Iceland Loses Its Banks, Finds Its Wealth

Ultima Thule learns that small is beautiful.


The most important question about Iceland these days (after "How come Iceland is green and Greenland is icy?") is what we can learn from its economic recovery. In 2008, the tiny island nation in the North Atlantic became a byword for both boom-time excess and recessionary disaster. After inflating its financial service sector with a pile of foreign-currency debt and risky combinations of short-term debt instruments with long-term loans, Iceland, which is not a member of the European Union, endured one of the most unpleasant recessions in recent memory.

The country's three largest banks, whose total assets were 11 times larger than Iceland's GDP, proved too big to fail and then too big to rescue, bankrupting the central bank that took them over and leaving foreign creditors empty-handed. Inflation in the import-heavy economy reached 18 percent, while the stock market plunged by 90 percent. Between 2007 and 2009, according to the World Bank, GDP dropped by 40 percent. The Icelandic króna turned into a pariah currency, and even the country's durable fishing and aluminum businesses were crippled by heavy leverage. 

A collapse of this size needs a villain, and it will surprise nobody to learn that libertarians, who exert an iron grip on political and economic practice throughout the world, took the blame. In a 2008 story for Fortune, Peter Gumble blamed deregulation and putatively free market reforms for destroying the banking system. New York Times economic poetaster Paul Krugman said the small nation had been "hijacked by a combination of free-market ideology and crony capitalism." Huffington Post columnist Iris Erlingsdottir blamed the late Milton Friedman (who had once praised 10th-century Iceland's approach to government) for failing to "take into account the predictably irrational character of human nature," and concluded, "It is time for the grownups to take over again."

As always, we had to look to the legendary Icelandic songstress Björk for real wisdom. In a London Times essay blasting the country's ruling conservatives, Björk lamented the way the boom/bust cycle had wiped out small entrepreneurs as big money pursued an oversupply of aluminum smelters—which was not an excrescence of the free market but a product of public industrial policy. Former Reykjavik mayor and Prime Minister Davíð Oddsson did indeed pepper his tenure as head of Iceland's central bank with free market rhetoric. But that's about as far as it went. In their new study of the crisis, Deep Freeze: Iceland's Economic Collapse, economists Philipp Bagus and David Howden illustrate how thoroughly Iceland's financial boom combined a Scandinavian nanny state—which consumes 41.1 percent of GDP and features unemployment insurance that provides three years of benefits—with the worst practices of boom-happy central bankers and government agencies everywhere.

For every government-driven bad improvement you can find in the west, you'll find boom-era Iceland taking it to the next level. Where the U.S. Federal Reserve's promise to backstop financial institutions was merely implicit, the Central Bank of Iceland in 2001 gave an explicit guarantee to big banks, making it inevitable that they would become bloated with risky and ultimately toxic assets. Our own government-sponsored—and as of 2008, government-owned—entities Fannie Mae and Freddie Mac made a hash of responsible lending by buying mortgages in the secondary market (and as we now know, lying about the poor quality of debt on their books). But Iceland's government-run Housing Financing Fund managed to do even worse, lending directly to borrowers and competing with private lenders on both interest rates and loan quality. By mid-decade 90 percent of Icelandic households had government loans, and no-money-down home purchases were as common in Iceland as they were in Florida. 

When the predictable emergency hit, neither the government nor the private financial institutions had cash to redeem the large number of foreign-denominated loans. While the International Monetary Fund eventually cobbled together a small bailout package, for the most part Iceland was alone. U.K. Prime Minister Gordon Brown invoked anti-terrorism legislation against the charter member of NATO, trying to force Icelandic banks to repay British lenders. Russia promised a bailout but failed to deliver. The E.U. was, and remains, too preoccupied with its own profligate states to give attention to remote Iceland.

This international neglect turned out to be Iceland's saving grace. The  crisis ended almost as quickly as it had begun. The Organization for Economic Co-operation and Development expects Iceland's economy to grow by 2 percent this year and next. That's not enough to replace the post-2007 loss, but it's more than enough to return to the pre-boom trend line, and it's much stronger than the performance of Portugal, Italy, Ireland, Greece, and Spain, affectionately know as the PIIGS economies. Iceland's long-term interest rate, a not-inconsiderable 8 percent, compares well with a rate of over 13 percent for Greece, which is astounding when you consider that Iceland endured a default that Greece, in name at least, has so far avoided. The difference in unemployment—5.8 percent for Iceland against 16 percent for Greece—is even more striking. Iceland expects to have a balanced budget in 2013.

Paul Krugman naturally draws the wrong conclusion, contending that Iceland saved itself through rapid inflation and capital controls. This is like saying the March tsunami gave the people of Tohoku a nice chance to go swimming: Iceland's central bank tried desperately to control the króna's collapse before giving up. Nevertheless, Erlingsdottir is right: The "grownups"—a center-left coalition led by Social Democrat Johanna Sigurdardottir—are back in charge and have done their best to double down on the bad policies of the past, including reducing fish quotas when local fishermen most need to be producing and selling. The government is also, in the face of strong popular opposition, moving toward E.U. membership, which has worked out so beautifully for other troubled European economies.

So what's causing the recovery? The plain-sight answer is the one nobody will consider. Iceland is coming back specifically because its banks went out of business. That happened in spite of strenuous public efforts, but the removal of the tiny nation's colossally bloated financial sector turns out not to have eliminated all that much value. 

It bears repeating that banks are not creators of wealth. They are places where you store the surplus value generated by productive enterprise. In very narrow circumstances that surplus value can be loaned out at a profit, but a financial sector is the icing, not the cake. This should be common sense, but apparently it is wisdom so rare it can only be learned in countries small and remote enough to avoid the deadly medicine of the global financial markets. 

Tim Cavanaugh is a senior editor at reason.