The International Financial Crisis The Case of Iceland Are there

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					   Working Papers on
   Global Financial Markets

                                                           No. 3
                               The International Financial Crisis:
                                             The Case of Iceland
                                – Are there Lessons to be Learnt?
                                             Jón Baldvin Hannibalsson


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        +49 345 5523180


                              January 2009
                                        Working Papers on Global Financial Markets No. 3

The International Financial             The ratings companies (Moody´s,
Crisis: The Case of Iceland             Standard and Poor´s etc.) moved
                                        swiftly to downgrade the creditwor-
– Are there Lessons to be               thiness of the Icelandic state, reflect-
Learnt?                                 ing the view that it was beyond the
                                        goverment´s means to stand by the
                                        banks´ obligations. The risk sur-
I. Introduction                         charges imposed on loans to the Ice-
                                        landic banks rose sharply. The Ice-
On Monday morning September             landic bank system was teetering on
29th before the opening hours of        the brink. Thus started a week that
banks, the government of Iceland        ended in the collapse of the entire
(GOI) announced that GLITNIR,           financial system of Iceland.
one of Iceland´s three major com-
mercial banks, had been national-       On Monday October 6th the GOI
ized. A few weeks earlier the finan-    rammed a special emergency legisla-
cial supervisory authority of Iceland   tion through Althingi (Parliament).
(FME) had given the bank a clean        It gave extraordinary powers to the
bill of health. What had happened?      FME (Financial Supervisory Board)
                                        to take over the running of the
A few days earlier, the chairman of     banks. To avoid a run on the banks
the board and the director of           the law stipulated that all savings
GLITNIR had secretly met with           deposits with the Icelandic banks
the Central Bank directors to tell      were fully guaranteed by the gov-
them that GLITNIR was in trou-          ernment. The National Bank of Ice-
ble. Although GLITNIR had long          land (Landsbankinn) was next in line
term contracts for refinancing their    to declare insolvency. The National
short term debt - a significant part    Bank had branches abroad, in the
had been with Lehman Brothers.          U.K., Holland and elsewhere. The
Now, Lehman Brothers no longer          British government moved swiftly to
existed. GLITNIR, therefore, was        freeze their assets in the U.K. in or-
in desperate need for foreign cur-      der to safeguard their citizens´ inter-
rency. Having rejected collaterals      ests. By this time all Icelandic com-
offered on GLITNIR´s behalf the         panies abroad were under a cloud of
Central Bank, in consultation with      suspicion. The British government
the government, decided to buy          went so far as to apply the recently
majority share in the bank.             adopted “terrorist-law” to take over
                                        British registered companies owned
Evidently, the Central Bank reck-       by the Icelandic banks, including the
oned that this action would reassure    third and biggest Icelandic bank,
the markets and restore confidence      Kaupthing. The government of Ice-
in the Icelandic banks. By hind-        land (a NATO ally) and both the
sight, they evidently miscalculated.    Icelandic banks operating in London,

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                                         Working Papers on Global Financial Markets No. 3

