daníelsson and zoega

Two respected Icelandic economists, one based here at the University of Iceland (Gylfi Zoega), and one based at the London School of Economics (Jón Daníelsson), have just published an excellent post-mortem of the Icelandic bubble and systemic collapse. (The full paper, "Collapse of a Country", is available here, einnig á íslensku.) The paper begins with an excellent, readable history of how the Icelandic economy evolved from a fishing-driven command economy to the Manhattan-on-Faxaflói of the past decade. It then gets into the run-up and collapse itself, including the effects of speculators, external warnings, and the shockingly incompetent response of the government here. Finally, the IMF "rescue" and some idea of where we might go from here. I recommend this paper highly.

This thing is so chock-full of good quotes, I had a hard time paring them down. So here are a few. And then a few more:

• On the government response: "By not addressing the pending failure of the banking system, perhaps in the hope that the instability would disappear, we cannot escape the feeling that the Icelandic authorities gambled for resurrection and failed."
• On the flood of money: "For most of the 2000s the monetary policy was inflation targeting, which failed in lowering inflation, but the resulting interest rate rise both motivated domestic households and firms in order in order to borrow in foreign currency and attracted foreign speculative capital - carry traders. The amount of hot money inflows is not publicly known, but it appears to have exceeded 50% of GDP."
• On banking-sector corruption in days of yore, with just a whiff of what lingers today: "The banking system was heavily regulated and politicized, with politicians represented on banks’ boards and loan decisions often made on the basis of political affiliation and connections."
• On verðtrygging (indexation), the insane Icelandic system of ever-increasing mortgage principal, and how it only feeds the inflation beast: "Widespread inflation indexation of lending was adopted, particularly at longer maturities. Indexation persists to this day, hampering efforts to control inflation."
• More on the flood of cash: "The Icelandic banking system was deregulated and privatized in the 1990s and early 2000s. At that time, the world was awash in cheap credit and the newly privatized banks experienced little difficulty in raising capital internationally. They used this capital to fund expansion domestically and abroad. This expansion was subject to little regulatory scrutiny, neither in Iceland nor abroad."
• On the rise of banking: "Banking quickly became a large part of the economy. This happened in an economy where there is little evidence that either the government or the private sector had a sufficient understanding of the necessary risk management processes and banking supervision needed when a banking sector becomes such a large part of the economy."
• The rising flood of cash lifts all boats: "The banking expansion was the source of the rapid economic growth that took place between 2003 and 2007. It enabled households and enterprises to take advantage of the abundance of low-interest funds in international capital markets to finance domestic investment and consumption, as well as the acquisition of domestic and foreign firms. Because the banks got funds in the international wholesale market – this was an externally-financed boom – the inflow of credit had a predictable effect on the exchange rate, the stock market and the current account."
• Endless cycle of high interest rates drawing yet more foreign dollars: "The reasons for the failure of inflation targeting are not completely clear, but a key factor seems to be that the massive currency inflows effectively became a part of the local money supply, with interest rate increases further stimulating the growth of currency inflows by encouraging speculative inflows of currency and motivating households and firms to borrow in foreign currency."
• "We're rich!": "...large foreign-currency inflows and an exchange rate appreciation that gave Icelanders an illusion of wealth and rewarded the carry traders."
• The blame lies at home: "A part of the blame for the collapse of the banking system is due to the global crisis. However, by and large the blame lies more at home than internationally ... we suspect that even if the world had not entered into a serious financial crisis, the Icelandic banks would have failed."
• The octopus: "A handful of large shareholders seem to have controlled both the banks and a significant number of non-bank firms, running them jointly as highly leveraged holding companies with apparent scant regard to minority shareholders rights or prudential regulations."
• Central banks need to be credible institutions, not handouts to political hacks: "But perhaps the biggest failure of the Central Bank lies in the lack of leadership. It falls on the Central Bank as a guardian of financial stability to take a leading role in tackling financial crises. For that it is essential that the central bank is independent, impartial and competent. Given the high degree of politicization of the Central Bank, it has been unable to assume the necessary leadership role."
• "We're rich! Rich = smart": "At this stage a myth emerged about the business acumen of Icelanders, and universities initiated research programs on the nature of their business success."
• The whole thing was an illusion: "Ultimately, the superstructure of the Icelandic economy was built on sand."
• Groupthink to inaction: "We therefore cannot escape the feeling that the board and directors of the Central Bank and the financial services authority, along with senior officials there knew what was happening. Similarly, all government ministers, along with senior bureaucrats in the ministries of finance, commerce, foreign affairs, and office of the prime minister had to have known. Still the government failed to act."
• This didn't have to happen: "[The government] could have at any point taken decisions that would have alleviated the eventual outcome. If the Government had acted prudently the economy would have been left in a much better shape."
• Don't I know it: "These events have an immediate impact on the Icelandic society. The closing of the international part of the payment system immediately affected foreign trade, importers could not pay suppliers and exporters could not transfer funds to Iceland to meet domestic costs. Cash in Iceland was temporarily rationed and it became almost impossible to obtain foreign currency.
• Never even read the book Central Banking for Dummmies: "The Central Bank’s lack of understanding of the situation is evidenced by some of its measures taken during the crisis. Examples include an announcement from the central bank October 7th of a pending loan from Russia in the amount of €4 billion, which later turned out to be illusionary. It then pegged the exchange rate to the euro, an operation that lasted only a couple of hours. On October 15 the governors lowered interest rates by 3.5% to 12%, only to raise them to 18% on October 28."
• Looking for a new gig: "The fact that the main driver of economic growth in the recent years, banking, is unlikely to play a big role in the near future means that unless some new industry emerges, recovery is likely to be slow."
• Can someone who actually knows how to run a bank come open a branch?: "The speedy restructuring of the existing banking system as well as the introduction of subsidiaries of foreign banks is important."

But, as I said, this is a great paper. Go read it.