"The first casualty of the crisis: Iceland"

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.

Print Friendly, PDF & Email


  1. thomas j


    I know its off topic from Iceland but given recent discussions about China I found it noteworthy that yesterday, Zhou Xiaochuan, the president of the PBoC said that China will consider devaluing RMB to stimulate its exports and keep its economy growing.

    My question is whether the RMB is starting to come under pressure in the currency markets. And Zhou is simply seeking to get out in front of this trend and characterize the devaluation as a recent policy change in order to prevent a potential currency crisis. Or is Zhou intentionally seeking to provoke Europe and US into an all out trade war?

  2. Jojo

    We should offer Iceland statehood. Then we could island states in both the Pacific and the Atlantic Oceans!

    Iceland best be getting their fishing boats refurbished. I suspect that they did better in fishing than in banking and international finance.

  3. Glory's List

    Terrific Article!

    Economics and finance is not my area of expertise (but I’m learning a lot from this blog, so thank you!), but one thing did strike me:

    I hear so much about how this crisis is mostly due to deregulation and “market failure,” but the anatomy of the Icelandic meltdown seems to be government/policy failure.

    The lesson seems to be: yes, markets fail — but governments fail more, and bigger.


    P.S. See An Open Letter to my Friends on the Left

  4. Glory's List

    Terrific Article!

    Economics and finance is not my area of expertise (but I’m learning a lot from this blog, so thank you!), but one thing did strike me:

    I hear so much about how this crisis is mostly due to deregulation and “market failure,” but the anatomy of the Icelandic meltdown seems to be government/policy failure.

    The lesson seems to be: yes, markets fail — but governments fail more, and bigger.


    P.S. See An Open Letter to my Friends on the Left

  5. a

    Methinks Iceland is only the first in a long list of dominoes of sovereign states.

    I guess you can send gunboats and take over the country, but when debts reach 100% of GDP even that option won’t work. How about slavery?

  6. anewc2

    A note for the innumerate. GDP is measured in money per year. What the Dutch and UK governments are demanding is money. It is wrong to state one as a percentage of the other. What is being demanded is more than one year of GDP. If it were really more than 100%, they would be demanding that amount every year which I don’t think is the case.

  7. RK

    Let me propose a question. If Boxcar Willie set up a
    folding chair behind a card table, with a glass jar on
    top, offering 15% interest per annum, and if the Pension system of Great Britain decided to put all its’
    assets into that jar, who would be to blame if things
    went badly? In the name of free capital flows, how can
    an allegedly sophisticated nation allow its’ citizens
    to take such risks? I recall Archimedes is supposed to
    have said, “Give me a lever long enough, and a place
    to stand, and I can move the earth.” Well, you need
    BOTH, not just the lever.

  8. Anonymous


    Off-topic, but I know that you have followed this parameter in recent weeks – do you have an update on CDS pring for the US Government? Last I saw was early October at 37 bp.
    Is there a link that I can go to on a regular basis?


  9. River

    Look for currency controls of some type going forward.

    The G 20 communnique that Yves linked recently hinted at such a move.

    Homebuyers in Iceland and Eastern European countries purchasing homes with loans denominated in foreign currencies? …It leaves me shaking my head in disbelief.

    What will be the destination of the30% of Icelanders wishing to migrate? Iceland has been a very closed society, much like Japan. Ask any US Navy personnel that have been stationed at Keflavic.

  10. John Haskell


    You seem to have fallen out of the stupid tree and hit every branch on the way down.

    By your “logic” the demands of the Netherlands and the UK are less than 0.1% of GDP, because Iceland will be around indefinitely, therefore its GDP is for all intents and purposes infinite, therefore paying GBP 5 billion to foreign creditors is very easy.

  11. Zweiblumen

    This may be slightly off topic, but I’m wondering if anyone has good news analysis about what this actually means for the people of Iceland. Links requested.

  12. Anonymous

    It is all rather murky really. Iceland claims that the UK and Holland jumped the gun and it was in the process of trying to organise compensation for icesave savers. The laws the UK used also really should not be used in the way they have been and in an international context are hardly legitimate.

    While there were a lot of private investors in Icesave it was local government(county level) who really went to town on this. While Iceland’s banking sector was doomed to failure, UK political saving of face tipped the balance.

    As a UK citizen how do I explain to an icelander why my government acted the way it did. Do I say sorry that prices are in turmoil and sometimes you have to queue up for things. How will you feel about your governments external policy actions and will you be prepared to be critical.

  13. Anonymous

    We don’t trust you so we label you combatants. A financial war and nary a shot was fired.

    Interesting when the slaves flee the ship, who pays the bills or the loss in this case?

    Some argue that Germany’s reparations were the direct cause of the Great Depression. This default is even worse.

    Start printing Iceland, it’s your only hope.

  14. Anonymous

    I was going to post a comment that the Icelandic banks were for all intents and purposes Hedge Funds. Then I thought naaawwww, that’s a stretch. I decided to do a quick scan of the Buiter and Siebert report to see what the resolution might be. Lo and behold there it was : “Iceland has indeed
    become a highly leveraged financial institution with
    massive asset-liability mismatch . a ‘hedge fund’….”

