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Iceland Abandoned
Brown's actions helped to worsen the island's financial crisis.
By HANNES H. GISSURARSON
REYKJAVIK, Iceland
As recently as last year, Iceland was considered an economic success story. After 16 years of free-market reforms, it was one of the world's 10 richest and freest countries. Efficiently managing its fish stocks -- elsewhere operated with huge losses -- it also enjoyed a strong pension system. Massive tax cuts had led to strong economic growth and rising tax revenues. At the same time, extensive privatization generated about $2 billion for the state, allowing it to pay off most of its debt. The newly privatized banks were flourishing. Income distribution was relatively even, and the poverty level one of the lowest in Europe. Like other Nordic countries, Iceland was a stable democracy under the rule of law.
Then, in the first week of October 2008, all went wrong. The three main Icelandic banks collapsed and the government took over their domestic branches. It is still unclear what will happen to their foreign operations. The local currency, the krona, went into free fall. Foreign trade came to a standstill, as it became almost impossible to transfer money to and from the country.
Why did the international financial crisis hit Iceland so hard? A plausible answer is that Iceland's banks were oversized: With assets worth more than 10 times the country's GDP, the Icelandic Central Bank simply could not act as their only lender of last resort. In hindsight, Iceland's Financial Supervisory Authority should perhaps have demanded much earlier that financial institutions significantly scale down their foreign operations.
While some Icelandic bankers may have behaved recklessly, there is another side to the story. In 1994, Iceland joined the European Economic Area, a free-trade zone that unites the 27 EU member states with Norway, Liechtenstein and Iceland. The idea was that any company based within the EEA could operate freely throughout the area, provided it followed the rules.
The Icelandic banks took this seriously and began operations in other European countries, working under EEA regulations. Efficient, aggressive and technologically advanced, they often offered better terms than their competitors, undoubtedly causing some resentment.
At the beginning of the financial crisis in 2007, the Icelandic banks were quite solvent. They had almost no subprime loans. But there was a foreseeable liquidity problem. When the Icelandic Central Bank tried to obtain credit lines from other central banks in the EEA, it was refused almost everywhere. Suddenly, it did matter where the banks had their headquarters. Once the financial markets realized that there was no credible lender of last resort in the Icelandic financial system, a run on the banks became almost inevitable.
One or two of the Icelandic banks might have survived, though, if on Oct. 8 British Prime Minister Gordon Brown had not used the country's antiterrorist law to take over the assets and operations of two Icelandic banks in the U.K., Kaupthing and Landsbanki. The Icelandic Ministry of Finance and Central Bank even found themselves briefly on the list of terrorist organizations published on the Web site of the British Treasury, alongside al Qaeda and the Taliban.
These British measures significantly worsened Iceland's financial crisis. The island's banking system and foreign trade collapsed. Unsurprisingly, banks are reluctant to transfer money to and from "terrorists."
Mr. Brown justified his draconian actions by saying that the Icelandic government was unwilling to honor its legal obligations to British depositors of Icelandic banks. There is no evidence for this charge. To the contrary, the Icelandic government repeatedly asserted that all legal obligations to depositors in the EEA area would be honored. These obligations are covered by the Icelandic Depositors' and Investors' Guarantee Fund set up under EEA rules. The fund is an independent body, guaranteeing all deposits up to about €20,000. However, if the fund is unable to fully meet its obligations, then there is no requirement, under EEA rules, for the Icelandic government to step in.
Prime Minister Brown also talked darkly of last-minute bank transfers from England to Iceland. Whether that is true or false remains to be seen. But interestingly, the last-minute transfer of $8 billion from Lehman Brothers in England to America in September did not land the U.S. Treasury or the Federal Reserve on the British list of terrorist organizations.
Having helped to bring down two of the three Icelandic banks, Mr. Brown, using the position of London as a financial center and his country's influence in the IMF and the European Union, demanded that the Icelandic government go far beyond what the Depositors' and Investors' Guarantee Fund is obliged to do under EEA rules. The prime minister, fearing that the fund does not have sufficient means, insisted that the Icelandic government must guarantee foreign deposits in Icelandic banks. Late Sunday, Reykjavik succumbed to this pressure and agreed to reimburse European savers for up to about €20,000. This might put a debt of perhaps $10 billion on the shoulders of 310,000 people, close to 100% of the country's GDP.
The central banks in the EEA that refused to come to the assistance of the Icelandic Central Bank probably did not anticipate the damage their inaction would cause even beyond Iceland's shores. And Prime Minister Brown probably did not understand that bringing down the Icelandic banks would inflict much higher costs on British depositors than if he had stayed calm and participated in resolving the situation.
Little wonder that Icelanders these days feel rather abandoned by their European friends.
Mr. Gissurarson is a board member of Iceland's central bank and a professor of political philosophy at the University of Iceland.
