Iceland, Crisis and the Wrong Way to Recovery

Northern Bright-lights

It is a 50-minute journey along a straight and isolated highway from Keflavic International Airport to Iceland’s capital city, Reykjavik. Time enough for my taxi-driver to wind himself up into a tower of apoplexy over the British behaviour during the Cod Wars.

The Cod Wars ended in 1976, and were triggered by Iceland unilaterally expanding their territorial waters from 50 to 200 nautical miles. At their height, the British supplied 22 frigates, seven supply ships, nine tug-boats, and three support ships to protect only six to nine fishing trawlers from having their nets cut by plucky Icelandic coast-guard.

The war ended when the British realised that there weren’t enough fish in the world to justify the expense of such a ridiculous military operation.

Iceland has been invisible since then. Its total population is only 313,000 people. They pop up only briefly when the annual league tables of nations with the highest standard of living are published. Then Iceland is usually in the top three for per-capita income, education, health care, life expectancy and that sort of thing.

When Iceland’s banking sector was deregulated in the late 1990s, a generation of smart young bankers went out into the world leveraging the frugality of their countrymen to offer big loans to borrowers around the world. Icelanders were getting fantastic returns on their savings with families getting a 45% return over the five years to 2007.

Nothing feeds irrational behaviour like irrational returns.

Before long, Icelandic banks were offering 100% unsecured loans in foreign currency. By early 2008, a country with a total GDP of $ 14 billion a year was underwriting over $ 100 billion of loans around the world.

When the credit crisis erupted, Iceland had its heart ripped out. Their three main banks were nationalised as depositors lost their savings. The British guaranteed $ 4 billion from UK depositors and threatened to sue the Icelandic government, hence my taxi-driver’s rage.

The worst, for the Icelanders, is their frustration and humiliation. They weren’t the ones that borrowed unwisely, but they certainly lent unwisely.

The response from the state has been to borrow. $ 10 billion has been secured to prop up the economy. The state’s solution to a problem caused by unwise borrowing is to borrow unwisely.

The legacy will be appalling recession, soaring inflation, and generations of low economic growth and high taxation. The krona has already fallen almost 70% in value since the beginning of the year. Up to a third of Icelanders are threatening to emigrate.

“If business taxes go up, we’ll leave too,” said one executive I spoke to.

Iceland is not alone in this. Governments around the world are promising massive cash injections to stabilise their economies and give consumers money to spend. Instead of individuals borrowing to support a life-style they can’t afford, governments are now borrowing on their behalf to keep entire countries in a style they can’t afford.

This is unwise. Countries will have to raise taxes in a year or two to finance this profligacy. Citizens and businesses will enjoy the largess for the moment but, once the bill arrives, many of the most productive will pack their bags and head for more welcome environments.

Stability now may be at the price of collapse in two years.

The advice given to all unwise borrowers is to cut their expenditure and live within their means. Governments have opted to nationalise their economies, spend vast amounts of cash on new entitlements and hope that a miracle happens.

There isn’t one. Instead of declaring an end to free-markets, the only hope for governments is not to pledge vast borrowings, but to cut existing state subsidies and entitlements and find a way to hand these expensive programs back to the free market.

Only through the cutting of expensive liabilities can governments hope to bring economies awash in debt back into balance.