The model that will be used to compare to the financial crisis in Iceland is a model that has been set out by host of classical economist including John Stuart Mill, Alfred Marshall, Knut Wicksell, and Irving Fisher, and many economist have later set out with personal variations. Kindleberger (1978) covers it in his book Manias, Panics and Crashes. Events leading up to a crisis start with a “displacement”, some exogenous, outside shock to the macroeconomic system. The nature of this displacement varies from one speculative boom to another.
It may be the outbreak or end of a war, a bumper harvest or crop failure, the widespread adoption of an invention with pervasive effects – canals, railroads, the automobile – some political event or surprising financial success. But whatever the source of the displacement, if it is sufficiently large and pervasive, it will alter the economic outlook by changing profit opportunities in at least one important sector of the economy. As a result, business firms and individuals with savings or credit seek to take advantage of the former and retreat from the latter.
If the new opportunities dominate those that lose, investment and production pick up. A boom is underway. In the case of the Icelandic financial crisis we can say that the “displacement” in the economy has started in 1994 when Iceland entered the EEA. Other factor that leads to the financial crisis is the privatization of the banks. That’s not a bad thing in itself but in our opinion a stricter rules had to be set on the ownership of the banks. Government should have set a limit on proportional ownership for each investor and require foreign investors to be part owners of the banks.
We think those two factors are the main outside shock to the macroeconomic system, though it happens over a number of years. The boom is fed by an expansion of bank credit which enlarges the total money supply and for a given banking system at a given time, monetary means of payment may be expanded not only within the existing system of banks, but also by the formation of new banks, the development of new credit instruments, and the expansion of personal credit outside of banks.
Crucial questions of policy turn on how to control all these avenues of monetary expansion. Number of financial institutions, and their businesses, increased dramatically in Iceland from 2000 and proportion of income tax coming from financial institutions has increased from being 15% in 2004 to 43% in 2006. (Icelandic Financial Services Association, 2008) With the ever growing financial sector and access to cheap capital on foreign capital markets, the increase in money supply was enormous, like can be seen in figure 4.
The increase in the money supply in the Icelandic economy ignited for expansion in transactions and consumption which increased asset price dramatically, mainly on housing prices and securities. The large amount of the increase in money supply coming from abroad did nothing but increase the asset price, even more, and the exchange rate of the krona was way above what could be regarded as normal. Let’s assume that the urge to speculate is present, and is transmuted into effective demand for goods or financial assets.
After a time, increased demand presses against the capacity to produce goods or the supply of existing financial assets. Prices increase, giving rise to new profit opportunities and attracting still further firms and investors. Positive feedback develops, as new investments leads to increases in income that stimulate further investment and further income increases. This stage is called “euphoria”. Excessive gearing arises from cash requirements which are low relative both to the prevailing price of a good or asset and to possible changes in its price.
As firms and households see others making profits from speculative purchases and re-sales, they tend to follow. When the number of firms and households indulging in these practices grows large, bringing in segments of the population that are normally aloof from such ventures, speculation for profits lead away from normal, rational behaviour to what have been described as “manias” or “bubbles”. The word “mania” emphasizes the irrationality; “bubble” foreshadows the bursting. At a late stage, speculation tends to detach itself from really valuable objects and turn to delusive ones.
A larger and larger group of people seeks to become rich without a real understanding of the processes involved. We think that the “euphoria” and the “mania” mentioned above is a good description of Iceland for last few years. Everything has been spinning around money and profit. The households have been building and buying new houses. Buying expensive luxury cars from abroad and the Icelandic nation hitting the news world wide for spending highest amount of money in the first day of opening of a global chain stores, like Toys “R” Us.
(Icelandic Review, 2007) Meanwhile, Icelandic investors, usually referenced as “investor Vikings” have been gearing themselves heavily and investing all around the world, mainly in the Nordics and in UK, where they have been buying a good proportion of the high street. While the “investor Vikings” have been striking new deals around the world, politicians, the president and other people have been touting them as geniuses.
