For those of you who only caught bits and snippets of the Iceland crisis, this VoxEU post by Jon Danielsson provides a useful recap. And if you are familiar with broad outlines of the unravelling, the piece also recaps the policy errors that fed into the crisis.
The article focuses on the role of high local interest rates in attracting hot money inflows, and the author is a bit perplexed as to why inflation targeting failed. Not that I am a fan of economic theory (not that theorizing is bad, theorizing is good, provided you use it to generate testable hypotheses. But most economists seem to just like the theorizing bit) but inflation targeting, while popular, is (from what I can tell) a made up approach. For instance, some economists have criticized it for failing to allow for the role of imports in raising or lowering the official inflation rate. Domestic interest rate policy will have no impact on import prices (save through changes in foreign exchange rates). Increasing interest rates in Iceland, for example, will not slow down inflation on good imported from the EU.
Once you have read this piece for background, do go and read the excellent article by Willem Buiter and Anne Siebert (which Danielsson references), who were invited in by Iceland to analyze their situation while the crisis was developing, and were asked to keep their paper confidential because it would be inflammatory. Now that the worst has past, they are free to publish their work.
Back to VoxEU:
Iceland’s banking system is ruined. GDP is down 65% in euro terms. Many companies face bankruptcy; others think of moving abroad. A third of the population is considering emigration. The British and Dutch governments demand compensation, amounting to over 100% of Icelandic GDP, for their citizens who held high-interest deposits in local branches of Icelandic banks. Europe’s leaders urgently need to take step to prevent similar things from happening to small nations with big banking sectors.
Iceland experienced the deepest and most rapid financial crisis recorded in peacetime when its three major banks all collapsed in the same week in October 2008. It is the first developed country to request assistance from the IMF in 30 years.
Following the use of anti-terror laws by the UK authorities against the Icelandic bank Landsbanki and the Icelandic authorities on 7 October, the Icelandic payment system effectively came to a standstill, with extreme difficulties in transferring money between Iceland and abroad. For an economy as dependent on imports and exports as Iceland this has been catastrophic.
While it is now possible to transfer money with some difficulty, the Icelandic currency market is now operating under capital controls while the government seeks funding to re-float the Icelandic krona under the supervision of the IMF. There are still multiple simultaneous exchange rates for the krona.
Negotiations with the IMF have finished, but at the time of writing the IMF has delayed a formal decision. Icelandic authorities claim this is due to pressure from the UK and Netherlands to compensate the citizens who deposited money in British and Dutch branches of the Icelandic bank Icesave. The net losses on those accounts may exceed the Icelandic GDP, and the two governments are demanding that the Icelandic government pay a substantial portion of that. The likely outcome would be sovereign default.
How did we get here? Inflation targeting gone wrong
The original reasons for Iceland’s failure are series of policy mistakes dating back to the beginning of the decade.
The first main cause of the crisis was the use of inflation targeting. Throughout the period of inflation targeting, inflation was generally above its target rate. In response, the central bank keep rates high, exceeding 15% at times.
In a small economy like Iceland, high interest rates encourage domestic firms and households to borrow in foreign currency; it also attracts carry traders speculating against ‘uncovered interest parity’. The result was a large foreign-currency inflow. This lead to a sharp exchange rate appreciation that gave Icelanders an illusion of wealth and doubly rewarding the carry traders.
The currency inflows also encouraged economic growth and inflation; outcomes that induced the Central Bank to raise interest rates further.
The end result was a bubble caused by the interaction of high domestic interest rates, currency appreciation, and capital inflows. While the stylized facts about currency inflows suggest that they should lead to lower domestic prices, in Iceland the impact was opposite.
Why did inflation targeting fail?
The reasons for the failure of inflation targeting are not completely clear, a key reason seems to be that foreign currency effectively became a part of the local money supply and the rapidly appreciating exchange-rate lead directly to the creation of new sectors of the economy.
The exchange rate became increasingly out of touch with economic fundamentals, with a rapid depreciation of the currency inevitable. This should have been clear to the Central Bank, which wasted several good opportunities to prevent exchange rate appreciations and build up reserves.
Peculiar Central Bank governance structure
Adding to this is the peculiar governance structure of the Central Bank of Iceland. Uniquely, it does not have one but three governors. One or more of those has generally been a former politician. Consequently, the governance of the Central Bank of Iceland has always been perceived to be closely tied to the central government, raising doubts about its independence. Currently, the chairman of the board of governors is a former long-standing Prime Minister. Central bank governors should of course be absolutely impartial, and having a politician as a governor creates a perception of politicization of central bank decisions.
In addition, such governance structure carries with it unfortunate consequences that become especially visible in the financial crisis. By choosing governors based on their political background rather than economic or financial expertise, the Central Bank may be perceived to be ill-equipped to deal with an economy in crisis.
Oversized banking sector
The second factor in the implosion of the Icelandic economy was the size of its banking sector. Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP, with debts to match. In normal economic circumstances this is not a cause for worry, so long as the banks are prudently run. Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts.
If banks are too big to save, failure is a self-fulfilling prophecy
In this crisis, the strength of a bank’s balance sheet is of little consequence. What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. Therefore, the size of the state relative to the size of the banks becomes the crucial factor. If the banks become too big to save, their failure becomes a self-fulfilling prophecy.
