Abstract
Unsustainable accumulation of debt precedes financial crises. The recent Western financial crisis was no exception in this regard. The external debt of Greece, Iceland, Ireland, and Spain increased exponentially, in Iceland at a rate higher than the rate of interest on foreign debt. The Ponzi scheme that played out in Iceland begs the question why a country would set out on a path that could lead to a financial crisis. We address this question and describe the private incentives faced by bankers, financiers, politicians and others. In particular, we show how private incentives and a culture that valued financial gains above all else collided with socially desirable outcomes. The root of the problem in Iceland as well as in other crisis countries was a failure at the state level to align private incentives with what was socially prudent, a failure due, at least in Iceland, to a combination of mistakes, incompetence and what can only be called corruption. Furthermore, misplaced belief in a market economy where morals and ethics play no role paved the way to serious lapses in accounting and in the operation of the banks.
The authors are indebted to Gunnar T. Andersen, Lars Jonung, Gylfi Magnússon, and Stefán Svavarsson for their helpful reactions to an earlier version of the text. A preliminary version of this paper appeared as CESifo Working Paper 7874, 2019.
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Notes
- 1.
- 2.
The IMF’s initial estimate of seven times GDP can be reduced to six times GDP in view of better-than-expected asset recovery. See Gylfason (2015, 2019) and Benediktsdóttir et al. (2017). These estimates are incomplete, however, as they include, e.g., the decline in the value of stock-market and pension-fund assets from an artificially inflated value before the crash. On the other hand, they do not include the loss of net worth of the 10,000 households, one household in 12, that lost their homes. Homes lost to banks should count as losses rather than as cost-neutral transfers of wealth from households to banks. Several such complications arise in a comprehensive accounting of the total cost of financial crashes, which is beyond the scope of this study.
- 3.
The U.S. government unilaterally withdrew its forces from Iceland in 2006 against the protests of the Icelandic government, protests best understood in the light of the reduction in rent accruing to the local economy.
- 4.
More than a hundred years later, import restrictions against farm products remain largely intact as high tariffs replaced an outright ban against importation of dairy products and meat.
- 5.
The contribution of the NATO base to the Icelandic economy was particularly large in the early years, amounting to 15%-20% of total foreign exchange earnings during 1953–1955, for example (Ingimundarson 1996, p. 282).
- 6.
For comparison, the Norwegian Pension Fund, earlier Oil Fund, the world’s largest sovereign wealth fund, amounts to about USD 800,000 for each family of four in Norway.
- 7.
Iceland’s fisheries rent is not included in the World Bank’s recent tabulation of natural resource rents around the world from 1970 onward in the World Development Indicators.
- 8.
Statistical endogeneity bias is hardly an issue here because corruption 2012–2018 cannot have exerted but a minor effect on resource rents 1970–2017.
- 9.
The Special Investigation Commission (2010, vol. 8, pp. 164–169) reports that during 2004–2008 the banks granted financial support to political parties and politicians in the amount, in today’s money, of almost 20 euro per vote cast in the 2007 parliamentary election.
- 10.
The tourism boom in Iceland may not last, however. Ghalia and Fidrmuc (2015) study the relationship between tourism and growth in 133 countries during 1995–2007 and find that a dependence on both trade and tourism tends to reduce economic growth, an effect they attribute to the Dutch disease.
- 11.
The Finger-Kreinin index (FKI) of export diversification, a relative index that compares the structure of exports across countries by showing the extent to which the structure of exports by product of a given country differs from the world average, tells the same story (not shown here). Both indices, the HHI and the FKI, vary inversely with country size as measured by output or population, because small size encourages specialization. When the HHI is adjusted for country size by taking as a measure of concentration the difference between the actual average HHI during 1994–2014 and the HHI predicted by a linear cross-country regression of HHI on the log of the average population during the same period, similar results obtain. But size does matter: Iceland moves from 76th place down to 98th place in a sample of 202 countries ranked by export concentration, where Iraq, Nigeria, and Chad head both lists. With the adjustment for population, Italy moves up the list from 202nd place to 187th. The adjustment method is taken from Gylfason (1999), where it was used to extract an index of openness to trade from exports-to-GDP ratios that, like the HHI and the FKI, vary inversely with country size as measured by population.
- 12.
- 13.
In fact, to accommodate the banks’ wishes, the Central Bank reduced the reserve requirement before the crash.
- 14.
- 15.
See Chap. 12 of Keynes’s General Theory.
- 16.
The outsiders include Icelandic and foreign university professors, some of whose pre-crash writings appear in Aliber and Zoega (2011). Many other academics and journalists stayed silent, however, or cluelessly towed the line of the banks, the business community, and the government. Some still do. For more, see Gylfason (2015, 2019).
- 17.
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Gylfason, T., Zoega, G. (2020). Individual Behavior and Collective Action: The Path to Iceland’s Financial Collapse. In: Paganetto, L. (eds) Capitalism, Global Change and Sustainable Development. Springer Proceedings in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-030-46143-0_11
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