Lessons From a Catastrophe

By Heidar Gudjonsson


There is a saying, I think it's from Russia: the smart learn from the mistake of others, the stupid learn from their own mistakes.  So what can we learn from Iceland?

Globalization is a magnificent force that has greatly benefited the world economy.  The discussion on globalization has been focused on the trade side and dwelt little on the financial side.  This is unfortunate and I would argue that the financial side of globalization is no less important.  The flow of international finance, which is not directly related to trade in goods, brought down the Bretton Woods system, and is now forming a new system, quite different from what neo-classical economists expect.

The logic of floating currencies with a central bank on an inflation target has been put into question.  That setup has only been around for 20 years, but in that short time it had been generally recognized as the way forward. Iceland is a poster child for how many systems were not prepared for financial globalization. The system Iceland had in place is similar to what many other countries have, and it is flawed. Iceland can serve as a warning.


The first lesson is: Do not venture into international finance with a small independent currency.  I like to call it a national currency, asopposed to an international currency. The biggest bankers in Eastern Europe are from Austrian banks, the second biggest are from Hungary. If it had not been for the Euro, the Schilling would have been decimated and with it the Austrian financial system and the Austrian economy.  The Hungarian Forint and the economy are now under severe pressure and will continue to suffer until they cut their banking system down to size.

The second lesson would be: Do not lend international money to institutions that are backed by governments with national currencies. Moody's awarded Icelandic banks a AAA rating early 2007, putting them on par with Switzerland and the US, even though they were not formally backed by any central bank, and the Central Bank of Iceland could only print ISK.

The third lesson is that international banking is a recipe for disaster. All good banking is local.  Banks try to convince us that they are necessary for international payments and funding of international business, but this is wrong.  Internationalmarkets are essential, not international banks.  With all the local regulators failing to get sufficient oversight, how could a global regulator do any good?

But there are further lessons.  What happens when a developed society sees a collapse in its economy of 60 percent, in dollar terms? (Paul Krugman and many other economists compare apples to oranges when they claim Iceland has suffered less than, for instance, Ireland. You cannot compare ISK and Euro.)  What are the social and political consequences?


Many people questioned the funding in the Icelandic financial system.  There were even rumors that Iceland’s banks were money-laundering machines for the Russian mafia.  Where did all the money come from?  With the system collapsed, it’s been easy to find out. A majority of the capital came from so-called institutional investors—German banks being the largest.  Practically nothing came from Russia. The collapse hit internationals harder than locals, especially since all deposits in ISK were guaranteed by the government, so the public in Iceland suffered limited direct loss.

The EU has a common market for capital, labor, goods and services.  An Icelandic bank which had access to the common market through the EEA agreement could set up shop in the common market but be regulated by its home regulator. The deposit insurance scheme in the EU wasn't fully clear on who would bear the cost if a deposit-taking foreign company would default on its obligations.  As a result there are now tense relations between Iceland, the UK and the Netherlands. The first negotiations were marked by severe bullying by the Brits and the Dutch, but now the governments are settling their dispute with Icelanders paying back the minimum deposit guarantee, with minimal interest, out of the estate of the collapsed banks.


What is very interesting, to me, is how the system is shaping up two years after the collapse. Unfortunately it seems the system will be resurrected without any significant changes, so the flaws will still be there and lead to another collapse in the future. Rather than blaming the system for the collapse, the establishment and the media have mostly blamed individuals.  But what kind of system cannot withstand the onslaught of a few individuals? Such a system has to be severely flawed.

There are three major flaws in the current system:

1)  The ISK is the smallest independent currency in the world. You cannot have both an independent monetary policy and free movement of capital. The case of Brazil and the Real is proving this, yet they have a currency which is bigger by a factor of a few million.

2)  The public sector has increased over the last 20 years dramatically, going from 30 percent of GDP to current 55 percent.

3)  The build-up of energy production has been in the hands of the government, and has doubled in the last 10 years and will probably double again in the next 10, if plans go ahead.  Rather than choosing the most commercially sensible projects, the politicians are trying to appease lobby groups from the outskirts of the country.  The size of the last project, which was built to service an Alcoa aluminum plant, was 25 percent of the GDP, spread out over 4 years!

It is quite amazing how much resistance there is towards change. The employer’s federation, the unions and the politicians all go by the old script.  Even the bankers could not be taken on, with all the banks gone bust, which is remarkable.  It is very sad how banks have been able to mortgage the future of the republic, by becoming too big to fail, and too connected to be tackled.  The banks in the US spent hundreds of millions last year lobbying against change. No money was available for bankers in Iceland, but still the utilities (retail banks) have not been split away from the casinos (investment banks).

Iceland catches 20 times more fish than it consumes—that is high class protein from a stable, renewable resource.  Iceland produces currently five times more energy than it needs for its domestic use, and the potential is there to triple that production. Iceland has an abundance of land and clean water, and with the melting of the Arctic, the oil exploration around Greenland and Iceland is becoming attractive. The shipping route via the Arctic could be a complete breakthrough for Iceland.


It is simple, really.  Iceland has this abundance of natural resources.  It only has 300,000 inhabitants.  What the system needs to do is to actively try to harvest these resources in an efficient manner.  Having an independent currency hinders that. The size of the public sector drags down all private enterprise.  The energy sector needs better management. There is so much stranded power up there.


In Iceland, the biggest casualty of the financial collapse was trust.  The trust in Government, media and experts has evaporated.  In such a situation, how do you encourage change?  What is the medium to get the message across?

It will take a long time, but I certainly hope that one can convince people that debt is bad, that Iceland has great potential, and that isolationism is not a way out.  But to have all this wealth squandered in a flawed system is extremely sad.  Rather than having Iceland as a horror story, if it changes it system, it could actually serve as an example of how to build solidly, for the future.

Heidar Gudjonsson is an economist and the managing director of Ursus, an investment company in Zürich, Swtizerland. He is a former Managing Partner of Novator, a private investment firm managing €7Bn in public and private equity, based in London, UK.  Previously, Mr. Gudjonsson managed a trading account at Íslandsbanki London and was Head of Institutional Sales and Trading at Íslandsbanki Reykjavik.  He was active in developing the markets in Iceland after capital controls were lifted in the mid 90´s.

Image via Flickr, user jff ryn pmr

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