Robert Wade, ³Iceland pays the price for financial excess,² Financial Times,
July 2 2008.
belief. The external deficit was 25 per cent of GDP in 2006 and 17 per cent
in 2007. Gross short-term foreign debt amounted to 15 times the value of the
central bank's foreign exchange reserves at the end of 2007, or roughly 200
per cent of GDP. Gross long-term foreign debt amounted to another 350 per
cent of GDP. Bank assets swelled to 10 times GDP by the end of 2007. These
imbalances are the other side of the Icelandic purchases of companies in
Britain , Denmark and elsewhere.
How could such a minnow exercise so much leverage? The answer
starts before 2000, when most of the banks were still publicly owned and run
like government departments. Real interest rates were low and even negative
for long periods. Facing excess demand for credit, the banks operated like
political patrons, allocating credit to favoured business clients. The
resulting inefficiencies in resource allocation were offset by ever-rising
amounts of debt relative to equity and by the longest hours of work in
western Europe. These factors helped Iceland to become one of the most
prosperous countries in the world in terms of per capita income and several
indicators of quality of life.
The banks were privatised around 2000 in a hasty and politically
driven process. Ownership went to people with close connections to the
parties in the conservative coalition government, which had scant experience
in modern banking. The central bank and the finance ministry were staffed at
the top by people who preferred as light a regulatory touch as possible.
[Me: re Glass-Steagall]
The banks soon extended their operations from commercial banking
to investment banking. Neither they nor the regulators separated the
implicit guarantees they received as commercial banks from their operations
as investment banks. The extension of the safety net allowed them to take
big bets at home and abroad. They operated like hedge funds, financing their
expansion largely from foreign borrowings rather than domestic deposits.
The central bank tied its own hands so as to leave only the
interest rate as its control instrument. It gave up reserve requirements on
grounds that the banks did not want them; and it also failed to exercise
moral suasion. Its efforts to restrain inflation by raising short-term rates
(to 15 per cent by 2008) had the effect of sucking in more "carry trade"
capital, undermining the intended curbing of demand and leading the krona to
appreciate despite the huge external deficit.
During the 2000s, Icelandic companies and households have taken
to borrowing as though there is no tomorrow. Now Iceland 's external
liabilities swamp the central bank's ability to act as lender of last
resort, and other Nordic central banks have felt obliged to offer support
lest an Icelandic implosion blow a hole in their own banking systems.
The "great unwind" currently under way is the result of the
excesses built up in this framework of light regulation - itself the product
of hasty, though overdue, privatisation. Now the new coalition government
itself is in deep trouble. Rumours swirl that the second largest party, the
Social Democrats, which came into government in the elections of May 2007
for the first time in 14 years, may end its coalition with the biggest
party, the conservative Independence party, precipitating new elections.
Opinion polls suggest that the Independence party would be likely to suffer
a big loss and the Social Democratic party, its reputation less tarnished by
the financial crisis, could get enough support to form a new government with
one of the smaller parties.
That could signal a welcome change of direction in Iceland 's
economic policy towards a more Scandinavian model, where finance does not
rule the economy and macroeconomic imbalances are taken seriously.
The writer is professor of political economy at the London School of
Economics and winner of the Leontief Prize in economics, 2008
July 2 2008.
In the second half of last year, as the subprime crisis gathered
strength in the US , articles appeared in the international press about
Iceland as the "canary in the mine". They suggested tiny Ice- land
(population: 315,000) was a leading indicator of how the crisis was mutating
into something much bigger, affecting many countries beyond the US .
Since then Iceland 's economy has continued to decline. Gross
domestic product shrank by almost 4 per cent in the first quarter of 2008
compared with the final quarter of last year, when growth was barely
positive. The stock market and the currency have both fallen by about a
third since the start of this year.
The size of the accumulated macro-economic imbalances beggarsstrength in the US , articles appeared in the international press about
Iceland as the "canary in the mine". They suggested tiny Ice- land
(population: 315,000) was a leading indicator of how the crisis was mutating
into something much bigger, affecting many countries beyond the US .
Since then Iceland 's economy has continued to decline. Gross
domestic product shrank by almost 4 per cent in the first quarter of 2008
compared with the final quarter of last year, when growth was barely
positive. The stock market and the currency have both fallen by about a
third since the start of this year.
belief. The external deficit was 25 per cent of GDP in 2006 and 17 per cent
in 2007. Gross short-term foreign debt amounted to 15 times the value of the
central bank's foreign exchange reserves at the end of 2007, or roughly 200
per cent of GDP. Gross long-term foreign debt amounted to another 350 per
cent of GDP. Bank assets swelled to 10 times GDP by the end of 2007. These
imbalances are the other side of the Icelandic purchases of companies in
Britain , Denmark and elsewhere.
How could such a minnow exercise so much leverage? The answer
starts before 2000, when most of the banks were still publicly owned and run
like government departments. Real interest rates were low and even negative
for long periods. Facing excess demand for credit, the banks operated like
political patrons, allocating credit to favoured business clients. The
resulting inefficiencies in resource allocation were offset by ever-rising
amounts of debt relative to equity and by the longest hours of work in
western Europe. These factors helped Iceland to become one of the most
prosperous countries in the world in terms of per capita income and several
indicators of quality of life.
The banks were privatised around 2000 in a hasty and politically
driven process. Ownership went to people with close connections to the
parties in the conservative coalition government, which had scant experience
in modern banking. The central bank and the finance ministry were staffed at
the top by people who preferred as light a regulatory touch as possible.
[Me: re Glass-Steagall]
The banks soon extended their operations from commercial banking
to investment banking. Neither they nor the regulators separated the
implicit guarantees they received as commercial banks from their operations
as investment banks. The extension of the safety net allowed them to take
big bets at home and abroad. They operated like hedge funds, financing their
expansion largely from foreign borrowings rather than domestic deposits.
The central bank tied its own hands so as to leave only the
interest rate as its control instrument. It gave up reserve requirements on
grounds that the banks did not want them; and it also failed to exercise
moral suasion. Its efforts to restrain inflation by raising short-term rates
(to 15 per cent by 2008) had the effect of sucking in more "carry trade"
capital, undermining the intended curbing of demand and leading the krona to
appreciate despite the huge external deficit.
During the 2000s, Icelandic companies and households have taken
to borrowing as though there is no tomorrow. Now Iceland 's external
liabilities swamp the central bank's ability to act as lender of last
resort, and other Nordic central banks have felt obliged to offer support
lest an Icelandic implosion blow a hole in their own banking systems.
The "great unwind" currently under way is the result of the
excesses built up in this framework of light regulation - itself the product
of hasty, though overdue, privatisation. Now the new coalition government
itself is in deep trouble. Rumours swirl that the second largest party, the
Social Democrats, which came into government in the elections of May 2007
for the first time in 14 years, may end its coalition with the biggest
party, the conservative Independence party, precipitating new elections.
Opinion polls suggest that the Independence party would be likely to suffer
a big loss and the Social Democratic party, its reputation less tarnished by
the financial crisis, could get enough support to form a new government with
one of the smaller parties.
That could signal a welcome change of direction in Iceland 's
economic policy towards a more Scandinavian model, where finance does not
rule the economy and macroeconomic imbalances are taken seriously.
The writer is professor of political economy at the London School of
Economics and winner of the Leontief Prize in economics, 2008
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