After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

Why Iceland?: How One of the World’s Smallest Countries Became the Meltdown’s Biggest Casualty, by Asgeir Jonsson (McGraw-Hill, 224 pp., $22.95)

Nearly a year ago, tiny Iceland’s financial institutions collapsed, just as banks and investment firms did all over the West last autumn. But Iceland differed from the rest of the developed world in forcing its insolvent financial institutions’ bondholders to take their losses. Alone among the world’s nations, Iceland has efficiently taken the principle of “too big to fail,” which governs taxpayer rescues of large or complex financial institutions, to its inevitable end: failure. Other nations, including the United States, risk eventually following Iceland, unless they understand its lesson.

As Asgeir Jonsson, chief economist at one of the banks at the center of the crisis, observes in Why Iceland?, Iceland had a tense relationship with finance long before 2008. A century ago, the island nation benefited from creative financial growth, with a foreign-owned bank supporting the modernization of its fishing industry. But when the Depression came, that bank failed, and Icelanders opposed spending money to benefit the overseas speculators who owned it. Rather than create regulations to support a healthier private-sector financial industry, as much of the West did, Iceland nationalized its banks, causing a “50-year pause in Iceland’s financial development,” writes Jonsson.

Iceland gave little thought to banking again until the 1980s, when a severe recession soured its citizens on postwar statism and pushed them to embrace the Thatcherite reforms taking hold in Britain. The Nordic country slashed taxes, broke inflation, gradually sold off its banks (completing that process in 2003), and signed an agreement to gain access to European markets.

The previous decades of government dominance continued to haunt finance, though. A “lack of institutional memory” in the industry “allowed all participants, bankers and government officials alike, fundamentally to underestimate systemic risk,” Jonsson writes, while private firms, until 2003, had to compete against the remaining state firms, which retained the advantage of government backing. (Similarly, in America, few financiers or regulators after the 1980s remembered the lessons of the Depression five decades earlier, and America, too, had its fair share of government distortion of finance, especially in the Washington-dominated mortgage markets.) In Iceland, this government shadow helped define one upstart private-sector bank, Kaupthing. Kaupthing made up for its disadvantages against state-owned competitors with what seemed at the time like smart aggression. Eventually, the rest of Iceland’s banking system followed suit, with Iceland’s two big banks matching the growing Kaupthing risk for risk.

In the decade leading up to the 2008 crisis, Iceland’s banks, along with the rest of the world’s financial economy, became short-lived beneficiaries of the global debt and derivatives bubble. They could attract tens of billions of dollars from global investors partly because Iceland had no public-sector debt, but largely because international banks desired the Icelandic banks’ bonds, folding them into AAA-rated securities and selling them to other international banks. Absent this global hunger for debt, Iceland’s banks couldn’t have grown so quickly, as Icelanders’ savings were tiny compared with the size of their banks’ ambition. Much of the debt was in dollars—a tremendous risk, since if the local currency fell against the dollar, the banks would owe much more. But the bankers didn’t let this concern slow them down. The derivatives they used would hedge that risk, they thought, just as financial institutions around the world convinced themselves that they had solved similarly irresolvable problems.

But the fundamental reason for Icelandic banks’ growth—and financial growth around the world—was the universal faith that because finance had grown so complex and interconnected, no Western nation would allow any of its big, complex financial institutions to fail. As Jonsson writes, “Banks in the western world have operated for decades under the assumption that both bondholders and depositors have a government guarantee against their loss. . . . This assumption of state support unquestionably helped to fuel the Western banking bubble, and it also helped the Icelandic banks to shine.” By 2007, Iceland’s banks had amassed assets ten times the nation’s annual GDP—tenfold growth in a decade. But even as foreign investors grew nervous in 2006, bond analysts at Moody’s assuaged their worry, determining that each of Iceland’s banks was “too important to fail” and declaring that if the need for government support arose, “access to finance will always be available.”

This happy thought proved ephemeral. When, starting in 2007, the world’s lenders lost confidence in the main technique behind all that global debt—securitization—they also lost confidence that financial firms’ assets could hold their values without the easy debt that securitization had provided. As exuberance turned to pessimism, the financial world used unregulated credit derivatives to bet against the Bear Stearns and Lehman Brothers investment banks—and against Iceland’s banks, too. With cheap debt gone and with unregulated financial instruments monetizing and magnifying fear, the banks faced the prospect of selling into a plummeting market, forcing more distressed sales as prices fell.

After the U.S. government bailed out Bear Stearns’s bondholders and trading partners in March 2008, investors stopped pretending to trust financial institutions and looked instead to the strength of national governments. In June, Iceland had an opportunity to shore up its banks with public money, but that would have required extensive borrowing, and it saw the interest rate, while affordable, as unfairly high. Iceland’s central bank also sought help from the world’s central banks, including the Federal Reserve, attempting to secure access to dollars and euros in an emergency. But Iceland failed to get the help it needed, partly because Icelanders “seemed not at all ready to abandon their aggressive international banking model, an impossible dream made real,” Jonsson writes. In this stubbornness, Iceland was like Lehman Brothers, which, during the spring and summer of 2008, balked at selling out to a stronger outside investor at what seemed like an unfair price.

