The small island of Iceland has lessons for the world. It held a referendum in April to decide, more or less, whether ordinary people should pay for the folly of the bankers (and by extension, could governments control the corporate sector if they depended on it for finance). Sixty per cent of the population rejected an agreement negotiated between Iceland, the Netherlands and the UK to pay back the British and Dutch governments for the money they spent to recompense savers with the failed bank Icesave. That was less resistance than the first referendum last spring, when 93% voted no.
The referendum was significant since European governments, pressured by speculators, the IMF and the European Commission, are imposing austerity policies on which their citizens have not voted. Even devotees of deregulation are worried by the degree of the Western world’s servitude to unconstrained financial institutions. After the Iceland referendum, even the liberal Financial Times noted with approval on April 13 that it had been possible to “put citizens before banks”, an idea which does not resonate among European political leaders.
Iceland is an unusually pure example of the dynamics that blocked regulation and caused financial fragility across the developed world for 20 years. In 2007, just before the financial crisis, Iceland’s average income was the fifth highest in the world, 60% above US levels; Reykjavik’s shops were stuffed with luxury goods, its restaurants made London seem cheap, and SUVs choked the narrow streets. Icelanders were the happiest people in the world according to an international study in 2006(1). Much of this rested on the super-fast growth of three Icelandic banks that rose from small utility institutions in 1998 to being among world’s top 300 banks eight years later, increasing their assets from 100% of GDP in 2000 to almost 800% by 2007, a ratio second only to Switzerland.
The crisis came in September 2008 when money markets seized up after the Lehman meltdown. Within a week, Iceland’s three big banks collapsed and were taken into public ownership. Moody's now listed them among the 11 biggest financial collapses in history.
After more than 600 years of foreign rule, Iceland’s social structure was the most feudal of all Nordic countries at the beginning of the 20th century. Fishing dominated the economy, generating most of the foreign-currency earnings and allowing the development of an import-based commercial sector. This created urban economic activities: construction, services, light industry. After the second world war the economy grew strongly, because of Marshall Plan aid (there was a large US-NATO military base); an abundant export commodity, cold-water fish, unusually blessed with high income elasticity of demand; and a small, literate population with a strong sense of national identity.
As Iceland became more prosperous it established a welfare state, in line with the tax-financed Scandinavian model, and by the 1980s had attained a level and a distribution of disposable income equal to the Nordic average. Yet it remained both more regulated and more patron-client-dominated than its European neighbours; a local oligopoly restricted the political and economic landscape.
There is a direct line of descent from the quasi-feudal power structures of the 19th century to the modernised Icelandic capitalism of the later 20th century, when a bloc of 14 families, popularly known as the Octopus, were the economic and political ruling elite. The Octopus controlled imports, transport, banking, insurance, fishing and supplies to the NATO base and provided most top politicians. The families lived like chieftains.
The Octopus controlled the rightwing Independence Party (IP) which dominated the media and decided on senior appointments in the civil service, police and judiciary. The local, state-owned banks were effectively run by the dominant parties, the IP and the Centre Party(2). Ordinary people had to go through party functionaries to get loans to buy a car, or for foreign exchange for travel abroad. Power networks operated as webs of bullying, sycophancy and distrust, permeated with a macho culture, something like the former Soviet Union.
This traditional order was challenged from within by a neoliberal faction, the Locomotive group, which had coalesced in the early 1970s after law and business administration students at the University of Iceland took over a journal, The Locomotive, and promoted free-market ideas. Their aim was not just to transform the society but also to open career opportunities for themselves, rather than wait for Octopus patronage. At the end of the Cold War their position strengthened materially and ideologically, as the communists and social democrats lost public support. The future IP prime minister, Davíð Oddsson, was a prominent member.
Oddsson, born in 1948 with a middle-class background, was elected as an IP councillor to the Reykjavik municipal council in 1974; by 1982 he was mayor of Reykjavik, leading privatisation campaigns, including selling off the municipality’s fishing industry, to the benefit of members of the Locomotive group. In 1991 he led the IP to victory in the general election, and reigned (not too strong a word) as prime minister for 14 years, overseeing the growth of the financial sector, before installing himself as governor of the Central Bank in 2004. He had little experience or interest in the world beyond Iceland. His Locomotive group protégé Geir Haarde, finance minister from 1998 to 2005, took over as prime minister shortly after. These two men most directly steered Iceland’s great experiment to create an international financial centre in the North Atlantic, midway between Europe and America.