    There’s more. Iceland banks had a teeny exposure to Mortgage backed securities. Their downfall was because they were offering extremely high interest rates to investors and attracted deposits from primarily the UK and Netherlands equal to 100% of their GDP. Their artificial exchange rate added fuel to the fire, or is that pyre. This simply proves that the basis of the worlds economic crises is not mortgages, it is leverage.

  15. Simon

    I think we’ll see a lot of sovereign defaults in the future, and eventually it will dawn on people that sovereign default isn’t such a bad thing. It was bad in Argentina only because Argentina didn’t take advantage of the default to clear out old bad policies and create new good policies. Instead, they kept most of the old bad policies and then added some more new bad policies. Iceland could do a lot better than this.

    Widespread sovereign default would lead to widespread distrust of government debt, especially by foreign creditors, which would in turn reign in government debt expansion–not a bad thing, in my opinion.

  16. Anonymous

    “What will be the destination of the30% of Icelanders wishing to migrate?”
    Scandinavia is probably the primary choice. Normally the UK would be the second choice but I have a feeling Icelanders are thinking anywhere but there.

    This whole sorry episode reminds me of something Jared Diamond wrote in Collapse. Iceland underwent terrible ecological damage during it’s first centuries of habitation. After that the Icelanders became incredibly conservative, preferring poverty over new ideas and inventions because in their fragile environment most changes only made matters worse. Can’t help but look at these events and see yet another bright idea inflicting terrible pain on their island home.

  17. Peter T

    Glory's List:
    > The lesson seems to be: yes, markets fail — but governments fail more, and bigger.

    In Germany, definitely: Some commercial German banks got greedy and burnt themselves, but the biggest losses are with the banks that are sponsored by the government, Landesbanken and KfW. Their bosses are most often politically connected through patronage.

  18. Mara

    I suppose this is the moral of actually producing something useful as your primary means of sustenance. Looking for hot money flows, like prostitution, is not a good long term activity, tho it may seem very remunerative for a while.
    As for Britain and Holland being up in arms, I’m not particularly sympathetic. If you’re getting “too good to be true” int rates, there’s a good chance that they are also too good to last. Plus I feel that once you (the depositor) send your money out of the country, all of the laws, safety and guarantees you’re used to are out the window, regardless of UK regulators OK’ing it.
    Inevitably folks tasked with keeping up outrageous returns (and the fees that go with them) will fudge the stats, camouflage holes and otherwise lie, cheat and steal to keep the party going. No one wants to hear that they’re too old, too fat or that their investments aren’t making it like they used to.

  19. Anonymous

    Regarding the Horowitz link provided by Glory’s List, I can’t believe how many people want to believe they are not idealogues when they are clearly idealogues. Let me first state that I’m a measured libertarian centrist, and the Road to Serfdom is one of my favorite books. But at the same time, Hayek was no knee-jerk anti-regulation maverick. He was against state control of industry, real socialism, not the use of the state to control obvious market failures like externalities, misaligned incentives and asymmetric information. Why on earth would Horowitz title a piece against corporatism an open letter to the *left*? How in the world can he still see liberty as a left/right issue after what has happened in this country over the last 30 years? Has he read the Republican platform? I currently vote against the conservative establishment exactly *because* I have libertarian inclinations. While (in my opinion) he correctly states that corporatism is the most important issue, I have no idea why he thinks his letter needs to be addressed to the “left.” Corporatism is the result of the right’s policies in the country. The government did not shrink under Reagan or either Bush I or II. These are provable facts. Instead, there was a shift away from using government to protect the poor and to protect labor, and there was a shift toward using the government to protect the high wage earners and those with capital (i.e., regulation specifically geared toward thwarting competition rather than encouraging competition…my WWHS? What Would Hayek Say?). Despite all the enormous amount of rhetoric on the right, there was no reduction in regulation. Regulation was just used for other purposes, mostly to perpetuate the riches and the power of the rich and powerful. We’ve had a de facto plutocracy the last 8 years. So stop telling me and everyone else that “regulation” is bad. There are market failures. Regulation can limit those market failures. Just because sometimes the attempt to control a market failure backfires is not sufficient proof that we should never attempt to deal with market failures. I want taxes to be as low as possible, and I would like to have as much freedom as possible, but that does not mean that I think “regulation” is always bad. Try to attune yourself more to the subtleties of the world. There is a middle ground.

  20. luther

    "There is a middle ground."

    here hear. this whole left/right paradigm is something that needs to be transcended if we all want to move forward with as much freedom, liberty & dignity as possible i/m/h/o.

    it's a false prison…a noble lie.

  21. Boomer

    I suppose Iceland could dissolve it’s gov’t and ask Denmark to take them back. Then the entity that owes the money to the British and Dutch would no longer exist.

    In such circumstances, what could the creditors do? Invade?

  22. Anonymous

    I’ve been thinking now may be a good time to retire in Iceland. Prices are going down, and they have those lovely views.

Comments are closed.