March 30, 2009 (Revised, April 8, 2009)

Brief Considerations after Visiting Iceland (March 9-13, 2009)

By Yoshimitsu Onozuka, Professor of Doshisha University, Kyoto, Japan


Iceland is one extreme case of the current global financial crisis. It has the smallest independent currency, the first government that saved the all main banks, the first country that changed the prime minister and beat the dominant party, the shortest fixing the exchange rate, only one day, and so on.


The following essay is based on my interviews conducted in Reykjavik and experience working around the city. I hope my considerations are stimulating to other people, and contributes to the debates over Icelandfs future prosperity.


l         g10 times GDP debth - What is this? If the US government, as some critics say, is gan anaconda swallowed a hippopotamush, we should say, Iceland is an anaconda swallowed a house.


l         A gLender of the Last Resorth? - A country with only 300,000 people has an independent currency. Has it still a glender of the last resorth? - Main banks are gtoo big to rescueh as well as gtoo big to fail.h Iceland central bank (ICB) and the government should have intervened or prohibited their expansions in the global financial markets. It should be applied to Luxemburg, Switzerland and even London.


l         A gHedge Fundh state with the gInvestment Bankh model. - Iceland has transformed into ga new global financial centerh, at least in dreaming, from ga poor developing countryh relaying upon its fish exports (the catches and the international fish market). It was not until 20-30 years ago that the political and economic system of this country depending on the international fish market begun to be modernized. Iceland privatized its banking sector a few years ago, and surfed on the wave of the global financial boom to become one of the richest OECD member countries. It was recognized as a marvelous success story.


l         The fundamental mistake - Iceland krona (ISK) was attacked in 2006. But the government avoided the crisis. Iceland showed its confidence and the banks expanded even more. Then it owed much more short-term debt comparing with foreign exchange reserves. It was growing rapidly with the current account deficit that was enabled just because of huge capital inflows. It was not sustainable, for instance, looking at the level of Iceland krona exchange rate.


l         Globalization and monetary policy – Any country could prosper with flexible exchange rates and inflation targeted monetary policy, couldnft it? Globalization was supposed to be efficient resource allocation and gain more wealth. But Icelandfs economy got overheated, import increased, asset prices went up, naturally, the inflation rate rose up. ICB raised the short-term interest rate, but the speculative capital inflows accelerated. We may say that it should have raised it more early and more quickly. Who believes that it could do so in opposition to politiciansf claims before the election?


l         Two Stories: One side, the formal story – The market psychological change was so drastic. ICB knew the overheated economy, and warned the risk of ISK exchange rate fluctuation. It paid much attention to the rapid expansion of the banking sectorfs liabilities. But, you know, the activities were glegalh, regulators were strictly gdividedh (so week, non-coordinated), they were private decisions (so government should not intervene), and, in short, it was the same as the Wall St. did.


l         The other side, the informal story – This is a small society. It was a group of, say, only 30 people that decided everything important. Bankers, dominant politicians, top officials of the government and the central bank, regulators, and professors in the committees are all connected, so they were never assumed to know nothing with each otherfs activities. The government privatized and sold the banks to the capitalists who had close connections with dominant parties and politicians. The expansion of the banking sector was truly supported by Icelandic people, especially who held the stocks, and who worked there with gorgeous salaries. The government blew the bubbles. All of them were deeply committed, during the boom, they gained too much. So who was responsible? Who should pay the price of the current crisis?


l         The first victim of the global financial crisis – As, even in the US, the investment banks collapsed and such s business model perished, the Icelandic way of gfinancial centerh has ended with no doubt. During the age of speculators, I heard, the banks invited customers to the glamorous dinner parties or football matches of the English premier league, but all has gone. Construction of the intelligent building for the financial companies has stopped. The housing boom has finished. People cannot pay the car loans. Huge stocks of imported cars were left on the site for waiting buyers, in addition to the sold cars which were owned by former rich bankers and citizens.


l         The current situation – A kind of quietness. Strangely calm. It is not exactly what I expected in Japan. It has been stabilized by the IMF foreign exchange market interventions with capital controls. It was partly because Japan expressed the willing provision of its foreign exchange reserves to the IMF. However the interest rate was raised to 18 percent. In addition, people have a social welfare system, a lot of unemployed foreign workers went home, and jobless young talented people flowed out and looked for better opportunities abroad. A nation may restrain their discontents and grievance at least until the election in late April.


l         The future - Surely the calm time cannot continue. Because the unemployment will go up, and the fiscal deficits will grow. After the coming election, the future government must negotiate with the IMF how it will cut the deficits. At the same time, Iceland needs more exports in order to pay the debt, so it will be also important to negotiate with foreign creditors how to reduce the debt burdens. Devaluation of the currency and limiting the fiscal deficits will lead to the deterioration of the living standard. Even if they know that they cannot keep the assumed level with the speculative wealth, Icelandic people will suffer from that adjustment process. To moderate the pains and rebuild the long-term reliability, they probably need to get the EU membership and to adopt euro as their currency. Nevertheless, they are likely to doubt that their fish would be robbed by foreigners under the EU regulation.