were under this law blacklisted          unrealistic. In the phase of easy ac-
along with al Qaeda and other ter-       cess to cheap money from abroad,
rorist organizations. This was the       double digit Central Bank rate
last straw. Kaupthing fell and with      turned out to be not only ineffective
it the entire financial system was in    in restraining inflation but had the
ruins.                                   unintended side effect of strengthen-
                                         ing the value of the króna. This had
                                         many adverse consequences. It
II. Roots of the problem: Compla-        stimulated excessive imports, con-
cency and Exuberance                     sumption and debt accumulation as
                                         well as a balance of trade deficit, that
The American bank crisis (with the       spiraled out of control. When the
fall of Lehman Brothers) can be          interest-rate differential between Ice-
said to have been the spark that         land and abroad reached double digit
ignited the fire that consumed the       numbers, speculative capital started
financial system of Iceland. Nont-       flowing in, collecting quick profits in
heless this national disaster can only   currency speculation. This further
be fully explained in terms of do-       strengthened the exchange rate and
mestic Icelandic policies of the past    the imbalance of the overall econ-
few years. Most economists agree         omy.
that coordinated macro-economic
policy to restrain an imbalanced         When foreign speculators, sensing
economy had been conspicuously           imminent danger, started withdraw-
lacking. The government presided         ing their money, the value of the
over a major investment boom in          króna fell. Collapse is actually a bet-
the energy sector as well as letting     ter word to explain what happened.
loose a real estate bubble through       From the beginning of the year 2008
easy credit. A rapid rate of growth      until the fall of the financial sytem in
(3.6% per year on the average since      October, the value of the króna had
the turn of the century) fueled by       fallen by 70%. For a while the króna
foreign loans and unrestrained con-      was no longer an officially registered
sumer spending, was reflected in         currency and could only be traded in
explosive balance of trade deficits.     the black market. Iceland is thus suf-
                                         fering a twin crisis: A bank-crisis and
The expansion of the public sector       a currency crisis at the same time. And
(from 36% to 48% of GNP during           of those two, the currency crisis is the
the boom) under a conservative           more devastating.
government, was a world record.
The Central Bank since 2001 de-
clared a floating currency regime        III. Iceland and Ireland: A fateful
and pretended to restrain inflation      difference
within 2.5% limit, plus or minus
4%. This turned out to be totally        In this context it is interesting to

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                                       Working Papers on Global Financial Markets No. 3

compare the fates of the sister is-    Else we might have been in the same
lands of Iceland and Ireland. Both     situation as Iceland”. He is right. Of
island economies had been enjoying     all the fateful policy mistakes made by
sustained periods of rapid economic    the GOI and Central Bank of Iceland
growth. In both countries eco-         in recent years – and they are many –
nomic growth had been fueled by a      the stubborn resistance against joining
steady influx of foreign capital in-   the European Union and adopting the
vestments. In both countries the       euro, were the gravest.
real estate boom spiralled out of
control and turned into a bubble.      It is beyond doubt that had Iceland
In both countries the standard of      been a member of the eurozone rely-
living and the level of consumption    ing on the European Central Bank in
exploded. Both economies were          addition to the domestic authorities,
thus feeling the strain of overheat-   Iceland would not be in such dire
ing. But that is where the compari-    straits as it finds itself in now. Of
son ends. The big difference is that   course the Icelandic banks could
Ireland is a member of the Euro-       have gotten themselves into trouble
pean Union and a partner in the        none the less, just as individual banks
European Monetary Union, using         within the eurozone certainly have.
the euro as a national currency.       But it was not the lack of Icelandic
Iceland, on the other hand, has        krónur that made the Icelandic banks
been experimenting with its own        ultimately insolvent. It was the lack of
króna, within the smallest currency    foreign currency – euros – and the fate-
area of the world, in an environ-      ful weakness of the Icelandic govern-
ment of a free flow of capital under   ment and the Central Bank, that
a regime of wide open financial        caused the crash.
markets. This has turned out to be
a world of difference                  Had Iceland been a member of the
                                       European Union and a eurozone part-
When the Icelandic commercial          ner as well it would not have escaped
banks expanded from having been        the impact of the international finan-
one third of the Icelandic GNP         cial crisis any more than Ireland. But
into becoming twelve times the         it would not have been the helpless vic-
GNP, the GOI and the Icelandic         tim of both a bank – and currency
Central Bank were unable to pro-       crisis at the same time. This is the ma-
vide the necessary back-up. The        jor lesson to be learnt from the case of
banks had grown too big for Iceland;   Iceland, both for the Icelanders them-
or Iceland was simply too small for    selves and also for the smaller nations
the banks. This explains why the       within the EU, still trying to fend off
Irish taoiseach, Mr. Brian Cowen,      the impact of the financial crisis with
said: “Thank God that Ireland is a     their weak national currencies.
member of the European Union
and has long ago adopted the euro.

