How Easy Credit Led to Iceland's Bankruptcy in the 21st Century

Iceland's Economic Crisis

Web

Iceland's bankruptcy

The purpose of banking in Iceland: speculation and hedging

The central issue: too much too soon

Iceland's Transition

Replicating Wall Street

Taking on foreign "assets" at a ratio to GDP of 10:1

Is debt an asset?

Easy credit and the role of the Housing Financing Fund

Low interest rates

f. Inflation

g. The end of short-term financing in the wake of Lehman's collapse

h. The bubble bursts

The plight of the average citizen

j. Aliber's speech

k. Left holding the bag

The effects of financial deregulation

A prime opportunity for shorting

Iceland and Nationalization

Not Bailing out the Banks

Introduction: Statement of Purpose

The bankruptcy of Iceland in 2008 can be explained in one line from Michael Lewis's Boomerang: Travels in the New Third World. The line is stated by a representative of the International Monetary Fund (IMF) who is tasked with assessing whether Iceland should be bailed out with a loan. Iceland, historically populated with "rational human beings" was now at the mercy of the IMF, historically capable of turning nations into debt-colonies. The IMF agent told Lewis that "Iceland is no longer a country. It is a hedge fund" (Lewis, 2011, p. 1). Therein lies the secret nugget of information that helps to explain not only the collapse of Iceland's economy in the 21st century but also the collapse of the global economy as well. But to understand how this helps to explain that, one must understand just what is meant by the alarming words said by the IMF agent: how does a nation (especially one whose previous industry was primarily fishing, energy and services related) be transformed into a hedge fund -- and, more importantly, what does this mean? The story of Iceland's bankruptcy can serve as a starting point in understanding the global financial situation today. This paper will discuss the economic conditions surrounding Iceland's bankruptcy and what can be learned from it in relation to the wider global financial situation.

Issue

The central issue of this paper is how and why Iceland recklessly transitioned from a service industry nation to a financial industry nation and what that transition means in terms of human and capital cost. Icelanders were not prepared to become a finance nation nor for the standards needed to keep such an institution afloat. Iceland's bankers saw easy money on a global scale arising out of debt monetization and wanted in. Easy credit and overleveraged accounts full of foreign "assets" caused Iceland to experience rapid inflation before going bust.

Iceland's Transition

Beginning in 2000, Iceland began to focus more and more on the financial sector than ever before in the country's history (Jackson, 2008). As Lewis (2011) puts it, Iceland's bankers saw what Wall Street was doing and wanted to replicate it. The problem was that Iceland had little to no experience in the world of "high finance," let alone the GDP to validate the in excess of $100 billion worth of assets that the nation's three largest banks acquired over the course of 3 years from 2003 to 2006 (Lewis, 2011). This rapid accumulation of "assets," a term which is at best misleading (for labeling "debt" as an "asset" is a manipulation of the English language that only makes sense in a world where derivatives markets thrive because interest rates are kept artificially low by a central bank that prints money for governments and then loans the money to them for an interest fee), was accompanied by easy credit which flooded the Icelandic economy with cash, thus creating an immense real estate bubble like that which burst in the U.S. In 2008. But the housing bubble was not the only bubble in Iceland: the stock market became an enormous bubble as well, comparable today to what China's stock market is doing (Deng, 2015). As Lewis (2011) notes, while the U.S. market doubled in four years time starting in 2003, the market of Iceland went up by a factor of 9x. Icelanders believed they were rich when in fact they were simply heavily in debt, having overpaid for virtually everything they now possessed.

When the bubble burst they also realized they were on the hook for the banks' $100 billion losses.

What had caused this gigantic bubble in Iceland? The Housing Financing Fund (HFF) was offering low interest rates on mortgages, with which the Icelandic banks at first attempted to compete by offering even lower rates. When prices began to skyrocket and inflation to runaway, the central bank raised rates in an attempt to stop inflation. The HFF, however, continued to provide lower interest rates, which were more attractive to consumers, and which thus only made the housing bubble blow up even more (Jackson, 2008). But the banks were still giving home-equity loans, and since the "value" of housing was going up exponentially, the amount that Icelanders could borrow was rising as well. In short, easy credit and a currency inflation, due to foreign investors, was priming Iceland for a short attack (Lewis, 2011).

To make matters worse, Iceland's banks expanded internationally throughout Europe following banking deregulation. They did this by acquiring "short-term financing for 75% of their funds" (Jackson, 2008, p. 2), or, in other words, by maxing out the biggest credit cards they could find with the best teaser rates, and not bothering to have a plan for how to proceed once the teaser rates went away and they needed more credit to fund their operations. If Charles Ponzi served as the poster boy for criminal finance in the 1920s, today he serves as the poster boy for common finance. Nations which adopt Ponzi's tactics are encouraged by foreign investors and then shorted into oblivion when it becomes evident that the music is about to stop. As goes Iceland, so goes the rest of the world. In effect, Iceland's banks had gotten too big to save (Danielsson, 2008). Danielsson, ironically, would offer to help Iceland in its moment of crisis by steering it through its economic maelstrom -- but his offer would be "spurned," as Lewis (2011, p. 25) observes wryly. They continued operations could not be guaranteed by the State, as the banks that were too big to fail in America had been.

When the market retracted following the collapse of Lehman Brothers in America and short-term debt financing went up in smoke, the banks of Iceland found themselves in a precarious position. Their "assets," which were mainly "large foreign debts held," became "unsupportable" in lieu of the short-term financing dry-up. The Icelandic krona collapsed and the IMF swooped in to give Icelanders a $2 billion loan. The central bank of Iceland raised its rate to 18% in October of 2008 as other European nations agreed to match the IMF's loan. Average Icelanders saw their "wealth" decrease by 85% almost overnight, making the old maxim true -- "easy come, easy go."

