Lessons from Iceland

If we are to build support for an alternative to capitalism we need clarity on the causes and consequences of the contemporary capitalist drive for greater liberalization and privatization, as well as the benefits from and limits to state direction of capitalist economic activity. Although a small country, Iceland’s recent experience has much to teach us about capitalist dynamics and strategies of transformation.

In 1991, the Icelandic government began an aggressive program of liberalization and privatization which gave rise to the hyper-expansion of three Icelandic banks. Their highly leveraged growth fueled massive stock market and housing bubbles, all of which combined to make Iceland’s per capita GDP one of the world’s highest by the mid–2000s. Iceland’s economy collapsed in October 2008 when the three banks were forced into bankruptcy; the country suffered one of the deepest downturns in the world.

In a response that remains unique in Europe, the Icelandic people forced the political leaders responsible for the neoliberal program to resign. They then elected a social democratic coalition government which aggressively intervened in financial, currency, and housing markets, and engaged in a targeted expansion of key social programs. As a result, Iceland has experienced one of Europe’s most rapid and broad-based economic recoveries. Unfortunately, the scope of these state actions was limited by still powerful capitalist-class relations. Working-class gains may well be reversed, particularly with the political reversal in April 2013, and the election of a conservative government representing the dominant interests.

Capitalist Class Dynamics and Neoliberalism

Iceland is certainly not unique either in the 1990s or more recently in electing a government promoting neoliberal policies. Moreover, the class dynamics producing such an outcome are not the same in each country. Still, a study of the Icelandic process does provide useful insights into the broader phenomenon. Among the most important is that neoliberalism is, above all, a capitalist-class project. As such, state decisions about liberalization and privatization are carefully made with the aim of expanding capitalist profit-making opportunities, an aim that often contradicts the libertarian claims used to give them legitimacy.

Iceland was one of the poorest countries in Western Europe at the end of the Second World War. It had been a colony of Denmark and only gained its full independence in 1944. As a consequence of its colonial history, “Icelandic capitalism was dominated from the start by a bloc of some fourteen families, popularly known as The Octopus, which constituted both the economic and the political ruling elite.”1

The Octopus was not a formal group. Rather the name reflected the fact that these families jointly dominated most key industries. The Octopus projected its power through its control over the country’s most powerful political party, the Independence Party; many of the party’s top leaders were members of the most influential Octopus families. A second, less powerful group of families was known as the Squid. They dominated the Progressive Party, which often served as the Independence Party’s junior coalition partner.

Iceland, like most of Europe in the immediate post-Second World War period, had a highly controlled economy. Beginning in the 1960s, Iceland, again following European trends, began a controlled liberalization of economic activity. However, because of its history, Iceland’s economy remained more regulated and shaped by clientelism than other Western European economies.

For example, the largest banks were state owned, “capital was rationed between different industries by the government, nominal interest rates were set by the Central Bank of Iceland (CBI), which was controlled by the government, and real interest rates were kept negative until the late 1980s.”2 At the same time, these banks were largely managed for the benefit of the major political parties and their respective backers. For example, Independence Party appointees ran the state-owned Landsbanki and directed its loans to Octopus-controlled businesses.

In broad brush, the Icelandic economy performed well in the post-Second World War period. Despite its poor starting point, “by the 1980s [Iceland] had attained both a level and a distribution of disposable income equal to the Nordic average.”3 Yet, developments were underway that would soon transform the country’s political economy.

The first and most important development was the rise of a “neoliberal/libertarian” political interest group in the early 1980s known as The Locomotives. The group was dominated by former Law and Business Administration students from the University of Iceland. They took their name from a similarly called journal which the students ran in the early 1970s and used to promote free-market ideas.

Members of the Locomotive group argued that Iceland needed to unleash market forces to break the state-corporate stranglehold on the Icelandic economy. Their message found an increasingly receptive audience as Icelandic growth slowed over the 1980s, labor-capital conflict intensified, and governments advocating neoliberal policies came to power in Europe and the United States.

