It is curious, when one considers how obvious it now seems that the Icelandic financial miracle was a giant bubble, that this idea has really not received any attention from academic economists. In fact there are no academic studies that address the question whether or not the Icelandic financial miracle was a bubble—or if it was, when it became one. This is all the stranger because of the centrality of finance in the Icelandic economy during the past decade—one would have assumed that Icelandic economists would have taken up this question. After all, it is one of the reoccurring themes of financial economics and financial history.
Perhaps all the economists were too busy engineering derivatives or working at complex deals for the banks to spend time on idle research? Perhaps the question didn‘t seem important? Perhaps the answer was too obvious and the existence of a bubble too glaring to warrant any research? Why spend time studying something and proving the existence of something that is apparent to any casual observer?
Or, perhaps, the question was too controversial. After all, it might have caused a bit of alarm had an Icelandic economist—as opposed to some foreigner “who doesn’t understand Iceland and the Icelandic economy”—had pointed out the obvious: That the ‘financial miracle’ was nothing more than a bubble.
Whatever the reason, this is a strange omission in Icelandic economics scholarship. An omission that probably tells us something about the state of the economics profession in Iceland.
A BUBBLE OF HISTORICAL PROPORTIONS
One measurement of bubbles is the size of the price increases while the bubble is inflating, and then the size of the fall as it comes crashing down. If we employ these measures the Icelandic financial bubble does, in fact, seem rather enormous. During the great bull market of the 1920s, between 1921 and September of ’29, the Dow Jones index rose by 490%. In the internet bubble of the ‘90s, NASDAQ gained an impressive 570% between 1995 and March 2000. The Icelandic Financial Miracle, however, outdid both, as the Icelandic market grew by a staggering 680% between 2002 and July 2007, when the market peaked.
The Icelandic crash was similarly spectacular. When the internet bubble burst, NASDAQ dropped by 78% in two and a half years, between March 2000 and October 2002. In the ‘Great Crash’ of ’29—which actually lasted for nearly three years, between September 1929 and July 1932—the Dow Jones lost 91% of its value. During the Icelandic crash, which lasted a little over a year, the Icelandic market lost 95% of its value. This is actually a world record for a stock market crash!
So, it was no ordinary bubble. It was a bubble of historical proportions. The only viable alternative is that ‘something remarkable’ happened in Iceland around the turn of the century, something so amazing that it suddenly made Icelandic assets far more valuable than they had been, triggering a 680% ‘price correction,’ only to be followed by another equally drastic 95% ‘price correction,’ caused by a sudden unforeseeable change in the underlying fundamentals.
HOW TO DENY A BUBBLE
This latter scenario would be the basic model of any paper that followed the ‘efficient market hypothesis,’ the idea that market participants are rational and that stock markets are efficient—that they always incorporate all available information, making prices a correct reflection of underlying economic realities. The rise could not have been caused by the madness of crowds, an irrational exuberance of investors who were picking and choosing what information to act on, over-hyping positive news and ignoring warning signs. No, if prices rise spectacularly, it must be because the underlying fundamentals warrant such a rise. When they fall, it is because the underlying fundamentals have changed. And if the fall is very sudden, it must be because the change was unforeseeable and the information about these changing underlying fundamentals arrived very suddenly.
How would one go about making this argument? Well, one simply goes back to the boosters of the bubble and assumes their arguments were correct—or rather, that there was no way to know, at the time, that they were anything but rock solid. Financial economists can also use all kinds of statistical tools to show that market indicators were all ‘normal,’ that even the most advanced statistical tools could not have predicted the collapse and so on and so forth. But since we don’t have such statistical tools at hand, and since such statistical exercises are dreadfully boring anyway, I suggest we explore the former route, assuming that people were right when they observed the bubble inflating, proclaiming to themselves, “this time it’s different.”
HOW WAS IT DIFFERENT?
Just as in all other cases of irrational exuberance, those who claimed things were somehow different could, at the time, point to some pretty compelling arguments to bolster their case. All episodes financial historians have identified as bubbles begin as reasonable price increases, a strong bull market, based on some sound fundamentals, a price correction triggered by some dramatic economic change which justifies increased optimism. At some point, however, prices simply lose their moorings to these underlying fundamentals and start heading toward the stratosphere.
Icelandic economy had undergone a dramatic transformation in the 1990s, due in part to massive free market reforms. At the same time all currency controls had been lifted, opening the financial system up to global markets. All of this seemed to have unleashed tremendous energy—pundits and politicians were particularly fond of pointing to the foreign investments of the banks and allied Icelandic business Vikings as proof of this explosive energy.
