Avarice, Affluence, Cronyism and Neoliberal Economics; The Collapse of Iceland in the Global Financial Crisis ( Part 1)
“We cannot base prosperity on the participation of the few and the disillusionment of the many.” Mr. Árni Páll Árnason – Icelandic Minister of Economic Affairs
Mr. Árnason spoke these words to a conference of economists, politicians, civil society members and IMF professionals gathered together in October 2011, three years after Iceland plunged into one of the worst financial crisis experienced during the global financial meltdown. The high-level conference was brought together to assess the damage as the dust settled on three years of protest, litigation, nationalization, borrowing, belt tightening and ruined reputations. Iceland, once the poster child of free-market ideology, sat barely upright in the ruins of a country who had once the highest GDP per capita of any OCED nation. A country of 300,000 who at the beginning of the 21st century managed to burst out of obscurity and on to the world stage as a major financial player. From the acquisition of major investment firms, to luxury shops on Bond Street, corporate jets, 10 foot tall statues of Viking conquers, helicopters, and soccer clubs; it was a hectic time of avarice, affluence, cronyism and neoliberal economics–and not just for Iceland.
Iceland’s collapse occurred within the context of a larger global financial crisis, brought on, in part, by the collapse of the enormous investment bank Lehman Brothers in the United States. It was a confluence of forces, a perfect storm so to speak of speculative investment, excessive leveraging, poor oversight, cheap and accessible credit, and an unwavering dedication to the ideology of the free-market. Politicians, economists and intellectuals alike rallied around key precepts of the ‘neoliberalization project’ begun in the 1980’s through the policies of Ronald Regan and Margaret Thatcher, most notably (Anderson, 1996). The roots however of the this theoretical economic perspective reach back to the post-WWII period, as several thinkers including Friedrich von Hayek sought to respond the types of social welfare policies stemming from the depression era policies of Theodore Roosevelt’s New Deal as well as the some of the economic-nationalist measures blamed in part for precipitating WWII (O’Brien, 2004, pp.14-15). The dismantling of “l’Etat-providence” and protection of the entrepreneurial class (also known as trickle don economics) is the foundational the edict of Milton Friedman’s “right to choose,” who’s work would be of major influence on many key political and business figures in the world for years.
It also formed the basis of David Oddsson’s liberalization strategy in Iceland. Vists from Friedrich von Hayek and Milton Frisdman in the 1980’s inspired Oddsson and “many of his generation” towards free-market ideologies (Gissurson, 2004, para 9). As Prime Minster of the Independence Party, Oddsson aggressively and passionately undertook an agenda of structural reforms including privatization, the creation of an independent central bank and a free floating exchange rate for the Icelandic Krona (ISK) (Centonze, 2011, p.133). The Icelandic economy had historically been dependent on their two main resources, fish and geothermal energy, and to a lesser degree some mineral extraction (Boyes, 2009, p.82). It was the fishing industry and it’s many related processes however, which dominated the economy and lives of the Icelandic people to the extent as it became known as the “tyranny of fish” (Boyes, 2009, p.82).
By early 2000, after nearly a decade of Oddsson’s feverous campaigns of privatization and deregulation, the concept that banking could become Iceland’s “third pillar of the economy”–thereby freeing them from their marginal economic base–started to gain momentum (Benediktsdottir at el., 2011, p.188). Between 1999 and 2003 two state-owned banks, Landsbanki and Buraoarbanki (later Kaupthing) were privatized (Centonze, 2011, p.134) and a securities market and stock exchange created and capital flows deregulated. All of which facilitated the unprecedented growth of the Icelandic banking sector and the acceptability of the types of financial risk-taking required to drive it (Centonze, 2011, p.134). Much like what was seen in the United States after the 1999 Gramm-Leach-Bliley Act (GLBA), which lifted the provisions of the Glass-Steagall Act (1933) restricting affiliations between commercial banks and securities firms (Macey 2000, p. 716. Wilmarth 2002, p. 219), the ‘big three’ Icelandic banks merged with other investment, securities, and insurance firms, both domestically and internationally (Centonze, 2011, p.133).
However it could be argued that Oddsson’s dream of a functional liberalized economy was derailed by the oligopic ownership of an established entrepreneurial class which emerged to take primary owernship of the banks. These new Vikings–as they would become referred to–were driven by nepotism and ancient grievances which resulted in a system of complicated cross-ownership and ‘internal looting.’ Key figures such as Jon Asgier, would progressively take ownership of the system to finance exorbitant and risky expenditures (Boyes, 2009, p.58). Even prior to becoming a shareholder in Glintir, Iceland’s third largest bank, Jon Asgier’s Baugur Group owned 50 to 60% of the grocery market in Iceland, a large stake in Icelandair and dominated the construction market, along with the distribution of medicine and petrol (Boyes, 2009, p.108). Asgier used his clout to keep import prices down (Boyes, 2009, p. 63) and pushed the banks to “diversify their income stream and depositor and investor bases” by increasing stakes in foreign markets (Centzone, 2001, p.135) much of which was required to capitalize the bank sufficiently enough to afford financing his 145-foot yacht, football teams and seven-thousand-square-foot penthouse in New York’ (Boyes, 2009, p.62).
