From Iceland — Bubblicious!


Published August 4, 2010


The collapse of the Icelandic financial system in October of 2008 did not only squash any dreams Icelanders had of turning their tiny island into a ‘global financial centre’—it swept the so-called ‘Icelandic economic miracle’ into the dustbin of history.
In the wake of the SIC report many culprits have been fingered for the collapse of the ‘Icelandic economic miracle’. On one hand, one can point to a potent mix of global financial conditions (a glut of cheap money) and misguided governmental economic policies. The policies included badly timed tax cuts and expansionary industrial and investment policies. Those, along with an overvalued currency, attracted global hot money that then pushed up asset prices, encouraging consumers and businesses to take on ever more debt, as well as providing the ‘Corporate Vikings’ with the necessary leverage to undertake reckless foreign adventures.
On the other hand one can point to massive government failure: Lack of financial regulation along with understaffed and under-funded regulatory institutions (with unclear mandates) created the conditions in which greed and short term thinking by oligarchs, corporate raiders and investment bankers lead to things like the Enron-esque accounting frauds and massive market manipulation carried out by Kaupthing and its top brass. It appears that public opinion has been gravitating to the latter explanation, seeing the ‘economic miracle’ as little more than a gigantic bank heist.
However, when commentators seek to sum up the economic miracle they most commonly resort to is the idea of a bubble.
Bubbling under
But what exactly is a financial bubble? And does the ‘Icelandic economic miracle’ qualify as one? It is remarkable that this question has never been explicitly addressed. For example, the SIC report refers to a bubble in Iceland on several occasions, but does not rigorously define this bubble or answer when it started.
Defining bubbles is notoriously tricky—leading many economists to reject their very existence. Usually bubbles are simply defined as a shared speculative hallucination—followed with a spectacular crash. The American Federal, under Alan Greenspan, emphasized that it was in fact impossible to identify bubbles as they were inflating. In a 2002 speech Alan Greenspan argued that it’s “very difficult to definitively identify a bubble until after the fact – that is, when its bursting confirmed its existence.” According to Laurence H. Meyer, a governor at the Fed in the ‘90s, one could safely assume that a bubble had burst if stock prices came down by 40 percent or more.
Free market fundamentalism
Others reject the idea of bubbles entirely. Among those are the free market fundamentalists, who believe in the strong version of the ‘efficient market hypothesis’—the idea that financial markets always reflect all available information and that they are therefore a correct measure of underlying economic fundamentals—that financial markets correctly measure risk and uncertainty and always discover the correct price of all assets. According to this theory financial bubbles are simply impossible; they do not exist.
There even exists a large academic cottage industry that is dedicated to proving this idea, employing historians and economists who write articles proving that past financial bubbles are, in fact, not bubbles. That irrational exuberance was an inconsequential factor, if not completely absent in the Dutch Tulipomania of the 17th century or the English South Sea bubble of the 18th century, Wall Street of the late 1920s or the dot-com mania of the ‘90s.
Pantagruelian asset inflation
It is unlikely, though, that anyone will argue that the Icelandic economic miracle was not a bubble. In the span of a few years the Icelandic banking system grew to gargantuan proportions. By 2007, the banks had grown to an astounding 873% of the annual domestic product of Iceland, having more than doubled annually since the turn of the century. The growth was especially explosive after 2004, as the total assets grew sevenfold. During this time a similar inflation took place in the stock market as the ICEX index rose by 56% in 2003, 50% in 2004 and 67% in 2005. All in all, the stock market grew by 539% between January 2002 and July 2007, when it peaked.
Iceland also experienced a housing bubble. Real estate in Reykjavik rose by 72% between January of 2002 and when the market peaked in April of 2006. When the price of a square meter in Reykjavik had reached 3.000 Euros, almost double the price in Berlin, bank analysts and real estate agents claimed that they were in no way unreasonable, pointing to the undeniable fact that real estate was more expensive in other cities. For example Luxembourg or Manhattan. Whether this was a reasonable comparison was conveniently left unanswered.
It seems safe to assume that in the fall of 2008, a bubble burst.
The foundations of the bubble
