Iceland's Near Collapse: What Can We Learn?

By Reyna Gobel AAA

While it's common to hear of companies going bankrupt, many were shocked when the entire country of Iceland almost fell into a state of bankruptcy in 2008. How could a country get to this point? And, once there, what could be done to mitigate the problem? Read on for a cautionary tale's description of what preceded Iceland's near economic collapse.

Cause of the Crisis
During the mid-1990s, Iceland flourished. Business was booming as financial products such as bank loans, investments and entrepreneurship became Iceland's biggest export. The country's economic reach became greater than ever. In fact, when you walk into the posh Handley's toy store in London to buy a five-foot-high plush Kangaroo, you're standing in an Icelandic company's investment.

Other new things were shaping up for Iceland during this time as well. For the first time in history, Iceland established its own domestic stock market in 1985. The growing economy greatly improved income for citizens, and wages increase by 45% between 1995 and 2000.

But with much of the banks' capital being loaned outside of the country, Iceland became overly dependent on other countries' economies staying afloat and those countries' residents and businesses paying off their debt.

Iceland's problems really began when it became a victim of poor currency trading rates, called carry rates. When currencies dropped in other markets, the Icelandic krona's value fell catastrophically. (For more information on what causes a country's currency to fall, read What Causes A Currency Crisis?)

Impact on the Average Icelandic Citizen

  • Skyrocketing Interest Rates. Banks and the Icelandic government - which was forced to nationalize to stabilize some of Iceland's banks - needed to raise capital. Banks raise capital either by selling stocks or bonds. Unfortunately, both options were impossible in this situation. The third option was to raise interest rates, which limits lending in difficult times and encourages people in other countries to once again invest in Iceland's banking systems in the hope of a high return on a now-risky investment. But for the average Icelander, this rate hike caused mortgage rates to skyrocket, hitting a key interest rate of 18% in October of 2008, the highest level in Europe.
  • International Travel Woes. When a national currency and homeland banks aren't viewed as very stable, traveling outside of the country becomes difficult for citizens. This is because other countries will have issues with accepting large amounts of Icelandic krona as payment.

The Rescuers: The International Monetary Fund
The International Monetary Fund is an international organization of 186 countries that aims to help nations avert financial crises by providing loans to countries with balance of payment issues, along with technical assistance. In October 2008, IMF announced a $2.1 billion loan plan with Iceland with the goal of restoring confidence in the banking system. Iceland must also adhere to an IMF-supported economic program. By March 2009, conditions in Iceland appeared to be improving, although it was maintaining very stringent controls on the flow of capital. (Chances are you've heard of the IMF. But what does it do, and why is it so controversial? See What Is The International Monetary Fund?)

What Lessons Should You Learn?

  • The Dangers of Unmanaged Growth. Let's say you get a huge promotion and raise at work. You look at everything you own and think about upgrading your lifestyle. Should you get a bigger house, hire a personal trainer, or replace all your clothes in one Neiman Marcus shopping spree? Before you adjust your lifestyle, you should think about how long the raise could last. Maybe you should wait a year or two and see if your higher income persists. And even if your company does well, what happens to your job when the rest of the country cuts back on expenses?

    Just as with Iceland, in a globalized world, no person, company or even country is a self-contained and independent entity. Therefore, Iceland's troubles showed that thinking ahead, even in the best of times, is an important survival strategy. (For related reading, check out The Globalization Debate.)

  • One Country's Problems Can Impact the Global Economy. In a world where global economies are as important as national economies, one country's woes can either echo across the world, or the world's woes can encroach on any country worldwide. Iceland's banks had account holders and investors in a variety of countries shivering out of fear of losing their money. (For information on the global economy read Taking Global Macro Trends To The Bank.)
  • Government Oversight of the Banking Industry. After the U.S. credit crisis of 2007-2008, mortgage rates didn't rise above 18% as they did in Iceland. However, pension and mutual funds dropped rapidly in value, home foreclosure rates skyrocketed and banks lost money to the extent of needing federal bailouts. The situation in Iceland questions the balance between a deregulated banking system and securing the stability of financial institutions that provide most of the funds for citizens' personal and professional lives. Iceland's crisis, as well as the one in the U.S., suggests that a line has to be drawn showing exactly when and how to intervene and stabilize a financial crisis. (To learn more, read Free Markets: What's The Cost?)

Conclusion
Iceland went to the brink of bankruptcy due to unmanaged, rapid growth of the banking industry in the mid-1990s. Icelandic citizens deal with high interest rates and some difficulty using their currency in other countries. Learn from this unfortunate event, and avoid the chill of unmanaged growth by analyzing and planning for major purchases in your own life - because you never know when a financial ice storm will hit your personal economy.

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