Iceland from doom to boom

Iceland saw a deep financial crisis in 2008-9. It is a small economy, with a population of 320,000, roughly the same as Leicester’s. Iceland’s escape from financial chaos offers almost a text book lesson in how an economy can recover from a major shock.

In the long history of financial crises Iceland’s rates as a big one. The country’s three main banks collapsed and were nationalised in the space of a week. Their assets were equivalent to ten times Iceland’s GDP. The economy fell into deep recession, shrinking by 15% in less than two years. The Icelandic Krona virtually halved in value, pushing inflation to a peak of 18.6%.

Yet four years later the Icelandic economy has been turned around. This year Iceland is expected to grow by 1.3%, a stronger growth performance than most European countries. Unemployment is lower than in the UK, Germany or the US. Inflation has dropped sharply. And international investors are buying Icelandic government bonds even as they shun Greek debt.

As the euro area contemplates a long painful adjustment for its crisis stricken members, does Iceland’s speedy recovery from crisis hold any lessons?

Iceland didn’t bail out its banks – indeed, they were too big to save – with the result that shareholders, many of them overseas, took the pain. This avoided a transfer of huge liabilities from the banks to the taxpayer as happened under Ireland’s bank rescue scheme. Iceland prioritised the functioning of the domestic financial system over the interests of foreign investors and depositors.

Without government support almost half of Iceland’s banks failed, cutting their total number to just fourteen. The authorities swiftly recapitalised these remaining banks, and this led to a significant increase in government debt. But the general consensus is that the speed of Iceland’s bank restructuring programme contributed to the economic recovery.

The Icelandic government allowed public spending to surge during the initial stages of the crisis. This bolstered demand at the moment of maximum weakness in the economy. Since then the government has tightened fiscal policy and the deficit has shrunk.

The collapse in the Krona gave an overnight boost to competitiveness. In just three years Icelandic exports, dominated by fish, aluminium and manufactured goods, rose by more than 30%. Iceland prevented this devaluation from turning into a rout and kept money in the country by imposing controls on movement of capital out of the country.

A financial crisis forces an economy into deep, structural change. This process is easier for more flexible, competitive economies. Iceland ranks a respectable 30th in the World Economic Forum’s league table of competitiveness, well above all the southern euro area nations and on par with Ireland. Greece, by contrast, ranks in 90th place, below Rwanda, Namibia and a number of other developing countries. This flexibility stood Iceland in good stead during its financial crisis.

Contrary to received wisdom, Iceland’s experience shows that letting banks fail, and walking away from foreign creditors, can work. The Irish government took a different route, and absorbed its banks’ debts, in the process quadrupling the level of public sector debt.

Iceland also benefited from the devaluation of its currency, an option that does not exist for individual members of the euro area.

But for us the strongest message is a positive one – that, under the right circumstances, countries can recover surprisingly rapidly from deep financial crises.

A headline from the Times in October 2008 captured the prevailing mood of the time – “Terror as Iceland faces economic collapse”. Less than four years later, the picture had changed. Last month the Daily Telegraph announced – “Booming Iceland makes second early loan repayment to IMF”.