Iceland’s way out of its financial crisis

“Do not listen to the financial markets, but to the people” (Olaf Ragnar Grimsson, President)

by Dr rer publ Werner WŁthrich

Recently, the Icelandic government notified the EU Commission and the EU Council of its intention of withdrawing its application for membership (see Current Concerns No 8 of 22 March 2015). The Red-Green government had applied for membership in July 2009, when the US financial crisis had hit the country’s banks devastatingly. As the country recovered remarkably quickly the negotiations were put on hold when a new government came to power in April 2013. Foreign Minister Gunnar writes on his website, “Iceland’s interests would be better served outside the EU …” The population would not agree to the accession, as it had experienced in recent years how much it can achieve on its own. Iceland is an island in the Atlantic Ocean, with 350,000 inhabitants. The country has rich fishing grounds. Its inhabitants do some farming with a lot of sheep and they extend their hospitality to more and more tourists who visit the country and wander through it for the sake of its natural beauty and hot springs. Like this, it is quite a good life.
Iceland is a special case in the recent global financial crisis – in many ways. For one thing, the crisis in Iceland was far worse than anywhere else. In 2008 – at  the height of the debt crisis – the pile of debts was much larger than that in the southern EU countries. Whereas, for example, the debt in Greece at that time amounted to 175 percent of the gross domestic product, the debt of the Atlantic island (notably the bank debt) was equivalent to ten times the GDP, i.e. 1,000 percent – a veritable disaster scenario. And yet, today – seven years later – Iceland is looking relatively good. How did this come about and what made it possible?
In the years after the turn of the century Iceland stood out because for its very high growth rates. The reason for these was, however, not the income from fishing, but it lay elsewhere: the three big banks had embarked on a risky game and turned the island into a globally oriented financial centre. They attracted foreign savings with exorbitant interest rates, for instance, and invested this money in risky funds around the world – initially with success. The responsible bank managers presented themselves as “modern” and “open” and broke with the traditions of their banks and their profession – all according to the adage: “The pitcher goes often to the well but is broken at last.” The fracture or respectively the slump occurred – in quite an incisive way – seven years ago and led to the rapid collapse of the three major banks.

The people pointed the way as to the foreign debts

The treatment of the three Icelandic banks’ external debts, for which according to Western doctrine the state and thus the taxpayers had to assume liability, at least in part, was controversial. The controversy was mainly about the so-called Icesave deposits. As internet bank of the nationalized Landsbanki, Icesave had over the years attracted many foreign small savers with its high interest rates, but their funds were not covered by the Icelandic deposit insurance. Notably the UK and the Netherlands, from where most of the foreign funds came, now demanded that the state Iceland should repay these funds. It was a matter of about 4 billion euros (i.e. about  12,000 euros per inhabitant of Iceland). The government negotiated with the two countries, which granted low interest rates and a long time for repayment. The Icelandic parliament accepted the outcome of these negotiations and passed a law regulating the arrangements for repayment on 30 December 2009. But now the people armoured with pots and pans took to the streets (hence Kitchen Implement Revolution) to express their anger about having to assume liability for something they were not responsible for. Foreign speculators should have to bear the consequences for their actions themselves, they said. After all, their investment had yielded them an interest of 10 percent and more. “Is it morally and legally justifiable to transfer the risk to the state and the taxpayers?” was written on their banners and leaflets. The citizens’ initiative Defence organized protests of various kinds. They collected over 60,000 signatures (there are only 350,000 inhabitants) and demanded a popular referendum. The citizens besieged the President’s residence, equipped with red bengalos, which could be seen from afar as a “stop” sign for this policy. President Olaf Ragnar Grimsson listened to the voice of the people and arranged a referendum: “The core of our Icelandic political system is that the people are the supreme judge of the laws’ validity. In this light, I have decided, in accordance with the Constitution, to refer the decision about the law in question to the people.” – In March 2010, 93 percent of the voters said no to the state’s  payment of the bank debt.
Great Britain and the Netherlands were then willy-nilly prepared to renegotiate the bank debt repayment. In a new agreement Iceland obtained further concessions and payment accomodations. The repayment was extended until 2046, so that even the next generation would be liable, too. The Icelandic parliament accepted. The president asked the people to vote again. In April 2011, the people again voted with a majority “No”. – What to do next?
The Icelanders solved their banking problem as follows: All three major banks had to file for bankruptcy. The Landsbanki with its internet bank Icesave was nationalized, and the other two banks were divided into a “New Bank” and “Old Bank”. All business areas that were needed domestically, such as payment transactions, cash machines, a credit department, etc., were incorporated in the New Bank (which was recapitalized). The huge debt mountain and the entire international business with many dubious assets which were liquidated in the bankruptcy proceedings were transferred to the Old Bank. In this way, the bank counter halls remained open and the cash machines were always in operation. The banks were given new names. The former Kaupthing Bank is now called Arion, and the former Glitinir is now called Islandsbanki. All three banks (which are now partly in foreign hands) are restricted to traditional, domestic banking procedures.
These bankruptcy proceedings are reminiscent of the Swissair collapse, where immediately a new small company – Swiss – was launched (which is now controlled by Lufthansa) and in which the remaining assets of the old society and the huge mountain of debt were liquidated in the bankruptcy processes.

