Iceland After the Meltdown: Lessons For the US

Iceland After the Meltdown: Lessons For the US
By Carl Horowitz
5/19/2012

The European Union (EU) is now in a full-scale panic over how to arrange financial bailouts for its least capable members. Yet few officials within the 27-nation federation have pondered the possibility that the best arrangement may be no bailout – and no EU as well. The recent experience of Iceland, which isn’t a member (yet), could serve as a lesson for both Europe and the U.S.

One need only pick up a newspaper – almost any will do – to realize that financial conditions in Europe, our principal ancestral continent, are approaching a breaking point. The clearest manifestation of collapse is riot-torn Greece, on the cusp of secession (or expulsion) from the EU. Not far behind are Ireland, Italy, Portugal and Spain.

Germany, the de facto leader of the Brussels-based European Union, and especially its 17 countries using the euro currency (i.e., the “eurozone”), is an increasingly reluctant paymaster. Most Germans, led by Chancellor Angela Merkel, deeply resent being pressed into service as the ultimate backstop for troubled EU countries, only to be cast in the role of villain by those countries for insisting on fiscal austerity as a prerequisite for receiving aid. Germany argues, and rightly, that austerity is the price one should pay for forbearance of uncollectible loans. Yet paradoxically, European leaders, with few exceptions, want to continue the sorts of policies that have prompted austerity measures; witness the recent presidential election in France of avowed socialist Francois Hollande, sworn in this week, over the incumbent and more EU-friendly Nikolas Sarkozy.

The casualties are mounting. Last summer, German officials expressed fear that they might not be unable to rescue the Italian economy, even given a hypothetical tripling of a 440 billion-euro loan guarantee fund, the European Financial Stability Facility, created in 2010 as part of a larger 750 billion-euro (at present, 1 euro = $1.2707) package to stave off collapse among eurozone nations; the other 310 billion euro consisted of a new separate entity, the European Financial Stabilization Mechanism (60 billion euro), and an additional International Monetary Fund (IMF) pool of funds (250 billion euro). A combined roughly 250 billion euro already has been spent on bailouts for Ireland and Portugal. That doesn’t leave over much for Italy, whose public debt of 1.8 trillion euro represents about 120 percent of its Gross Domestic Product. Nor does it leave over much for Spain, where the unemployment rate reached 24.1 percent this March during which time the eurozone average was 10.9 percent.

Greece, where the debt-to-GDP ratio now stands at roughly 160 percent (the eurozone average is 90 percent) and where GDP during 2008-11 shrunk on average by 3.45 percent annually, is in a class by itself. It has received separate joint EU-IMF bailouts of about 110 billion euro in 2010 and 130 billion euro this year (a combined equivalent of $305 billion), the most recent round forcing a debt write-off of 100 billion euro. Additionally, this aid comes with tough austerity targets for government spending, much to the displeasure of the Greeks.

Conceivably, the Greeks could exit the euro currency zone and avoid further political dependency. But such a move most likely would further depress bond purchases and bank lending, and not just in Greece. And with unemployment running at 21.7 percent in March, rioters periodically running amok in the streets for the last two years, and depositors this past Monday withdrawing around 700 million euro (nearly US$900 million) from banks, EU officials fear the worst if they don’t stand firm. “Greece has no option but to reform and repay its debts, and if it doesn’t do that, it will be a very serious problem, not just for Greece, but for everyone,” remarked Dutch Finance Minister Jan Kees de Jager at a meeting on Monday in Brussels. Making the Greek situation even more precarious is the failure thus far by negotiators to form a new government following the country’s general election of May 6.

Further European bailouts may be counterproductive. University of Maryland business economist Peter Morici explains: “By establishing a 750 billion euro fund to bail out Greece and aid other struggling governments, Germany and other strong European states are chasing a dream – single European currency and broader European unity – that may have no place in reality.” And British financial columnist Heather Stewart, writing last November in The Observer, noted: “The deeply undemocratic nature of the euro project had already been laid bare in Cannes by the European elite’s outraged response to (soon-to-be-ex-Greek Prime Minister) George Papandreou’s announcement that he would hold a referendum on the latest ‘rescue’ package for his country.”

Far removed from this turmoil is Iceland. Ironically, it was a wave of spectacular bank failures in 2008 in this country of 320,000 that triggered a worldwide financial domino effect, a fact serving as the back story to the 2010 movie documentary, “Inside Job.” Michael Lewis’ article in the April 2009 issue of Vanity Fair, “Wall Street on the Tundra,” provided an extensive account of how Icelandic bankers, viewing home mortgages as the key to untold riches, sought to transform their economy, long primarily dependent on fishing and metals-smelting, into a major global player following bank deregulation in 2001.

