Tuesday, 11 December 2012

Iceland: Coming in from the cold

Authors: Andrew Whitehead and Thomas Viegas

In 2008 Iceland became the first country to be hit by the ugly aftermath of the global financial crisis; the now infamous sovereign debt crisis that has now engulfed the rest of Europe. In the now familiar story the years prior to this were characterised by the embracement of unfettered capitalism and financial liberalisation that lead the newly privatised Icelandic banking industry to grow to a monstrous 1000% of GDP, economic policy described by the Chief Economist at Citigroup as “collective madness”. Although, by no means alone in the pursuit of such policies, the relative size the banking industry to a country of only 300,000 people made it unique.    

When the crash did happen it was spectacular: the stock market plummeted 90%, unemployment shot up to an all-time high and inflation rose to 18%. All the ingredients for at best, a prolonged depression and at worst the complete collapse of the economy. The situation was so dire that around 2-3% of the population immediately fled the country! This remarkable implosion not only left their economy in tatters but also resulted in the country being widely mocked. In particular the SNP leader Alex Salmond was roundly sniggered at for his previous quote that an independent Scotland could join some small nations such as Iceland to form an “arc of prosperity”, while across the water with the Irish banking system collapsing the Irish media consoled themselves by joking “at least we’re not Iceland!”

However the mockery has now quickly receded. Employment levels in Iceland have fared far better than in many other European nations, even in the depths of the crisis unemployment never reached double figures while in Greece and Spain it remains above 20%. While their employment rate is the second highest in Europe, in the latest figures (78.5%) this compares favourably against economic powerhouses Germany (72.5%) and the UK (69.5%) and even more so when compared with other small nations hit by the crisis such as Latvia (61.5%) and Ireland (59.2%)

But how has Iceland fared so well despite such an economic catastrophe? The reason is part dumb-luck and part excellent management from the Icelandic Government and, for once, the International Monetary Fund (IMF). I say dumb luck because it is the very nature of the “collective madness” described earlier that makes Iceland such an excellent test of economic doctrine accepted (or forced) on the rest of us. Due to the huge magnitude of their banking crisis (the largest ever relative to GDP), they were forced to use unorthodox measures to save their economy. In the words of economist Paul Krugman “Iceland zigged when all the conventional wisdom was that it should zag”. The rest of the developed world has followed the path of huge bailouts, resulting in the shift of private debt to public balance sheets, and the slashing of public sector spending with the hope that this would restore the much needed confidence in markets to stimulate private sector spending.

These hugely unpopular policies were sold to the public on the basis that there was no other alternative. The case of Iceland however proves that this is not true. While everyone else rushed to give taxpayers money to the banks, Iceland let them fail. While the bankers at the heart of the crisis were protected and in some cases rewarded in the US and Europe, in Iceland they were jailed and while the rest of Europe embarked on a social spending slashing binge, Iceland expanded its social safety net.  At the time, the consequences of these unconventional policies were warned against by many economists, who predicted punishment from global credit markets leading to bankruptcy and economic Armageddon. This has not been the case. Compared to Ireland, which took full responsibility for its banks debt, both suffered similar drops in GDP (14 and 15% respectively from peak to trough) but credit default swaps in Iceland are now much lower than in Ireland, indicating increased confidence in the ability of the Icelandic government to service its debt. Furthermore this year has seen the Iceland successfully return to the international credit markets for the first time in five year.