The relative size of the Icelandic banking system means that the government was in no position to guarantee the banks, unlike in other European countries. This effect was further escalated and the collapse brought forward by the failure of the Central Bank to extend its foreign currency reserves.
The final collapse was brought on by the bankruptcy of almost the entire Icelandic banking system. We may never know if the collapse of the banks was inevitable, but the manner in which they went into bankruptcy turned out to be extremely damaging to the Icelandic economy, and indeed damaging to the economy of the United Kingdom and other European countries. The final damage to both Iceland and the rest of the European economies would have been preventable if the authorities of these countries have acted more prudently.
While at the time of writing it is somewhat difficult to estimate the recovery rate from the sale of private sector assets, a common estimate for the net loss to foreign creditors because of private debt of Icelandic entities is in excess of $40 billion.
The Icelandic authorities did not appreciate the seriousness of the situation in spite of being repeatedly warned, both in domestic and foreign reports. One prominent but typical example is Buiter and Sibert (2008). In addition, the Icelandic authorities communicated badly with their international counterparts, leading to an atmosphere of mistrust.
The UK authorities exasperated with responses from Iceland overreacted, using antiterrorist laws to take over Icelandic assets, and causing the bankruptcy of the remaining Icelandic bank. Ultimately, this led to Iceland’s pariah status in the financial system.
British and Dutch claims on the Icelandic government
The current difficulties facing Iceland relate to its dispute with the Netherlands and the UK over high interest savings accounts, Icesave. Landsbanki set these savings accounts up as a branch of the Icelandic entity, meaning they were regulated and insured in Iceland, not in the UK or the Netherlands.
Icesave offered interest rates much above those prevailing in the market at the time, often 50% more than offered by British high street banks. In turn, this attracted £4.5 billion in the UK with close to one £billion in the Netherlands. While Icesave was regulated in Iceland, both the UK and the Dutch regulators approved its operations and allowed it to continue attracting substantial inflows of money. Since the difficulties facing Landsbanki were well documented, the financial regulators of the three countries are at fault for allowing it to continue attracting funds.
Landabanki went into bankruptcy early October. The final losses related to Icesave are not available at the time of writing, but recovery rates are expected to be low, with total losses expected to be close to £5 billion. The amount in the Icelandic deposit insurance fund only covers a small fraction of these losses.
Both the Dutch and the UK governments have sought to recover the losses to their savers from the Icelandic government. Their demands are threefold. First, that it use the deposit insurance fund to compensate deposit holders in Icesave. Second, that it make good on the amounts promised by the insurance fund, around EUR 20,000. Finally, that it make good on all losses. The last claim is based on emergency legislation passed in Iceland October 6, and the fact that the government of Iceland has promised to compensate Icelandic deposit holders the full amount, and it cannot discriminate between Icelandic and European deposit holders.
Murky legal situation
The legal picture however is unclear. Under European law 1% of deposits go into a deposit insurance fund, providing savers with a protection of €20,000 in case of bank failure. Apparently, the European law did not foresee the possibility of a whole banking system collapsing nor spell out the legal obligation of governments to top up the deposit insurance fund. Furthermore, the legal impact of the Icelandic emergency law is unclear. Consequently, the Icelandic government is disputing some of the British and Dutch claims.
Blood out of a rock
Regardless of the legal issues, the ability of the Icelandic Government to meet these claims is very limited. The damage to the Icelandic economy is extensive. The economy is expected to contract by around 15% and the exchange rate has fallen sharply. By using exchange rates obtained from the ECB November 7 the Icelandic GDP is about EUR 5.5 billion, at 200 kronas per euro. In euro terms GDP has fallen by 65%. (This calculation is based on the Icelandic GDP falling from 1,300 billion Icelandic kronas to 1,105 and a Euro exchange rate of 200. One year ago, the exchange rate was 83. In domestic currency terms the Icelandic GDP has contracted by 15% due to the crisis, in Euro terms 65%.)
The total losses to Icesave may therefore exceed the Icelandic GDP. While the amount being claimed by the UK and the Netherlands governments is unclear, it may approximate 100% of the Icelandic GDP. By comparison, the total amount of reparations payments demanded of Germany following World War I was around 85% of GDP.
Resolution and the way forward
Any resolution of the immediate problems facing Iceland is dependent on the UK and the Netherlands settling with Iceland. Unfortunately, the ability of the Icelandic government to meet their current demands is very much in doubt.
Opinion polls in Iceland indicate that one third of the population is considering emigration. Further economic hardship due to Icesave obligations may make that expression of opinion a reality. Meanwhile, many companies are facing bankruptcy and others are contemplating moving their headquarters and operations abroad.
With the youngest and most highly educated part of the population emigrating along with many of its successful money factoring and export companies, it is hard to see how the Icelandic State could service the debt created by the Icesave obligations to the UK and the Netherlands, making government default likely.
The economic rational for continuing to pursue the Icesave case with the current vigor is therefore very much in doubt. If a reasonable settlement cannot be reached and with the legal questions still uncertain it would be better for all three parties to have this dispute settled by the courts rather than by force as now.