Iceland Financial Crisis Was A Precursor Of The Global Crisis

The financial crisis in Iceland began with the overflow of capital into it, which was much beyond the capacity of its economy to handle. The speculative capital inflows were a signal of surplus capital, impending asset bubbles and an eventual crisis, as much in the global economy, as in Iceland. These were vital signs of deteriorating economic health, but no taken note of. Our optimistic bias prevents taking such signals into account.
Iceland Financial Crisis was a Precursor of the Global Crisis
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Sometimes, a systemic problem that can lead to a major damage makes it presence felt in the form of smaller signals that may not be as problematic on their own. For the ships sailing in the Atlantic, floating pieces of ice may be a signal of the presence of an iceberg. One such iceberg sank a massive ship called ‘Titanic’, which its designers have claimed as being ‘unsinkable’. That fateful night too, there were warnings of ice floating in water, which somehow did not arouse adequate attention and response from the Titanic crew, resulting in more than a thousand deaths.

Signals

of impending economic crisis are also all too apparent, but it is often not easy to decipher them. When unsustainable paradoxes exist in the economy, it should be taken as a sign of a threat. Unfortunately, very often, our optimistic bias prevents us from taking that perspective till the disaster has actually struck.

Thus, it is often only in the hindsight that one can actually understand the significance of the financial crisis in Iceland.

A Tale that Began in the first decade of this Century

The genesis of the financial crisis of Iceland that actually got precipitated in 2008, lay in the excessive flow of foreign direct investment as well as the over-extension of its financial sector. The roots of this crisis were laid down in the years prior to 2008, as the financial inflows into Iceland swelled to unsustainable limits.

In 2008, Iceland became the first developed country to approach IMF for financial assistance in the face of a severe banking crisis and default by some of its major banks. Unlike other countries, the government of Iceland could do very little to solve the problem because the size of its banking sector was approximately ten times that of its GDP, and even though government sector accounts for about half of its GDP, its resources were nowhere even close to prove useful in this hour of crisis.

Combination of Excessive Financial Inflows and High Interest Rates

The roots of the problem did lie in the FDI inflows during the last decade or so, which appreciated its currency even in the face of a current account deficit. In addition, they also caused inflation. The overzealous response of the Central Bank to control inflation, and use of high interest rates as the primary means for doing so, proved to be counterproductive as the high interest rates caused further capital inflows into Iceland, which in turn raised the value of its currency as well as inflation even further. It also caused carry over trades using Iceland Krona making the situation even more vulnerable. The fact that this sector of the economy had far outgrown the real economy should have alarmed the regulators. Unfortunately, no steps were taken to ensure stability, and the ground for a crisis was allowed to develop.

Finally, when the bubble burst in 2008, by the abrupt use of anti-terror laws to seize assets of Icelandic banks


in U.K., the crisis was big enough to lead to a default, and as the state did not have enough resources to handle this crisis, there was little option except seeking assistance from a third party.

A Precursor of Global Economic Crisis

Though this crisis has its foundation in easy and unregulated flow of capital into Iceland, a large part of which was FDI, it will still not be wrong to say that Iceland ended up becoming the first self-confessed victim of an ongoing global economic downturn, which the whole global economy had to confront. A substantial trade deficit, migration of its younger age group to other parts of Europe, and most of all, the instability in the global economy caused the Icelandic banking sector to collapse. To some extent, the regulators in UK and Netherlands, who allowed ICESAVE, the saving accounts with an interest rate around 50% higher than those in rest of Europe, were also responsible for enabling a flawed financial system to take deposits from their investors. Later, the UK authorities' action against these banks only served to make the situation irretrievable and further worsened the crisis.

The Underlying Problems were the Same

The main problem that led to the financial crisis in Iceland was not very different from the excessive speculative financial flows around the world. Capital is useful only when it gets transformed to investment and leads to supply for goods and services for which adequate demand exists in the economy. Since individuals can only consume as is humanely possible, accumulated capital does not lead to demand for consumer goods. Instead, it only fuels the demand for assets.

During the first decade of this century too, the accumulated capital, largely a result of massive trade surpluses of China and oil exporting countries, was getting invested largely as US treasuries, thereby leading to falling interest rates and asset inflation. As the spread between the Fed rate and the mortgage rate widened, it led to high risk taking in the form of sub-prime mortgages. While the real estate and stocks got hot, it all led to a huge asset bubble around the world, which then burst due to sub-prime loan crisis, taking the whole financial sector in the United States and the global economy into a crisis. Around the same time, the Iceland Financial Crisis, the signals of which had been much more apparent for a while, also burst.

If only someone had been able to point out that the excess of capital in Iceland was a sign of deteriorating health of global economy, perhaps... we might have been better prepared for a hard landing of global economy!



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