Economic crises 101: Iceland

The 2008 financial crisis was bizarre for a lot of reasons. But few parts of it were as baffling as what happened in Iceland, a 300,000-person country (for you Dallasites: that’s roughly the size of Plano) whose banking system grew from a few billion dollars to $140 billion in just three-and-a-half years from 2003 to 2007—resulting in losses totaling $330,000 for every Icelandic citizen by the end of 2009. 

Few people are more familiar with Iceland’s role in the financial crisis than Bob Aliber, a world-renowned economist and longtime Professor Emeritus of International Economics and Finance at the University of Chicago who happens to have retired to Hanover, NH, just steps away from the Dartmouth campus. Tonight, my own International Finance professor invited him to speak to our class about his take on the bizarre early 2000s in Iceland. 

First, a little background on why the situation in Iceland was so freakish. Michael Lewis’s Boomerang not only outlines Aliber’s role in the crisis, but also gives context for what happened in Iceland at the start of the twenty-first century. Perhaps Lewis frames it best: “An entire nation without immediate experience or even distant memory of high finance had gazed upon the example of Wall Street and said, ‘We can do that.’” A book published in 1995 summarizes the Icelandic economic perspective: “Icelanders are rather suspicious of the market system as a cornerstone of economic organization, especially its distributive implications.” Yet, by 2007, the Icelandic banking system alone was the centerpiece of its economy. Boy, do things change fast. 

In May 2008, the University of Iceland Economics department, having heard that Aliber had for two years been prophesying the Icelandic economy’s implosion, invited him to speak to an audience of Icelandic students, bankers, and journalists. Aliber didn’t hold anything back. Boomerang recounts Aliber arguing that Icelanders, rather than “having an innate talent for high finance,” were simply riding a huge bubble that would inevitably result in a crash of epic proportions. According to one audience member, Aliber’s overall message to Iceland as a country was clear: “I give you nine months. Your banks are dead. Your bankers are either greedy or stupid. And I’ll bet they are on planes trying to sell their assets right now.” 

Aliber insists that what happened in Iceland between 2002 and 2007 is actually infuriatingly simple. In fact, not only is it infuriatingly simple, but it is eerily similar—completely analogous, even—to what happened in the Mexican peso crisis, the East Asian crisis in the 1990s, and several other crises in relatively recent memory.

Economically, the Icelandic cycle of disaster was what Aliber called a “very generic process.” In 2002, investors flooded Iceland with direct investment. Increased demand for the krona, the Icelandic currency, caused it to appreciate, which in turn caused the yields of Icelandic securities to increase across the board. Noticing these rising prices, Icelanders were quick to sell the securities they were holding for a profit. In the early 2000s, after selling his securities, an Icelander could have done several things: he could buy a new car, buy a new refrigerator…or, given that the prices of securities is still rising, he could buy more securities. (Take a guess at what he did.) Logically, the ever-rising prices and ever-increasing demand for Icelandic financial instruments was self-reinforcing. As Aliber put it, “the cash becomes the hot potato—and that hot potato becomes the ever-increasing prices of Icelandic securities.” 

Simultaneously, the amount of debt held by Icelandic citizens was growing at an astronomical rate, while the interest charged on that debt was growing, but at a much slower pace. Imagine that the debt was growing at 30% per year, while interests rates were growing at, say, 5%. In effect, as backwards as it sounds, Icelandic borrowers were able to get cash to repay their lenders in the form of new loans. Of course, such an economic process is unsustainable and did eventually come crashing down. 

Economists are famously good at providing autopsies, so to speak, after countries or companies have crashed. But autopsies are no help in preventing crises before they happen. Aliber says he saw the Icelandic crisis coming. Here’s hoping that, in the future, such prescient perspectives can be loud enough to stop disastrous economic cycles before they crash and burn. 

About John Michel

Dartmouth senior passionate about strategy, finance, marketing, and education.
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One Response to Economic crises 101: Iceland

  1. Michel Don says:

    John: It makes excellent good sense! We hope some of the folks in charge can learn from it.

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