After Lehman’s September 15 bankruptcy, each nation protected its own, but by now, Iceland couldn’t borrow to save its banks at any price. Officials tried, assuming that the impossibly high interest rates that the market was demanding to hold its banks’ debt would come down and meet the lower rates that bondholders had required to buy government debt, since the banks would now have government support. That was what happened in America and much of Western Europe. But in Iceland, the opposite occurred, and borrowing costs for the government skyrocketed out of reach. The world started to understand that Iceland’s financial sector was, not too big to fail, but too big to save. So Iceland—out of necessity, not ideology—did what no other Western nation has done: it let two of its three financial giants go under, nationalizing them and forcing losses on bondholders.

As the banks failed, Iceland, too, did what it could to protect its own. It pledged to expand coverage to all domestic deposits under its version of FDIC insurance. But the strategy had a weak spot. One Icelandic bank, Landesbanki, had marketed its “Icesave” accounts over the Internet to British customers, and it had used its own branches to do so, not a separate British company. That meant that Iceland’s deposit insurance applied to the Britons, too, and European regulations forbade Iceland from saving domestic depositors at the expense of equally insured foreign ones. This put Iceland in a fiscally untenable position, since Icesave had amassed foreign deposits worth 70 percent of the country’s GDP.

As Iceland dithered over whether it could make good on a liability that would take its debt from zero to levels that would have been considered high at the time even in the rest of the indebted West, British depositors panicked, and so did the British government, which feared that the public wouldn’t differentiate between Britain’s banks and Icesave. To maintain confidence in its banks, Britain offered Icesave account holders its own government protection. Then, using powers granted under antiterrorism law, the government seized the British assets of Landesbanki, by now Iceland’s last remaining big bank. The bank then collapsed back home, bringing 95 percent of Iceland’s financial system into bankruptcy and under state control. “Most ordinary Icelandic citizens felt as if they had been expelled from Europe,” Jonsson writes, with Icelanders abroad cut off from international credit-card and ATM systems.

So that its citizens and businesses could import necessities as its currency cratered, Iceland went to the International Monetary Fund, borrowing money on terms that included budget cuts and a promise to repay the British and the Dutch (whose government had also stepped in to protect its Icesave customers). In addition to the $2 billion IMF loan (with more likely to follow), Iceland now owes $5 billion because of Landesbanki’s Icesave obligations—roughly one foreign Icesave account for every Icelandic citizen.

It’s comforting to think, as Tufts professor Daniel W. Drezner wrote in the Wall Street Journal, that “what happened in Iceland will probably stay in Iceland.” Yet we ignore Iceland at our peril. “The biggest difference between the Icelandic banks and the banks abroad was first and foremost the level of assistance their government would be able to grant in times of crisis,” Jonsson correctly notes. But Iceland’s financial sector outgrew the nation’s ability to rescue it because global investors thought that the nation could rescue it—and unless the rest of the West credibly rejects its too-big-to-fail approach, the same thing, someday, could happen here. Thirty-five years ago, financial-sector debt in America was 17 percent of GDP; today, it’s 18 percent greater than GDP. We don’t know how big is too big for the government to rescue, but without adequate regulations, we risk finding out.

Yes, the U.S. and significant parts of Europe have obvious protections against an Iceland-style capital runoff. America borrows in dollars, the world’s reserve currency; Europe, too, has strength in the euro. America and Europe have more diverse economies than Iceland’s. But the first advantage can slowly erode the second. America’s access to debt could allow it to keep underwriting an unsustainable financial system. The government has already used its credit to bail out banks instead of financing modern infrastructure. Private capital could continue to find a home in a profitable, government-protected financial industry—at the expense of healthier growth in other industries and a robust economy maintained and refined through fair competition. Perversely, Iceland’s demise may accelerate concentration of financial services in seemingly stronger nations, crowding out other businesses, because nobody will recklessly lend money to a bank headquartered in a country that can’t back up its banks.

What’s next for Iceland—its economy sunk, its self-esteem ruined, its government slashing spending, and its citizens angry at becoming “Iceslaves” to reimburse foreign depositors? University of Missouri econ professor Michael Hudson wonders if Iceland will “be plunged into austerity in an attempt to squeeze out an economic surplus to avoid default.” Some observers believe that Icelanders will end up like the Germans after World War I, resentful at the world and tempted to spite global lenders. For now, Iceland’s economy depends partly on Western creditors’ giving it some slack; Britain and the Netherlands have agreed to delay the country’s repayment of the Icesave obligation and then limit it to 6 percent of future GDP per year. But Iceland can’t avoid cutting public spending as it weans itself from unsustainable financial services’ illusory wealth.

Icelanders may in time understand that they have bought something quite valuable with all of this debt, which now exceeds 100 percent of GDP: freedom from a too-big-to-fail financial system. Iceland’s taxpayers may owe a lot, but they’ve cut the tab off. “Iceland now enjoys the dubious distinction of being the only Western nation to have ‘solved’ its banking problem,” writes Jonsson. The rest of the West is still racking up charges.

As Iceland recovers, it should even think about returning to global finance. In a few years’ time, if Iceland reprivatizes its financial industry and improves regulation to limit borrowing, it could credibly argue that its rebuilt industry offers the West’s only real measure of financial risks, absent government guarantees. It might get few takers. That would say a lot about investors’ confidence in an industry upon which the West has become dangerously dependent for economic growth.

Nicole Gelinas, a City Journal contributing editor, is author of the forthcoming After the Fall: Saving Capitalism from Wall Street—and Washington.