David Oddsson, one of the Locomotive founders, became mayor of Reykjavik in 1982. His aggressive privatization policies won him support from other Independence Party members and he quickly rose through the ranks, eventually becoming party leader and prime minister of the country in 1991. He held power for fourteen years before resigning to become head of the CBI in 2004. Oddsson was a relative outsider in terms of Independence Party politics and his successful rise to become prime minister and architect of Iceland’s neoliberal transformation was predicated on his ability to “reassure the old, established wealthy families of Iceland that rapid, systematic privatization was not going to impoverish them or dilute their power.”4

Iceland’s ruling families were growing increasingly dissatisfied with their economic situation. The small size of the country as well as continuing state ownership of banking and other significant business sectors placed limits on their opportunities for profit. And, as economic problems and political tensions grew, Oddsson’s leadership of the Independence Party became ever more attractive to them.

Soon after becoming prime minister, Oddsson began lowering corporate tax rates and privatizing state-owned companies. Serious change came only after 1994, when Iceland joined the European Economic Area (EEA), the free-trade bloc of the European Union. Membership gave Iceland open access to European markets and the country’s political and business leaders were quick to grasp that a privatized, deregulated, and expanded finance sector was their best vehicle for overcoming the country’s profit-constraining market size.5

Bank privatization began in the late 1990s through a highly controlled and politicized process that was completed in 2003. The first privatization was of a small investment bank. A family associated with a relatively new business group known as the Orcas gained control of that bank, and through mergers and acquisitions created Glitnir, which became one of Iceland’s three major banks. The two large state banks—Landsbanki and Buradarbanki (later to become Kaupthing)—were the main prize, and the government ensured that the bidding process would deliver majority ownership of the former to supporters of the Independence Party, which meant Octopus families, and the latter to supporters of the Progressive Party, which meant Squid families. The new owners then established private holding companies which tapped their respective banks for funds to start new businesses, and in some cases took over existing businesses owned by other elites. The new owners also funneled money back to their respective parties and party leaders.6

The resulting transformation of the Icelandic economy did produce a change in the relationship between state and ruling elites, with the latter increasing its relative power. It also led to a restructuring of elite relations, in particular a weakening of ties among leading families and the rise of new power centers. However, despite the free-market/libertarian rhetoric that accompanied it, the transformation was never designed to, nor did it, destroy close state-business ties or end monopoly dominance over the economy.

Growth and Crisis

Iceland’s economy soared, especially over the years 2003 to 2007. The annual average growth in GDP was 5.5 percent and unemployment declined from an already low 3.4 percent to 1 percent.7 The IMF estimated that Iceland was the world’s third-richest nation in per capita terms in 2005.8 As we see next, these gains were fueled by the highly leveraged expansion of the country’s three leading banks, an expansion that contained the seeds of the country’s eventual 2008 economic collapse.

The rate of growth of Iceland’s banking system from 2003 to 2007 was unprecedented.9 Total end-of-the-year assets held by the three largest banks rose from less than twice the country’s GDP in 2003 to over eight times in 2007, and to almost ten times as of June 2008.10

The banks relied heavily on foreign money for their expansion. Early funding came largely from selling bonds in the European market. When foreign rating agency warnings about the health of Icelandic banks closed off the European market in 2006, the banks turned briefly to the U.S. bond market. The following year, Landsbanki and Kaupthing turned to yet another market, foreign retail deposits, especially in the United Kingdom and the Netherlands. All three banks also used their subsidiaries in Luxemburg to engage in indirect collaterized borrowing from the Eurosystem. By the end of 2004, Iceland was the world’s most heavily indebted country measured in terms of gross external debt to GDP.11

Underpinning and eventually destabilizing Iceland’s growth process was the complex relationship between and among the banks and their ownership groups. For example, this relationship was key in enabling Icelandic banks to tap foreign bond markets. Icelandic banks appeared especially creditworthy because of their high-capital-adequacy ratios. These high ratios were deceiving however, since they were largely the result of artificially inflated share prices. As Robert Wade and Silla Sigurgeirsdottir describe:

Iceland’s new banking elite rode the bubble, intent on expanding their ownership of the country’s economy, both competing and cooperating with each other. Using their shares as collateral, they proceeded to take out large loans from their own banks, some of which they spent on buying more shares in the same banks, inflating share prices. Their executives were instructed to follow suit. They performed the same task for other clients, including the other banks. Bank A lent to shareholders in Bank B, who bought more shares in B against the shares as collateral, raising B’s share price. Bank B returned the favor for shareholders in Bank A. The net result was that the share prices of both banks rose, without new money coming in.12

