Your Gateway

Gateway CU

GFC lesson

It was the most destructive financial shock since the Great Depression and it brought the free market to the precipice. The Global Financial Crisis (GFC) started as a localised issue in the US housing market and quickly escalated into a catastrophic global meltdown.

From continent to continent, stocks plunged, margin calls rose, banks collapsed, consumer confidence dived and reputations suffered. Fear and panic reached epidemic levels as trust in the global financial system plummeted.

Banks limited the supply of credit, consumers tightened their purse strings and governments spent unprecedented amounts on various forms of assistance. To avoid a systemic collapse, bank bailouts were the order of the day in some countries, but not in Iceland. 

No other country exploded more quickly and spectacularly than Iceland during the onset of the GFC. The Icelandic economy suffered one of the deepest meltdowns in the world. However, what Iceland did in response flew in the face of conventional economic wisdom.

The frozen island took the polar opposite approach to the US and Europe and let its three major banks collapse. Iceland refused to bail out the Icelandic banks in order to shield taxpayers from footing the bill for irresponsible lending practices. It also introduced measures to help indebted homeowners. 

Famed for its active volcanoes and lava fields, Iceland is now famous (infamous?) for rising from the ashes following the collapse of its banking system in 2008. While the “let them fail policy” drove a turnaround in Iceland’s economy, its unorthodox approach drew both praise and criticism.

Those who hold up Iceland as the poster child for how a nation ought to respond to a major economic crisis, argue that supporting households was more important than protecting bondholders. In short, forcing losses onto bank creditors was seen as the preferable thing to do. 

Not surprisingly, international financial institutions took a diametrically opposite view. They remain critical of Iceland’s decision not to honour its financial obligations. The damage inflicted on foreign creditors, investors and depositors in Icelandic banks tarnished Iceland’s reputation.

By way of background, during the 1900s and early 2000s, Iceland tried to become a “Nordic Tiger”. Its political leaders opened Iceland to the global economy. The dire state of the local fishing industry drove a series of sweeping economic reforms accompanied by a foray into global banking. 

Iceland privatised its banks, signed the European Free Trade Agreement and moved from a fixed exchange rate system to a floating Krona. The country (including households and businesses) then went into overdrive in borrowing and spending.

Between 2000 and 2007, domestic credit in the Icelandic banking system more than quadrupled as a share of GDP. Icelanders were able to access easy credit which resulted in escalating house prices and soaring consumption.

When the banks collapsed in 2008, Icelanders paid dearly for their extravagant ways with the savings of 50,000 local people wiped out. Moreover, the stock market plunged 90 per cent, unemployment rose ninefold and inflation skyrocketed past 18 per cent.

Citizens of other nations also suffered. Once privatised, the three Icelandic banks looked overseas for growth as the domestic economy of 300,000 people was considered too small. Iceland opened high-interest online bank accounts, attracting almost 500,000 customers throughout Europe

Many of these were British and Dutch depositors and the collapse of the Icelandic banks left the UK and the Netherlands with significant costs. The (then) UK Prime Minister, Gordon Brown, announced that his government would launch legal action against Iceland on behalf of the 300,000 UK savers.

Interestingly, the Icelandic banks did not go broke by buying worthless subprime securities. They obtained their money largely from international investors and the interbank lending markets, making them heavily dependent on foreign capital. These funding sources dried up in 2008 at which stage the foreign debt of the Icelandic banks had grown to over eight times GDP. 

The unique path that Iceland took in 2008 raises ethical questions about responsibility. I believe that individuals, corporations and governments have a moral obligation to do all they can to honour their financial commitments. Iceland broke this rule and got away with it, but does that make it right?

Yes, the Icelandic banks were reckless but so were Icelanders who became unsustainably wealthier prior to the crash by taking on record amounts of debt to income. Taxpayers are also voters and Icelanders knowingly voted in a reformist government that sided with bankers and allowed cavalier behaviour.

While many see Iceland’s decision to default on their debt to foreign financiers as some sort of Viking victory for the people, I think it sets a dangerous precedence. Iceland did not come up with a new economic disaster management plan, but a regrettable way to wipe the slate clean. 


Regards

Paul J. Thomas, CEO

Subscribe to blog - RSS

Posted Monday, May 25, 2015    View Comments 0 Comments    Make a Comment Make a comment  

RSS Feed