During the earliest phases of the Icelandic asset bubble, rising prices were explained with increased efficiency due to mergers and restructuring of existing firms made possible by the creation of a stock market and the transformation of the banking system. When the opportunities for mergers and takeovers in Iceland had dwindled and the banks and business Vikings had turned their eyes outward, the rising stock prices were explained by the potential and profitability of foreign expansion.
At first glance this reasoning seemed, and still seems, pretty convincing.
CIRCULAR LOGIC
The rule of thumb measures used to judge stock prices similarly appeared to justify higher prices. The price-earnings ratios of the Icelandic market were relatively low in international comparison, leading Kaupþing to suggest in April 2007 that market valuations were relatively low in international comparison (a price-earnings ratio, or a P/E ratio, is the number of years of current profits it would take a company to justify its market price). The P/E ratios of the investment companies which dominated the Icelandic stock market and which led the ballooning asset bubble appeared especially reasonable. In July 2007, the price-earning ratio of FL-Group was 9,4—which is not at all that outrageous—the historical average P/E ratio of firms in the S&P 500, a broad measure of the US stock market, was around 15.
Since the P in the P/E ratio was astronomically high (the market value of FL Group was over 400 billion ISK in July 2007, or some 6,7 billion dollars. To put that in perspective—Twitter was recently valued at 7 billion dollars), the P/E ratio could only be reasonable if the E of the equation was equally high. And of course it was—all these firms were making record profits. The profit of FL Group during the first six months of 2007 was 23 billion ISK. But since assets were booked at their current market price, rising asset prices showed up as profits on the books, meaning the massive profits of these companies were largely the result of a rising market, which in turn generated even larger profits.
This circular logic was constantly used to justify ever higher prices, and surprisingly few people pointed out how absurd this really was. A editorial in the business section of Morgunblaðið made a note of this in July 2004, remarking that this logic was made worse by the cross-ownership of financial firms and that it could work both ways: a drop in stock prices would lead to a chain reaction of losses and falling prices.
But the market apparently shrugged off these concerns. And, strangely enough, nobody made any attempt to explain why exactly it was reasonable to expect FL Group or any of these companies to maintain astronomical profits for a decade. Especially since such profits could only be maintained if asset prices continued their upward march unstopped, it seems odd to assume that they would continue to grow at the same rate as they had.
How on Earth was this supposed to work? The absurdity of these expectations is especially glaring when we consider the banks. Their stock prices rose by 444% (Glitnir), 536% (Landsbankinn) and 661% (Kaupþing) between January 2004 and July 2007, thanks to handsome profits caused by profitable investment banking operations at home and abroad. But their high stock prices could only be justified if they continued to grow. And who could seriously expect the banks to continue to expand their balance sheets? Between 2004 and 2007 the banks grew their books sevenfold—at the end of 2007, their assets were 870% of Iceland’s GDP. The FDIC, which regulates deposit institutions in the US, considers annual growth that exceeds 25% a red flag—indicating that the institution in question has taken on too much risk. The Icelandic banks would have raised a whole lot of red flags at the FDIC.
WAS ANY OF THIS REASONABLE?
Well, of course it was completely reasonable to expect this kind of growth if you seriously believed the hype of the banks and their cheerleaders. In a speech given in 2004, Kaupþing executive chairman Sigurjón Árnason announced that the bank was to become one of the five largest banks of Scandinavia within five years, a feat that meant the bank would ‘only’ need to double in size every year, for five years. And in 2005, then-prime minister Halldór Ásgrímsson, announced his ‘dream’ of Iceland as a ‘global financial centre’ in ten years, by 2015. Certainly, if one believed these goals were attainable, believing FL Group could continue to churn out record profits at least a decade and the banks could double in size every year seems reasonable enough.
Ok. But exactly what would that kind of growth have meant? For example, what would it have looked like if the inevitable crash had not come and the financial system had continued growing like did prior to 2007? Let’s say, for example, if the banks had continued their growth uninterrupted until 2015, the year Iceland was supposed to have reached its goal of becoming a ‘global financial centre’? Even if the growth had slowed down to the pace of the years 1999–2003, or 30% annually, and even if we assume a robust growth in the Icelandic GDP, it would still have meant that the banks would have become 48 times larger than the Icelandic economy.
At that time the Icelandic banking system would have been roughly as big as the entire economy of Switzerland. And if Iceland barely survived the collapse of a banking system that was nine times larger than its GDP, one can barely imagine the magnitude of the catastrophe had the bubble managed to inflate to the full extent of the dreams of its most enthusiastic proponents.
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