Iceland’s Textbook Financial Recovery

Sam Fearnley, Kettlemag, Iceland, Recovery
Written by Sam Fearnley

At the end of 2008, in the midst of the global recession, Iceland experienced the largest systemic banking collapse ever recorded, relative to the size of its economy. All three of its privately owned banks defaulted and the stock market fell by around 95%. The event marked the start of an economic depression that lasted two years. But Iceland’s recovery has been remarkably fast. It provides a useful and insightful case study for countries that experience similar financial crises.

The three banks – Landsbanki, Glitnir and Kaupthing – experienced huge growth in the years leading up to 2008. But, as the global financial crisis took its victims, these three banks were seen as increasingly risky investments. This lack of trust manifested itself as a severe depreciation of the Icelandic Krona – Iceland is not a member of the Eurozone or EU. The financial crisis that defined the country for years to come was, by this point, inescapable.

Lender of last resort

By the end of the second quarter of 2008, Iceland’s external debt was seven times more than its 2007 GDP, and the assets of the three banks totalled 11 times the GDP. Iceland’s financial system was unsettlingly large in comparison to its economy. The Central Bank of Iceland (equivalent to the Bank of England) became unable to lend as a ‘lender of last resort’: an institution which aims to provide liquidity (ability to help an asset purchase while mitigating drastic change to that asset’s price) in hard financial times.

The catastrophe created a sense of political unrest, nothing on the scale of, for instance, the Arab Spring, but people held the banks in contempt.

The short term solutions took on a rather emergency-like nature: the financial supervisory authority took control of financial institutions, and new banks were established to take over the work areas where the three banks had previously operated. Iceland also received bailout money from the International Monetary fund ($2.1 billion) and other Nordic countries ($2.5 billion).

In terms of a longer term solution, Iceland reduced spending. Its austerity measures were harsher than those of Ireland, Spain and Britain. Interest rates were also pushed up – they were 18% during the immediate aftermath, but have since come down.

Harsh effects of austerity 

When countries suffer an economic decline on such a large scale, the ensuing lower salaries mean the general public finds it more difficult to pay back their debts, which are still the same value. They then save more money and so have less disposable income for spending. Businesses then see a decline in customers, and have little reason to carry on investing. Iceland, however, was able to escape this vicious spiral because it had (and has) its own currency, and it held on to its competitiveness. If the country had been part of the Eurozone, the story would have been very different. Ireland, for example, uses the Euro and so could not devalue its currency. Ireland suffered (and continues to endure) the harsher effects of austerity, including severe unemployment.

The fall of the Icelandic Krona was dramatic, but certainly not uncontrolled. Iceland placed restrictions on people taking money out of the country. This had the subsequent effect of downsizing foreign investment – people did not want to invest somewhere from which they could not subsequently withdraw. To this day, Iceland still suffers with a paucity of overseas money.

What caused Iceland’s misfortune?

One of the main reasons for (and effects of) Iceland’s misfortune was mistrust in its financial institutions and government. This lack of confidence came from both in and out of Iceland, and from individual people through to large multinational corporations.

Iceland, like other Nordic countries ranks highly in cross-country lists of transparency and corruption, but the financial crisis severely compromised this. All financial systems are complex and arcane at the best of times, and crises like Iceland’s inevitably exacerbate the public doubt.

The Icelandic government later regained its integrity by prosecuting a small contingent of bankers. 26 bankers have been jailed, receiving 74 years of jail between them.

Bjarni Benediktsson, the current Minister of Finance, is even proposing that every single Icelander should receive a 30,000 Krona pay-out via the transfer of ownership of Íslandsbanki to the government. He raised the possibility at the National Convention of the Independence Party:

“I am saying that the government take some decided portion, 5%, and simply hand it over to the people of this country.”

He also said that he believes the expropriation of the bank will bring foreign capital into the country.

The success of Iceland’s recovery is not purely fortuitous. The austerity measures and tight regulations were apposite for the type of crash Iceland experienced. As such, the country has benefitted from a rapid, model recovery, both from its financial crisis, and its political and social unrest too. Many countries would do well to learn from it.