In March I had the pleasure of meeting Professor Yoshimitsu Onozuka from Doshisha University in Japan for discussions on the economic crisis in Iceland.

The professor is especially interested in the crisis in comparison with the Japanese crisis of the nineties. He met with several Icelanders to gather information and just sent me his notes. Professor Y was kind enough to let me publish them and they make for an interesting read. 

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 an extreme case of the current global financial crisis. It has the smallest independent currency, the first government that saved its main banks, the first country that changed the prime minister and ushered out 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 on my experience working around the city. I hope my considerations are of interest to others and contributes to the debate on Iceland’s prosperity in the future.

Iceland has a debt of “10 times GDP”!
If the US government, as some critics say, is “an anaconda that swallowed a hippopotamus”, we could say, Iceland’s is an anaconda that swallowed a house.

A “Lender of the Last Resort”? 
A country of only 300,000 people with an independent currency. Is it still a “lender of the last resort”? – Main banks are “too big to rescue” as well as “too big to fail.” Iceland central bank (ICB) and the government should have intervened or prohibited their expansions in the global financial markets. It should have been applied to Luxembourg, Switzerland and even London.

A “Hedge Fund” state with the “Investment Bank” model.
Iceland has transformed into “a new global financial center”, at least in its dreams, coming from being “a poor developing country” relying upon its fish exports (the fish it caught and the international fish market). It was not until 20-30 years ago that the political and economic system of this country that depended 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.

The fundamental mistake
The Icelandic krona (ISK) was attacked in 2006. But the government ignored the impending crisis. Iceland showed its confidence and the banks expanded even more. Then it owed much more in short-term debt compared 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.

Globalization and monetary policy 
Any country could prosper with flexible exchange rates and inflation targeted monetary policy, couldn’t it? Globalization was supposed to be efficient resource allocator and produce more wealth. But Iceland’s economy got overheated, imports increased, asset prices went up, naturally, the inflation rate rose. 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 politicians’ claims before the election?

Two Stories:
One side, the formal story – The market psychological change was so drastic. ICB knew that the economy was overheated, and warned the risk of ISK exchange rate fluctuation. It paid attention to the rapid expansion of the banking sector’s liabilities. But, the activities were “legal”, regulators were strictly “divided” (so week, non-coordinated), they were private decisions (so government should not intervene), and, in short, it was the same as what happened on Wall Street.

The other side, the informal story – This is a small society. It was a group of, say, only 30 people that decided on 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 about each other’s activities. The government privatized and sold the banks to capitalists who had close connections with dominant parties and politicians. The expansion of the banking sector was truly supported by Icelandic people, especially those who held the stocks, and who worked there with handsome salaries. The government blew the bubbles. All of them were deeply committed, during the boom as they gained so much. So who was responsible? Who should pay the price of the current crisis?

The first victim of the global financial crisis
As the investment banks collapsed and their kind of business model perished as it even did in the US, the Icelandic dream of becoming a “financial center” has ended without doubt. During the age of speculation, I heard, the banks invited customers to the glamorous dinner parties or football matches of the English Premier League, but all that has stopped. Construction of the intelligent building for the financial companies has stopped. The housing boom has finished. People cannot pay their car loans. Huge stocks of imported cars were left on the lots for prospective buyers, in addition to the cars which were owned by former rich bankers and citizens of Iceland.

The current situation
A kind of quietness. Strangely calm. It is not exactly what I expected while 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. The nation may restrain their discontents and grievances at least until the election in late April.

The future
Surely the calm times cannot continue. Because 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 the Euro as their currency. Nevertheless, they are likely to suspect that their fishing industry would be robbed by foreigners under the EU.

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. That makes the national currency an important means of re-distribution. The EU membership and Euro adoption imply the loss of these priviledges, 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 their interests in these natural resources.

“Bad Banks”
They said that Iceland did not nationalize the banks. It was, in a sense, surprised. Main banks were saved by the government last October. But they seemed to separate the commercial banking part from the investment banking part within the same banks. Because Iceland’s companies and people need the commercial banks right now, the government saved those. But they didn’t need the failed investment banking part. It was a very natural idea for them. Differently from Japan’s “bad loan problem”, both the creditors and their assets of Iceland’s investment banking are foreigners. Therefore, after the government separated investment banking part as “bad banks”, foreigners would negotiate themselves and decide whether 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.

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, these factors had been argued. The collapse of Iceland’s financial boom should have been 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 prompted Iceland to compete aggressively, because, for instance, Iceland’s banks issued quite high rate bonds. We need to correct the imbalances and the abnormal incentive system, and to make common observances and guarantees for financial activities on a global scale.

Radical restructuring of Iceland’s political and economic system
The 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. Also, 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 control of the “bad banks” should be occupied by a Germany. The new Iceland’s government was so serious that the old political system cannot be saved. The old elite will definitely resist it. We are only waiting for more intense conflicts.

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 creditor’s 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.

“Social Responsibility” and the new “Growth Strategy”
What was wrong? “The profits of banks and companies are not equal to the social prosperity.” There are acute collisions of ideologies, which is embodied in rivalry between the contrasting two major parties. While the “Independence” Party is similar in many ways to that of the US Republican Party, the Social Democratic Alliance” party is oriented in the EU-style social democracy. The aggressive activities, for examples, building a 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, should 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.

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 wouldn’t make any sense for Iceland to think about the EU membership and Euro. Others made a case for a monetary union with Norway only, even if they don’t believe in the value of the Nordic political and economic integration. Norway has oil!

“A Canary in the Mine”
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 leadership 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 “a canary in the mine” to express the symbolic meaning of the future global governance as well as the current financial crisis. Despite this the people didn’t think much of the role of the IMF and the global governance. I wonder if it is the Icelandic ethos.

Related posts:

1. Global systemic crisis Alert – Summer 2009: The US government defaults on its debt
2. Google Zeitgeist: Iceland 3rd Most Searched Word Regarding The Economy In 2009
3. The Similarity Between Iceland And Latvia
4. Channel 4, March 2008: How Safe Are Your Savings?
5. Iceland banking inquiry finds murky geysers run deep