What's the lesson of Iceland's collapse?

Q: How did Iceland get to this point?
Iceland has, certainly for the last half of the 20th century, been in most respects successful economically. It had a GDP per capita that was on a par with the rest of Scandinavia, maybe in the top 20 in the world, though its economy was somewhat different, because it was resource-based to a larger degree — both fisheries and energy-intensive industries.

Despite having this fairly successful economy, Iceland never had a very well developed banking sector. The banking sector was almost purely local. It was to a large extent government owned and somewhat politicized. It was fairly costly, but it was sound in the sense that it wasn’t very adventurous. They weren’t taking any great risks. They weren’t highly leveraged, and they were basically serving the needs of the economy.

We didn’t really have a stock market until about 20 years ago. We also had, historically, problems with monetary policy. The currency was unstable. Both the exchange rate and inflation were problems, so it was very much an underdeveloped financial sector, whether you looked at the monetary side or the banking side.

And then things started to change. The change started in the early ’90s, when Iceland joined what is called the European Economic Area, which basically means that Iceland is part of the European Union’s common market, including for finance, without being a member of the European Union. This meant that Icelandic banks could operate anywhere they wanted in Europe, and the currency was convertible, which it hadn’t been before. So, basically, we had a financial sector that all of a sudden was open to business all over Europe.

But this didn’t have much of an effect initially, because the banks were still more or less government owned and run, and they weren’t very adventurous.

Then, between 1998 and 2002, the picture changed dramatically when the banks were privatized. And they were basically privatized without putting in place any sort of controls beyond what was the practice in Western Europe at the time, so they were given free rein. There was, of course, a financial supervisory authority and the Central Bank had a role in insuring systemic stability and liquidity, but there were no controls put in place that took into account the fact that this was a very small economy that didn’t have the resources to back up great international expansion of the banking sector.

The people who bought the banks turned out to be not quite the kind of people you would want to run banks because they were fairly aggressive and risk-loving. They very quickly changed the strategy of the banks completely and went into very rapid expansion abroad, particularly in Europe, mainly the U.K., Scandinavia, and Luxembourg. They added branches and they bought small financial institutions and made them grow very rapidly. The growth was financed by foreign borrowing because they had very little access to domestic savings. Domestic savings have never been great in Iceland. The banks were financing themselves by selling bonds in the European markets and to a small extent in other markets, and they also had easy access to interbank loans, so funds were freely available and they actually got very good terms.

They went from having a combined size of about one year’s GDP to close to ten years’ GDP in a period of seven or eight years, so it was phenomenal growth. And on paper, this seemed like it was working great. They were showing great profit. They were hiring people left and right. They basically hired the best and brightest in Iceland. But one of the problems was that, because of the history of the Iceland banking sector, Iceland didn’t really have much human capital with a serious banking background. They were basically hiring people right out of school.

But the banks still seemed to work wonders, and the flow of funds into the country meant that asset prices in Iceland rose, Icelandic companies had easy access to funds and they also expanded. Companies based in Iceland were buying retail chains in London or Copenhagen and they were setting up all sorts of investments. The companies were showing great profits, but the profits usually came from some sort of asset manipulation rather than operating profits, so it was very much bubble-induced profits.

Still everything seemed rosy until about 2006, when people both within Iceland and abroad started questioning the viability of this model and pointed out the weaknesses, one of them being that you had a banking system that was by then predominantly operating in foreign currency — euros, British pounds, and various other currencies — but had a lender of last resort which didn’t have great reserves in those currencies. The Icelandic Central Bank, of course, was able to provide local currency but it didn’t have any real back-up from, for example, the Bank of England or the European Central Bank, which could have provided funds in pounds or euros or other needed currencies.

People also started pointing out that asset prices had become somewhat suspect, and that this was becoming unstable. It became gradually harder for the Icelandic banks to raise cash in the interbank market or the bond market, and at the same time, the global financial markets were overall becoming tighter. So it was not just the Icelandic banks that were feeling the squeeze, but they felt the squeeze harder than most.

Then two of Iceland’s main banks — we basically had three banks that were involved in this expansion and accounted for about 85% of the banking system — found a way to solve their liquidity problems. Their solution was to start attracting deposits abroad and they used their branches or subsidiaries in Europe to attract internet deposits, and did that with astounding success, at least temporarily. They attracted billions of pounds or euros over a period of a year or two.