While the banking elite used their access to funds to purchase control of many Icelandic businesses, they also engaged in heavy investing outside of Iceland. Major targets were fashion outlets, toyshops, soccer teams in Britain, and supermarkets in the United States and throughout Scandinavia.13

This activity boosted Icelandic stock prices, creating a stock market bubble. Average share prices rose at an annual average rate of 43.7 percent between 2003 and 2007. Easy credit coupled with rising stock prices also generated a housing market bubble; housing prices rose an average of 16.6 percent a year over the same period. These developments produced a sharp rise in corporate and household wealth, borrowing, and spending, and thus economic growth. They also produced an enormous trade imbalance; the current account deficit grew from 5 percent of GDP in 2003 to 20 percent in 2006.14

This finance-driven growth process was further encouraged by CBI policy. Worried about rising prices, the CBI pushed up interest rates. However, as the interest rate differential between Iceland and other countries grew, financial traders—Icelandic and foreign—took advantage of the fact that they could make money borrowing outside of Iceland and lending in Iceland.

Icelandic banks intensified their domestic retail lending. “Brokers crisscrossed the country, persuading households to load up on more debt and to convert new or existing Icelandic krona debt into much lower-interest Swiss francs or Japanese yen.”15 Foreign banks bought Icelandic bonds, and then repackaged and sold them as “Glacier” bonds; they offered interest rates as much as five times higher than the rates in Europe.

The resulting inflow of money pushed the krona up relative to the euro and other European currencies, enriching Icelanders and encouraging them to go on an import binge. However, as Wade and Sigurgeirsdottir point out, “the carry trade is risky and unsustainable, and currency traders flee at the first sign of trouble. That’s what happened when the banks—heavily indebted, illiquid and unable to meet their obligations when credit dried up—finally collapsed.”16

As noted above, warnings were issued in 2006 about the stability of the Icelandic banking system. Among the top concerns: the quality of bank assets and the fact that government resources were inadequate to backstop the country’s banks if problems developed. The concerns were real. Without continuing inflows of money to cover a current account deficit that had grown to 20 percent of GDP, the krona would dramatically fall. That, in turn, would create a debt repayment problem for those who borrowed in foreign currency, threatening the solvency of the banking system. Prices of imports would also soar, undermining domestic spending and production. The combination could be expected to sink the Icelandic economy.

The currency did fall briefly in 2006, as did the stock market. However, the “mini-crisis” was quickly overcome. The Icelandic government and Chamber of Commerce launched a major public relations campaign to deny that the Icelandic banking system was unsound. Both the Columbia Business School economist Frederic Mishkin and the London Business School professor Richard Portes issued separate endorsements. More importantly, the banks doubled down on their debt strategy.

The banks were well aware of their vulnerabilities and need for new funds. Thus, Landsbanki and Kaupthing took advantage of Iceland’s membership in the EEA to establish retail operations in several European countries, which enabled them directly to access foreign deposits. Landsbanki launched an Internet-based banking service called Icesave in the United Kingdom in October 2006 and the Netherlands in May 2008. More than 300,000 people and many institutions—including Oxford and Cambridge Universities, the Metropolitan Police, and 116 local governments—deposited money in Icesave accounts. In the Netherlands, more than 125,000 people opened accounts.17 Kaupthing followed by establishing Kaupthing Edge in 2007 in Germany and several other European countries.

Although the strategy was the same, the two banks pursued it differently. Landsbanki operated though overseas branches while Kaupthing operated through subsidiaries. The difference mattered: branches fall under the supervision and insurance of the bank’s home country, while subsidiaries fall under the supervision and insurance of the bank’s host country. In 2008, European investors had approximately $10.5 billion in Icesave accounts.18 That amount was over half Iceland’s GDP; there was no way that Iceland’s monetary authority could cover a failure of Icesave’s operations.