We are accustomed to think about bubbles as market phenomena, something that develops in asset markets and can best be seen in rising prices. As Robert Shiller has argued, however, bubbles are primarily social phenomena that manifest themselves not only in the market, but perhaps more importantly in the broader culture, in the attitudes and beliefs of people and the national discourse. Shiller has argued in this context that it might be best to think of bubbles as a psychological or cultural epidemic. Greed and speculative fever, and other expressions of the madness that inflate bubbles, is present, to some degree at least, in all societies. At some point however, the intensity of irrational expectations reaches a tipping point, infecting the entire society.
When we trace the Icelandic bubble it might therefore be instructive to map the spread of some of the ‘extraordinary popular delusions’.
The most obvious example of this is the recurring belief that “this time it’s different”: All bubbles are founded on the conviction that somehow a ‘new era’ has dawned, an era in which everything is possible, the business cycle has been defeated and asset prices can only continue to rise to the sky.
The economic miracle as ‘new era’ philosophy
In the case of Iceland, the ‘new era’ was believed to have been ushered in by the market reforms, privatisation and shredding of the last vestiges of depression era economic restrictions during the 1990s. After the turn of the century these developments provided a simple and ideologically appealing explanation for the explosive growth of the financial sector and the apparent economic boom.
This main prophet of this idea was Hannes Hólmsteinn Gissurarson, professor of Political Science at the University of Iceland. In countless articles and several books, Hannes Hólmsteinn argued that Iceland’s full integration into global markets, market liberalisation and privatisation, had unleashed such incredible energies that Iceland could easily, and in a relatively short time span, expect to become the “richest country in the world”.
Hannes Hólmsteinn was by no means the sole prophet of ‘new era thinking’. The President of Iceland, Ólafur Ragnar Grímsson, explained the growth of the financial system with Icelandic exceptionalism: Icelanders, by virtue of their genes, were simply better businessmen than their foreign colleagues. In December of 2004, Sigmundur Ernir Rúnarsson, currently an MP for the Social Democratic Alliance, wrote a scathing critique of Scandinavian commentators who had pointed out that there were signs of a bubble in the Icelandic financial markets. Sigmundur Ernir mocked the Scandinavians, dismissing their worries as nothing more than envy and misunderstanding.
What makes his article interesting is the way in which he ties together the free market fundamentalism of Hannes Hólmsteinn and the bombastic nationalism of Ólafur Ragnar. Sigmundur Ernir argued that the privatisation of the banks and the market reforms had released the inherent entrepreneurialism of Icelanders which had been unleashed when “the lid was taken off the boiling pot,” ushering in an era of unprecedented and limitless growth in the financial sector. This mixing of free market triumphalism and nationalistic megalomania are in fact a common theme of financial bubbles.
Speculations such as this became more fanciful as we drew closer to the collapse. Hannes Hólmsteinn’s prophesies of Iceland becoming the richest country in the world, and the dreams of Iceland as a centre of global finance are symptomatic of new era thinking—delusions of limitless economic growth without any thought to the where this growth was supposed to come from.
The stages of the bubble
We can therefore say with certainty that by 2008 Iceland had two of the key characteristics of a bubble: Seriously overvalued asset markets and a solid new era philosophy to justify the unrealistic valuations. By 2004 the pathogen, a potent ‘new era’ philosophy, had mutated into a particularly dangerous form of an arrogant, bombastic exceptionalism.
But when did the infection reach a tipping point? Although it is difficult to pinpoint this transition with certainty, it seems that by early 2006 Icelanders had made the transition.
In late 2005 and early 2006, market analysts at several foreign financial institutions published reports that were quite critical of ‘the Icelandic economic miracle’ warning, among other things, that asset prices in Iceland were overvalued, the economy overleveraged, the banks overextended and that they posed a systemic risk to the economy. Icelandic commentators and elected officials reacted with amazing ferocity, accusing the foreigners of having ulterior motives and of wanting to “talk down” the Icelandic banks. Others were more generous toward the critics, arguing that the mysteries of Icelandic business were such that the naysayers probably just didn’t ‘get it’. In this spirit, the banks launched a major PR-campaign to boost their image.
The silencing of sanity
While there were critics and Cassandras who warned that the economic miracle was a mirage and that the bubble was about to burst—the vast majority of the chattering class, politicians and pundits, as well as the general public, went along with the spin that marginalized the voices of sanity.
This squashing of dissent is perhaps the most dangerous feature of bubble mentality. Not because it serves to reenergise speculators and thus protects overvalued asset markets, but because it creates an uncritical atmosphere where people wilfully ignore warning signs and critics keep silent out of fear of being ridiculed or branded enemies of the market.

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