But the problem with that sort of deposit is that it can basically leave overnight. If you have a deposit base that’s based on a long-term relationship with a customer, you’re not likely to see a run from those customers. But if you attract Internet deposits from people or institutions that you really don’t have any sort of banking relationship with, they’re obviously very liquid. This was somewhat alarming, that they were basing their financing to such a large extent on very liquid deposits.

Another very alarming fact, certainly from the viewpoint of the Icelandic government, was that a lot of these deposits fell under Iceland’s deposit insurance scheme. There is a fairly complicated arrangement in Europe dealing with how deposit insurance is paid out, but the deposits that were accepted in foreign branches of Icelandic banks were to a large extent covered by Iceland’s deposit insurance scheme. That made no sense at all, because the Icelandic government or the Central Bank really didn’t have the resources to back up that deposit insurance scheme. At one point, one of the banks had something like the equivalent of 40% of GDP in deposits covered by deposit insurance, so it was a ridiculous situation by any measure.

Q: Was there any regulatory oversight at this point in 2006?
All the regulation was in place, but it was European regulation that originated in Brussels and didn’t take into account the specifics of the Icelandic situation, which was that you had a very small country backing up a very large banking system.

But this seemed to work for a while, and the banks didn’t do what they might have been able to do at the time, which is to start to scale down and reduce the size of the problem. This would have been a very reasonable response to the fact that people were criticizing the viability of the business model and questioning the ability of the Icelandic government to back it up. But they didn’t do that.

They kept on growing, even if it was fairly obvious that this was very unstable. You had highly leveraged banks dependent on short-term financing, you had an asset bubble, and you had no lender of last resort, so this was a recipe for disaster. And that’s what happened.

Over a period of a little over a year, first the stock market started to slide, then the exchange rate started to slide. Asset prices, including real estate, started falling. When that happened, everything unraveled quite quickly.

A lot of the banks’ customers had actually been very leveraged themselves. Many of them had borrowed in foreign currency but had no foreign currency earnings. They had Icelandic assets but liabilities in yen or Swiss francs or other low-interest rate currencies, and with a fall in the exchange rates they very quickly got into trouble. And with the fall of the stock market, a lot of people that invested in stocks and borrowed to finance that found themselves in problems very quickly. They got margin calls and that made the whole thing go even faster downwards.

It took about 14 months from the start of the fall in the stock market and the exchange rate until the whole banking system collapsed, which was in October 2008. That’s basically how we got into this mess.

Q: What attracted the capital to fund the banks’ expansion?
It was mainly two points: One was that interest rates in Iceland were fairly high and that attracted funds through the carry trade. People were borrowing in yen or Swiss francs and buying assets in krona and trying to gain from the interest rate differential, and that basically sucked foreign funds into the country.

Another point was that the banks pointed to the fact that they were all systemically important banks, basically too big to fail, and they used that to get the rating agencies to give them a very good rating. They said, here we have a bank that obviously has sovereign backing because it’s too big to fail, this is a Western country with all the right regulations, and so it should be perfectly safe to lend to us. At one point, all three major Icelandic banks had AAA ratings, which was ridiculous.

Perhaps the governmental or the Central Bank should have done something to actually stop this from happening, but then they would have had to say publicly that the banks were on their own. The government did exactly the opposite. The politicians at the time said that worries about the stability of Iceland’s banking system were unfounded. They were sending out signals that were meant to help the banks, but that also meant that the banks could grow more and faster.

But anybody who just looked at GDP and currency reserves should have figured out that this didn’t work. You couldn’t have a banking system that was ten times GDP and a Central Bank with reserves that were maybe two percent of the liabilities of the banks. That whole equation didn’t compute.

Q: Do you think that if the government had made those public statements in 2006 things would have just unraveled quicker?
That would probably have happened. In retrospect, that would actually have been good. It would have been less damaging if things had collapsed before they got even bigger, but it was politically unthinkable to take down the banks in 2006. They really should have said this in 2002 or 2001, before the banks actually started growing. After they had grown, it was basically too late. So the government kept on supporting them, hoping that they would get through the troubles, but the problems just got bigger.

Q: One argument I’ve read is that because Iceland had its own currency, investors were taking advantage of an anomaly in international markets. In other words, you were partly globalized. Is that an accurate characterization?
I think there’s definitely some truth to that. The fact that Iceland had, and still has, its own currency allowed it to play a different game than, for example, countries in the euro zone. So Iceland could have higher interest rates. But that was not part of the government’s plan. The Central Bank was trying to fight inflation with high interest rates. It was not trying to attract capital, but that’s what happened.

