‘Deep Freeze: Iceland’s Economic Collapse’ (Ludwig von Mises Institute), by Philipp Bagus and David Howden―both economists specialised in business cycle theory―is hot off the presses, and packs a punch. The authors propose that Iceland’s economic collapse of 2008 was almost entirely down to poor regulatory policies, and point their proverbial fingers straight at the Central Bank of Iceland and its master helmsman, Davíð Oddsson.
In the poignant foreword, Toby Baxendale, founder of the UK’s Cobden Centre (an advocacy promoting deregulated trade and business policies) and a fish trader with strong ties to Icelandic fishing industry, paints a picture of a government in constant fear of losing control of its natural resources. “The [Icelandic] government,” he says, “not wanting the lifetime of fish quotas to get into the hands of a nasty foreign creditor, would not and still does not allow them to go bust. This irresponsible action on behalf of government will ensure these zombified fish companies will continue undead for many years to come.”
Bagus and Howden make a strong case. In the boom years, a major money-spinner for Iceland’s three largest banks at the time—Glitnir, Landsbanki and Kaupþing—was ‘maturity mismatching’: the use of short-term liabilities to invest in long-term assets. Not that this tactic was unusual in the global banking sector, but there were high risks, which the bankers took for granted—perhaps even with just cause—believing that the Central Bank would cover their backs. We all know that at the time, Icelandic banks were churning ten times more money than the nation’s entire GDP.
The authors specify: “The Central Bank of Iceland had effectively given a green light to the banks to shoulder increasing amounts of short-term risk uncompensated by assets of corresponding risk or duration. This seemed to work well until global liquidity dried up…” At the end of the day, it was a simple cash flow problem. And mismatching is considered an acceptable, albeit risky undertaking. The Central Bank, it appears, was ready to burden all their bankers’ risks. With the 2001 New Act of the Central Bank of Iceland, “the Central Bank had committed itself explicitly to providing this function.”
And things were going well, so why worry?
The major other factor, according to the authors (hazardously brushed aside by the Central Bank), was increased speculation in the Icelandic króna. This was mostly due to the underpricing of risk: “Domestic interest rates were higher than those of foreign central banks, which had under-taken even more extreme loose-money politics than the Central Bank of Iceland.” As Bagus and Howden elucidate, investors preferred to indebt themselves in dollars, euros or yen at ridiculously low interest rates to invest in local assets. They then ask the obvious question: Why did Icelandic banks engage in such Las Vegas-style tactics? The answer, they explain, is because the bankers believed in governmental and institutional guarantees— even beyond the Central Bank of Iceland—all the way to the IMF. They took for granted that the exchange rate risk was minimal. There is an illusion, they say, that “consists of the notion that government intervention can and will help keep exchange rates more stable than is really the case.”
Inferring, of course, that even now some may still be harbouring such illusions.
The authors remind that the IMF reported in 2004 that Iceland’s move into foreign markets could only be seen positively. The curious thing is that the Central Bank appeared oblivious to the fact that in 2004 over 20 percent of foreign-denominated lending was with companies without any export income. It seemed that the króna would never falter.
Finally, Bagus and Howden propose that three things need to change in order for life to return to normal. Firstly, those misaligned firms and investments—many of which are still being supported by the government—should be entirely liquidated. Secondly, a financial sector should be commensurate with the size of a country; and thirdly, experience garnered from past misadventures needs to phase into a healthy production and consumption mix. Let the recession iron out all the snags. “Anything that delays the reassignment of labour to more productive uses [by governmental regulation and intervention] will increase the time until the economy returns to normal.”
And so it seems Iceland was not an innocent bystander of the liquidity crisis. It was Iceland’s government policies that “fostered an oversized, indebted, and mismatched banking system.”