Even if Oddsson began to lament that privatization was turning the banks into “cash machines for tycoons” (Boyes, 2009, p.115) he and Iceland itself were being hailed as a “miracle” for having discovered the free market (Gissurason, 2004, pp.2). In an article published in the Wall Street Journal in 2004 Hannes Gissuarson praised him for transforming Iceland’s “dysfunctional socialist economy,” by reducing the size of government, cutting subsidies and waves of privatization (Gissurason, 2004, para 3-5). “Smallness,” he argued, “is not only a challenge; it is also an opportunity Iceland has seized this opportunity and is becoming an attractive place for international corporations and capital (Gissurson, 2004, para 13). If only Mr. Gissurson could see how well that opportunity would serve them four years down the road.
Chronology of Crisis
The rapid ascension of the Icelandic banks over 2000-2006 was aided by a number of factors including the effect of high interest rates–used to combat Iceland’s ongoing problem with inflation–which encouraged carry-trade transfers and foreign speculation and contributed massive capital inflows. Carry-trades–a process whereby speculators will borrow money from a country where the interest rates are low such as Japan and then lend that money out in a country where the interest rates were higher–contributed approximately €4 billion in capital inflows to Iceland (Boyes, 2009, p.140) and provided Icelandic banks the capital they need to justify much of their expansion and investment abroad (Boyes, 2009, p. 88, Contonze, 2011, p.134). This propping up of the economy through speculative investment also contributed to the excessive appreciation of the krona (Benediktsdottir, at el., 2011, p.186). However these types of investments are prone to shocks and rapid flight at any sign of risk. With the increasing liberalization of the global economy transnational capital flows continue rise, subject to “investor sentiment.” Meaning that any change in conditionality could trigger a widespread outflow of capital from a country ( Tagi, 2009, p116) as was seen in the Asian financial crisis in 1997. Iceland’s membership in European Economic Area (1994) removed many capital controls and paved the way for the banks to have access to EU markets, both for investment and borrowing purposes (Benediktsdottir, at el., 2011, p.188).
As growth continued to heat up and success stories these anomalous New Vikings became the new Icelandic lore (Benediksdottir, at el., p.188). Their success legitimized their requests for continued deregulation, and blinded authorities content to rest their decisions in the in the wisdom of the capital class. Not wanting to ‘mess with a good thing’ the government overseers allowed the baking sector to run rampant (Benediksdottir, at el., p.186). Credit growth of 30%/year continued unabated and account deficits grew to 15% of GDP by 2005, while external debt climbed to over 400% of current accounts (the net of a countries exports) (Boyes, 2009, p.124). Borrowing was made possible by the banks stellar AAA credit ratings, without consideration that as EEA members much of this rating was supported by the implicit guarantee that the sovereign would act as lender of last resort in a crisis and on the perception of Iceland as a country by the international community (Benediksdottir, at el., p. 191). Between 2004 and 2005 alone the three banks borrowed close to €21 billion (Benediksdottir, at el., p. 191). Membership in the EEA also meant that economic decisions of the Central Bank of Iceland (CBI) were almost impossible as the vast flows of money coming into the system created a trompe-d’ouil, allowing Iceland to fool itself and the world at large, that its economy was bigger than it really was (Boyes, 2009, p.112-13).
However, not all the criticism can be launched at the Icelandic banks who were were merely playing a game of monkey-see, monkey-do by following their contemporaries overseas, who were also leveraging broadly to expand their balance sheets; activities further supported by under-priced risk, robust access to liquidity, inaccurate credit ratings and most significantly perhaps “a compensation system rewarding risk taking” (Benediksdottir, at el., 2011, p.193). Maynard Keynes stated in a passage in his 1936 book, The General Theory of Employment, Interest and Money that while, “[s]peculators may do no harm on a steady stream of enterprises. . . the position is serious when enterprise becomes a bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done (Keynes, 1936, p.159). Keynes wasn’t the only one who would make the observation about the dangers of speculation for profit. In her 1996 book aptly titled, Casino Capitalism, Susan Strange also argued that when money is out of control, exchange rates and interest rates fluctuate widely and “sheer luck begins to take over and to determine more and more of what happens to people (Strange, 1996).” She also argues “a monetary system cannot work effectively unless there is a political authority . . . (Strange, 1996, p.90). Something we now know was severely lacking not just within Iceland, but also from all major players of the 2008 Global Financial Crisis (GFC).