For a while, the country had the Midas touch. During 2003-07 the Icelandic stock market grew ninefold, while real estate prices tripled. But the newfound riches proved fool’s gold. The three largest banks, whose assets at their peak were nearly 10 times the national GDP, collapsed in the fall of 2008. The Icelandic currency, the krona, lost more than half its value against the euro and became all but worthless outside the country. Employers shed jobs and inflation reached 20 percent. The stock market took an 85 percent dive. And Icelanders were now on the hook for an estimated $85 billion to $100 billion in bank losses, or roughly $300,000 for every man, woman and child. And you thought we had it bad.

Yet here it is, 2012, and Iceland appears to have recovered from this debacle rather nicely – and without a bailout from the IMF. Put simply, the government allowed major banks to fail and told foreign creditors to bite the bullet. It dismantled the failed banks, paid off creditors from the proceeds of asset sales, and tightened bank capitalization requirements. The country still faces major problems. Household and business debt remains high. And some Icelanders are migrating to Norway and elsewhere in search of a job. Yet on balance, the country is far better off than could have been predicted three years ago.

Here’s how the Washington Post’s Brady Dennis this January described the scene in the principal city of Reykjavik:

On the snowy streets of this capital city, the economic panic of 2008 has mostly faded. The trendy cafes along Laugavegur brim with customers. Restaurant menus feature $40 grilled minke whale and $60 racks of lamb, and hardly a table goes empty. Boozy youths line up to pack nightclubs that thump all night. It’s even okay now to joke about the crash, or kreppa, as it’s known: “We may not have cash, but we have ash!” reads one T-shirt with a picture of the Eyjafjallajokull volcano that erupted in 2010.

“Three years later,” the author writes, “the unemployment rate has fallen. Tourism has increased. The economy is growing. The government successfully raised money from investors in the summer for the first time since its crisis.”

In many ways, Iceland is an easy country to like. The 40,000-square-mile North Atlantic republic, located just south of the Arctic Circle some 500 miles from its nearest European neighbor Scotland, is a hybrid of Old Norse and modern culture. Average life expectancy at birth is now 81. Median income (2011) is around $38,000. The nonprofit watchdog group Transparency International continues to rate Iceland as one of the least corrupt countries in the world, even after the banking collapse. The country has spectacular natural scenery, including more than 100 volcanoes. One of its filmmakers, Baltasar Kormakur, directed a hit Hollywood movie this winter, “Contraband,” starring Mark Wahlberg; Kormakur, in fact, had starred in the 2008 film on which it was based, “Reykjavik-Rotterdam,” directed by another Icelander, Oskar Jonasson. And, of course, there is the instantly recognizable female singer-songwriter, Bjork, whose mix of folk-rock, post-punk and electronica has won tens of millions of fans the world over.

But the main reason to like Iceland may be its reluctance, at least when it counted, to transfer part of its sovereignty to the European Union. Iceland, despite its short-sighted bank deregulation of a decade ago, had a 7 percent unemployment rate in 2011, to be sure, way above the 1 percent preceding the collapse and yet slightly lower than the average of the immediate post-crash years – no mean feat. Annual GDP has been growing at 3 to 4 percent since 2009. “For a country whose entire financial system collapsed, Iceland is doing remarkably well,” admits Julie Kozack, IMF mission chief for Iceland.

This raises the question: Why? How could a nation witness the evaporation of its financial assets and yet stabilize the situation within a relatively short time, while much of the rest of Europe approaches the abyss? Certainly, Iceland is in far better shape without international aid than is subsidized Greece. So given all that it did wrong, Iceland must have done a few things right since.

Without discounting the importance of cultural explanations, arguably the main reason for Iceland’s resurgence is related to the economics concept of moral hazard. In essence, moral hazard refers to the additional risks that a particular party – be it a person, a corporation or a nation – takes on when it does not have to bear the costs of its mistakes. People by nature are less cautious when they know in advance that an outside party will cover them. As a corollary, the outside party, typically armed with better information about motive and action, is more likely than otherwise the case to behave irresponsibly, believing he won’t get caught or otherwise bear the cost. Think of Michael Douglas’ character, Gordon Gekko, in the two “Wall Street” movies.