But having the krona, not the euro, is also very important for the collapse for at least three reasons: One reason is that because we didn’t have the euro, we didn’t have access to the European Central Bank to provide liquidity. It was also possible that the krona could depreciate very quickly. That really contributed to the fall and made the consequences of the collapse, at least in the short run, much deeper, because we had all this foreign-denominated debt which basically doubled overnight when the currency collapsed, causing all sorts of trouble for companies and households.

But the third effect of having our own currency was actually beneficial, and that is that after the crash, we basically have very competitive export industries and imports have collapsed. So Iceland went from having a very substantial trade deficit, which was one of the problems of the past, to running a trade surplus, as early as November last year.

Q: Could you elaborate on why Iceland has chosen not to become part of the euro zone?
As part of the European Economic Area, Iceland gets probably 90% of the economic benefits of being an EU member. We have free trade, a free flow of capital, free flow of labor, and we have to have more or less the same regulations on all things commercial as the European Union. That used to be more or less what we wanted.

What was very important for Iceland was that we kept sovereignty over our natural resources, in particular the fishing grounds. If we become a full-fledged member of the European Union we have to adopt the European Union’s common fisheries policy, which basically makes various major decisions on fisheries policy in Brussels. For most Western European countries, fisheries are a side issue, so having a common fisheries policy is not a big deal, but for Iceland it’s a very big deal because fisheries have contributed something like 30% to 40% of export revenues, maybe 10% of GDP. The people involved in the fisheries industry don’t want Spanish or British vessels fishing in Icelandic waters.

But the question of whether we want to join or not has come up again in the last few months principally because of the currency. People see adopting the euro as the most logical way to restore order in the financial system and restore confidence in the financial system. But the euro is nevertheless not a short-term fix for anything; it’s more of a long-term goal.

Q: Is there a way to adopt the euro without actually being a full-blown member of the EU?
Theoretically, I guess Iceland could unilaterally adopt the euro but I think that would be disastrous because it would mean that we had a currency without the implicit or explicit support of the Central Bank issuing it.

Q: Did the privatization of the banks come about because of a change in government to one with a center-right ideology?
There wasn’t a change of government, per se, because we had the same party. We’ve always had coalition governments, but the same party had been a majority member of the coalition from 1991 until the current government took power in February. But there was an ideological shift within the political arena, and it was very much in favor of deregulation and privatization, and probably influenced by what had happened with Ronald Reagan and Margaret Thatcher.

To some extent we imported much of this from the European Union, because after we joined the European Economic Area we imported all our regulation for finance and commerce from the European Union.

Q: How big a factor was consumer behavior in the development of the bubble, compared to institutional behavior?
Consumers certainly got caught up in all this. You can see something similar in the U.S. and several other countries. On paper their wealth was going up quite dramatically. Some of them were invested in stocks and the stock market was booming. Even if they were not invested in stocks, you had the real estate market booming. So all of a sudden, they had, on paper, a lot of equity and they used that to increase their consumption. They would take out a second mortgage and buy an SUV or they would buy a home abroad.

This obviously contributed to several things. It contributed to the overheating of the economy, to increasing the exchange rate, and to the trade deficit. It meant that local savings were even less than they had been before, so consumer behavior certainly contributed to the problems.

Just to take one example, the import of cars, especially fairly expensive cars, just went through the roof. At one point, Iceland was importing more Range Rovers than the rest of Scandinavia, which is 100 times as large a market. People were caught up in the euphoria and feeling very rich and using it to finance that sort of expenditure. Now nobody wants to be seen in one of those Range Rovers because they’re considered part of the bubble economy that burst.

Q: Compared to actions taken by the banks, was that a significant factor? Or does it all twine together?
It all twines together. The banks, to some extent, are responsible for the consumer behavior because the banks were marketing credit very aggressively to consumers, which helped the consumers take on more debt, often in foreign currencies. This was very different from the old banking system, which had always been very conservative in lending. You had to wait in line to get a loan.

Q: How big was the banking sector as part of the stock market in Iceland?
Before the market started declining, financial companies were probably between 80% and 90% of the stock market. At its height, the market cap of all the companies in the stock market was something like two times GDP. This is not really out of line with what you see in other countries. But that has now all basically been wiped out. The stock market has come down by nearly 96%. So, on paper, two times GDP vanished.

Q: There’s so much in the story of what happened in Iceland that sounds very similar to what’s happened in the U.S., in terms of the growth of the financial industry and lending behavior. What’s been different in Iceland?
I think you’re right that a lot of the developments were similar — for example, a real estate boom and consumer debt growing — in the U.S. and some countries in Western Europe.