Through the early 21st century deregulation the finalization of markets began to infect and undermine the stability of the global economy at large. Predatory lending practices, debt commodification, over-extended borrowing, and risky speculative lending was encouraged by a reward structure based on tugging citizens into debt regardless of their ability to service it (Boyes, 2009, p.88). Mortgage commodities in Iceland were diversified and interest rates held artificially low in order to bring new demographics into the market. An overheated economy appreciated the Krona, inflation began to grow again and many people financed assets under the assumption that “inflation would pay” (Boyes, 2009, p.79). However it is not to say that all Icelander’s were ravaged by greed, but rather gripped by a sense that their time to emerge as a major player on the world stage had come (Boyes, 2009, p.81). Then President Ólafur Ragnar Grímsson delivered a speech the Walbrook Club–a private dining club of some of London’s top business leaders–about the Iceland miracle economy (Boyes, 2009, p.115) stating:
“I am convinced our business culture, our approach, our way of thinking and our behaviour patterns, rooted in our traditions and national identity, have played a crucial role. We are succeeding because we are different and our track record should inspire the business establishment . . .The range of Icelandic success cases provides a fertile ground for a productive dialogue on how the modern business world is changing.”
Indeed it was.
In early 2006 when Japan decided to raise interest rates, investors began to sell their positions in Iceland and the financial community began to look at Iceland’s marvellous growth with more scrutiny (Boyes, 2009, p. 125). The rating agency Fitch downgraded Iceland in March 2006 stating that it reflected “new data on the balance of payments and the international investment position” and raised concerns about Iceland’s “external debt sustainability (Fitch, Press Release, 2006).” The Icelandic government and other concerned groups such as the Chamber of Commerce responded to reassure markets. Fredric Mishkin, a professor at Columbia Business School and advisor to Bill Clinton and several large US investment firms, was commissioned to write a White Paper on Iceland by the Icelandic Chamber of Commerce (Byrne, 2011, pp3). It’s perhaps not surprising that this White Paper found fiscal imbalcnes were “ not a problem in Iceland: quite the opposite,” Iceland had, “an excellent fiscal position (Mishkin, Herbertsson, 2005, p.8).”
Even The International Monetary Fund, right up until two months before the total collapse of Iceland’s economy, said in a Financial System Stability Assessment Update that; “[Iceland’s] banking system’s reported financial indicators are above minimum regulatory requirements [and] in light of concerns about market access stronger capital and liquidity buffers appear appropriate (Caruna, Chopra 2008). However there were more than legitimate concerns. Banks had loan loss reserves of 0.8% (Boyes, 2009, p. 140). Net external debt had increased to 142% of GDP in four years.
In order to sure-up the banks and bring in more capital to maintain their ratings Landsbanki decided to launched Icesave, an online savings account for depositors in Britain (and later the Netherlands) (Boyes, 2009, p.127). These deposits were used mostly to finance the decline in wholesale deposits after the Fitch rating decrease. Kaupthing also launched Kaupthing Edge, in Germany in a similar way (Benediksdottir, at el., 2011, p.192). The Icelandic banks had the same problem as other commercial banks, however magnified by their small economic base, that with narrow interest margins on deposits, traditional bank is actually is barely profitable. Banks have a constant need to expand in order to remain profitable.
Finally when Lehman collapsed in early 2008, the first shockwaves of the global crisis resonated across global markets, and the true depth of the problem was revealed. As access to credit dried up, the three large commercial banks were incapable of withstanding the shock. Depositor distrust caused a run on offshore as well as domestic accounts and Landsbanki and Kaputhing froze their Icesave and Kaputhing Edge products. British depositors–which included other banks, government institutions, schools, and pension funds–had deposited €5 billion, and in the Netherlands 125,000 customers had invested €1.7 billion (Boyes, 2009, p.133). The financial sector’s highly leveraged position, dependence on foreign financing, and an overall lack of liquidity in the international financial markets brought on by the global financial crisis, led to the collapse the three major banks (Centonze, 2011, p.140). Without banking activities, a breakdown of payment systems and the complete derailment of the economic activities of the country would surely have followed.
The cascading effect on Iceland was profound. Overnight asset prices plummeted, trading was suspended, the foreign exchange market disappeared, and the Krona collapsed (Centonze, 2011, p.140). Unable to finance their debt the banks turned to the CBI, however the CBI reserves were only approximately €2 billion. Glintir alone had an immediate debt servicing call of €50 billion (Centzone, 2011, p141). When the UK Financial Services Authority requested that Landsbanki pay for the deposits of their Icesave accounts, they couldn’t and neither could the Icelandic government (Centzone, 2011, p141). In order to avoid total economic collapse, Norway, Denmark, the Faroe Islands, Sweden, Finland, and even Poland each provided emergency currency swaps. While the full extent of the liabilities were coming to light over September and October of 2008, it would ultimately become very clear that further support would be needed. For the first time in the 1970’s, an OECD country would have to turn to the IMF for support.
 Mr. Gissurarson was a professor of politics at the University of Iceland at the time and vice president of the Mont Pelerin Society.