Understanding How the Bubble Burst

Rapid Fall From Highest Standard of Living and Lavish Lifestyles to Debt and Despair. How it happened.

Iceland, a volcanic island in the North Atlantic Ocean with a rugged landscape and unpredictable weather, was dubbed as the happiest country in the world after it ranked first in a 2008 United Nations’ human development index report. A country once dependent on fishing and farming, Iceland catapulted to one of the richest countries in the world during the go-go ‘90s, with the sixth highest GDP per capita income and a highly educated population boasting of the world’s highest life expectancies.

But when the global financial crisis hit hard last September, Iceland’s fragile economy quickly collapsed like a deck of cards as one financial fundamental fell after another. Within one week, the government nationalized Iceland’s three biggest banks, the krona plummeted more than fifty percent, and inflation and unemployment reached historic highs. How did one of the richest nations in the world become the recipient of a $10 billion bailout from European countries and the IMF?

Borrowed more than could pay back

In a nutshell, Iceland’s economy collapsed because it overleveraged, or borrowed money to make investments, more than it could pay back. When the financial crisis hit and credit lines dried up, Iceland’s three largest banks, Glitnir, Landsbanki and Kaupthing, were not able to pay back their debt, causing the small island economy to implode. While the banks, the Central Bank, the Financial Supervisory Authority and the government blamed each other, understanding Iceland’s bust traces back to the changes in economic policies that changed the whole economic system.

Iceland’s economic liberation began in the early 90s when the government lowered corporate and individual tax rates and further opened Iceland’s economy by joining the European Economic Area in 1994.

“We had strong currency regulations but when we joined the European Economic Area we had to remove our conservative currency policy and entered a completely free movement of money between countries,” Vifill Karlsson, an economist at the Regional Development Office of West Iceland, said.

“This, along with an increasing supply of money worldwide, we went into a huge investment both here in Iceland and especially abroad. We bought up companies abroad in Britain, Denmark, Holland, Germany and Nordic countries.”

With the privatization of banks at the turn of the millennium, banks looked to expand abroad beyond Iceland’s small economy and population of 300,000. By the end of last year, the banks’ assets and loans grew to 10 times the nation’s GDP.

The krona attracted foreign money because of the promise of strong interest rates, adding to Iceland’s exposure to the global markets. As money poured in, the krona became stronger, allowing consumers to binge on imported goods because they were cheap. Icelanders also borrowed in foreign currencies to finance their houses and cars.

The liberal – some now say ridiculously under regulated - economic policies left Iceland’s small economy open and vulnerable to the rest of the world. As long as there was easy credit and foreign money flowing in, the economy was sustainable. But when the global credit crunch hit, Iceland was the first to fall.

Now banking losses has amounted to $100 billion in losses, leaving an equivalent of $330,000 in debt for each of its 300,000 residents. The IMF and other European countries have agreed to give Iceland a bailout for $10 billion, which works out to about $33,000 for each Icelander. Karlsson likened the collapse of the economy to an capsized ship that could not carry its load. As the newly formed left-wing majority government decides how to restore the economy, the country’s most likely option is to join the European Union to stabilize itself and support its financial appetite.

Per capita income: http://www.invest.is/news/37/default.aspx
Education http://www.statice.is/?PageID=444&NewsID=2537
Life Expectancy: http://statice.is/?PageID=444&newsid=2968&highlight=life%20expectancy
Bailout: http://www.imf.org/external/pubs/ft/survey/so/2008/INT111908A.htm http://www.reuters.com/article/marketsNews/idUSLK60810820081120
GDP: http://online.wsj.com/article/SB123032660060735767.html#project%3DSLIDES...
Krona: http://www.portfolio.com/interactive-features/2009/03/Chronology-of-Icel...