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                                          Working Papers on Global Financial Markets No. 3

IV. After the Crash: The Plight of        heavier and bankcrupties are increas-
a Nation                                  ing daily. Unemployment – un-
                                          known in Iceland since the early
Before the crash Iceland was classi-      nineties – is rapidly spreading. The
fied in OECD statistics as the 6th        pensionfund system – a bastion of
most affluent nation on earth in          strength in the Icelandic economy –
terms of per capita GNP. The crash        suffered heavy losses through the fall
will change all that. The question        of the banks. Hard won pension
remains if the debt burden will turn      rights will foreseeably be severly cut.
out to be way beyond the nation´s         But the youngest generation – the
ability to pay so that it will cripple    best educated in the history of Ice-
recovery through economic growth          land - will be most severely hit by the
any time soon. The immediate con-         crisis. They are the most indebted
sequences of the fall of the banking      ones and they will lose their jobs dis-
system are that the shareholders          proportionately. Young professionals
have lost their overvalued equity.        are already seeking jobs abroad. The
                                          most severe long-term consequences
But the crash of the currency has         of the crash will be emigration of the
immediate and severe consequences         young – the best and the brightest.
for the nation as a whole. Import
prices are increasingly inflated. This
is reflected in the consumer price        V. A Failure of Preventive Action
index (the measurement of infla-
tion). Since all long-term loans in       The rapid expansion of the Icelandic
Iceland are price indexed, any infla-     banks, coupled with the evident vul-
tionary spurt is permanently pro-         nerability of the króna, should have
jected through every houshold             sent strong warning signals to the
mortgage. Foreign currency de-            government and the Central Bank of
nominated loans will double in a          Iceland several years ago. What were
short space of time. For heavily          the options? One was to expand the
indebted firms and households, this       Central Bank´s foreign currency re-
is beyond their ability to pay. And       serves commeasurate at least with the
the fall in real estate and other asset   banks´ short term debt. This would
prices precludes the possibilty of        have been a very expensive solution
relying on liquidity of assets as a       as well as a risky one. Later, when
solution.                                 access to cheap money abroad be-
                                          came more difficult, this solution was
An IMF stipulated bank rate of            no longer feasible.
18% makes this debt burden unsus-
tainable. The shock effect is being       Another solution would have been to
felt immediately throughout the           have the banks, or at least the bigger
economy: Purchasing power is fal-         ones, relocate their headquarters to
ling, the debt burden is getting          the euro-area. Approximately 4/5ths

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                                          Working Papers on Global Financial Markets No. 3

of their activity was by then outside     heavily indebted. Although the Ice-
of Iceland, mostly within the euro-       landic state was at that time relatively
area. This would have removed the         debtfree, Icelandic banks and house-
present currency risk and brought         holds were hugely indebted. Hence,
the banks under the savings guaran-       the rating agencies imposed heavy
tee system of the relevant central        risk-surcharges on loans to Iceland
banks as well as secured the support      which in the end became prohibitive.
of the European Central Bank. Al-         Ultimately the rating agencies down-
though this issue was raised in pub-      graded the credit- worthiness of both
lic dialogue it was never seriously       the Icelandic banks and the State as
contemplated by the authorities.          well. By that time, by mid-year 2008,
                                          Iceland had no option left but to
The third option was for Iceland to       seek help from abroad.
join the European union and to
seek fullfilling the Maastrict criteria   Appeals for loan guaranties were
for adopting the euro. This option        made to the Nordic Central Banks,
was never politically feasible due to     to the Federal Reserve, the Bank of
the anti-European instincts of the        England and even to the European
Conservative Party´s leadership           Central Bank in Frankfurt. But by
which was, and still is leading the       this time Iceland was considered “too
government. Their euro-sceptisism         hot to handle.” The banks´ size
is in part inspired by their soul-        compared to the Icelandic economy
mates among the British tories, in        and their scale of indebtedness was
part by the influence of American         considered extraordinary and suspi-
neo-conservative ideologues, who          cious. After consultations the GOI
look upon the European Union as           was advised to seek help from the
some sort of a socialist conspiracy,      IMF.
and in part by their nationalist heri-
tage.                                     The first perfunctory analysis of the
                                          Icelandic situation did not inspire
By the year 2007 the warning sig-         confidence in the capacity of the Ice-
nals were already flashing both at        landic government or Central Bank
home and abroad. The American             to handle the situation. Under the
bank crisis, initially due to reckless    circumstances an IMF rescue-plan
subprime mortgage lending, was            for Iceland was considered a precon-
spreading fast. The fall of Northern      dition for help from other central
Rock in the U.K. was a milestone.         banks. Thus Iceland became the first
Access to cheap money for refinanc-       so-called developed country to seek
ing short-term debt was no longer         shelter with the IMF in 36 years.
easy. The rate of interest was rising.    There was no other option left open.
Ultimately the rating agencies had a      Since then other European countries
second look at countries and finan-       have had to follow into Iceland´s
cial institutions that had become         footsteps. By now the IMF has be-

