Iceland's Economic Crisis: Causes, Consequences, and Recovery, Slides of Business Administration

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Months

% of short-term debt

 Stock market rose by a factor of 9 from 2001

to 2007

 44% average annual increase six years in a row

 World record

 Clearly a bubble, and hence unsustainable

 Even before bank collapse, stock market fell by more

than 50% from 2007

 Real estate prices rose by a factor of 2.

from 2001 to 2008

 11% per year on average

 Led to construction boom

 Count the cranes! (Professor Robert Aliber)

 Also, a bubble, unsustainable

 Accident waiting to happen

Source: Financial Supervisory Authority of Iceland.

 Monetary restraint, business as usual

 Transparent bank restructuring (takes too long)

 Floating exchange rate

 Supported by strict but temporary capital controls

• Due to delays in program implementation and other

issues, there is still no sign of relaxation 4 years later

 Fiscal space provided in 2009, with government

budget deficit of 14% of GDP; turned out at 9%

 Fiscal restraint kicked in from 2010 onward

 Cut spending from 50% of GDP in 2009 to 40% in 2017

 Keep revenue at 41% of GDP from 2009 to 2017

 Adjustment equivalent to 10% of GDP in 8 years; tough

 Different from Asian programs 10 years ago

 IMF tolerates capital controls, grants fiscal space

temporary

 Gross external debt, public and private

 291% of GDP at end-2010, even after huge write-

offs of private debt equivalent to ca. 500% of GDP

 Scheduled to drop to 157% by 2017, still heavy

 Net external debt said to drop to 50%-70%, some say 100%

 Public debt, domestic and foreign

 Gross public debt: 93% of GDP at end-

 Up from 29% in 2007, scheduled to drop to 77% 2017

 Crisis has increased public debt by about 64% of GDP

 Net public debt: 63% of GDP at end-

 Recapitalization of Central Bank cost 18% of GDP

 Recapitalization of the 3 banks cost another 18% of GDP

 Scheduled to drop to 53% by 2017

 Did Iceland stand up to the banks?

 No, debts of Iceland’s private banks were so

large that there was no way for the

government to bail them out

 Yet, foreign creditors were led to believe that

the government stood behind the banks

 Private banks defaulted while sovereign default

was averted, and remains unlikely

 In Ireland, bailout seemed feasible at the

time, but may turn out not to be feasible

 Ireland may have to renegotiate with its

creditors

 General rule is pay back if at all possible

 But, if you cannot pay back, you don’t

 Many households and firms in dire straits

 Nominal, indexed debts rose while real wages fell

 Oldest trick in the book is to allow moderate

inflation to equitably deflate debts

 But this is sensitive in a high-inflation country that

introduced financial indexation 30 years ago in

reaction to the inequitable consequences of high

inflation for borrowers and lenders

 Banks made illegal foreign-currency-indexed loans

 Two banks owned by US venture firms, one by government

 No plan in sight for future organization of banking system

 Iceland is not alone, given Europe’s woes  Two views  Pessimists warn that debt burden threatens to match that which the allies imposed on Germany at Versailles after World War I, with predictable economic and political consequences

 France, UK, US, Italy imposed war damages on Germany

equivalent to 80% of GDP, then reduced their claim by half

 Victors also took land, reducing Germany by more than 10%

 Claim was not paid in full, was settled peacefully in 1932

 Optimists emphasize that the Faroe Islands emerged from their deep financial crisis in early 1990s with an external debt to Denmark equivalent to 120% of GDP, and were able to repay with interest within 6- years

 Long-term loss to Faroes despite recovery in other respects

 Net emigration of about 10% of population

 This Iceland (pop. 320,000) must avoid

 Successful recovery rests on two pillars

 Continued economic revival backed by further

reforms

 Decision by Parliament in 2009 to apply for EU and EMU

membership will, it is hoped, send encouraging signal to

international community

 This prospect looks less attractive now to some voters

 Must uncover the causes of the collapse, including

massive failure of policy and institutions

 Special Investigation Commission, appointed by

Parliament, produced a scathing 2,300 page report

 Former Prime Minister was indicted by a Court of

Impeachment

 New post-crash constitution is underway