a new financial Armageddon."

That story pretty much ends there, and the book returns to Jonsson's usual sources of information: research reports, economic stats, official documents and press clippings. (Editing by Lisa Von Ahn)









August 2, 2009


Delhi Noir

edited by Hirsh Sawhney (Akashic)

Chaos is a word that aptly describes India's capital city. With more than 15 milion people, how could it be any other way? This of course, makes it fertile ground for another in the "Noir" series, which began with Brooklyn in 2004. Among the characters we're introduced to in the 14 original stories are a young con artist who works the bus station, thieves who target a yuppie drug addict and various other scammers, cops and crazies.

The Slippery Year

by Melanie Gideon (Knopf) A lot of bad things happen to a lot of people -- when they're growing up or when they've grown up. And lately, a lot of those stories end up as memoirs. But not for San Francisco mom and wife Melanie Gideon. Her memoir is based on a good life, not bad. It's subtitled "A Meditation on Happily Ever After," but don't let that scare you away. She raises questions of regular life as an adult, what some think of as middle-age malaise, many can identify with. And she writes with wit, too.

Why Iceland? How One of the World's Smallest Countries Became the Meltdown's Biggest Casualty

by Asgeir Jonsson (McGraw-Hill)

Fearsome Vikings discovered Iceland. Hedge funds knocked it down. It was a humiliating tumble for the former financial powerhouse, which was proud of its status in Europe. A late bloomer, Iceland had been the last country in Europe to be settled, the Nordic nation rapidly caught up with its wealthier relations. It was all fine until October 2008, when country's banking system collapsed in a week. Written by an Icelandic economist, "Why Iceland" chronicles the meltdown, in the context of the nation's history.

King of Heists

by J. North Conway (Lyons Press)

On an October day in 1878, thieves broke into the Manhattan Savings Institution, a formidable fortress of a building at Bleecker and Broadway, and made off with nearly $3 million -- that's something like $50 million(!) in today's dollars. Three years in the planning, the heist was masterminded by George L. Leslie, an architect and ladies' man who led a double life. Conway, a college prof and ex-newspaperman, follows this Guilded Age tale in a way that makes it a hot news story even though it happened more than a century ago.

Long Story Bit by Bit: Liberia Retold

by Tim Hetherington (Umbrage)

From 1989 on, Liberia, founded by freed American slaves, was wracked by civil war. Three presidents in a row left office, let's just say not by losing an election. Photographer/filmmaker Hetherington spent more than four years in Liberia, at one time one of only two journalists living behind rebel lines. The result is a collection of vivid photos, oral histories and personal observations which, together, create a picture of a country many of us know little about.