The Immediate Future Looks Pretty Grim

Economist Gylfi Magnússon warned against the dangers of the Icelandic economy before the crisis. He mans the post of Minister of Business Affairs, courtesy of Iceland’s new minority government. He also is a Professor of Economics at the University of Iceland, and holds a Ph.D. from Yale and a Master’s degree in Philosophy. “There were a lot of mistakes made and warning signs ignored,” he says. “The debts will rise and the banks’ size need to be controlled, but Iceland has the resources to surmount the problems.”
How do you explain to the people that they have to pay the banks’ foreign debts?
First of all, with regard to Kaupthing Edge in Germany, I have been told that it seems almost certain that there are sufficient assets within the bank to pay off depositors. There is a much bigger problem with Landsbanki’s Icesave accounts in the U.K. and the Netherlands. It seems inevitable that when all accounts have been settled, some part of these Icelandic debts will be paid by the Icelandic government and then, of course, by the Icelandic taxpayers.
Are the Icelandic banks doomed to remain domestic because Iceland is such a small country and the banks shouldn’t exceed the GDP?
You can say that for now. The banks over-extended very dramatically. Our main concern now is to get the New Banks fully functional in order to be able to serve the domestic economy. Basically, all their foreign operations have either been seized or are waiting to be sold off. At some point their finances and reputation may recover, and then they may be able to expand a little bit abroad but that won’t happen in the immediate future. We have to do everything that it is needed for the domestic business and will not spend resources on expansion. The Icelandic government has to set up a regulatory framework to make sure that nothing similar to what happened in the recent past will be repeated. Obviously a number of things went wrong in Iceland. There were some bad decisions made by the bankers and the owners of the banks, but there was also regulatory failure.
In what way?
In many ways. Our regulatory framework puts very little limits on how large the banks could become and there were no serious attempts made to try to reduce their growth. There was domestic and foreign criticism before the banks collapsed. But those voices were not listened to.
Why not?
On the surface everything looked extremely rosy. The banks were growing rapidly, generating huge profits. They were hiring people left and right on very high salaries. The stock market was booming. The real estate market was booming. But the banks were relying to an ever-increasing degree on horrendous borrowing. There was a real danger that if there was some disruption in the flow of foreign capital, we could have a very rapid negative spiral where the asset prices could fall and the Króna could depreciate. Which unfortunately is exactly what happened.
Do you think that the banks should have had the obligation to advise Icelandic customers not to take foreign currency loans?
They should have done that. Instead, they advertised risky behaviour and risky products. And it’s quite clear that when a banker tells a customer, without any foreign currency earnings, to make a huge bet on the Icelandic Króna by taking a foreign loan, the current exchange rate fluctuations can make the customer bankrupt overnight. But one more reason why people were taking foreign loans was the high interest rates in Iceland. This was a policy mistake by the Icelandic Central Bank.
How highly is Iceland in debt now?
This is complicated. The government will take on sizable debts as part of the IMF program, the settlement of the Icesave deposits and also some domestic debts due to the refinancing of the banking sector. We will have a sizable budget deficit this year and next year as well. That said, the gross debt will be somewhere around one year’s GDP, which means that the situation here is somewhat worse than the situation in Belgium or Italy before the worldwide financial crisis.
How is Iceland supposed to pay these debts considering the depression, companies going bankrupt, consumption decreasing and interest piling up?
It’s certainly going to be tough. I don’t want to say a year or two, because it will take longer than that, but the immediate future looks pretty grim because of all those factors and with government tax receipts falling at the same time. Demands towards the government, like unemployment benefits, are also rising. But we have to keep in mind that the crisis doesn’t destroy real assets. We still have a very well educated, hard-working, flexible labour force. We have infrastructure and natural resources. We can use these real assets to regenerate goods and services, including export. And the government is getting a lot of assets as well. For example, it now owns the banks and even if they won’t be sold they should become healthy companies that provide revenues. So, the government’s net debt should end up similar to the ones in the Western European countries, maybe 50-60% of the GDP, even if we don’t paint a very rosy picture. Also, our weak currency, even though it contributed to the downfall and the big problems, can help to Icelanders recover through exports quicker than countries that have a strong, stable currency.
Do you think that other countries might face the danger of bankruptcy in the course of the worldwide economic crisis, countries like Greece, Portugal or Ireland?
I certainly hope not. And what is strikingly different in these countries is the fact that they don’t have a small floating currency like we have, and they have the backup of EU Central Bank and maybe even of their fellow governments within the EU.
Your predecessor said that he regretted not having pushed Iceland more towards EU-membership. Do you think EU-membership would have prevented or reduced the consequences of the crisis for Iceland?
It would not have prevented a crisis but it would have made the dynamics different, especially when it comes to debts and the loans and the crushing exchange rates. But I doubt that Iceland as a EU-member with the Euro would have escaped the financial crisis, if nothing else had changed.
Are you in favour of EU-membership?
I am in favour of finding out what it would entail. Most economists claim that having its own floating currency, without any ties to another currency, is not a viable long-run option for Iceland. We should start negotiating with the full intention of entering but of course not decide to enter until we know what the framework would look like. Icelandic negotiators would presumably call for some sort of exemption or special treatment with regard to the fishing industry. A deal where we lose all sovereignty over the fishing rights would never be politically viable. Iceland already has almost all other benefits of EU-membership through the EEA: labour mobility, freedom of investment, re-trade etc.. So it really boils down to the fishing rights. But I think that a reasonable plan of entering and adopting the Euro would be very helpful to bringing financial stability to Iceland.