So the “euphoria” and the “mania” haven’t just been by the households and firms but by virtually the whole nation, except some scholars and few sceptics. (Times Online, 2009a) As the speculative boom continues, interest rates, velocity of circulation, and prices all continue to mount. At some stage, a few insiders decide to take their profits and sell out. At the top of the market there is hesitation, as new recruits to speculation are balanced by insiders who withdraw. Prices begin to level off.
There may then ensue an uneasy period of “financial distress”. A considerable segment of the speculating community that a rush for liquidity – to get out of other assets and into money – may develop, with disastrous consequences for the prices of goods and securities, and leaving some speculative borrowers unable to pay off their loans. As distress persists, speculators realize, gradually or suddenly, that the market cannot go higher. It is time to withdraw. The race out of real or long-term financial assets and into money turns into a stampede.
The specific signal that precipitates the crisis may be the failure of a bank or firm stretched too light or a fall in the price of the primary object of speculation as it, at first alone, is seen to be overpriced. In any case, the rush is on. Prices decline. Bankruptcies increase. Liquidation sometimes is orderly, but more frequently degenerates into panic as the realization spreads that there is only so much money, and not enough to enable everyone to sell out at the top. The word for this stage is “revulsion”.
What eventually un-winded the collapse of the Icelandic banks, and therefore the whole Icelandic economy, was the global financial crisis. Banks around the world hadn’t the same access to capital as before and because of the structure the Icelandic banking system, the credit lines for the Icelandic banks were the first to be shut closed which resulted in a collapse. We are pretty sure that the same would have happened sooner rather than later though there wasn’t the global financial crisis.
Because of the size of the banking system and the excessive gearing of the banks as a proportion of GDP the central bank couldn’t serve its role as a lender of last resort. Conclusion Ahead is probably the deepest recession that Icelandic economy has gone through in years. Households and firms fight for their lives because of high interest rates, inflation and weak krona. The interest rates are today 18% and inflation 18. 6 %. It has been more difficult to restructure the financial system for the Icelandic government than was predicted.
GDP is expected to be -8.3% 2009 and -2% 2010 and get to positive number after that. Unemployment rate is expected to be over 10% 2009 to 2011. We think these estimations are a bit optimistic but it really depends on how successfully Icelandic government and IMF will stabilize the krona and also how well and soon they can restructure the financial system in order to get confidence back in the system. (Central Bank of Iceland, 2009) We think it was a positive step to enter the EEA to open up the economy because that led to easier access to capital, easier to do business across borders among other things.
However, we think that by entering the EEA we should have set stricter rules for institution, especially financial institutions. Supervision of the financial system should have been better as can be seen on the enormous size of the banking system in proportion of GDP. The central bank should have increased the reserve requirement for banks, but that will probably be part of discussions about changing of financial regulation all over the world in continuation of the global financial crisis. We think that the privatization can easily be criticised.
In our opinion stricter rules should have been set for the ownership of the banks and foreign investors should have been participants in the ownership. It was part of the agreement, but it was never followed. It’s our opinion that the directors and the owners of the banks are responsible for the collapse of the banks by gearing the banks excessively and investing rashly all over the world. However, we think that government, mainly the independence party, should take huge proportion of the responsibility. They privatized the banks and have been setting the regulations on the market.
As can be seen from the background and causes of the collapse of the Icelandic banking system the regulations and supervision have been heavily lacking. It’s obvious that the Icelandic central bank has failed in his role of being monetary authorities and managing high-powered money to influence the price level and real activity. In order to tackle the inflation target, interest rates were raised but without any success because of the inflow of foreign capital which increased the money supply which leads to higher inflation.
We think that interest rates should have been lowered some years ago in order to prevent the increase in money supply. Next thing to do for the Icelandic government and the nation is to decide whether to join the European Union (EU) and entering in to the European Monetary Union. Although, we are not sure if Iceland should join EU because of the enormous natural resource the country has, but we think that the country needs new currency.