Negative reports on the Icelandic economy, as published in several foreign newspapers recently, come as a surprise to us . . . All indicators and forecasts are consistent that the prospects are good, that the situation in the economy is by and large strong and the banks are sound. This has been thoroughly confirmed by well-known scientists such as Frederic Mishkin, who has become a governor of the us Federal Reserve, and Richard Portes, a well-known academic expert in this field.
Prime Minister Geir Haarde, March 2008footnote1
In 2007, average income in Iceland was almost $70,000 per annum, the fifth highest in the world and 160 per cent of that of the United States. Reykjavik’s shops brimmed with luxury goods, its restaurants made London look cheap, and suvs choked its narrow streets. Icelanders were the happiest people in the world, according to an international study in 2006. Much of this prosperity rested on the super-fast growth of three Icelandic banks. They rose from small, utility institutions in 1998 to join the ranks of the world’s top three hundred banks eight years later, increasing their ‘assets’ from 100 per cent of gdp in 2000 to almost 800 per cent of gdp by 2007, a ratio second only to Switzerland’s. As the value of their houses soared, Icelanders also loaded up on debt, including foreign-currency debt, living out Plautus’s dictum: ‘I am a rich man, as long as I do not repay my creditors’.
The crisis hit at the end of September 2008, as the money markets seized up in the wake of the Lehman meltdown. Within a week, Iceland’s three big banks collapsed and were taken into public ownership. They now joined a less glorious league—Moody’s list of the eleven biggest financial collapses in history. Since then Iceland has been pioneering an uncontrolled experiment in how a modern economy can function in a combined currency crisis, banking crisis and sovereign-debt crisis. By November 2008 the Icelandic króna had fallen to 190 to the euro, from a previous exchange rate of around 70—a massive cut in the islanders’ purchasing power. The foreign-exchange market stopped working, and world currencies were available only for government-approved imports. The stock market plunged by about 98 per cent, and by March 2009, the banks’ senior bonds were trading at between 2 and 10 per cent of their face value. Average gross national income fell from 1.6 times that of the United States to 0.8 times in February 2009, at market exchange rates. These are measures of a calamity.
Iceland is interesting partly because it is an unusually ‘pure’ example of the larger dynamics that produced the rising levels of financial fragility across the developed world through the 1990s and 2000s. In many countries the finance sector grew relative to the rest of the economy, thanks to a combination of three factors: the ‘post-Bretton Woods’ architecture of floating exchange rates and free capital movements; the internet; and surging concentrations of income and wealth in the top few percentiles of the population in the advanced-capitalist countries and several other major economies, including China and India, that raised the demand for complex financial instruments in which to store their accumulating funds. In earlier periods when finance was in the driving seat—for example, at the start of the twentieth century, in the Belle Epoque—financiers retained close ties to production. They sat on the boards of the great electrical, chemical, metallurgical, railroad and shipping conglomerates; they helped to create oligopolies and decide where to invest in production. The difference this time, especially after the high-tech crash of 2000, is that finance in the driving seat has been able to generate giant profits and remuneration ‘within itself’, by ‘casino economy’ operations far from production.
Then the positive-feedback loop kicked in, as many governments—notably those of Britain and the us, home to the City of London and Wall Street—became more beholden to their financial industries than to any other sector. Commentators celebrated the ‘great stability’, the apparent success of policymakers in smoothing the ups and downs of the economic cycle and sustaining long periods of non-inflationary growth. Governments’ dependence on the financial sector, and mood of self-congratulation, led them to signal that they would use state revenues to bail out large financial organizations that made ill-judged investment decisions, creating a largely unnoticed danger of ‘moral hazard’. Financiers became confident that ‘we won’t face the downside if we screw up’. They modelled stress tests for only modest levels of difficulty since, as one British banker put it, ‘the authorities would have to step in anyway’ in the event of trouble.footnote2 Not only was national over-sight ineffective; global regulation, such as Basel rules, was even laxer, or even counterproductive; and within Europe there was little serious cross-border regulation.
In Iceland the problems of financial-casino economy, regulatory capture and moral hazard were intensified, because the economy and population—around 300,000 people—are small and the state, though ‘modern’ in appearance, did not have regulators with specialized knowledge of international banking. Instead, the government relied increasingly on the banks themselves for information about the economy. Furthermore, from the early 1990s the country was ruled by zealous neoliberals, who believed that financial markets were ‘efficient’ and self-adjusting. These were ideal conditions for regulatory capture.