Individual Assignment:

Case Study- Iceland: Small Fish in a Global

Pond

Global Economic Theory & Issues

BDMF 7053

Name
: Mohd Fadli Bin Mahmud
Matric No.
: 95592
Lecturer
: Prof. Dr. K. Kuperan
Visnawathan
Date
: May 2014

| Global Economic
Theory & Issues

Table of Contents
1.0 Introduction.......................................................................................................... 1
2.0 What was the Global Economic Problem that Iceland was facing?.......................................1
3.0 What caused the problem?........................................................................................ 2
4.0 What possible solutions are there for Iceland?................................................................3
5.0 If you are the economic and business advisor to the Government of Iceland what suggestion will
you give to solve the economic problems?.........................................................................4
6.0 Conclusion........................................................................................................... 6

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Case Study- Iceland: Small Fish in a Global Pond

1.0 Introduction
In 1991, the Icelandic government began an aggressive program of liberalization and
privatization which gave rise to the hyper-expansion of three Icelandic banks. Their highly
leveraged growth fuelled massive stock market and housing bubbles, all of which combined
to make Icelands per capita GDP one of the worlds highest by the mid2000s. Icelands
economy collapsed in October 2008 when the three banks were forced into bankruptcy; the
country suffered one of the deepest downturns in the world.

2.0 What was the Global Economic Problem that Iceland was facing?
Icelands explosive growth during the past decade has been accompanied by macro-economic
imbalances and an accumulation of huge foreign debt, mostly incurred by the banking sector
borrowing freely on the international capital markets. In the wake of the global credit crunch,
the Icelandic economy now faces severe challenges.
Macro-economic imbalances:
Icelands central bank has battled inflation through high interest rates. Yet inflation has
remained at close to double the banks target of 2.5%16 in the past several years, partly due to
easy access to low-interest foreign-currency loans and partly due to a booming economy and
a sharp increase in the equity and housing markets. High interest rates have made Iceland a
prime target for the carry trade in recent years, resulting in a strong Krona. A strong Krona
encouraged further spending and foreign-borrowing and a vicious cycle emerged leading to
an enormous current account deficit (peaking at 26.2 % in 2006). High inflation, and reduced
carry trade due to the global credit crunch, led to severe deflationary pressure on the
Icelandic Krona, which has lost more than a fifth of its value against the euro in 2008 (22 %).
Inflation is now (May 2008) running as high as 11.80% (a 20 year high) and the Central Bank
recently (April 2008) increased its policy rate to 15.50 %, the highest of all OECD countries.
Rumors of speculative attacks on the Icelandic currency by foreign hedge funds surfaced in
early 2008, perhaps exacerbating the problem1.

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High Foreign Debt:

The explosive growth of Icelandic firms has been financed by aggressive borrowings by
Icelands three largest banks and the total external debt of the economy is now more than 5
times GDP2, i.e. the economy is highly leveraged. The negative debt position is partially
explained by investment in new power plant capacity, the rapid expansion of Icelandic firms
abroad, high levels of outward FDI, young population, consumer spending and, perhaps,
misleading accounting.
In any case, it seems clear that the global credit crunch hit Iceland at a vulnerable time.
Icelandic banks, consumers and firms are suddenly faced with a falling currency and
prohibitively high borrowing costs. Doubts have been cast on the governments ability to
support the Icelandic banks, simply due to the fact that the combined balance sheets of the
three largest banks were 887% of GDP at the end of 2007 3. The vulnerabilities of maintaining
an independent monetary policy have also become clear and debate has been vigorous on
how to better defend the currency or, alternatively, to adopt a stronger currency. Government
officials point to a debt-free government, healthy banks and a flexible economy as key
buffers, but recession seems likely.

