This book is part of a series of books published by economists affiliated with the Mises Institute, a libertarian think tank that focuses on educating the public about the teaching of the Austrian School of Economics and its founder, Ludwig von Mises. This book investigates the causes and aftermath of Iceland’s Economic and Financial Crisis of 2008, which led to the default of all Icelandic banks and the near-collapse of the entire financial and social system.
One of the peculiarities of the Icelandic Crisis is that it happened in a notoriously financially savvy Nordic country, with a strong welfare state and a developed capital markets economy based on the so-called Nordic model. As per usual, some financial economists at the time were quick to blame the default on “free market deregulation” that turned Iceland into a “giant hedge fund”.
Iceland indeed turned out to be a giant hedge fund, but the reasons behind the crisis involved warped incentives and moral hazard caused by the government and the Central Bank’s implicit (or explicit) backing of the country's financial system. Far from being a free-market economy, in 2007 Iceland's taxes and social security contributions amounted to more than 41% of GDP, one of the highest levels among OECD nations.
The Central Bank of Iceland (CBI) was a peculiar case among developed economies because two out of three of the governors at the bank were political appointees, undermining the notion of a Central Bank's supposed independence from political influences. Again, far from being a free-market economy, budget deficits were the norm in Iceland up to 2008.
The issues
Icelandic Banks engaged in two dangerous economic practices: maturity mismatching and currency mismatching. Maturity mismatching is a common problem in banking since short-term deposits are used to fund long-term assets (loans and mortgages) and banks only keep a fraction of their assets in deposits and are thus susceptible to bank runs. Currency mismatching is also a common problem in finance, and that usually entails borrowing in a currency to fund asset purchases in another currency (this is also known in finance as carrying trade). If the currency in which the assets are denominated depreciates versus the currency in which the liabilities are denominated, debts become increasingly expensive to service.
The Icelandic banking sector financed seventy percent of its debt in foreign currency and bank customers could for a time have their mortgage or their car loan tied to another currency (ex. euro or yen), thus paying a considerably lower interest vs an equivalent loan in Icelandic kronur.
The system was further weakened by existing institutions that were considered to be standing ready to bail out the financial sector in case of trouble, thus exacerbating the problem of moral hazard: the IMF and the Central Bank of Iceland. Maturity mismatching was enticing because it consists in borrowing short-term (at low interest) and lending long-term (at high interest) and pocketing the spread between these two. Banks are supposed to monitor the duration mismatch between their assets and liabilities and act accordingly, but the incentives to do so for Icelandic Banks were simply not there since the Central Bank of Iceland and IMF were ready to come to the rescue in case of default.
This literally meant socializing costs and privatizing profits for the financial sector as a whole. Currency mismatching worked the same way as maturity mismatching in the sense that borrowing in a low interest (and stable) currency like the Yen or the Euro and investing in a high-interest currency (the Icelandic Kronur) ensure quick profits for the financial institutions active in this line of business (i.e. most Icelandic banks at the time).
Development of a Crisis
As mentioned before, all sorts of warped public incentives contributed to pushing the economy to the brink of total collapse. The authors note that usually central banks are constrained somewhat in their monetary policy options since they control only the short-term rate level. But maturity mismatching translates artificially low short-term rates into artificially low long-term rates since banks increase the supply of long-term funds by lending long.
Another financially warped policy in place was the one promoted by the Housing Financing Fund (HFF), which was a fund set up by the government to encourage homeownership. This fund basically underwrote all credit risk borrowers faced in opening a mortgage, thus greatly exacerbating moral hazard in the economy and misallocating capital resources further.
The role of lender of last resort of the IMF (and the World Bank) usually has a stabilizing effect on currencies of emerging economies, since financial actors engaging in risky activities know that the institutions will stand ready to intervene in case of crisis. This implicit guarantee leads to an overall underpricing or currency risk and currency volatility that greatly contributed to the build-up of currency mismatching in Iceland before 2008.
In the case of Iceland, the guarantee was explicit, in the sense that the Central Bank of Iceland declared that it stood ready to bail out banks in any possible case.
As confirmed by financial history, governments can only control the exchange rate up to a certain extent: at one point, imbalances in the rate of exchange will lead to a currency devaluation (usually preceded or accompanied by the emergence of a black market for hard currencies). As mentioned previously, Icelanders could effectively take out loans in currencies other than the Icelandic kronur so as to pay a substantially lower interest rate on the debt. This was possible as long as foreign liquidity was abundant and international banks and lenders had trust in the Icelandic economy and financial system. At one point assets denominated in foreign currency held by banks and by Icelanders were less than 60% of liabilities denominated in foreign currency, a very risky imbalance that contributed to the collapse of the Icelandic Economy.
Tipping point
The credit-fueled boom also created substantial imbalances in the labor market, with young talent attracted to the financial sector creating labor shortages in other industries, like fishing, that was the backbone of the Icelandic economy. Therefore, the country became over-reliant on the financial sector, with companies, citizens, and financial institutions indebted in short-term debt denominated foreign currency and invested in domestic and foreign assets with great leverage.
The collapse of Iceland was triggered by the collapse in liquidity in the rest of the World following the financial crisis of October 2008. In the beginning, the Central Bank of Iceland raised interest rates up to 12% to keep foreign capital flowing but the build-up of malinvestment and economic imbalances, in the end, caught up with the Icelandic economy. Global loss of confidence in the banking system triggered a withdrawal of easy credit from the rest of the World, with leverage acting as a negative amplifier triggering a vicious cycle and downward economic spiral. At its peak, Icelandic banks had borrowed $120B in foreign currency against $20B of Iceland GDP, an unsustainable amount.
Conclusion
The size of these liabilities also meant that the financial sector itself was too big to save for the Central Bank of Iceland, which was also critically short of foreign assets to sell to repay short-term debt denominated in foreign currency. With confidence in the kronur plummeting and rapid currency devaluation, Iceland had few options left other than asking for foreign aid from the IMF and other international organizations. The stock market lost 95 percent of its value, interest payments on loans increased to more than 300 percent, more than 60 percent of bank assets were written off-balance sheets within a few months, and interest rates were raised to around 18 percent.
Help from these organizations which opened swap lines at favorable terms with Iceland to provide hard currency prevented the total collapse of the Icelandic economy. Even so, a painful readjustment ensued with multiple reforms of the financial system and social safety net. Rather than slashing wages, which would have reduced both spending and the ability of Icelanders to pay back their loans, Iceland devalued its currency by more than 60 percent, so as to keep wages at around the same level but making the krona worthless. This is one of the reasons why foreign products are now so expensive in Iceland.
The case of Iceland teaches us that even the most developed nations are not immune to financial euphoria and the dangerous impact of excessive financial leverage on the real economy.
Author: Edoardo Cicchella
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