Waking up to reality in Iceland

Protesters have demanded that those responsible are held accountable

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

Iceland experienced the worst economic crash of any country in peacetime in October last year.

Its authorities have denied responsibility, but widespread protests eventually forced the government to resign on 26 January, the first government to do so because of the global crisis.

The Icelanders decided a few years ago that their economic future lay in banking. They privatised and deregulated their banking system, and with strong government support, the banks grew to 10 times the size of the economy.

The bankers and government effectively turned Iceland into a gigantic hedge fund sitting in the middle of the North Atlantic.

The role models were easy to find - other small countries, such as Luxembourg and Switzerland, do quite well out of banking.

There were ample warnings that something was amiss, long time before the banks collapsed.

What the Icelanders forgot was that those countries have centuries worth of experience running banks and the associated infrastructure, while Iceland has less than a decade.

The Icelanders had all the banking regulations of the European Union because of their European Economic Area membership.

What they failed to implement was the necessary supervision or enforcement of banking regulations.

The government, the Central Bank and the financial regulator at times seemed to act as cheerleaders for the banks, not as responsible authorities.

'Thetta redddast'

The government initially denied responsibility for the crisis

The banks started to get into trouble borrowing from other banks, and decided that opening up high interest savings accounts in the UK and elsewhere in Europe was a good idea.

The Icelandic banks used European savers to provide the liquidity they could not obtain from the better informed banking system.

This happened before the global crisis became serious. The Icelandic banks were set for failure because of excessive risk taking, inadequate management and rather lax government supervision.

The banks fell when the global financial markets became extremely volatile last autumn. The timing was dictated by the crisis, but not the eventuality.

There were ample warnings that something was amiss, a long time before the banks collapsed.

Foreign governments became increasingly concerned and urged the Icelandic government to address the issue.

We do not know why the Icelandic government failed to act. Perhaps it was in denial, hoping things would get better.

As the Icelanders say "thetta redddast" - it'll work out fine.

Maybe the government gambled for resurrection. The bet failed.

Massive layoffs

The cost of food and other essentials has risen rapidly in Iceland

The eventual losses would have been lower, and depositors might not have been left out of pocket.

Clearly Iceland would be in a much better shape than it is now.

Eventually the banks collapsed last October, the exchange rate collapsed along with them and the government passed emergency legislation to try keep the country going.

The IMF was called in and provided substantial lending - primarily to support the exchange rate - and strict exchange rate controls were implemented, with full IMF support.

But things were only beginning to get bad.

Both households and firms had borrowed extensively in foreign currency and with the collapse of the exchange rate were seeing the value of their debt explode.

Iceland imports most goods, so when the exchange rate collapsed, the cost of essentials shot up.

At the same time, a large number of firms were having severe difficulties. A number of firms have already failed, and there have been massive layoffs.

It is hard to accurately evaluate current government debt, but estimates are well in excess of the annual GDP

Salaries are frozen or even falling in nominal terms. The economy is expected to contract by around 10% this year, with the trend continuing next year.

The government came into the crisis with fairly low debt levels, but has now had to undertake massive obligations because of the banks' collapse.

It is suffering a sharp fall in tax revenues, whilst facing increased demand for government services such as unemployment benefits.

It is hard to accurately evaluate current government debt, but estimates are well in excess of the annual GDP.

If government financing is not brought under control, a sovereign default may happen.

Murky future

Up until events this week, the government had not assumed responsibility for the crisis.

ICELAND'S WOES October 2008 - Government takes control of three largest banks 20 November - IMF approves $2.1bn (£1.4bn) loan for Iceland 26 November - Annual inflation rate hits record 17.1% 20 January - Economy forecast to shrink by 9.6% in 2009 23 January - PM Geir Haarde calls snap election for 9 May 26 January - Government resigns following breakdown of coalition Timeline: Iceland's crisis Iceland bloggers react to crisis Activists fight Iceland woes

It stated that it had the right people to steer Iceland out of the crisis.

After all, in their view the crisis was only caused by the global credit crunch and risk seeking bankers, not government actions.

The population of Iceland thinks otherwise.

There have been widespread protests since October last year, which have been gaining momentum in recent weeks.

The protesters are demanding accountability - that those individuals responsible for the crisis should resign.

At the same time the government's support in opinion polls was in the low 20s.

Eventually the strain became too much to bear and the government collapsed.

The future is murky.

Some sort of temporary government will eventually be formed - set up to serve until elections can be held, probably in the spring.

The former partners in government - the Conservatives and the Social Democrats - are forecast to lose heavily, and the main opposition party - the far left Left-Green party - leads in the polls.

Iceland is likely to undergo further economic difficulties in the coming months.

If it is able to form a stable government and credibly address its economic difficulties, the economy will start to improve next year or in 2011.

Its economy is heavily export-based, and with lower exchange rates it is likely that primary exports and tourism will be the main drivers of the future economy, not banking.

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