3.0 What caused the problem?

Macro-economic imbalances:
The government had lowering corporate tax rates and privatizing state-owned companies.
Serious change came only after 1994, when Iceland joined the European Economic Area
(EEA), the free-trade bloc of the European Union. Membership gave Iceland open access to
European markets and the countrys political and business leaders were quick to grasp that a
privatized, deregulated, and expanded finance sector was their best vehicle for overcoming
the countrys profit-constraining market size.4
High Foreign Debt:
The banks relied heavily on foreign money for their expansion. Early funding came largely
from selling bonds in the European market. When foreign rating agency warnings about the
health of Icelandic banks closed off the European market in 2006, the banks turned briefly to
the U.S. bond market. The following year, Landsbanki and Kaupthing turned to yet another

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market, foreign retail deposits, especially in the United Kingdom and the Netherlands. All
three banks also used their subsidiaries in Luxemburg to engage in indirect collaterized
borrowing from the Eurosystem. By the end of 2004, Iceland was the worlds most heavily
indebted country measured in terms of gross external debt to GDP.5

4.0 What possible solutions are there for Iceland?

Currency Policy
Icelands currency remained strong during the countrys pre-crisis expansionary period in
spite of its enormous current-account deficit because of the large inflow of foreign funds.
With the collapse of the banking system, that inflow stopped and the krona went into free fall.
The decline intensified the countrys economic problems. Many households and businesses
held foreign-currency indexed debts that exploded in domestic cost. As noted above, the
government worked to minimize the economic harm from this development by forcing banks
to restructure their loans in domestic currency.
Icelands currency policy also includes the use of strict capital controls which make most
transnational capital movements illegal.6 These controls have blocked an estimated $8 billion,
roughly equal to 50 percent of Icelands GDP, from leaving the country. Had the government
not taken action, the resulting outflow would no doubt have led to a complete currency
meltdown. Thanks to the controls, the krona, although lightly traded, soon strengthened and
then stabilized.
Housing Policy
The government took strong steps to minimize the threat to household finances caused by the
collapse of the housing bubble and to restore stability to the housing market.
The government then introduced several new initiatives designed to provide more long term
relief. These lowered household debt and mortgage interest payments as well as provided
support for housing alternatives and renters. For example, the government first pursued a
strategy of encouraging householders to directly negotiate write-downs with their lenders,
often with the assistance of an ombudsman. Given the slow progress, the government
introduced a debt-forgiveness plan that wrote down underwater mortgages to 110 percent of a
households assets. To ensure that working people were the main beneficiaries of the plan, the

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amount of relief was tied to the value of a modest house and family size. More detailed
financial examinations were available for households in especially serious financial trouble,
with the possibility of greater write-downs.7
Social Policy
The Icelandic government faced a serious fiscal challenge as a result of the crisis, with its
budget deficit rising to 13.5 percent of GDP in 2009. Impressively, it reduced overall
spending and the deficit to 2.3 percent of GDP in 2011 while simultaneously strengthening
key social programs. For example, the government increased unemployment benefits over the
years 2007 to 2010 and also lengthened the period during which workers could receive
unemployment benefits from three to four years. In addition it significantly boosted the
means-tested social assistance allowance and the minimum pension benefit.7
Over the same period, the government also increased subsidies for mortgage interest
payments by 108.1 percent, far outstripping the 40.6 percent increase in mortgage costs. This
increase raised the average household subsidy for interest costs from approximately 13
percent to 20 percent of the total interest cost. Moreover, the interest rebates were largely
targeted at working-class households, which meant that about a third of the interest cost of
lower and average income households was paid by the government in 2010.7

5.0 If you are the economic and business advisor to the Government of Iceland what
suggestion will you give to solve the economic problems?
Recommendations to Policy Makers
Address current macro-economic imbalances:
This should, quite obviously, be the governments first priority. And since this is partly a joint
problem of the banks and the government they should work together to improve market
confidence. Specific recommendations are:

Provide clarity on how and under what circumstances the government will support the
banks

Formally collaborate with the financial sector to develop better accounting methods and
communicate Icelandic conditions abroad

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Improve fiscal discipline to help reduce the current account deficit

Strengthen the currency by either significantly increasing reserves or seeking formal

agreements with other European central banks to support it. Alternatively, consider
adopting another currency.