The main problems in Iceland were that the scale of it relative to the size of the country or the economy was considerably worse than it was in most other countries, and the fact that we were doing this with our own currency but borrowing mainly in foreign currencies, which made the consequences of the collapse so much harder. You can see something similar in several countries in Eastern Europe. People were taking out loans in, for example, Swiss francs to finance houses in Warsaw or Latvia.

Q: Does this story say that there are real differences between small country economics and the larger players, that borders do matter in this regard?
I think they do. In particular, if you look at the role of the government as a back-up to the economy and in particular the financial sector, size obviously matters a lot. A small country could easily have a fairly large financial sector, but they must then structure it so that troubles in the financial sector do not automatically cause troubles for the government’s balance sheet and that means no implicit or explicit promise of government support in times of crisis.

The fundamental mistake in Iceland was having the government pretending it was a lender of last resort and providing deposit insurance. That was a fundamental mistake for a country of this size with a banking sector that was this big.

Q: Did the global downturn and tightening in credit markets make it that much more difficult for the country to get out of it?
That was a fundamental factor in the downfall or at least in the timing. I think that the Iceland system was so unstable that it would have collapsed eventually, even if the global markets had been relatively calm. But trying to stop a downward spiral in Iceland with global conditions really bad was probably next to impossible.

In 2007 and 2008, you basically couldn’t get rid of financial assets. Nobody wanted to take them on. A strategy of selling off the assets and maybe actually moving the banks abroad was one thing that was contemplated. Those strategies weren’t viable in 2007, because everybody had their own problems and had no interest in taking on troubled Icelandic assets. If you had tried to scale down the financial sector, you would have had to sell assets at prices that were so low that it would have been obvious that it would have ended in bankruptcy. People weren’t willing to do that. They thought they would weather the storm, try to gather liquidity any way they could, including by attracting deposits, and hope that conditions would improve and they could survive.

Q: With the connectivity of global markets, what happens in one market necessarily has ripple effects throughout the world. Does that present a challenge?
That’s a big part of the problem. It basically means that local solutions are unlikely to work. If you take the solution for Iceland, it involves a severe contraction in domestic demand, cutbacks in government expenditures, raising taxes, cleaning up balance sheets, and then starting fresh with real assets that fortunately have survived. But that strategy does not work if too many countries do it, because they will cause immense troubles for their neighbors. Iceland not importing any cars may make perfect sense for Iceland, but if everybody does that, it’s terrible for manufacturing worldwide.

So that local solution, even if it’s the only solution Iceland has and therefore logical, is not a viable approach to the global situation. To solve the global situation, you basically have to take into account the fact that troubles in the financial sector in one country have very obvious ripple effects in the neighboring countries.

To solve it — if you don’t want to do it the Icelandic way by having everything collapse — the only solution is to have international cooperation where countries with strong reserve currencies like the euro or the dollar, maybe the yen, provide liquidity to the rest of the world. Even countries that are relatively large that have their own currency, like Britain, might not be big enough to survive without help from the European Central Bank or the Federal Reserve. Having your own currency, even if it’s not nearly as weak as the Icelandic krona, is seen as a liability. And if you need liquidity in a reserve currency like the dollar or the euro, you can’t get it unless the Federal Reserve or the European Central Bank are helping you.

Q: Can you give us a picture of what the collapse of the financial sector has meant in Iceland for industry and people’s lives?
It had a profound effect. The destruction of financial assets is on a scale you’ve never seen before relative to the size of the economy. Most financial assets are seriously troubled — stocks and even bonds. Many borrowers are having trouble servicing their debt. So the balance sheets of companies and households look fairly bleak.

But if we look at the real economy — using the Main Street/Wall Street split that you often use here — it has been affected but not nearly as much as you might expect.

Most of Iceland’s companies, even if their finances are not that healthy, are still operating. The export industries are actually not in much trouble. Some of them are doing better than before, because of the fall of the currency.

But there do have to be very substantial adjustments in the real economy. One obvious example is that the financial sector has shrunk considerably and laid off a lot of people. Construction has also been reduced considerably, so a lot of people have lost jobs there. With consumption generally falling, all sorts of services are being cut. If you were importing cars before, you’re probably doing something else now.

The adjustments are happening and faster than you would have thought possible. One example is that we’ve already started increasing exports and reducing imports. It was a very necessary development given that we have foreign debt.

We have indications of new industries coming up that before were not viable because the cost of doing business in Iceland was so high due to the strength of currency.

