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What happened to Iceland?

Analysis
Jon Danielsson
Economist, Financial Markets Group, London School of Economics

The crisis will hurt ordinary Icelandic households.

The first real casualty of the credit crunch is Iceland.

Its failure was caused by two distinct factors, the first entirely predictable, and the second less so.

The predictable element in Iceland's failure is linked to the actions of its central bank.

Over the past years, Iceland has pursued a policy of inflation targeting, similar to the UK.

This means the central bank targets inflation, raises interest rates if inflation is above the target, and lowers them if inflation is below target.

Such a policy has a sound foundation in economic theory and is often appropriate for large countries.

In the case of Iceland it was disastrous.

Wasted opportunities

Throughout the period of inflation targeting, inflation was above its target rate, resulting in interest rates exceeding at times 15%.

Your views: Iceland's credit crisis In pictures

In a small economy such as Iceland, high interest rates both encourage domestic firms and households to borrow in foreign currency, and also attract currency speculators.

This lead to large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth.

The speculators and borrowers profited from the interest rate difference between Iceland and abroad as well as the exchange rate appreciation.

These effects encouraged economic growth and inflation, further leading the central bank to raise interest rates.

The end result is a bubble caused by the interaction between domestic interest rates and inflows of foreign currency.

The exchange rate was increasingly out of touch with economic fundamentals, with a rapid depreciation of the currency inevitable.

This should have been clear to the central bank, which wasted several good opportunities to prevent exchange rate appreciations and build up reserves.

Independent bank?

Adding to this is the peculiar governance structure of the Central Bank of Iceland.

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Uniquely, it does not have one but three governors.

One or more of those has generally been a former politician.

Consequently, the governance of the Central Bank of Iceland has always been perceived to be closely tied to the central government, raising doubts about its independence.

Currently, the chairman of the board of governors is a former long-standing prime minister.

Such a governance structure carries with it unfortunate consequences that become especially visible in the financial crisis.

By choosing governors based on their political background rather than economic or financial expertise, the central bank may be perceived to be ill-equipped to deal with an economy in crisis.

State guarantee

The second factor in the implosion of the Icelandic economy this week has been the size of its banking sector.

Before the crisis, the Icelandic banks had foreign assets worth about 10 times the Icelandic gross domestic product (GDP), with debts to match.

Iceland's prime minister Geir Haarde has been under the spotlight this week.

In normal economic circumstances this is not a cause for worry, so long as the banks are prudently run.

Indeed, the Icelandic banks were better capitalised and with a lower exposure to high risk assets than many of their European counterparts.

In a crisis, such as the one we are experiencing now, the strength of a bank's balance sheet is of little consequence.

What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity.

Therefore, the size of the state relative to the size of the banks becomes the crucial factor.

The relative size of the Icelandic banking system means that the government is in no position to guarantee the banks, unlike in other European countries.

This effect was further escalated and the collapse brought forward by the failure of the Central Bank to extend its foreign currency reserves, even if it was under considerable pressure to do exactly that.

Real tragedy

This week's events were caused by the combination of those two factors, inappropriate monetary policy and an outsized banking system.

Throughout this year the Icelandic currency has been falling due to the currency speculators running for shelter.

This has caused doubts about the Icelandic economy and its banking sector.

What eventually tipped the balance was the current extreme global financial uncertainty.

The real tragedy in the crisis is the impact on Icelandic households; they are seeing payments on loans increased by up to 50%, and inflation which may reach 30% or more this year, with salaries frozen and mass layoffs.

Fortunately, the long run macroeconomic potential is good.

Iceland has plenty of untapped natural resources and a well educated workforce.

The long run economic outlook is therefore favourable.