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                                        Working Papers on Global Financial Markets No. 3

come a major player on the interna-     to borrow in the market. The Ice-
tional scene in dealing with the        landic fund had nowhere near the
international financial crisis.         resources required to guarantee all
                                        the savings deposits in the Icelandic
                                        banks´ subsidiaries abroad. The rele-
VI. The Ice-save Dispute: David         vant EEA-directive stipulates a
vs. Goliath                             minimum amount (20.887 euros) to
                                        be guaranteed to individual savings
Iceland´s appeal for help to the        depositors.
IMF, urgent as it was, was none the
less delayed for many weeks. The        This raised several questions for legal
reason was the so called “Icesave” -    interpretation: Was the amount
dispute between the Icelandic and       guaranteed actually dependent on the
the U.K. governments. What was at       fund´s resources? Or was it the
issue? The National Bank of Ice-        minimum amount defined in the
land (Landsbankinn) had estab-          EEA-directive? Was there an effective
lished branches in the U.K. and in      state guarantee, although it is not
Holland, offering a competitive rate    clearly defined in the text of the di-
of interest for savings deposits.       rective? Did the directive apply only
Other Icelandic banks did the same      when individual financial institutions
but in the form of daughter com-        failed or was it meant to apply as well
panies that were under the surveil-     in the case of total collapse of a na-
lance authorities and savings guar-     tional financial system? What about
antee system of the relevant coun-      national emergency rights? These are
tries. This was the Icelandic Banks´    some of the impertinent legal issues
method to solve their liquidity         raised in this dispute. Also, the U.K.
problems in foreign currencies.         government´s application of the “ter-
                                        rorist–law” against Iceland, which
When the Icelandic banks went           ultimately brought down the Ice-
down, the question rose immedi-         landic financial system, raised the
ately who should guarantee the sav-     question of the legality of the U.K.
ings deposits. Under the EEA-           government´s action and indemnities
agreement bank branches abroad          in case they were deemed illegal.
are under the surveillance authority
and the savings guarantee systems       The Icelandic prime minister initially
of the home country. Each country       insisted that the two issues, the Ice-
is obliged to run a savings guarantee   save dispute and Iceland´s applica-
fund which is financed by contribu-     tion for IMF support, were unre-
tions from financial institutions.      lated. He even gallantly declared that
This fund is an independent entity      he would not submit to British
without a formal state guarantee. If    threats on this issue. Instead he of-
this fund had insufficient money to     fered to have the issue solved by in-
stand by its obligation it was meant    dependent arbitration. In the end it

