How can the economy of a developed nation collapse in a matter of days. How can a country that is rich one day, the next day have to seek help from its neighbors to secure the import of necessary goods? This happened in Iceland in the days 6. – 8. October 2008. There are explanations. Adam Smith – the father of market liberalism – was concerned as early as 1772. He called what has now happened “overtrading” and did not really know how to deal with this weakness in theory. Nor did the Icelanders know it in 2008 after a promising experiment in market liberalism. For Icelanders, it can only be a meager consolation that Iceland is not the only rich country that is bad out there. Ireland, Greece, Latvia, Estonia and several other Eastern European countries have all run into major economic problems.
- What is the reason why things went wrong in Iceland?
- What has happened in the last year?
- Why has Iceland gotten into such big trouble?
- How has the outside world reacted to the Icelandic collapse?
What happened in Iceland was a typical banking crisis – and in extreme form. The banks had grown too large. A growth of 900 percent over the course of five years was too much. This growth is far higher than other countries have experienced in recent years. There were no real values behind – just borrowed money and inflated values in securities that no one eventually wanted.
A major cause of the crisis lies somewhat back in time. After the so-called IT bubble burst around the turn of the millennium, and after the terrorist attacks of September 11, 2001, the world’s central bank governors agreed to cut interest rates. The world economy needed stimulation and got it. Now it became favorable to borrow money and unfavorable to save.
In the years that followed, many things happened simultaneously in Iceland, a country located in Europe according to holidaysort.com. A series of unfortunate coincidences (see below) led to enormous economic growth, followed by the collapse of the economy.
2: Unregulated flow of money
DEREGULATION : The banks, which have long been state-owned, were privatized . This process was completed in 2003. Young, ambitious entrepreneurs – both on the owners ‘side and in the banks’ administration – took over the banks. They quickly saw that in order to grow, the banks had to go out – get money from abroad and invest abroad.
The process of privatization was and still is controversial. The government was accused of “hand-picking” a few businessmen and selling the banks to them for small change. They were not experienced bankers, but had political contacts in the government. No foreign banks showed interest in buying Icelandic bank shares.
The EEA agreement ensured the free flow of money. The Icelandic money market was also deregulated by Prime Minister David Oddsson’s center-right government. In the spirit of liberalism, the state should not disturb the free market. This was the beginning of an experiment in market liberalism.
In countries such as Germany and Japan, banks were full of savings. This is the case in rich and “old” countries with many pensioners. These banks had to get the money in circulation. The Icelandic bankers took advantage of this.
OVER-CONSUMPTION AND INFLATION: In Eastern Iceland, the development of a large power plant and an aluminum factory began at this time. Money flowed in, the krone exchange rate went up, there was a great shortage of labor, wages rose – so did inflation. Private consumption increased in Iceland, and already from 2003 the trade balance was in the red. The party had begun.
CASH FLOW FROM OUTSIDE: To cool the economy, the central bank raised interest rates to make it favorable for Icelanders to save and not to borrow. It did not go as expected. The banks got hold of cheap money in low-interest countries unhindered. Cash flow from abroad only increased as interest rates rose.
Banks in Japan, Germany and the Netherlands also began moving money to Iceland to enjoy interest rates of up to 15 percent. The krone exchange rate rose steadily as there was greater demand for Icelandic kroner.
CURRENCY LOANS: The banks were eager to arrange favorable foreign currency loans to finance the purchase of houses and more cars. House prices doubled in a couple of years. Inflation increased further, leading to even higher interest rates and even stiffer cash flow from other countries.
It was possible to make big money on what in the banking world is called “carry trade” . This means that you take out a loan in a country where the interest rate is low, and exchange the money for a currency where the interest rate is high and the exchange rate goes up. This is pure money speculation.
In 2005, former Prime Minister David Oddsson became central bank governor. He is now being criticized for not using other means than interest rates to prevent the economy from overheating. The central bank’s monetary policy worked against its purpose .
3: Overinvestment and corporate confusion
The money borrowed by the Icelandic banks was used only to a small extent in Iceland. It was now that the so-called “Buykings” – the acquisition kings – appeared. Icelandic investors began to buy up – and on a large scale – companies and real estate in other countries – especially in England and Denmark.
There were mainly three groups of investors. They eventually owned the three private banks in Iceland – Glitnir, Kaupthing and Landsbanki . The acquisition kings were both bankers and investors . It turned out to be an unfortunate combination. The banks took out loans abroad and lent on to their own owners to invest again in other countries.
Eventually, a large tangle of joint stock companies appeared around the three banks. The shares were pledged in the banks, and the bank’s equity consisted of these same shares. And investors traded shares, sold the companies to friends and bought back at ever-higher prices. This is how stock market values rose steadily. This is what Adam Smith called “overtrading.”
4: Cash flow reverses – breakdown
But then there were problems with money. From 2006, the distrust of Icelandic banks increased rapidly. Everything they owned was mortgaged, and they had great difficulty borrowing money. The money now flowed out again as fast as it had flowed in before. Industrial development in Eastern Iceland was completed, and the pressure on the economy eased.
The krone exchange rate fell again, and currency speculators began to move their money out of the country. Then there was a drought in the Icelandic banks. They had to take out new and more expensive loans from foreign banks at ever higher interest rates, and the payment deadlines became shorter and shorter. As early as 2006, many Icelanders suspected that something was wrong. In retrospect, it looks as if the bankers and the authorities chose to ignore the danger.