Nina Eichacker is a lecturer in economics at Bentley University. This blog post summarizes her recent Political Economy Research Institute (PERI) working paper “Too Good to Be True: What the Icelandic Crisis Revealed about Global Finance.” Cross posted from Triple Crisis.
Iceland’s 2008 financial crisis should have been foreseen. By 2006, banking and economic data described an overheating financial sector and aggregate economy, and analyses by private and public researchers had reports describing those trends and their likely consequences. However, many were still surprised by the onset of Iceland’s large financial crisis. These events point to the dominance of neoliberal theories about the necessity of financial liberalization, and an assumption that a northern European country would have the institutional sophistication to avoid financial crises like those observed in developing countries that rapidly liberalize their financial sectors. A wider adherence to Keynesian and Minskyian theories of financial crisis would have helped predict Iceland’s crisis, and future such episodes.
One factor that contributed to the Icelandic financial crisis was the lack of financial market transparency. Organizations that could have reported on the conditions of the Icelandic financial marketplace and the state of the Icelandic economy did not. Despite positive reports by Frederic Mishkin and others citing Icelandic institutions’ integrity, (Mishkin and Herbertsson, 2006), the Icelandic state threatened to defund public Icelandic institutions and agencies that published reports contradicting the narrative of a robust financial infrastructure and growth. Iceland’s Chamber of Commerce paid economists like Mishkin hundreds of thousands of dollars to write favorable reports about Iceland’s financial sector and overall economic growth prospects. (Wade and Sigurgeirsdottir, 2010) The Icelandic news media consistently underpublished reports critical of the Icelandic financial sector, while publishing many stories that praised Iceland’s big three banks (Andersen, 2011). Sigurjonsson (2011) identified the root cause of this disparity as the cross-ownership of media company shares by Icelandic financial actors and institutions and financial corporation shares by Icelandic media institutions. The interconnectedness of these industries created conflicts of interest for all involved. The under production of criticism, and the over production of praise for Iceland’s banks skewed public understanding of the nature of Icelandic banks’ activity.
Credit-rating agencies contributed to the notion that Iceland’s financial markets were safer than they were. After Fitch downgraded Iceland’s credit rating, Moody’s upgraded it, increasing broad confidence in Icelandic financial stability. Moody’s upgrade stemmed from the assessment that Iceland was so financially leveraged that its central bank would bail out the big three banks as the lender of last resort. This development further lulled international investors and retail banking customers into trusting Icelandic financial actors with their capital and fueled more Icelandic financial activity.
Global financial institutions forgot that Southern Cone nations in South America had liberalized financial markets with less than stellar results: those banks became less risk-averse, without becoming more efficient. Argentina’s Central Bank offered guarantees on bank deposits, which encouraged more capital inflows; though Chile’s government initially stated that it would not insure deposits, its Central Bank ultimately guaranteed them after several panics early in the liberalization process. Foreign governments’ economic and political pressure for governments and central banks to insure their investments guaranteed moral hazard problems for developing countries considering financial liberalization in the absence of an international financial regulatory body (Diaz-Alejandro, 1983).
Global financial institutions trusted in Iceland’s supposedly robust financial governance, despite Iceland’s short history of financial liberalization. Irrational exuberance and moral hazard also diminished caution about the risks of rapid financial expansion and crisis. Finally, Iceland’s crisis reveals the inherent instability created by rapid financialization. When a country adopts a financial approach to growth that deregulates banks, encourages international capital inflows through inflation-targeting monetary policy, and promotes wide-scale acquisition of shares and securities in those financial institutions by banks, households, non-financial firms and the government financial firms appear to be artificially profitable, and conflicts of interest develop that weaken the stability of the financial sector and broad economy.
Keynes and Minsky argued that financial systems without adequate regulatory apparatuses are inherently prone to crisis. The Icelandic Central Bank’s decision to change from stability-promoting to inflation-targeting monetary policy led to rising interest rates, precipitous increases in capital flows and prices, and asset bubbles in the housing market. The Icelandic government’s promotion of non-financial firms’ and households’ purchase of shares in Icelandic banks created perverse incentives for banks to raise share prices, and increased the scope of losses in the event of the banks’ decline. These processes increased Icelandic instability and the costs of the inevitable crisis.
Irrational exuberance and moral hazard nullified the effects of evidence that Iceland was dangerously over-leveraged. Investors had access to data demonstrating instability and illustrating the risks of investing in Iceland’s financial system and economy. Many, however, continued to follow the advice of economists like Mishkin and Portes who argued that Iceland should not be assumed to have the same financial risks as developing economies, despite the newness of its supercharged financial system. Outside investors’ continued willingness to lend to Iceland increased the leveraged state of Icelandic banks and the scope of the eventual financial crisis.
National and international unwillingness to compare Iceland’s policy actions and history to that of developing economies like Chile, Argentina, and Uruguay demonstrates an assumption that Icelandic institutions were ready for the job of supervising a radically transformed financial sector. The Icelandic government’s repression of data demonstrating instability, and the Icelandic media’s unwillingness to publish unflattering stories give lie to the notion that Western European states’ financial institutions and governments were robust enough for very liberalized financial sectors.
Iceland’s crisis indicates the need for the following policies: Any state that liberalizes or changes the fundamental premise of monetary policy rapidly should be subject to increased scrutiny. The consequences for Iceland’s population demonstrate that while some actors and institutions may recognize the potential for financial crisis and act in ways that maximize their profits the broader public must be aware of the changes of their new financial landscapes. Greater financial literacy insures local populations against broader losses in the event of a crisis. Finally, states should reconsider finance-led growth strategies. The costs of financialization, given moral hazard and irrational exuberance, expand rapidly without meaningful oversight; Iceland’s experience illustrates the effects of such to the rest of the world.