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                                         Working Papers on Global Financial Markets No. 3

was France, in her capacity as act-      of this sort. The IMF calculates that
ing presidency of the European           Iceland´s debt burden in the wake of
Union, who solved the issue. Ice-        the crisis will amount to 80% of
land was simply told that the EU         GNP. This is many times the
would prevent the implementation         amount Sweden had to borrow to
of the IMF rescue-plan, unless Ice-      bail-out the banks, as a percentage of
land accepted to pay the minimum         GDP, during Sweden´s financial cri-
guarantee as defined by the EU           sis in 1992-95.
directive, and decreed by the
Commission.                              The IMF, it seems, takes it for
                                         granted that the Icelandic banks´
At the same time the EU made sure        assets, meeting their debts, will main-
that Iceland would receive loans         tain their nominal value after the
that enabled the government to pay       crash, despite weak markets. This is
up. The EU argument was that any         hardly realistic. Some of those assets
doubt shed on the validity of the        have already been sold at fire sale
EU-wide savings guarantee system         prices. The global recession is also
could undermine the stability of the     negatively affecting such asset prices.
financial system of the EU as a          Thus authoritative chartered count-
whole. Also, Iceland was told that       ants reckon that the outstanding as-
since the government of Iceland          sets of the National Bank of Iceland
had in the emergency legislation of      have by now lost half their value.
October this year guaranteed all
savings deposits of Icelandic citi-      The Icelandic authorities are still in
zens, the same rule should apply to      the process of sorting out the net
all citizens of the EEA-area. Non-       position of the bankrupted banks
discrimination on the basis of na-       and negotiating with their foreign
tionality is a fundamental rule that     creditors. The overall picture is
applies      without     exemption       therefore far from clear yet. But the
throughout the EEA area.                 worst case scenario, taking into ac-
                                         count expected discounts in asset
                                         prices and a serious contraction of
VII. A Crippling Debt-burden?            Iceland´s GNP indicates, that the
                                         debt burden may reach one and a
This settlement raises two funda-        half GNP. This would amount to a
mental issues: One is if Iceland´s       per capita debt burden at least twice
debt burden in the near future will      the per capita debt burden for Ger-
be beyond the country´s ability to       many after World War I. In the case
pay and thus destroy the country´s       of Germany, the post war debt bur-
prospects of recovery any time           den imposed by the victors was so
soon. The other is the classical issue   heavy as to cripple the German
of moral hazard that always presents     economy for many years, leading to
itself in the wake of financial crisis   hyper-inflation and political up-

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                                          Working Papers on Global Financial Markets No. 3

heaval that in the end led to a new       entire country is already down and
world war. In the case of Iceland         out. The question is: Why should Ice-
the consequences may not be so far        landic taxpayers be forced by foreign
reaching. But they may be tough           governments or international institu-
enough to kill off any hope for re-       tions to pick up the bill left over by
covery in the near future.                Icelandic venture capitalists? The an-
                                          swer seems to be, because they have
                                          no other choice left – apart from
VIII. Moral hazard: Private gain –        emigrating. That is actually what a
Public loss                               sizeable proportion of the younger
                                          generation of Icelandic professionals
In economic theory hefty gains            is preparing to do. Iceland is now in
from risky investments are justified      the not so enviable position to be at
as a reward for venturing capital         the mercy of the IMF.
under uncertain circumstances.
High risk brings generous rewards
because the danger of loss is ever        IX. Enter the IMF: A Rescue-Plan
present. This means that when             or Collective Punishment?
risky investments fail, the investors
themselves should cover the loss. If      During the last two decades both the
not, the entire capitalist system is      World Bank and the IMF have been
undermined by moral hazard. Why           working under the heavy infulence of
should any investor remain pru-           the so called “Washington Consensus”.
dent, or even play by the rules, if he    This means they have been guided by
can count on others, i.e. the tax-        the neo-conservative ideology that
payers, to come to the rescue? In         the state is always a part of the prob-
the United States, the present-day        lem but never a part of the solution.
citadel of capitalism, the funda-         Countries should for their own bene-
mental rule applying to bail-outs of      fit open up for free trade and free
venture capitalists is, that since they   capital flows, without any restraint or
enjoyed all the profits, justified by     government interference. All prob-
risk, they should also bear the bur-      lems should be left for the markets to
den of failure. The big exception is      solve since they are also by nature
when the failing capitalist is big        meant to be self-correcting. Those
enough to threaten to bring down          countries that play by the rules will
the whole system with him. This is        be rewarded by dynamic innovation
what happened in the case of Long         and rapid economic growth, that will
Term Capital (LTCM) in 1998               gradually trickle down to the general
and it has applied to a few cases in      public. Those countries that disobey,
the current crisis.                       will be punished by stagnation and
                                          unemployment, since they will turn
This justification does not apply to      out to be non-competitive in the
Iceland. The financial system of the      global market place.

