Nina Eichacker: Lessons from Iceland’s Financial Crisis

Nina Eichacker is a lecturer in economics at Bentley University. This blog post summarizes her recent Political Economy Research Institute (PERI) working paper “Too Good to Be True: What the Icelandic Crisis Revealed about Global Finance.” Cross posted from Triple Crisis.

Iceland’s 2008 financial crisis should have been foreseen. By 2006, banking and economic data described an overheating financial sector and aggregate economy, and analyses by private and public researchers had reports describing those trends and their likely consequences. However, many were still surprised by the onset of Iceland’s large financial crisis. These events point to the dominance of neoliberal theories about the necessity of financial liberalization, and an assumption that a northern European country would have the institutional sophistication to avoid financial crises like those observed in developing countries that rapidly liberalize their financial sectors. A wider adherence to Keynesian and Minskyian theories of financial crisis would have helped predict Iceland’s crisis, and future such episodes.

One factor that contributed to the Icelandic financial crisis was the lack of financial market transparency. Organizations that could have reported on the conditions of the Icelandic financial marketplace and the state of the Icelandic economy did not. Despite positive reports by Frederic Mishkin and others citing Icelandic institutions’ integrity, (Mishkin and Herbertsson, 2006), the Icelandic state threatened to defund public Icelandic institutions and agencies that published reports contradicting the narrative of a robust financial infrastructure and growth. Iceland’s Chamber of Commerce paid economists like Mishkin hundreds of thousands of dollars to write favorable reports about Iceland’s financial sector and overall economic growth prospects. (Wade and Sigurgeirsdottir, 2010) The Icelandic news media consistently underpublished reports critical of the Icelandic financial sector, while publishing many stories that praised Iceland’s big three banks (Andersen, 2011). Sigurjonsson (2011) identified the root cause of this disparity as the cross-ownership of media company shares by Icelandic financial actors and institutions and financial corporation shares by Icelandic media institutions. The interconnectedness of these industries created conflicts of interest for all involved. The under production of criticism, and the over production of praise for Iceland’s banks skewed public understanding of the nature of Icelandic banks’ activity.

Credit-rating agencies contributed to the notion that Iceland’s financial markets were safer than they were. After Fitch downgraded Iceland’s credit rating, Moody’s upgraded it, increasing broad confidence in Icelandic financial stability. Moody’s upgrade stemmed from the assessment that Iceland was so financially leveraged that its central bank would bail out the big three banks as the lender of last resort. This development further lulled international investors and retail banking customers into trusting Icelandic financial actors with their capital and fueled more Icelandic financial activity.

Global financial institutions forgot that Southern Cone nations in South America had liberalized financial markets with less than stellar results: those banks became less risk-averse, without becoming more efficient. Argentina’s Central Bank offered guarantees on bank deposits, which encouraged more capital inflows; though Chile’s government initially stated that it would not insure deposits, its Central Bank ultimately guaranteed them after several panics early in the liberalization process. Foreign governments’ economic and political pressure for governments and central banks to insure their investments guaranteed moral hazard problems for developing countries considering financial liberalization in the absence of an international financial regulatory body (Diaz-Alejandro, 1983).

Global financial institutions trusted in Iceland’s supposedly robust financial governance, despite Iceland’s short history of financial liberalization. Irrational exuberance and moral hazard also diminished caution about the risks of rapid financial expansion and crisis. Finally, Iceland’s crisis reveals the inherent instability created by rapid financialization. When a country adopts a financial approach to growth that deregulates banks, encourages international capital inflows through inflation-targeting monetary policy, and promotes wide-scale acquisition of shares and securities in those financial institutions by banks, households, non-financial firms and the government financial firms appear to be artificially profitable, and conflicts of interest develop that weaken the stability of the financial sector and broad economy.

Keynes and Minsky argued that financial systems without adequate regulatory apparatuses are inherently prone to crisis. The Icelandic Central Bank’s decision to change from stability-promoting to inflation-targeting monetary policy led to rising interest rates, precipitous increases in capital flows and prices, and asset bubbles in the housing market. The Icelandic government’s promotion of non-financial firms’ and households’ purchase of shares in Icelandic banks created perverse incentives for banks to raise share prices, and increased the scope of losses in the event of the banks’ decline. These processes increased Icelandic instability and the costs of the inevitable crisis.

Irrational exuberance and moral hazard nullified the effects of evidence that Iceland was dangerously over-leveraged. Investors had access to data demonstrating instability and illustrating the risks of investing in Iceland’s financial system and economy. Many, however, continued to follow the advice of economists like Mishkin and Portes who argued that Iceland should not be assumed to have the same financial risks as developing economies, despite the newness of its supercharged financial system. Outside investors’ continued willingness to lend to Iceland increased the leveraged state of Icelandic banks and the scope of the eventual financial crisis.

National and international unwillingness to compare Iceland’s policy actions and history to that of developing economies like Chile, Argentina, and Uruguay demonstrates an assumption that Icelandic institutions were ready for the job of supervising a radically transformed financial sector. The Icelandic government’s repression of data demonstrating instability, and the Icelandic media’s unwillingness to publish unflattering stories give lie to the notion that Western European states’ financial institutions and governments were robust enough for very liberalized financial sectors.

