Much has been written about Iceland’s response to its banking crisis, and whether its decision to put its banks into administration and swiftly force losses onto bank creditors has proved to be the key to restoring economic stability. Does this provide a model that Ireland and others should have followed? Commentators such as Paul Krugman (see here) and the IMF were quick to point out that Icelandic GDP expanded by 2.2% in Q3 2010, setting it firmly on the path to recovery, though the subsequent 1.5% contraction in Q4 showed that Iceland’s problems were far from fully resolved. While it’s hard to place too much weight on notoriously volatile Icelandic macroeconomic data, given the small size of the economy (with a population of just 319,000, a single factory closure or even just a few families catching a nasty cold could materially influence output), it is worth digging beneath the surface to find out what is really going on as there are still some interesting lessons for the rest of Europe.
So what did Iceland do apart from putting the banks into administration? For a start, they were quick to prioritise national interests above obligations to other European countries, most notably in refusing to compensate the UK and Netherlands for the bail-out of Icesave depositors. While I am not arguing that this was in any way morally correct, it certainly did give politicians the breathing space needed to work on other measures, both by reducing the national debt burden and by giving citizens some say in their future. A further referendum on the subject is due in April, after previous compromise measures were firmly rejected by the Icelandic population (given the amounts involved, the outcome of these negotiations will be critical for Iceland’s debt position). Of course, it is much harder for the peripheral Eurozone countries to simply ignore the EU demands that their citizens honour not just their sovereign debt but also their banking sector liabilities to avoid banks in core Europe (and the ECB) having to crystallise losses on their periphery exposures. But equally it will be hard for elected governments in the periphery to maintain the long term support of their populations for the austerity measures needed to repay all the bank and sovereign liabilities if they don’t give their citizens some sort of say in the matter.
Secondly, Iceland was both willing, and, crucially, able, to embark on a comprehensive restructuring of other debts within the financial system, not just bank liabilities. Debt levels of households and corporates were also unsustainable, and simply writing off bank liabilities was never going to be enough to reduce the overall leverage of the country. The popularity of inflation linked mortgages in Iceland meant that when the currency collapsed in the wake of the banking crisis, and the soaring cost of imports led caused inflation to spike close to 20%, a large proportion of the population found themselves unable to service their mortgages. Similarly, a large number of corporate and consumer loans had been denominated in foreign currency, and the collapse of the Icelandic krona meant that these loans also created a heavy burden on borrowers. Like several other countries, Iceland proposed mortgage forgiveness, allowing for partial write offs of debts and capping loans at 110% LTV to limit negative equity. However, unlike other countries, Iceland also attempted to clarify how the inevitable losses would be shared; partly by the newly created (and primarily state and creditor owned) banks, partly by the state’s housing fund, and partly by the insurance and pension funds who had invested in Icelandic mortgages. After long wrangling with the IMF, it appears the basic principles of this restructuring agreement have been agreed by all sides, though the devil will of course be in the detail.
This ability to get savers and borrowers around the table together to hammer out a burden sharing agreement is critical – of course it is much easier in a small country, especially once foreign creditors have already been snubbed, but it’s a process that I believe other countries will have to go through. The politics are also much simpler in a country with a relatively young population, where borrowers outweigh savers – countries with different demographics and a strong savings and pensions sector will find it much harder to implement debt forgiveness measures. However, ultimately they may have to try. Interestingly, Hungary has set a precedent for dealing with recalcitrant private pension funds by effectively nationalising them, and while a drastic solution, it is not unthinkable that similar measures could be implemented elsewhere in the EU if that is what is needed to bring all creditors to the table.
Finally, in the wake of the crisis, Iceland imposed capital controls to prevent the flow of funds offshore. While this has costs to the population, particularly savers stuck with devalued krona savings, it has proved useful in enabling the government to fund its budget domestically. Again, this sort of measure wouldn’t be easy for Eurozone countries to implement unilaterally, but in a country such as Ireland where the banking sector is effectively state owned, it would be interesting to see whether capital controls could to some extent be achieved via administrative measures.
The jury is still out on whether Iceland’s restructuring will ultimately be successful, and as highlighted above it will be tricky for Eurozone members to implement the same measures, but Iceland certainly provides an interesting case study in dealing with a financial crisis.