A crucial part of the recovery was the relationship between the country’s government and the International Monetary Fund, who provided a $2.1 billion loan package. Just as Iceland’s economic catastrophe and road to recovery has been unique so has its co-operation with the IMF. While in the past the IMF has been severely criticised for its role in worsening crisis, most notably in Asia in the 90’s (in South Korea what we know as the “Asian Financial Crisis” they know as the “IMF crisis”), the IMF’s response in Iceland was different. They allowed the Government freedom to maintain fiscal control, altering spending and revenues how they saw fit. More surprisingly they allowed capital controls, a move normally regarded as heresy by the Fund’s free market priests. These capital controls, although controversial, prevented the collapse of the Icelandic currency as it prevented large amounts of funds leaving the country. The measures are still in place and are based not on time but on prevailing economic conditions (a lesson the US may which to observe as they approach their fiscal cliff). Another different approach used by the IMF was allowing the maintenance and even strengthening of the Icelandic welfare system. They allowed automatic stabilisers to do their job in protecting the citizens of the country from the depths of the crisis, as inflation rose and wages fell, delaying fiscal adjustment for a more stable time. A key factor in this economic salvation was the helping out of heavily indebted households, a policy recently recommended to the US by the former chair of the Federal Deposit Insurance Corporation. This freed up consumers to spend their money on other things, no surprise then that domestic demand has been a powerful aspect in the recovery. The extension of social security resulted in inequality actually falling during the crisis as the bond and shareholders as well as foreign creditors bore the brunt of the fallout from the banking collapse.

So although Iceland did experience severe economic damage and a substantial drop in living standards, the effects on its people were contained and the economy has been able to launch its own moderate recovery.  Although comparisons between a small island of 300,000 people and large dynamic economies such as the UK may seem far-fetched it is clear lessons can be learnt from the country that ‘zigged’. The case has clearly taught the IMF a lesson, explicitly shown in the recent conference set up by the fund “Iceland’s Recovery: Lessons and Challenges” in the countries capital Reykjavik. One such noteworthy lesson , outlined by the Funds managing director, is the importance of a wide range of tools for dealing with the crisis, even if such tools go against what is being practiced elsewhere. Another is the importance of the role of the welfare system in any economy’s recovery. It has long been an accepted view that more equal societies perform better on a variety of social indicators from crime to mental health but it has been extensively believed that a trade-off exists between equity and growth. But this conception is being gradually eroded and recent research undertaken by the IMF has shown that countries grow faster and more consistently when income is shared more equally. This coupled with their recent paper stepping away from the use of austerity shows a clear change of direction for the IMF, one that will hopefully see them become an increasing effective in achieving their main goal: the safeguarding of the global economy.

The message to take from Iceland’s experience is that contrary to what the majority of policy makers keep preaching to the public about austerity being the only way forward, there is a clear and credible alternative. While Iceland’s road to recovery will not necessarily be repeated to the same extent in other economies, due to the uniqueness of its crisis, its stance on several key policy decisions can be adhered to. Iceland’s policies centred on protecting its people, assisting indebted households and holding those responsible for the crisis to account and this has rescued its country from economic disaster. Hopefully Europe’s leaders will sit up and take notice of what has been achieved in the country that zigged as currently zagging has not only resulted in increased social unrests but also shows no clear signs of short to medium term improvement in growth.


  1. Iceland and Ireland are indeed two good nations to compare, to see the effect of the clearly different economic policies. So far, Iceland wins, hands down, but that hasn't convinced EU yet, unfortunately, to reverse their economic course.

  2. You forgot to mention the Icelandic Krona depreciation, 111.2% in 2008 first eleven months. Iceland was able to adjust via exchange rate depreciation, Euro countries could not.

  3. Yes that is a good point, as recently as 2011 politicians in Europe were hailing the Euro for protecting the continent from the worst of the crisis. Since then this feeling of self-accomplishment has undoubtedly disappeared, and is being replaced with a belief that being part of a large monetary union has in fact worsened the crisis for many countries. A big part of that is the disadvantage of not having control of your own currency.

  4. Just to add that the Eurozone's inability to deal with the crisis rests largely on failure to complete a 'complete' monetary union and deep economic ideological differences between states that won't be settled in the short to medium term. Transition to a Federal transfer system, a banking union, collectively issued bonds and a separate budget for the zone are all criteria that a sustainable and functioning monetary union require. The EMU has fallen far too short on most of these points and shows no signs currently of fully implementing them as major differences continue to fester.

  5. thanks for share..