Q: What happened to Iceland? How can an entire country go broke?
A: During the past ten or fifteen years, there were worse places to be than
Iceland, from an economic perspective. Unemployment was low, Icelanders earned more than the average European income, foreign money financed investmests in energy resources and aluminum smelting, and the country's exports rose steadily in value. By 2005 Iceland was assessed as one of the world's wealthiest countries on a per capita basis.
The events of 2007-2008, however, may become a future textbook lesson in national economic catastrophe, because without the drastic and unprecedented steps taken by its European neighbors, Iceland could have become literally bankrupt — a country whose banks, government and citizens were all flat broke.
Here is how it happened.
In the 1980s, Iceland began restructuring itself from a tiny isolated country dependent of fishing into a vibrant nation actively involved in technological developments.
The efforts paid off. Iceland evolved into the fourth most productive country in the world, based on GDP per capita. With unemployment below 1 percent and its economy growing 5 per cent annually, Iceland could claim that its government's policies were simultaneously prudent and successful. The county was committed to limiting foreign borrowing, controlling inflation, diversifying the economy and privatizing state-owned businesses.
Iceland established a business-oriented environment, becoming fifth in the world according to the Index of Economic Freedom in 2006 while boasting one of the world's lowest corporate tax rates and banks that operated with minimal government regulation. Which led to the nation's economic downfall.
The three Icelandic banks sent several young future financial stars to New York and London for training, and they returned bursting with enthusiasm to convert their homeland into Wall Street North, or at least a land known more for its financial power than for its fishing fleet.
Inspired by visions of grandeur from the new generation of bankers, the banks aggressively pursued almost any investment opportunity that floated their way. They built an investment treasure chest by borrowing first from the country's well-funded national pension plan, and turning later to the international money market. Impressed by their visions if not by their experience, international sources advanced billions of dollars to the Icelanders, creating substantial debt for the banks customers and shareholders.
Knowing their own citizens could never provide sufficient capital from retail deposits to play the the big boys in New York and London, the banks turned to the Internet to tap wider source of cash. It was both a stroke of genius and a flight of folly. Online banking, the Icelanders advertised, cut their costs so much that they could offer exceptionally high interest rates to people from Detroit to Dubai who sent cash to Reykjavik. (Let's be honest– why else would you send money to Iceland?)
Money flowed in from everywhere, attracted by the high interest rates offered to depositors. With full pockets, the hell-for-leather Icelandic banking honchos made highly leveraged investments in foreign markets. Kaupthing, the leading Icelandic bank, even purchased the U.K. merchant bank Singer & Friedlander for more than C$1 Billion. Icelanders, who for years had been compared to Canadians when it came to conservative saving and spending habits, grew giddy with their new found wealth. thanks to higher interest paid to depositors by Icelandic banks, the country's currency soared in value, reducing the cost of imports and inspiring a credit driven consumer spending spree. By 2007 Icelanders had amassed debts that were more than twice their disposable income. And the band played on.
The Icelandic Young Turks, believing the good times would last forever, borrowed and invested in a manic display of national pride and private greed. By 2008, when the mackerel hit the fan via global credit crunch, the banks were told to pay up. But they couldn't. The leveraged investments had collapsed, leaving and aggregate debt of all three Icelandic banks estimated at six times the country's gross domestic product. In canadian terms, this would be like Canada's major chartered banks owing $7.2 trillion, most of it to foreign banks and investors.
The banks could no longer meet their obligations, no one wanted to own an Icelandic krona, interest rates on credit balances shot to 19 percent or more, pension funds collapsed, and the entire country shuffled to the European Union and the International Monetary Fund, where it held out its cap and asked for spare change. By the end of 2008, the country remained 4 billion Euros short of amount it required to claim solvency. Foreigners who had sent money to the three Icelandic banks via Internet clamored to retrieve deposits estimated at US$8.2 billion, about half the size of the country's entire economy. They may never see a penny of it.
Iceland represents something of a test-tube experiment in which aggressive bankers weaned on Wall Street ambition with access to international funding opportunities were permitted to foist their own view of reality– the party's just getting started — on an entire nation. Whenever a hint of such unbridled exuberance appears in future years, let's hope that someone sits down and reads all the gory details of this unfortunate fiasco.
-Taken from the book "Bubbles, Bankers and Bailouts" by John Lawrence Reynolds.
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