The liberalisation of the economy began in 1994, when accession to the European Economic Area, the free-trade bloc of EU countries, plus Iceland, Lichtenstein and Norway, lifted restrictions on cross-border flows of capital, goods, services and people. The Oddsson government then sold off state-owned assets and deregulated labour. Privatisation began in 1998, implemented by Oddsson and Halldór Ásgrímsson, the leader of the Centre Party. Of the banks, Landsbanki was allocated to IP grandees, Kaupthing to their counterparts in the Centre Party, its coalition partner; foreign bidders were excluded. Later, Glitnir, a private bank formed from the merger of several smaller ones, joined the league.
So Iceland roared into international finance aided globally by abundant cheap credit and free capital mobility, and domestically by strong political backing for the banks. The new banks merged investment banking with commercial banking, so that both shared government guarantees. And the country had low sovereign debt, which gave the banks high marks from the international credit-rating agencies. The major shareholders of Landsbanki, Kaupthing, Glitnir and their spin-offs reversed the earlier political dominance of finance: government policy was now subordinated to the ends of finance.
Oddsson and friends relaxed the state-provided mortgage rules, allowing 90% loans. The newly privatised banks rushed to offer even more generous terms. Income tax and VAT rates were lowered to turn Iceland into a low-tax international financial centre. Bubble dynamics took hold. City planners aimed to move Reykjavik from the trajectory of an ordinary city to that of a world city (despite its small population of 110,000) and approved several grandiose new public and private buildings, saying “If Dubai, why not Reykjavik?”
Iceland’s new banking elite were intent on expanding their ownership of the economy, competing and cooperating with each other. Using their shares as collateral, some took out large loans from their own banks, and bought more shares in the same banks, inflating share prices. It worked like this: Bank A lent to shareholders in Bank B, who bought more shares in B using shares as collateral, raising B’s share price. Bank B returned the favour. The share prices of both banks rose, without new money coming in. The banks not only grew bigger, they grew more and more interconnected. Several dealings of this kind are now under criminal investigation by the special prosecutor, as cases of market manipulation.
Tiny Iceland soon managed to enter the big-bank league, with three banks in the world’s biggest 300 by 2006. The super-abundance of credit allowed people to consume in extravagant celebration of their escape from the earlier decades of credit rationing (on top of the earlier escape from foreign rule as recently as 1944). They saw themselves as fully independent at last, which may explain their happiness ranking. The owners and managers remunerated themselves on an ever-larger scale. The richer they were, the more they attracted political support. Their private jets, roaring in and out of Reykjavik’s airport, seemed to be visual and auditory proof to the part-admiring, part-envious population below. Income and wealth inequality surged, helped by government policies that shifted the tax burden to the poorer population(3). The bankers made large financial contributions to the governing parties and giant loans to key politicians. The leading Icelandic champion of free-market economics declared in The Wall Street Journal: “Oddsson’s experiment with liberal policies is the greatest success story in the world”(4).
In the euphoria, the dangers of a strategy of “economic growth based on vast foreign borrowing” were overlooked. Icelanders lived out the dictum of Plautus, the third century BC Roman playwright, who had one of his characters declare: “I am a rich man, as long as I do not repay my creditors.”
The 2006 mini-crisis
In 2006 there were worries in the financial press about the stability of the big banks, which were beginning to have problems raising funds in the money markets (on which their business model depended). Iceland’s current account deficit had soared from 5% of GDP in 2003 to 20% in 2006, one of the highest in the world. The stock market multiplied itself nine times over between 2001 and 2007.
Landsbanki, Kaupthing and Glitnir were operating far beyond the capacity of Iceland’s Central Bank to support them as lender of last resort; their liabilities were real, but many of their assets were dubious. In February 2006 Fitch downgraded Iceland’s outlook from stable to negative and triggered the 2006 “mini-crisis”: the krona fell sharply, the value of banks’ liabilities in foreign currencies rose, the stock market fell and business defaults rose, and the sustainability of foreign-currency debts became a public problem, The Danske Bank of Copenhagen described Iceland as a “geyser economy” on the point of exploding(5).
Icelandic bankers and politicians brushed aside the crisis. Iceland’s Central Bank took out a loan to double the foreign-exchange reserves, while the Chamber of Commerce, run by representatives of Landsbanki, Kaupthing, Glitnir and their spin offs, responded with a PR campaign. It paid the US monetary economist Frederic Mishkin $135,000 to lend his name to a report attesting to the stability of Iceland’s banks. It allegedly paid the London Business School economist Richard Portes £58,000 ($95,000) to do the same for a later report. The supply-side economist Arthur Laffer assured the Icelandic business community in 2007 that fast economic growth with a large trade deficit and ballooning foreign debt were signs of success: “Iceland should be a model to the world”(6). The value of the banks’ “assets” was then around eight times greater than Iceland’s GDP.
