Iceland’s Economic Recovery

In March 2017, Iceland ended capital controls, finally returning its economy to normal
after a catastrophic banking collapse back in 2008 and 2009.

Why does that matter? Because Iceland was the one country that defied the global
consensus and did not bail out its bankers. True, there was shock to the system. But it
was relatively short, and once the pain was dealt with, the country has bounced back
stronger than ever.

There is, surely, a lesson in that. It might well be better just to let banks go to the wall.
Next time around, we should follow Iceland’s example.

The crash of 2008 hit every country in the world. And yet none was quite so completely
destroyed as Iceland. A
tiny country, home to just
323,000 people, with cod
fishing and tourism as its
two major industries, it
deregulated its finance
sector and went on a wild
lending spree. When
confidence collapsed,
those banks were done
for.

In every other country in

the world, the
conventional wisdom
dictated the financiers had to be bailed out. The alternative was catastrophe. Cash
machines would stop working, trade would grind to a halt, and output would collapse.
It would be the 1930s all over again. The state had no option but to dig deep, and pay
whatever it took to keep the financial sector alive.

But Iceland did not have that option. Its banks had run up debts of $86bn, an
impossible sum for an economy with a GDP of $13bn in 2009. Even Gordon Brown, in
full “saving the world’” mode, might have baulked at taking on liabilities of that scale.
Iceland did the only thing it could do under the circumstances. It let its banks go bust:
as British depositors quickly found out to their cost.

So what happened next? Iceland collapsed? For the next few years, the Icelanders were
presumably shivering in their frosty homes, eating cod tails, and wondering where they
could scratch together enough money for a packet of candles to see them through the
winter?

Well, as it happens, not quite. Sure, there have been some very tough times. Interest
rates went all the way up to 18pc to try to find some kind of floor for a currency that
collapsed by more than 80pc. Strict controls on bringing money into and out of the
country were imposed. Iceland’s GDP, not surprisingly, took an immediate hit falling
by almost 7pc in one year. The krona, Iceland’s currency plunged in forex markets
pushing up the price of imports and inflation soared to 18%.
Overall, four out of 10 Icelandic households were declared technically insolvent,
mainly on account of the foreign currency mortgages they had taken out at the height
of the boom. The International Monetary Fund had to step in with an emergency
package of measures just to keep the country from sinking into the chilly depths of the
North Atlantic.

It was about as bad as the mainstream economic consensus predicted it would be. The
banks went down, and the economy went down with them. But there has been a twist
in the tail. As it turned out, Iceland recovered relatively quickly.

The Government secured $10 billion in loans from IMF and other countries. The
Icelandic government stepped in to help local depositors, seizing the domestic assets
of the Icelandic banks and using IMF and other loans to backstop deposit guarantees.
Far from implementing austerity measures to solve the crisis, the government looked
for ways to shore up consumer spending. For example, the government provided
means-tested subsidies to reduce mortgage interest expenses of borrowers. The idea
was to stop consumer spending from imploding and further depressing the economy.

With the financial system stabilised, what happened next is an object lesson in the
value of having a floating currency. The fall in the value of the krona helped boost
Iceland’s exports, such as fish and aluminium and tourism, while depressing demand
for costly imports such as automobiles. In 2009, krona was worth half as much against
the US$ and Euro as it was in 2007 before the crisis.

While the high costs of imports did stoke inflation, booming exports started to pump
money back into the
Icelandic economy.

In 2011, the economy

rebounded and grew by
3.1% and in 2016, its
economy expanded by
an impressive 7.2pc.
Unemployment has
dropped all the way
down to 3pc, a level
which means virtually
everyone who wants a
job has one. The krona
was up by 18pc in the
past year against a
basket of rival currencies as global investors started to buy into its rapid recovery.
Interest rates have been steadily reduced from emergency levels to 5pc, a sustainable
long-term rate that rewards savers and yet makes it affordable to borrow and invest.
Its debt to GDP ratio by 2015 was down to 68pc.

In March 2017, Iceland finally removed the last of the emergency measures put in place
after the crash. The Prime Minister, Bjarni Benediktsson, announced that all the
remaining restrictions on the movement of money into and out of the country would
come to an end. The move would “create more trust in the Icelandic economy”, and
“will make foreign direct investment easier”.