The Average Citizens

"The fishing guys," as Lewis (2011, p. 9) calls them, or rather the average Icelandic citizens, had discovered that there was more money to be made in trading currencies than there was to be made from fishing. All of Iceland was consumed with financial speculations. The average Icelander wanted to ride the wave of speculation to prosperity and was, in this sense, pursuing the American Dream. Says Lewis (2011) with a touch of irony, "By 2007, Icelanders owned roughly fifty times more foreign assets than they had in 2002," (p. 15). This mania for buying more than one needed or could afford at inflated rates trickled down from the top, whereat perched Iceland's bankers. Robert Aliber, the economics professor of the University of Chicago, was invited to Iceland to speak before the nation's finance students. He put the situation tersely: "Your bankers are either stupid or greedy…I give you nine months" (Lewis, 2011, p. 21). To the average citizen, this bit of worldly wisdom was a bombshell. The average Icelander assumed that what goes up must continue to go up more and more.

Aliber (2011), noting in his book Preludes to the Icelandic Financial Crisis that the primary cause of the bust was a boom that "generated large imbalances," in academic parlance (p. 43) went on to point out the nature of the problem in concise terms was simple: "tax cuts, an appreciated exchange rate, and an easing in household credit constraints stimulated private consumption" (Aliber, 2011, p. 43) contributed to the inflation of the Icelandic bubble economy. The ability for Icelanders to spend more in the aftermath of an economic recession proved too tempting and the economy became "the most overheated in the OECD area" (Christiansen, 2011, p. 89). If Iceland had been the U.S., at the center of the world's finance economy, creating fiat cash for profits, it is likely that the crash would not have been precipitated by a short attack or been prey to the IMF afterwards. Of course, in the U.S., a similar short attack occurred, and rather than the IMF coming around, the bill was simply placed on the shoulders of next-generation Americans, the can kicked down the road, and the too-big-to-fails bailed out for another go-around, which will likely see implosion within the next two-to-three years. Iceland's economy bursting was due to the fact that it got in over its head too quickly and every other swimmer saw that it was out of its depth and took advantage of the situation, raided Iceland's pockets while Iceland groped for a life preserver and found none but the predatory shark called IMF.

Iceland's average citizens still don't understand what happened (Lewis, 2011, p. 33) mainly because the complexity of the financial industry is not to what they accustomed. They are a service economy that was lured by the easy money of the early 2000s bubble. They paid the price, losing a great deal of wealth, 85% to be precise, and some degree of self-respect. Their currency ceased being traded on major markets. Its value was arbitrarily given by the government. Iceland went from being a stable economy to being unstable in less than a decade all because of bad banking, which can be explained simply: when nations monetize debt, which consists of bad loans, the bagholder is the one who pays (unless the bagholder has a minion in Office who will make the average citizen pay instead).

Conclusion

Financial deregulation and the rise of novice bankers in Iceland, coupled with easy credit and an increasing global bubble of the early 2000s, in which bad debt is monetized and sold to naive investors, led directly to the crash of Iceland's economy in 2008. A certain degree of hubris played a part in the crash, as Icelandic President Grimsson declared on the world stage that Iceland was a nation of "banking prodigies" because of its culture, heritage, training, and home market…none of which was really to the point or on par with reality (Lewis, 2011, p. 22). Iceland was not a banking prodigy and did not have the necessary foresight to see that it was embarking on extremely risky fiscal policy. Its banks' accumulation of "assets" that outnumbered GDP 10:1 coupled with the drastic rise in inflation and the accompanying trade deficit were signs of a bubble about to burst. Iceland had been pumped by the world's markets and was now waiting for someone to stick a pin in it. The shorts did exactly that and Iceland fell quickly and sharply.

The simple answer to what happened in Iceland is that manipulating market economies and attempting to artificially "control" interest rates while making credit so easy that anyone and everyone can get it is a recipe for disaster, especially when coupled with the idea of creating wealth out of debt. In today's global economy, everything is monetized right down to the weather (see weather derivatives). However, the bigger one's purse the more one is able to manipulate a small nation's economy (like Iceland). George Soros, for example, could potentially wreak havoc on an economy like Iceland that had gotten in over its head in terms of fiscal irresponsibility. Bear Stearns essentially did just that when it held a conference with other leading international banks in Iceland to discuss the possibilities of taking advantage of Iceland's incredibly awkward position in global finance.

Recommendations

As Lewis (2011) states, perhaps the best recommendation for Icelanders is to "stop banking and go fishing," i.e., return to the industry that made Iceland prosperous and self-sufficient -- leave the financial speculations for market economies that can shoulder them: the socialized-losses, private-profits States like the U.S. where banking institutions act as appendages of the Central Bank of the world (for now). For Iceland to imagine that it is on par with Wall Street or that it can do what Wall Street does is like a bush league athlete imagining he can go toe-to-toe with LeBron James and even win. It is unrealistic. Iceland is a small country with a small GDP. It loaded up on foreign debt thinking it was an easy score, and ended up being the world's bagholder when the other financial institutions like Bear Stearns decided maybe now was the time to short Iceland. The country should return to its roots, as Lewis implies. The financial industry today is one that heavily favors the major players. There is virtually no regulation (other than that which the major players want). It is a casino as more than one critic has put it. True, there are rules and laws and reasons for analyzing cash flow, etc., but at one level none of that really matters in the greater scheme of things: greed is still greed, pride is still pride. Borrowing over and above what one can afford is still called going recklessly into debt. Paying too much for items that one does not need can still lead to waste and loss.