Adopt cluster approach to support the financial sector:

The government played a key role in the rapid rise of the financial sector by providing a
favorable, progressive legal framework, and access to the European market but more should
be done going forward. Iceland now has a unique opportunity to build on the recent
successes, foster further development of the cluster and improve its long-term
competitiveness. Specific cluster-centric recommendations include:

Develop a realistic strategic vision for the cluster in cooperation with its players: define
what kind of financial center Iceland wants to become, how it can attract foreign
financial firms, and how to encourage links and knowledge flow with other financial
centers, such as London and New York

Establish formal, government-endorsed institutions for collaboration that support the

cluster. The purpose should be to organize the cluster to solve joint problems, improve
communication and marketing, foster competitiveness and innovation, etc.

Eliminate obvious cluster barriers: (1) prevent Housing Finance Fund from competing
with the banks (perhaps retain social function), (2) abolish taxes on repatriation profits
earned by foreign companies, (3) conduct tax reform to remove incentives for locals to
move assets to foreign holding companies

Invest in cluster-related base research and development. Create a finance-related, locally

linked, research institute just like the government is currently supporting energy and
fishing research through the Marine Research Institute and the National Energy Institute.
One of its goals should be to develop better accounting methods and metrics for the
cluster.

Directly address the risk of the banks leaving the country. Provide general incentives for
financial firms to keep their headquarters and main operations in Iceland. These

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incentives should also work to attract foreign financial institutions to set up shop in
Iceland.

Maintain a competitive general business environment.

6.0 Conclusion
Icelandic experience offers useful lessons for all those working to build movements capable
of initiating meaningful social transformations. The first lesson is that countries do not adopt
neoliberal policies because of a policy mistake or the takeover of government by extremist
elements. Rather it is an expression of a generally shared capitalist desire for bigger profits
coupled with the realization that this requires greater market freedom, both regulatory and
geographic.
The second is that expansion generated by neoliberalism contains the seeds of its own
undoing. Capitalism is a contradictory and unstable system and the more unchecked are
market forces, the faster the economic rise and the more dramatic the economic fall. The
Icelandic experience, in particular, offers a frightening illustration of how easily our wellbeing can be threatened by the machinations of financial interests.
The third is that states can effectively intervene in multiple, interconnected markets and
achieve impressive results. More to the point, comparing the experience of Iceland with that
of other countries makes clear that active state intervention in restructuring and directing
markets is the key to a socially desirable response to crisis.
The fourth is that crisis alone is not sufficient to deter capitalist interests from their support
for liberalization and privatization. In most countries, the same capitalist interests that
orchestrated the adoption of the neoliberal policies that generated the crisis remain adamant
defenders of the same policies.
The fifth is that social democratic policies, regardless of how successful they may be in
defending popular interests during a period of crisis, do not automatically generate support
for an agenda of social transformation. One reason is that social democratic parties tend to
present their interventions as temporary, made necessary by unusual circumstances. Once
stability is regained, capitalist interests are well positioned to argue that such interventions
need to be undone so as not to become fetters on expansion.
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The final lesson is that to advance a meaningful revolutionary process, activists must not only
build popular support for expanded public ownership and state capacities to direct economic
activity, but they must do so as part of a movement that directly challenges the legitimacy of
capitalist imperatives and encourages new visions of social ownership and patterns of
production and distribution.
Notes:
1. Tett, G. Indignant Iceland faces a problem of perception., The Financial Times, March
27, 2008.
2. Central Bank of Iceland, http://www.sedlabanki.is/, accessed April 2008.
3. Bank of Iceland (2008), Economy of Iceland. The banks 2007 annual reports.
4. Benediktsdottir, Danielson, and Zoega, Lessons From a Collapse of a Financial
System, 215.
5. Stefn lafsson, Icelands Financial Crisis and Level of Living Consequences, Working
Paper no. 3:2011, Social Research Centre, University of Iceland, December 2011,
http://thjodmalastofnun.hi.is, 4.
6. Ministry of Economic Affairs, Government of Iceland, Act No. 127/2011 Amending the
Foreign Exchange Act, the Customs Act and the Act on the Central Bank of Iceland,
article 13b.
7. lafsson, Icelands Financial Crisis and Level of Living Consequences, 19.

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