In the elections of May 2007, the Social Democratic Alliance (SDA) entered a coalition government with the still-dominant IP. To the consternation of many supporters, SDA leaders ditched their pre-election pledges and endorsed the continued expansion of the financial sector.
Though they had survived 2006, Landsbanki, Kaupthing and Glitnir had trouble raising money to fund their asset purchases and repay existing debts, largely denominated in foreign currencies. So Landsbanki pioneered Icesave, an internet-based service that aimed to win retail savings deposits by offering more attractive interest rates than high-street banks. Established in Britain in October 2006, and in the Netherlands 18 months later, Icesave caught the attention of best buy internet finance sites and was soon flooded with deposits. Millions of pounds arrived from Cambridge University, the London Metropolitan Police Authority, even the UK Audit Commission, responsible for overseeing local government funds, as well as 300,000 Icesave depositors in the UK alone.
Icesave entities were legally established as branches, rather than subsidiaries, so they were under the supervision of the Icelandic authorities, rather than their hosts. No one noticed that the Icelandic regulatory agency had a total staff, including receptionist, of only 45 and suffered high turnover as many went on to join the banks, which offered better pay. No one worried much that, because of Iceland’s obligations as a member of the EEA deposit insurance scheme, its population of 320,000 would be responsible for compensating the depositors abroad in the event of failure. Landsbanki’s shareholders reaped the short-term profits while most Icelanders didn’t know anything about Icesave at all.
The second “solution” to difficulties in raising new funds was a way to get more access to liquidity without pledging real assets as collateral. The Big Three sold debt securities to a smaller regional bank, which took these bonds to the Central Bank and borrowed against them, without having to supply further collateral; they then lent back to the initiating big bank. The bonds were called “love letters” — mere promises. By participating in this game and accepting as collateral claims on other Icelandic banks the central bank was conniving in the banks’ strategy of gambling for resurrection.
Then the banks internationalised the process: the Big Three established subsidiaries in Luxembourg and sold love letters to them. The subsidiaries sold them on to the Central Bank of Luxembourg or the European Central Bank and received cash in return, which they could pass back to the parent bank in Iceland or use themselves. The OECD calculates that just the domestic love letters, between the CBI and the Icelandic banks, incurred losses to the CBI and the Treasury of 13% of GDP (OECD Economic Surveys: Iceland, June 2011).
The Icelandic banks fell two weeks after Lehman Brothers. On September 29, 2008, Glitnir approached Oddsson at the Central Bank for help with its looming liquidity problem. To restore confidence, Oddsson instructed the Central Bank to buy 75% of Glitnir’s shares. The effect was not to boost Glitnir but to undermine confidence in Iceland. The country’s rating plunged, and credit lines were withdrawn from Landsbanki and Kaupthing. A run on Icesave’s overseas branches began. Oddsson moved on October 7, 2008, to peg the krona to a basket of currencies at close to the pre-crisis value. With the currency tumbling and in the absence of capital controls, the foreign-exchange reserves were exhausted: the peg lasted for only a few hours, just long enough for those in the know to change their money out of the krona at a much more favourable rate. Inside sources indicate that billions left the currency in these hours. Then the krona was floated, and sank. On October 8, the then UK prime minister, Gordon Brown, froze Landsbanki’s UK assets under the anti-terrorism laws. The stock market, bank bonds, house prices and average income went into free fall.
The IMF arrived in Reykjavik in October 2008 to prepare a crisis-management program, the first time the IMF had been called in to rescue a developed economy since Britain in 1976. It offered a conditional loan of $2.1billion to stabilise the krona and backed the British and Dutch governments’ demands that Iceland should honour the obligations of the European deposit-guarantee scheme and recompense them for their bailouts of Icesave depositors.
Iceland’s normally placid population erupted in an angry protest movement, principally targeted at Haarde, Oddsson and the IP, although the SDA’s foreign minister Ingibjörg Gísladóttir was considered tarnished too. Thousands of people assembled in Reykjavik’s main square on freezing Saturday afternoons between October 2008 and January 2009, banged saucepans, linked arms in a circle around the parliament building to demand the government’s resignation, and pelted the building with food.
In January 2009, the IP-SDA coalition broke. To date, Iceland is the only country to have shifted distinctly to the left after the financial crisis. An interim SDA-LGM (Social Democrats-Left Green Movement) government was formed in January 2009 to lead until April’s election. In the election the IP was reduced to 16 seats, despite the overwhelming bias of the electoral system in its favour, its worst result since its formation in 1929.