Q: What industries are those?
One, which is not at a big scale but is growing, is health services. Iceland has a very good health system that’s fairly cost efficient. But it hasn’t been viable as an export industry before because the krona was so strong. But with the fall of the krona, Iceland now can offer, for example, elective surgery, eye surgery, or breast enhancement, with Western quality, at fairly reasonable prices. They’re not competing with India or Thailand, but it’s very competitive within Western Europe.

Other industries that were in the pipeline before the collapse are being helped by what happened. One example is server farms — huge computing centers that need a lot of electricity. Iceland is a very good source of cost-effective and green energy, that is electricity that is not generated by burning fossil fuels but rather by hydropower or geothermal power. These industries see nothing but benefits from the collapse, because now local costs are lower and the real resources that they are using haven’t been harmed at all.

Q: In addition to these industries developing, what do you see as the way to rebuild the Icelandic economy?
The way out involves several pillars. One pillar is that we need to reestablish our financial sector and clean up the mess left by the collapse of the old financial sector. Work on that is ongoing and some of it is actually happening quite quickly. For example, Iceland set up, basically overnight, a new banking system. We’re using this good bank-bad bank model, where we set up good banks that are much smaller than the old banks. They take over mainly untroubled domestic assets and liabilities like deposits, along with the infrastructure of the old banks: the branches, computer systems, and those sorts of things. That leaves the bad banks with more or less all the foreign assets. The bad banks are technically bankrupt, but they are kept alive to be unwound in an orderly fashion.

The good banks serve as Iceland’s new banking system. We managed to have a functioning banking system more or less without interruption, so that domestic payment systems, for example, never stopped; international payments were somewhat troubled for a few weeks, but they’re now up and running.

A functioning banking system is necessary not just to keep the day-to-day operations of the economy going but also because it plays a vital role in the reorganization of the corporate sector. Companies have to go through financial reorganization. Some of them have to be sold. Others have to be provided with new equity and debts have to be written down. Having scores of companies just go bankrupt and stop operating is not a good option, so they somehow have to be financially reorganized without operations stopping.

Another pillar is that the government has to adjust to the fact that it has taken on a lot of debt, the tax base has been eroded, and there are calls for government expenditure for all sorts of things, like unemployment insurance, making the government’s finances pretty hard. We have an economic plan that was worked out in cooperation with the IMF and basically involves running a fairly substantial budget deficit in 2009 and then gradually reducing it and returning to surplus in a couple of years. This calls for some hard decisions, but it’s not impossible.

The third pillar is the involvement of the IMF, which is providing Iceland with foreign currency reserves to allow us to finance the restructuring of the economy. We’re getting about $5 billion — $2 billion from the IMF and $3 billion from various governments, mainly in Scandinavia.

All of this means that the government will take on very sizable debts temporarily. But since Iceland actually entered this crisis with very little debt, it will have debt that is basically on par with what is the norm in Western Europe, so nowhere near being unserviceable.

Q: Some countries have had contentious relationships with the IMF. What was Iceland’s experience?
Not everybody was happy with it, but by and large, it was not that controversial. One reason for that is probably that the Icelandic crisis was not really caused by the government’s finances. They were actually in good shape. So the solution is not as drastic as has been the case in other countries.

It’s hard to argue that the IMF is forcing Iceland to do something that we wouldn’t have done anyway.

Q: Is the IMF going to be one of the major solutions to the global crisis?
I’m sure that the IMF will play a major role but, unfortunately, the resources of the IMF are not sufficient to deal with our global crisis. They’re very good at dealing with local crises or even crises in a region, but if a crisis is more or less all over the world, then the IMF simply doesn’t have the resources. To solve a global problem, you need far more resources. Those resources cannot be had without contributions from the largest governments.

Q: Has there been an effective global response to this crisis or is there a need for a new mechanism?
I can’t say that it has been effective. Some fairly reasonable measures have been taken, and countries have tried to prop up their own economies or banking systems. But what I find lacking is a more global approach where those that have access to liquid reserves, primarily because they have reserve currencies, provide liquidity to countries that don’t.

I think that’s absolutely necessary, because if you have a collapse of several countries that are not part of these big trading blocks, then that’s going to cause enormous problems for everybody. Of course you can’t save every bank, but if you manage to keep healthy parts of the financial system alive in countries that do need foreign resources to get over this, that is a very important step in making sure that the problem doesn’t get worse than it actually has to be.

The financial system is de facto globalized and, as we mentioned at the outset, you have these ripple effects and nobody’s really isolated. And when that is the case, local solutions are not sufficient.

Interview conducted and edited by Jonathan T. F. Weisberg.