Iceland’s crisis indicates the need for the following policies: Any state that liberalizes or changes the fundamental premise of monetary policy rapidly should be subject to increased scrutiny. The consequences for Iceland’s population demonstrate that while some actors and institutions may recognize the potential for financial crisis and act in ways that maximize their profits the broader public must be aware of the changes of their new financial landscapes. Greater financial literacy insures local populations against broader losses in the event of a crisis. Finally, states should reconsider finance-led growth strategies. The costs of financialization, given moral hazard and irrational exuberance, expand rapidly without meaningful oversight; Iceland’s experience illustrates the effects of such to the rest of the world.

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About David Dayen

David is a contributing writer to He has been writing about politics since 2004. He spent three years writing for the FireDogLake News Desk; he’s also written for The New Republic, The American Prospect, The Guardian (UK), The Huffington Post, The Washington Monthly, Alternet, Democracy Journal and Pacific Standard, as well as multiple well-trafficked progressive blogs and websites. His has been a guest on MSNBC, CNN, Aljazeera, Russia Today, NPR, Pacifica Radio and Air America Radio. He has contributed to two anthology books, one about the Wisconsin labor uprising and another on the fight against the Stop Online Piracy Act in Congress. Prior to writing about politics he worked for two decades as a television producer and editor. You can follow him on Twitter at @ddayen.


  1. Ruben

    What strikes me as deserving careful consideration about the issues raised in this post is what led to suppress criticisms of the inherent instability of Icelandic financial system. Barring malicious cover up, or probably in conjunction with malicious cover up, there is one notion that seems to have permeated from physics to the general mindscape and that is exerting considerable influence. This is the notion that if you observe something, you affect it. Before this notion became established it was assumed that observing something was fundamental to controlling it. Now it seems that in many intellectual endeavors denying knowledge of the truth is necessary to bring those systems whose true state is not being observed to a nice place. It most likely applies to financial systems because markets are supposed to be reflective. To me, that this denial might be a rational management tool, is astonishing. I believe this is the main reason why “… many were still surprised by the onset of Iceland’s large financial crisis”.

  2. Hayek's Heelbiter

    Excellent discussion of the lead-up to the crisis.

    Could you do a follow-up post to the Icelandic response, which I believe was quite in contradiction to the reactions of other Western countries to the meltdown?


    1. John Zelnicker

      The Icelandic response was, indeed, very different. The most obvious difference is that they actually convicted some of the bankers of crimes related to the collapse of the banks and recently sentenced them to prison. And, the economy hasn’t cratered. Imagine that!

    2. Nina Eichacker

      That’s a great suggestion! Something may even be in the works on that angle… though others have also written about this. (See, for example, Kinsella and Zoega — I think they have a Vox piece comparing Iceland and Ireland’s responses to their crises.)

  3. Carla

    G.B. Shaw wrote a terrific play, and its title seems applicable to the GFC. He called it “Too True to Be Good.”

    See it if you ever get the chance.

  4. James McFadden

    To blame the Icelandic crisis on “irrational exuberance and moral hazard” and then offer a solution that institutions “should be subject to increased scrutiny” is just nonsense. Not once in the article does the author use the word “fraud”. Economists just seem incapable of understanding criminal behavior since they view the entire world through their lens of the “free market.” I suspect that economists would be an easy mark for a con man. Iceland’s crisis was criminal fraud. Mishkin’s participation in this fraud for financial gain was probably criminal, but at the very least it was unethical.
    Iceland dealt with this crisis in the correct manner – by jailing the bankers. As Bill Black has stated on many occasion, criminal prosecution of bankers is how the criminal fraud perpetrated by Wall Street should have been handled here.

    1. Nina Eichacker

      Well put sir. The longer article that this summarizes does refer to the fraud — love letters etc — committed by Icelandic banks.

  5. Brian M

    “As Bill Black has stated on many occasion, criminal prosecution of bankers is how the criminal fraud perpetrated by Wall Street should have been handled here.”

    And was during the Reagan era. Strange how complicit with Wall Street the Peace Prize President and his crew have been, no?

  6. BrianM

    Back in 2005 I was a fund manager specialising in financials and I had a meeting with the management of Kaupthing. It was terrible – it was really obvious that they had no idea how to run a bank in a prudent way. So bad I didn’t look at it seriously. With hindsight I wondered how they got away with it. Clearly their regulator didn’t do their job, but sounds like there wasn’t just regulatory capture, but country capture.

    Incidentally, the most repeated rumour back then was that the Icelandic banks were conduits for Russian money. Never found out if there was any truth in that. Anyone know anything on this?

  7. Knute Rife

    The Kreppa was created by Sjálfstæðisflokkurinn (Independence Party) policies designed to block inflation triggered by the aluminum boom. As the Party is a bunch of good, little neolibs, government intervention via budget was unthinkable, so they used interest rates. Returns on ISK-denominated paper skyrocketed while all other currencies remained on the floor, so global finance started saying to Iceland, “Shut up and take my money!” The Party had no problem with that so long as they and their cronies got their rake, which is where the banks and all the enabling legislation came from. The Party didn’t have any trouble ramming through anything it wanted, given that it had controlled the government for two decades and had full support from the business sector and all “serious” academics. Mix in blatant prostitution from ratings agencies and Mishkin, and voila: meltdown casserole.

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