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Many of the poorest countries of         taining some hope that they had
the world have, because of heavy         learnt from their mistakes. In the
indebtedness, been forced to accept      current crisis it is remarkable that no
this medicine. The ideological           developed country has applied the
prejudice against the proper role of     standard IMF austerity medicine. On
the democratic state in economic         the contrary Governments are com-
developement has led to a serious        peting with each other in administer-
neglect of investment in infrastruc-     ing stimulative packages, based on
ture and human capital, making           deficit spending, and even resorting
domestic production hopelessly           to outright nationalization. The rich
non-competitive in the face of im-       world is certainly not practising what
ports, leading to balance of pay-        they have so far preached to the
ments problems and further in-           poor.
debtedness. Far from keeping the
promise of economic growth, those        Since Iceland is the first so-called
countries have been locked up in a       developed country that has ended up
vicious circle of stagnation, deterio-   under IMF tutelage in 36 years, there
rating living standards, and general     is every reason to ask: Has the IMF
misery.                                  learnt from its past mistakes? The
                                         answer, it seems, is both yes and no.
In the case of the Asian crisis 1997-    The three pillars of the rescue-
98 the IMF applied its austerity         program for Iceland are the follow-
program to the countries inflicted       ing: (1) To stabilize the exchange
by massive capital flight. The main      rate. (2) In the name of “safeguard-
pillars of the program were a steep      ing international relations” to force
rise in the bank rate (to prevent        Iceland to pay foreign creditors more
capital flight and maintain the          than strict legal obligations would
value of the currency) and a fiscal      demand, according to the govern-
austerity program, involving deep        ment view. And (3) to impose “a
cuts in social expenditure, both for     medium-term fiscal sustainability”.
investment and welfare. It is gener-     Remarkably, the IMF has accepted
ally accepted that the IMF misread       the fact that the Icelandic króna has
the situation and applied the wrong      lost all credibility. In relaunching it
medicine. In the case of South-          they therefore allowed “capital out-
Korea for instance, the program          flow restrictions” in the near term.
failed to prevent capital flight and     This is realistic. But imposing a Cen-
maintain the value of the won (it        tral Bank rate of interest of 18%, said
fell by 49%) and it made the eco-        to be necessary to maintain the value
nomic and social situation much          of the króna, and to keep the re-
worse than was needed.                   mainder of speculative capital still
                                         within the system, will only make a
Later on the IMF formally apolo-         bad situation worse.
gized for their mistakes, thus enter-

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                                        Working Papers on Global Financial Markets No. 3

