Bankruptcy or bailout? The case of Iceland.

What saved the Icelandic economy from many years of "debt slavery" to which the countries on the periphery of the Eurozone are currently subjected?

In economic theory, there is often a debate about whether a company that has become insolvent should be “rescued” by the state or left to fail. Support for the first approach is related to preventing a domino effect and the creation of systemic risk in the economy. The arguments for the second are more market-based and state that if an economic unit becomes insolvent, it means that it has operated inefficiently and its bankruptcy will lead to the entry of more efficient players into the market.

In general, viewing bankruptcy as something extremely negative is unwarranted. The process of firms disappearing and being replaced by new ones is what makes the free market the most successful economic system known to man. Schumpeter defined creative destruction as “the fundamental impulse that starts and drives the machinery of capitalism.” Businesses that make bad business decisions, whether they are banks, factories, or barbershops, must suffer the consequences—only then can the market’s corrective mechanisms correct the mistakes.

If we look at the beginning of the global financial crisis, which later turned into an economic crisis, we see how almost all governments decided to save financial institutions from bankruptcy. In the US, the Federal Reserve poured a huge amount of liquidity into the country's banking sector; in the UK, the government nationalized one of the largest banks, the Royal Bank of Scotland; in Ireland, the debts of the six largest banks were guaranteed. There are examples at a much more macro level - the bankruptcy of entire countries (Greece, Portugal, Ireland) was prevented with the help of loans from the so-called Troika (IMF, EC and ECB). One single country decided to act differently.

The example of Iceland

Iceland is one of the smallest (by population) countries in Europe, but also one of the richest (measured by GDP per capita) and liberal economies in the world (see Chart 1).

Graphics 1

The small northern island's economic boom began in the early 1990s when the country joined the European Economic Area (EEA), allowing it to participate in the free movement of goods and capital between EU and EEA countries. Despite its rapidly growing economy, Iceland has never had a well-developed financial system - it has often been characterized by volatile inflation, interest rates and currency (see Chart 2).

After the privatization of the banking sector in the period 1998-2002, it began a massive penetration into Europe, especially in the Nordic countries (Great Britain, the Netherlands, Luxembourg and Scandinavia). The expansion of the banks was financed mainly with debt in foreign currencies – yen, euro and Swiss francs – due to the low interest rates on loans in these currencies. The high interest rates in Iceland during this period and the free movement of capital created the sufficient and necessary conditions for the so-called “carry trade” (borrowing funds in a currency with a low interest rate and investing in a currency with a high one). And while this leads to the relatively rapid enrichment of Icelanders, it also creates great risks for the economy. One of these risks is the emergence of large bubbles in asset prices. In addition, the balance sheets of banks expanded to unprecedented sizes, and at the peak before the start of the financial crisis the banking sector in the country was about 10 times larger than the gross domestic product. The problem is even more serious because a large part of the banks' liabilities are denominated in foreign currencies, and the Central Bank of Iceland, from the perspective of a lender of last resort, has very few reserves in these currencies. Furthermore, during the economic boom, the banking sector in Iceland was concentrated in three banks, which accounted for 85% of the entire sector.

In 2006, Icelandic banks began to struggle with foreign currency funding due to their bloated balance sheets and a slowing global economy. To counter this, they used their branches in northern Europe to attract deposits from the local population. The attractive interest rates on these deposits lured residents of the UK and the Netherlands into depositing huge amounts of money into Iceland’s banking system. Everything was going well until the global financial crisis. In October 2008, after the collapse of Lehman Brothers and the drying up of liquidity in financial markets, Icelandic banks ran into liquidity problems and the country’s banking system collapsed. The Icelandic krona followed suit, making it impossible to repay loans in foreign currencies (see Chart 3).

At this point, due to the size of the economy, the Icelandic government cannot choose whether to bail out the banking sector or not – it simply does not have the necessary funds and no way to obtain them. This is actually the different path that Iceland is taking, unlike the countries on the periphery of Europe.

After the crisis

After the collapse of the banking system, Iceland nationalized the sector, transferred the deposits of local residents to newly established banks and left all debts to the country's external creditors in the old banking institutions. In this way, the government practically saved the deposits of its residents and went bankrupt on the debts of foreign creditors. In two referendums, the inhabitants of the island state refused to repay these debts (only the deposits of the Dutch and English in Icelandic banks amounted to 6 billion euros, which is equal to half of the Icelandic economy). This saved the Icelandic economy from many years of "debt slavery", to which the countries on the periphery of the Eurozone are currently subjected.

Iceland’s bankruptcy was followed by a very severe recession. In 2009, the economy contracted by 6.8%, and in 2010 by another 4%. Inflation also rose during these two years, leading to a record depreciation of the krona (see Chart 3). In relative terms, Icelanders became poorer, imports collapsed, but on the other hand, exports grew and became the engine of recovery. Despite the hardships of Icelanders in the years after the crisis, the economy grew by 3.1% in 2011 - much higher than most developed countries. Expectations for 2012 are also optimistic. Although still high, inflation in the country has been brought under control and is far below its post-collapse levels. Impressively, the government is expected to register a budget surplus in 2013.

Iceland’s approach to the debt crisis can be compared to what is happening south of our border. Greece, which decided to bail out its creditors and chose the Troika bailout model, is already in a depression and, in the most optimistic scenario, will have a debt-to-GDP ratio of 120% by 2020. In addition, the unemployment rate there is over 20%, while Iceland’s is just over 7%. Although the two countries are not entirely comparable, Iceland’s approach shows how bankruptcy is not fatal and, despite the problems it creates in the short term, it is the right decision in the long term.

Finally, the important thing to note is that the Icelandic economy not only managed to part with financial institutions that made bad business decisions, but also saved itself from the moral hazard that is now an integral part of the US and European banking systems. The “big ones” were shown that with the right political support, they could shift the burden of their mistakes onto the taxpayers. When will they hand us their debts again?

[1] A situation in which one person/organization decides how much risk to take, while someone else bears the costs of a possible bad turn of events.

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