The flip side of moral hazard is aversion to it. That is, in assessing a possible transaction or long-term agreement, a principal party may decide that the risk of an agent mishandling his money isn’t worth the gain in expertise. Equally to the point, he may sense that taking responsibility for the consequences of his own mistakes will reduce the likelihood of making them in the first place.

Iceland is an example of the second scenario. Its government during those dark months of late 2008 and early 2009 wisely eschewed a “too big to fail” policy in dealing with the nation’s financial institutions, recognizing, if out of necessity, that it can’t compensate reckless banking decisions. “No responsible government takes risks with the future of its people, even when the banking system itself is at stake,” said then-Prime Minister Geir Haarde in an emergency address to the nation in October 2008. He would resign on February 1, 2009. Johanna Sigurdardottir, a Social Democrat, would take over.

But why did the recklessness occur in the first place? It happened in large measure because country’s bankers thought Iceland was ready for the big time. The global economy, especially the demand for homeownership, was expanding. The bankers believed they could grow rich by radically ramping up mortgage lending and then packaging the loans as marketable securities to investors on Wall Street and elsewhere – sound familiar? Escalation in house prices presumably could cover any shortfalls, and the Icelandic government or the IMF could rescue them if prices didn’t keep rising. Who wanted to be a fisherman when the world was your oyster anyway?

“You had to be crazy not to want to become a banker,” says University of Iceland student Heimir Hannesson, looking back at those years. “You went to college, studied business. You became a millionaire overnight. That was the dream. And for a few years, it was the reality.”

Unfortunately, the reality of Geir Haarde, who served as prime minister for less than three years, is that he’s out of a job and likely headed for prison. The Sigurdardottir administration is bent on meting out justice to those whom it sees as responsible for the financial collapse. Her predecessor makes for a good trophy. This March, former Prime Minister Haarde, facing four separate criminal negligence charges, took the witness stand in his defense, arguing that no government could have prevented Iceland’s crash since nobody outside the banks was aware of how much debt they were carrying. He would be found guilty anyway in April on one of the charges.

Under its new leadership, Iceland may go the way of European integration. Finance Minister Oddny Hardardottir affirmed her commitment to adoption of the euro. The country applied for membership in the European Union in July 2009 and opened talks in 2010, despite widespread domestic opposition. Hardardottir believes that using the euro isn’t in conflict with becoming more solvent, and that the euro is a superior alternative to the highly fluctuating krona. “I’m not concerned about the future of the euro,” she remarked early this year. “The demand is that countries become more disciplined in their economic management. That’s something that we should also take to heart, although we’ve shown great effort and performance in that regard following the economic collapse.”

One only can hope. But in the meantime there are a couple reasons why Americans should pay close attention to the situation in Iceland.

First, like it or not, from the beginning of the EU, we have been committed to its solvency via the International Monetary Fund. And lately we’ve become more committed than ever. This spring, IMF officials cobbled together an additional $430 billion in pledges on top of the $380 billion in existing IMF lending capacity and the aforementioned 750 billion euro (US$950 billion) EU-IMF crisis package. Our total IMF liability now stands at $172 billion, second only to the $186 billion of Japan. (It could have been higher, actually, had the Obama administration pushed Congress on the issue.) The U.S. helped pay for the Irish and Portuguese bailouts this way. Now we’re covering the Greeks.

Second, having instituted our own bailouts over the last four years, we should be experts by now on the risks of growing an economy based on moral hazard. The Bush and Obama administrations, each aided by Congress, have created large-scale emergency conduits to support the automobile and financial services industries. In the short term, we mitigated a highly painful collapse. But in the long term, we are laying the groundwork for a potentially far deeper and intractable collapse. By signaling to “too big to fail” enterprises that they need not fear going extinct, we are enabling them to make bad decisions at taxpayers’ expense. The ever-expanding federal deficit is in some measure a consequence of this. Take heart, at least, that we’re not the lead player in some North American Union; one only can imagine the ultimate cost of bailing out Mexico.

One wishes Iceland well in its ongoing recovery. It may have only roughly one-hundredth of our land area and one-thousandth of our population, but its aversion to joining the EU during the Haarde years likely has benefited other nations, ours included. “I don’t want the euro, hell no,” remarked a female food truck operator in Reykjavik several months ago. “The countries that have the euro, it’s going pretty badly.” Iceland may well get the euro anyway. If that happens, it’s conceivable the U.S., if indirectly, will be responsible for some of its bills.