The Icelandic economy is by now         consequences. The government re-
in a deflationary spiral. Raising the   acted helplessly to events rather than
rate of interest beyond 20% will        initiating any preventive action in
indeed be highly effective in bank-     time. After the event, attempts at
rupting what is left of indebted        damage control have been fumbling
companies still in operation in the     and erratic. The handling of the Ice-
country and thus increasing unem-       save-dispute was slow and ineffective.
ployment and general misery. This       Work on the restoration of the bank-
goes contrary to what central banks     ing system, now under state owner-
are doing all over the world, namely    ship, has been secretive and con-
lowering the bank rate in the hope      spicuously lacking in transparency.
of stimulating the economy. By
under-estimating Iceland´s long-        General lack of concrete information
term indebtedness the IMF may be        on government action in mitigating
crippling the economy and thus          the consequences of the disaster, for
putting at risk any recovery in the     both businesses and households, has
near future. On the other hand the      created an atmosphere of suspicion
fiscal austerity program must be        and mistrust. The government and
considered relatively mild since it     the Central Bank have been unable
does not really begin to bite until     to conceal their differences on major
the year 2010. But even that is a       issues, such as the IMF rescue plan,
doubtful strategy as the former         foreign debt obligations, the rate of
prime minister of Sweden, Göran         interest and the relaunching of the
Persson, has pointed out, but he        króna. There is a divergence of opin-
administered the Swedish rescue-        ions on all of those issues and more.
program during the Scandinavian
financial crisis in 1992-95.            To add further to the confusion, the
                                        coalition partners are entirely at odds
                                        on basic issues. The Social-democrats
X. Future Prospects                     have officially denied any responsibil-
                                        ity for the Central Bank director´s
Iceland´s prospects in the near fu-     actions and utterances. It is a lamen-
ture are bleak, to say the least. The   table anomaly in this situation that
present coalition government of         the Central Bank director is a former
Conservatives and Social-democrats      chairman of the Conservative party
seems to have been caught com-          and ex-prime minister, without any
pletely off-guard by the crisis. By     academic qualifications in monetary
hindsight it is beyond dispute that     economics. Despite his position as
the government, the Central Bank        Central Bank director he is generally
and the supervisory authorities all     seen to be playing politics as the de
disregarded the warning signals and     facto leader of the anti-European Un-
failed to act in advance to prevent     ion faction of the conservative party.
the crash or to stave off the worst

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                                         Working Papers on Global Financial Markets No. 3

This is the crux of the matter: The      XI. A Political Upheaval?
coalition parties are entirely at odds
on the fundamental issue for the         The demand for new elections is get-
future of the country: Should Ice-       ting louder day by day. Thus the
land apply for membership in the         economic crisis has generated politi-
European Union or not? The Con-          cal turmoil and uncertainty about the
servatives say no (applauded by the      future. The demand for new elec-
left-wing opposition); the Social-       tions, early in the year 2009, can
democrats say yes (supported by          hardly be resisted much longer. The
now by the middle-of-the road            overriding issue to be settled by new
Progressive party). According to         elections is the European issue. Dur-
opinion polls a vast majority of the     ing the boom years it was easy for the
population now wants Iceland to          political leadership to sidestep the
start membership negotiations and        issue. Iceland seemed to be doing
to adopt the euro as soon as possi-      pretty well on her own, admittedly to
ble. According to those same polls       a large extent on borrowed money.
the Conservative party´s following       Therefore most Icelanders felt little
has fallen from almost 40% down          incentive to make up their minds on
to approximately 20%. But to con-        this issue. The crash has changed all
fuse the situation further still, the    that. The majority of Icelanders
anti-European Left-green opposi-         seem, at least for the time being, to
tion party has doubled its following     have drawn the lesson from their
from 15% to above 30% and is by          economic misfortune, that this would
now seen to be the biggest party,        not have happened, if Iceland had
followed by the Social-democrats         joined the European Union and
with a little less than 30%.             adopted the euro while the going was
                                         good. This seems to be the main les-
In short: Super-imposed upon the         son to be drawn from the crisis.
economic crisis there is a political
paralysis. The Conservative Party        But even European Union member-
leadership is trying to gain lost        ship within a year or two will not
ground by convening an extraordi-        help Iceland a lot in her present dire
nary party congress at the end of        circumstances. What Iceland needs
January 2009 where the party will        beyond anything else, to help her
try to redefine its policy on the        recovery, is a stable currency. Unfor-
European issue amidst a serious          tunately the prospect of being able to
threat of a party split. Should they     adopt the euro seems to be receeding
fail to unite on a pro-European          far into the future. The Icelandic
program the days of the govern-          economy is in a terrible shape. With
ment are generally considered to be      a weak and volatile currency the
numbered.                                prospects for recovery any time soon
                                         look dim. Despite the strong long-
                                         term fundamentals of the economy

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                                         Working Papers on Global Financial Markets No. 3