l         Sea Empire and Nationalism – Iceland has rich resources in the ocean and in the land. That means fishery and geothermal energy (electric power and aluminum smelter). In the course of the international legal framework concerning the ocean, the Law of the Sea, Iceland has gained more fisheries. The traditional ideology is the basis of such dominant political parties as the Independence and the Progressive parties, because the monopoly and exclusive benefits matter in politics. Then the national currency is the important means of re-distribution. The EU membership and euro adoption imply the loss of these privileges, especially to the local elite class. So, I suppose, they cannot easily approve them. The country has significantly benefitted from the international legislative framework concerning interests in these natural resources.


l         gBad Banksh – They said that Iceland did not nationalize the banks. It was, in a sense, surprised. Main banks were saved by the government in last October. But they seemed to separate the commercial banking part from the investment banking part within the same banks. Because Icelandfs companies and people need the commercial banks right now, the government saved it. But they didnft need the failed investment banking part. It is a very natural idea for them. Being different from Japanfs gbad loan problemh, both the creditors and their assets of Icelandfs investment banking are foreigners. Therefore, after the government separated investment banking part as gbad banksh, foreigners would negotiate themselves and decide to choose selling at the market prices, or hold them for a long term as their assets. Even if the loss might be huge, Icelandic government has nothing to do with it.


l         The lessons from Iceland – We need a global standard for banking regulation, foreign exchange reserve, foreign exchange rate adjustment and stabilization, the lender of the last resort, the rules of monetary policy, the fiscal funds to moderate financial crises, and so on. Before the current global crisis happened, they had been argued. The collapse of Icelandfs financial boom should be duly expected. But we had not prepared the concrete rules to avoid and manage the crisis. There had not been any global consensus for settlements in national defaults. Moreover, the global financial boom promoted Iceland to compete aggressively, because, for instance, Icelandfs banks issued quite high rate bonds. We had rather need to correct the imbalances and the abnormal incentive system, and to make common observances and guarantees for financial activities on a global scale.


l         Radical restructuring Icelandfs political and economic system – Prime minister resigned, under the pressures of angry protesters. The Social Democratic Alliance came into power. The new prime minister forced the central banker to resign and nominated a Norwegian. On the other hand, she called a French inspector as a top of the committee to investigate financial crimes. One interviewee welcomed Icelandic banks to be bought by foreign banks, and agreed that the top of the gbad bankh should be occupied by a Germany. The new Icelandfs government was so serious that the old political system cannot be saved. If so, the old elite will definitely resist it. We are only waiting for more intense conflicts.


l         Conflict of Interests – The economic, political and social conflicts surely matter. There is also a conflict between Icelandic people with foreign denominated debts and the foreign creditors who hold Icelandic securities issued by the banks. The government would reject the payments to the latter in order to save the former. Even defaults and devaluation, as Argentina chose, could be preferred. From the point of creditorfs view, as those banks and investors in Germany and Japan hope, it would be more important to keep the long-term value of assets, and for Iceland to take those policies that can continue the debt service payments. In the process of hard negotiation, the government may possibly use the nationalistic sentiment.


l          gSocial Responsibilityh and the new gGrowth Strategyh – What was wrong? gThe profits of banks and companies are not equal to the social prosperity.h There are acute collision of ideologies, which is embodied in rivalry between the contrastive two major parties; while the gIndependenceh Party is similar in many ways to that to the US Republican Party, the Social Democratic Allianceh party is oriented the EU-style social democracy. The aggressive activities, for examples, building Sea Empire to monopolize fish, international investment banking to attract foreign depositors by abnormally high interest rates and to buy foreign banks and companies in the short-term perspectives, hurt the trust in the international community. International creditors and organization, like the IMF, would persuade the government to take a part in a global burden-sharing, and keep the long-term benefit of investment and broad market opportunities in the mind. The new growth strategy for Iceland, then, will be emerged in the common political and economic order.


l         Not necessarily EU or euro – Some argue now that Iceland should apply for the EU membership to get a stable currency and a large competitive market, with hope of a fiscal help in difficulties. But many of the people I interviewed did not agreed on this point. In addition to the defective EU regulation of fishing, they noticed that similar problems happened in the eastern European member countries. After admitting the membership, huge capital inflows resulted in financial expansion and asset bubbles. People there are suffering from the serious recession with capital outflows, but they cannot expect much help from the EU. As Ireland could happen to leave the EU or euro, they said, it wouldnft make any sense for Iceland to think about the EU membership and euro. Others made a case for a monetary union with only Norway, even they donft believe in the value of the Nordic political and economic integration. Norway has oil!


l         gA Canary in the Mineh – Restoration of the banking sector in Iceland is a part of the new international financial regime, which is now discussed at the G20, the IMF, and so on. The lack of global leaderships dealing would prolong and spread the recession. Iceland, even with rich resources@and a flexible labour market, could hardly regain its economic growth. We should correctly call an Icelandic case ga canary in the mineh to express the symbolic meaning of the future global governance as well as the current financial crisis. Despite the people didnft think much of the role of the IMF and the global governance. I wonder if it is the Icelandic ethos.


Persons in Reykjavik were so kind that they helped me and answered to my questions patiently. I would like to thank all of you from my heart.