The rise and fall and rise and ___ of Iceland
Classical economist believed that there should be no/minimum government intervention in the economy of a country. According to them, free market forces are enough for the economy to maintain an equilibrium which in one way or other means that there should be no economic recession in this type of self-sustaining economy. The world believed this idea of the “no recession” until there was a “recession”.
Classical economist had a rigid theory which took situations and assumptions which were valid in the long run, but then came a man who contradicted this belief by saying, In the long run, we are all dead. Of course, he had his theory and facts to support his theory “The Keynesian economics”. Today we follow a mix of these two theories which seems reasonable given that both theories had their loopholes. In this article, we will see how these modern theories have hugely impacted a tiny nation called Iceland.
The tiny Nordic country of Iceland played an unlikely role in the global financial crisis of the late 00s. By the time the crisis hit, Icelandic banks had accumulated assets worth nearly nine times the country’s annual output — up from under twice its gross domestic product (GDP) in 2003. The banks had loaded up on huge amounts of toxic assets (assets that were designed to fail). Michael Lewis writes in his book, Boomerang, that Wall Street investment bankers structured various fundamentally unstable financial products for their clients to bet against. Someone obviously has to take the other side of these bets — and often it was the Icelandic banks. Lewis writes that word on Wall Street was that the Icelandic banks would buy the assets no one else would touch.
In this way, the Icelandic banks took on massive exposure to the subprime mortgage market in the United States and other foreign assets of questionable quality. The Icelandic banks’ problems were made worse by the method through which they decided to fund their overseas buying binge: they had promised Dutch and English depositors high-interest rates and guaranteed return of capital. Thus, Icelandic banks found themselves with an incredibly unsustainable business model. As the banking sector grew, so did stock market values, which doubled in a matter of under three years. The entire financial system was, of course, built on very shaky foundations, and collapse was inevitable.
When Lehman Brothers declared bankruptcy in late 2007, the short term lending market dried up, and with it, the source of funding for Iceland’s banks. The banks were rendered insolvent, with debts so large that they could not possibly have been bailed out by Iceland’s government. The stock market, heavy in financial shares, plummeted. Within a year, the market capitalisation of stocks on the Icelandic market dropped by nearly 95 per cent, causing a massive loss of wealth for investors.
Worsening global financial conditions throughout 2008 resulted in a sharp depreciation of the krona vis-a-vis other major currencies. The foreign exposure of Icelandic banks, whose loans and other assets totalled nearly nine times the country’s GDP, became unsustainable.
The crisis of confidence in the Icelandic banking system resulted in a massive flight from the Krona. With faith in the government’s solvency at a low, Icelandic people were taking their money out of the country as fast as they could, selling their Kronas for currencies perceived as more reliable — primarily the US dollar and the British pound. This put significant downward pressure on the Krona, which in a matter of months lost sixty per cent of its value.
The Icelandic government was mandated to impose austerity measures. The government significantly hiked taxes on its people and imposed taxes wherever possible. This helped plug gaps in the government budget, although it had the adverse effect of constricting consumer spending in the economy. In addition to this, the government drastically cut back it’s spending, and the central bank hiked interest rates up to 18 per cent to shore up Krona. Combined, these measures put significant pressure on the economy, as elaborated upon in the discussion of Iceland’s GDP. Ultimately, however, the government’s measures were able to restore confidence in its solvency and its commitment to fixing the economy. Additionally, because the government allowed the Krona to drop 60 per cent, the Icelandic economy became far more competitive. Exports became cheaper on the international market, and unemployment did not increase as it would have had Iceland been unable to change the value of its currency.
One of the key growth driver for Iceland after the crisis of 2008 was Tourism. What would you expect from a country with a falling currency and beautiful places?
In a country where the value of the currency is low, hot water is available in an environment of a freezing surrounding, isolated beaches with comfortable weather, tourism is bound to explode.
For decades the Icelandic economy depended heavily on fisheries, but tourism has now surpassed fishing and aluminium as Iceland’s main export industry. Tourism accounted for 8.6% of Iceland’s GDP in 2016, and 39% of total exports of merchandise and services. From 2010 to 2017, the number of tourists visiting Iceland increased by nearly 400%. Since 2010, tourism has become the main driver of Icelandic economic growth, with the number of tourists reaching 4.5 times the Icelandic population in 2016.
Iceland has more than quadrupled the number of annual foreign visitors that arrive on its shores in just six years.
In 2017, a three-hour flight from the UK, counted 2.1 million tourists through its doors, a figure it had not anticipated reaching until 2020. In 2010 just 459,000 people visited Iceland.
Iceland is well and truly back on track. It remains one of the world’s richest economies, growth is where it was, and the inflation and unemployment have stabilised. It seems like the Icelandic people have lost their appetite for investment banking — leaving the country’s darkest days behind it.
Iceland now faces a new crisis; the current infrastructure is not enough to support the humongous tourism boom.
The unchecked growth in the number of people visiting a country with a population of just 334,000 has already sparked concern that Icelandic infrastructure would not cope, that the majesty of its natural landscape could not be protected and that its capital, Reykjavik, would become “Disneyland”.
The number of people visiting Iceland rose to nearly 40 per cent in 2016 but only 24 per cent in 2017. In these two years, the economy grew at an annual rate of 7.4 and 4 per cent respectively.
The International Monetary Fund has recently said the effects of a strong krona between 2014 and 2016 were now being felt on tourism growth and domestic demand. It listed strong oil prices, mounting competition in the air transport sector, “escalating world trade tensions” and “uncertainty around Brexit negotiations” among the potential risks facing the economy.
We don’t know what’s next in the line for this small and adventurous country. But what we do know is, this country has given us some important lessons in modern economics.
