Warnings from Iceland

Iceland went from boom to bust and could be headed for a double dip. Could the same happen in the U.S.?

By Harold L. Sirkin

When I arrived this summer at Keflavik International Airport, about 30 miles west of Reykjavik, the capital, I expected to see a devastated country. Iceland's three major banks had all failed and been taken over by the government. The art collections that the banks once owned were given to the National Museum, so the public could derive some benefit from the only bank assets that still had real value. Iceland's currency, the kroner, had collapsed, declining more than 40% in value. The government itself had to go begging: securing the promise of a $2.1 billion loan from the International Monetary Fund (IMF) and a further $2.5 billion in aid from its European neighbors. For a while, even credit cards issued by Iceland's banks were cut off.

Despite the economic collapse, what I found was mostly business as usual. My plane was full, and there were long lines at immigration. Covering just 39,769 square miles, Iceland is slightly smaller than Kentucky, and has a population of 319,000, just a little larger than Pittsburgh's. Nearly two-thirds of all Icelanders live in the Reykjavik area. And every one of them, it seemed, was either shopping or relaxing in a coffee bar when I arrived.

When the banks fail and the currency collapses, you are supposed to see bread lines and shanty towns, similar to the Hoovervilles that sprang up in the U.S. during the Great Depression. I saw nothing but a clean and thriving capital. But appearances can be deceiving. While Reykjavik is a beehive of activity, not unusual in the political capital even of a country under great stress, the country is living on borrowed time.

Leveraged-Buyout Spree

Daniel Drezner of Tufts University provides an excellent crash course on what went wrong in an August Wall Street Journal review of a book by Asgeir Jonsson, former chief economist at Kaupthing, one of Iceland's big-three banks prior to the collapse. Drezner explains: "To help liberalize its financial sector, Iceland privatized its largest banks roughly six years ago and then allowed them to go on a leveraged-buyout spree across Scandinavia and Great Britain. When Iceland's central bank raised interest rates, the country became an epicenter of the 'carry trade,' in which money managers borrow from one country with a low interest rate and place deposits in a country with a higher one."

In the span of just three years, Drezner explained, "Iceland's per-capita income tripled, and its stock market capitalization increased by a factor of eight. Then the credit bubble burst. Iceland's overvalued currency plummeted, and there was a run on the country's banks… By October 2008, the financial sector had racked up debts equivalent to eight times the country's gross domestic product." Through it all, he notes, "Iceland's politicians seemed almost clueless."

A ticking time bomb

In some ways, the recent bust represents a return to normalcy in Iceland. Despite the swaggering prosperity and meteoric rise in per-capita gross domestic product during the boom, Iceland historically has not had one of the world's "go-go" economies. The people were frugal and hard-working, but not worldly sophisticates. As late as the 1950s, many Icelanders didn't normally carry cash with them; they bartered for their needs. Credit cards were all but unheard of. Even now, according to the CIA World Factbook, 70% of Iceland's exports and 40% of its export earnings come from fishing and fish processing, which employ more than 5% of the entire workforce.

Despite the appearances of business as usual in bustling Reykjavik, the situation in Iceland remains grim. For now, people are enjoying themselves, and life goes on, as they use their income and savings to make payments on their debts. But this can't go on indefinitely, since many Icelanders borrowed in euros, while their income and savings are in the devalued kroner.

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