Icesave debt rejected
The SDA-LGM government came under immediate pressure to repay the Icesave debt; much of the IMF loan was withheld until Reykjavik agreed. The new government was also divided on whether to apply for full membership of the EU and Eurozone, with most of the SDA strongly in favour. After long negotiations, the government presented the terms they had agreed on the Icesave debt to the parliament in October 2009: 5.5 billion ($7.8 billion), or 50% of Iceland’s GDP, was to be paid to the British and Dutch treasuries between 2016 and 2023.
The party’s health minister resigned in protest, five dissidents refused to vote with the government. The bill was forced through on December 30, 2009, against high feelings in the country. On January 5, 2010, President Grímsson announced that he would not sign it into law, out of respect for the national sentiment. In the ensuing referendum the bill was decisively rejected. In the May 2010 Reykjavik municipal elections, the SDA slumped to 19% and a comedian was elected as the city’s mayor. In October protests resumed, and the coalition conceded the election of a constitutional assembly to draw up a new constitution (the existing one having been inherited from Denmark on independence in 1944). When the election was invalidated by the Supreme Court, the assembly was reconvened as a constitutional council appointed by parliament.
The deal on the table in this April’s second Icesave referendum involved substantial concessions on the part of the British and Dutch governments. After the no vote, the disagreement may have to go to international courts.
The postponed crisis
The cost of losses on loans and guarantees, added to the cost of restructuring financial organisations, brings the total direct fiscal costs of the crisis to about 20% of GDP, higher than in any other country except Ireland (OECD Economic Surveys, Iceland, June 2011). But the postponement of major public spending cuts until this year has given the economy breathing space; and the sharp devaluation has helped to generate a trade surplus for the first time in many years. So far, Iceland has experienced smaller falls in GDP and employment than big public-spending slashers like Ireland, Estonia and Lithuania. The unemployment rate, only 2% in 2006, has been between 7% and 9% since 2009; but the rate of outmigration of Icelanders and other European workers (predominantly Polish) has been the highest since 1889. However, the SDA-LGM government has announced drastic cuts in public spending for 2011 and beyond. Local governments have no budget for fresh projects. Hospitals and schools are cutting salaries and sacking employees. The freeze on house repossessions expired in 2010.
Finance in the driving seat
The IP-SDA government’s decision to provide unlimited bank deposit guarantees illustrates its debt to the financial elite. Had it limited the guarantee to 5 million krona ($70,000), it would have protected the entire deposits of 95% of depositors; only the wealthiest 5%, including many politicians, benefited from the unlimited guarantee, which now means further constraints on public spending.
Iceland’s tiny scale seemed to make it easier to challenge the government’s denial of the impending crisis, but the opposite was true. The Oddsson government undertook an extreme privatisation of information. Iceland’s National Economic Institute had a reputation for independent thinking, and Oddsson abolished it in 2002. From then on the banks, international rating companies and the Chamber of Commerce provided almost the only information and running commentary on the state of the economy, present and future.
Paradoxically, a number of critical reports were published when the bubble was in the early stages, including one by the CBI. But by 2007-08, when the dangers were acute, reports, including those by the IMF, became noticeably softer in tone. It seems that the official financial institutions, as well as bankers and politicians, understood that the situation was so fragile that just to speak of it might trigger a run on the banks.
In October 2010 the parliament decided to charge Prime Minister Haarde for breach of ministerial responsibility. The permanent finance secretary Baldur Gudlaugsson (former member of the Locomotive group) has been given two years in prison for using inside information for his personal advantage while selling his shares in Landsbanki in September 2008. But the special prosecutor in charge of the investigation of the banks has been working with a team of 60 lawyers and others for the past two years and has so far brought no charges. Meanwhile Oddsson was appointed in September 2009 as editor-in-chief at Morgunblaðið, the leading Iceland daily, and orchestrated coverage of the crisis. A commentator said that was like appointing Richard Nixon editor of The Washington Post after Watergate. Iceland’s elite looks after its own.
[Robert Wade is professor of political economy at the London School of Economics; Silla Sigurgeirsdottir is lecturer in public policy at the University of Iceland. This is an updated version of “Lessons from Iceland”, first published in the New Left Review, London, September-October 2010.]
(2) Among the opposition are the Social Democrat Party and the further left Common People’s Party.
(3) Stefán Ólafsson and Arnaldur Sölvi Kristjánsson, “Income Inequality in a Bubble Economy: the Case of Iceland 1992-2008”, paper presented at the Luxemburg Incomes Study Conference, 28-30 June 2010; www.lisproject.org/conferenc...
(4) Hannes Gissurarson, “Miracle on Iceland”, The Wall Street Journal, New York, 29 January 2004.
(5) Danske Bank, “Iceland: Geyser Crisis”, Copenhagen, 2006.
(6) Arthur Laffer, “Overheating is not dangerous”, Morgunblaðið, Reykjavik, 17 November 2007.