Iceland Found Another Way to Clean Up a Financial Crisis

(Bloomberg Opinion) --  While flying last week to a conference in Reykjavík, it dawned on me that I knew almost nothing about Iceland. What little understanding I had was based on Michael Lewis’s epic tale of the nation’s financial collapse in Vanity Fair magazine entitled “Wall Street on the Tundra.” His 10,000-word missive is a Norse saga of its own. Other Icelandic literature included entries in Carmen Reinhart and Ken Rogoff’s “This Time is Different: Eight Centuries of Financial Folly,” and some academic work on bubbles and collapses. It all added up to a cursory understanding of a brief but wrenching period in the long arc of the country’s history.

That understanding proved dated and left me ill-prepared for what greeted me upon arrival: a booming economy, one that has been greatly transformed from the depths of the crisis. Growth has topped 4 percent in each of the past three years and the economy is forecast to expand 3.3 percent this year, according to data compiled by Bloomberg.

How Iceland recovered from one of the most traumatic shocks experienced by any nation during the financial crisis is worth reviewing. It boils down to a three-step process that might well serve as a model for how nations should deal with the next financial crisis, whenever that might be. I like to sum up it up as the three Ds: default, devalue, develop. Let’s consider each in turn.

1. Default: The first step was to allow a default on the $85 billion in debt accumulated by the nation’s banks. The three largest banks in Iceland — Glitnir, Kaupthing and Landsbankinn — had accumulated liabilities that amounted to almost 10 times the country’s gross domestic product. It was simply unimaginable that any bailout could have been possible, given losses of about $330,000 for every man, woman and child on the island. Thus, rather than give the banks room to work their way out of the debt via restructuring and government aid, Iceland simply tore off the Band-Aid, allowing them to fail. The result was a painful reaction to the defaults — the Icelandic stock market plunged 85 percent — but a much faster economic recovery followed than in the U.S., with fewer side effects.

Also important: The country protected the accounts of Icelanders’ deposits in banks. Foreign investors were not so lucky. And the government forgave debts for a quarter of the population. As Bloomberg News reported in 2012, “Iceland’s approach to dealing with the meltdown has put the needs of its population ahead of the markets at every turn.”

Iceland did something else: It charged its bankers (and some government officials) with breaking the law, bringing more than 28 cases and 60 prosecutions.

2. Devalue: The local currency, the kroner, was widely assumed to be a goner at the height of the crisis. It had declined in value by two-thirds versus a basket of international currencies.

That was enough for Icelanders — they voted out the government in power, and a new party and prime minster was put in place. The new government was willing to use the collapsing kroner to its advantage (see the next entry). The country’s high court handed debtors another break, ruling that loans — in many cases mortgages — indexed to foreign currencies were illegal. That meant households didn’t need to repay debts with krona that had lost so much purchasing power.

3. Develop: The country which had a rash and ill-considered fling with high finance, tried a different tack for economic development after the crisis passed: tourism. From 2010 to 2017, the number of tourists visiting Iceland increased by almost 400 percent. In 2003 a little more than 300,000 tourists visited the country. By last year, that number had increased to 2.2 million. Indeed, since 2010, tourism has become the “main driver of Icelandic economic growth, with the number of tourists reaching 4.5 times the Icelandic population in 2016” according to the CIA World Factbook. I don’t know of many other countries capable of managing the expansion of a sustainable industry like that. All those visitors pumped money into the economy: The country, which had a current account deficit that reached more than 130 billion krona in mid-2008, now runs a fairly consistent surplus.

Political economics entails the study of how scarce resources get apportioned. The arguments in favor of bailing out U.S. banks during America’s financial crisis were simply one set of claims by vested interests for those trillions of taxpayer and Federal Reserve dollars. There were distinct winners and losers in the U.S. bailouts; a different approach would have created a very different set of winners and losers.

Iceland effectively made the counterargument, showing there was another way.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He is the author of “Bailout Nation.”

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