(recovering fish stocks and plenty of    from Iceland´s debacle, surely they
clean and renewable energy) the          will have to include the following:
short-term outlook is grim: Ram-
pant inflation, serial bankruptcies          1. In a world of massive and un-
and subsequent unemployment,                    fettered capital movements
coupled by heavy fiscal deficits and            across national borders, a tiny
a crushing debt burden. The crucial             “independent” currency area
question on the future of Iceland               does not have a chance of sur-
therefore remains unanswered: Will              vival in a financial hurricane
the debt burden cripple the econ-               of the present (and future)
omy´s potential for recovery? Or                fortitude.
will the strong fundamentals of the
economy and the traditional resil-           2. Had Iceland shown the fore-
ience of the Icelandic people enable            sight, like Ireland, of joining
them to pay off their debt and full-            the EU and adopting the
fill the preconditions for joining a            euro, following in the foot-
stable currency area?                           steps of her former EFTA-
                                                partners (Finland, Sweden
This is what early elections will be            and Austria) in 1995 or the
all about. But the political line-up            period thereafter, Iceland
remains uncertain: On the one                   would surely have had to face
hand there will be the Social-                  the domestic bank-crisis, - but
democrats and the Progressives,                 would have escaped the devas-
propagating a pro- European fu-                 tating currency crisis which
ture. On the other hand there will              threatens to make Iceland´s
be the Left-green anti-European                 foreign debt burden unbear-
movement with the question of the               able.
Conservatives hanging in the bal-
ance. Will they split at the extraor-        3. For the other small nations of
dinary party congress in January,               Europe, in central and eastern
with the right wing joining the na-             Europe, the lesson seems to
tionalist anti-European forces, and             be to speed up disciplinary
the more liberal wing joining the               economic programs with the
Social-democrats on the road to                 aim of fullfilling the Maastrict
Europe? Or will the increasing po-              criteria for adopting the euro.
litical turmoil split all the existing
parties and create new ones with             4. For the EU it is time to re-
the possibility of opening up an                consider    the     regulatory
abyss of anarchy and confusion?                 framework for surveillance of
                                                financial markets as well as to
XII. Lessons to be learnt?                      coordinate the EU-wide guar-
                                                antee systems for savings de-
If there are any lessons to be learnt           positors.

                                                                                  Page 13
                                            Working Papers on Global Financial Markets No. 3

    5. For the world at large the           Minister of Finance 1987-88 and Minis-
       lessons to be learnt from the        ter for Foreign Affairs and External Trade
       current spectacle of financial       1988-1995. He led Iceland’s negotiations
       markets run amock by greed           with the EU on the European Economic
       and recklessness is to reim-         Area (EEA) 1989-1994. In the years
       pose discipline through an           1998-2006 he served as Ambassador of
                                            Iceland in Washington D.C. and in Hel-
       international agreement on a
                                            sinki, also accredited to the Baltic Coun-
       new regime of tough regula-          tries. Since then he has been a visiting
       tion and surveillance – with         scholar and a guest lecturer at several uni-
       harsh diciplinary powers             versities at home and abroad. He is an
       against errant actors.               honorary citizen of Vilnius, Lithuania.

    6. The final lesson to be learnt
       by the international com-
       munity is to put an end to
       the shady operations of tax
       havens in faraway places,
       operating as money launder-
       ing shelters, beyond the
       reach of the rule of law.

The text of this working-paper is an
elaborated version of a lecture given by
the author at a seminar held by the
Graduate School “Global Financial
Markets” at the Friedrich Schiller Uni-
versity at Jena in Germany November
27, 2008. The text has been revised to
bring it up to date as of end of year

The author studied economics and re-
lated subjects at the Universities of Ed-
inburgh and Stockholm 1958-1963 and
was a Fulbright scholar at Harvard
1976- 1977. During his career he has
been an educator, journalist and editor
of a newspaper. He was a member of
Althingi 1982-1998, a leader of the
Social-democratic party 1984-1996; a

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