Coping with everyday life and recovery

Life on the island had been difficult since the beginning of the crisis. The Icelandic krona dropped in value. Prices rose. Real wages fell. Life became expensive. Unemployment rose. As early as 2009, economic output had fallen by seven percent. The government needed a $ 10 billion loan from the IMF to survive these hard times. As usual – the IMF set conditions. However, the left-green government rejected slashes in the social sector. It managed nevertheless to meet the IMF program. Also friendly countries such as Norway and Sweden helped with money. For the population, the taxes were increased, personal income taxation became more keenly progressive and a number of unorthodox measures were taken to reduce the debt. For instance, loans linked with foreign currencies were declared illegal. The government introduced special programmes of debt rescheduling for companies. A haircut on real estate loans followed. Small home owners were conceded payment facilities. In order to protect the currency and prevent capital flight, the government introduced capital controls, which have been maintained to this day. So foreign-going leisure travellers might exchange only a limited sum of euros.
The IMF respected this government approach. More than that – the Icelandic  Minister of Finance Steingrimur Sigfusson was asked whether he would like to  become the IMF executive chiefly responsible for Greece. However, he declined the offer (Frankfurter Allgemeine Zeitung of 21 February 2015).
The crisis in Iceland did not last long. The energetic, popularly supported policy soon showed results. Tourism and the fishing industry benefited greatly from the weak currency. Iceland was getting cheaper. Less expensive consumer goods were imported, but more were produced domestically. After the drop of seven percent in 2009, an increase of three percent followed just three years later – an increase that was higher than the EU average. Inflation had disappeared and today, the unemployment rate is at four percent – the same as in Switzerland. There is no youth unemployment, which has reached catastrophic proportions in other countries. – The rating agency Fitch raised the country’s credit status again. It justified this step explicitly with the “success of unorthodox responses to the crisis”.
What helped further was the EFTA Court decision in 2013, which ruled from the point of view of the people in this case and rejected state liability for the foreign bank debt.

Success based on state sovereignty and direct democracy

Why did the country recover so quickly? Crucial for its rescue was for one thing the voice of its people. The Icelanders set the course not only in two plebiscites. The population participated in controlling proceedings actively – but  always without violence – by means of a variety of actions. For instance, the Icelanders used witty websites to defend themselves against British attempts to drive them into a terrorist corner and to freeze all UK bank deposits owned by Icelanders. For another thing, the Icelanders rolled up their sleeves and put their economy back on track. The three “new” massively shrunk banks fulfilled their traditional role in this. The population also hindered the bank managers responsible for the undesirable development to leave their posts with high severance pay as it is usual elsewhere. Several of them have to face a trial today. A parliamentary inquiry committee created a 2,000-page report, which identified a small group of about 30 bank managers, government officials and central bankers as mainly responsible for the financial debacle. The Supreme Court recently sentenced four of them to five to six years in prison for fraudulent market manipulation and breach of trust, the hardest punishment that Iceland has ever imposed in the area of economic crime.
In addition, it was of crucial importance for its rescue that Iceland had its own currency: The massive slump of the Icelandic krona did not lead to the collapse (as some financial prophets had prophesied), but in contrast was crucial for the rapid recovery. Today, the Icelandic krona has levelled off with a minus of about 30 percent compared to the pre-crisis period. Other countries could seek inspiration here! For a Euro country an exit from the common currency is a prerequisite for a similar path.
The successful Icelandic way out of the banking crisis differs from the centralist, top-down EU methods of bank bailouts and “liability management”, which keep bankrupt banks on life support and force the taxpayers to bail them out. Iceland has thoroughly refuted the opinion that there is “no alternative” to the rescue of big banks (too big to fail). Even if the Icelandic way can not be copied par for par by other countries, they may yet draw their inspiration from it to boldly seek new ways. It also shows how a small country with its own currency can confidently assert its place in the global financial world. Withdrawal of application for EU membership is the logical consequence. Financial problems can not be solved by a small elite behind closed doors, but the people and taxpayers can constructively help to find the way to success. The fact that the IMF applied to the Icelandic Minister of Finance to assist in addressing the debt crisis in Greece, speaks for itself.     •