The growing domination of finance was not limited to Iceland, nor was the contradictory nature of the process. In particular, the collapse of the U.S. bubble economy triggered a series of financial shocks with international ramifications. Lehman Brothers, the fourth-largest investment bank in the United States at the time of its demise, declared bankruptcy in September 2008. Its collapse led to a freezing of international credit markets and the unraveling of Iceland’s banks and economy.

Glitnir, the weakest of Iceland’s three major banks, felt the effects first and approached the CBI for help. Oddsson, who now headed the CBI, ordered the central bank to buy 75 percent of Glitnir’s shares. Regardless of intent, the action undermined international confidence in the country’s entire banking system. Credit lines were canceled and a run began on Icesave’s overseas branches.

Iceland’s three major banks failed within the first two weeks of October 2008 and were taken over by the Icelandic government. To put their bankruptcies in perspective, if taken together, their closure would “rank third in the U.S. history of bankruptcies, with Lehman ($691 billion) first and Washington Mutual ($328 billion) second. As separate entities, Kaupthing ($83 billion) would rank fifth, Landsbanki ($50 billion) ninth and Glitnir ($49 billion) tenth.”19

The default of the banks led to a rapid and interrelated series of crises: a currency crisis, a stock market crisis, a repayment crisis for Icelandic businesses and households, and a housing crisis. The krona fell by more than 80 percent against the euro in 2008 and the stock market lost 75 percent of its value.20 Real wages fell by 4.2 percent in 2008 and another 8 percent in 2009.21 The unemployment rate soared from 1 percent in 2007 to 8 percent in 2009 and those with jobs lost hours in addition to pay.22 Not surprisingly given the rapidity and shaky underpinnings of the country’s growth, Iceland suffered one of the developed world’s worst economic declines, with its GDP falling by a combined 9.3 percent from 2008 through 2010.23

Households were hit especially hard by currency and price movements. Household debt at the beginning of 2008 was equal to 100 percent of GDP and an even more staggering 225 percent of disposable income. Approximately 13 percent of the debt was foreign-currency-indexed loans which doubled in domestic-currency terms from 2008 to 2009.24 Approximately 80 percent of household debt was indexed to inflation, and prices rose by 27 percent over the same period. Many people, unable to pay their debts, lost their cars and homes. Non-financial businesses were also hammered. Their debt at the end of 2007 was over 300 percent of GDP; approximately 70 percent of all bank loans to these businesses were foreign-currency-indexed loans.25

With its banking system frozen and its currency in freefall, the Icelandic government turned to the International Monetary Fund (IMF) for help in October. However, the IMF made its assistance conditional on Iceland agreeing to reimburse the governments of the United Kingdom and Netherlands for the money they spent compensating their respective Icesave depositors. Since Icesave was a branch of Landsbanki, the Icelandic government was responsible, under the terms of its membership in the EEA, for providing a guaranteed minimum-deposit insurance of 20,887 euros for each account. But, the United Kingdom and Netherlands wanted more from Iceland. The two governments, without waiting for Iceland to act, had themselves reimbursed their own depositors the full amount they lost—and they now wanted Iceland to reimburse them, with interest.

While the United Kingdom and the Netherlands pressed Iceland to agree to their terms, the great majority of Icelanders strongly opposed any such agreement, well aware that it would require sizeable tax hikes and cuts in government spending, and all to cover a private bank’s failed overseas operation. Desperate for foreign exchange, the Icelandic government eventually “agreed to compensate at least some of the depositors at some time in the future.”26 This commitment satisfied the two governments and Iceland received a $2.1 billion loan from the IMF and an additional $3 billion loan from the Nordic countries and Russia.

Resistance, State Intervention, and Recovery

Protests against the Icelandic government began in late October almost immediately after the start of the crisis, anchored by ever-larger Saturday rallies at Reykjavik’s main square and Monday evening meetings in Reykjavik’s main theater. The most common demands were for the resignation of the prime minister and the election of a new government. In January 2009, two thousand demonstrators banging pots and pans outside the parliament building were attacked by riot police. This touched off what the Icelandic press labeled the “pots and pans revolution” as demonstrations grew in size and militancy.

Unable to pacify popular anger, the ruling Independence Party first announced new elections for April 2009. Then, when its coalition partner the Social Democratic Alliance withdrew its support, the prime minister and cabinet resigned. An interim government headed by the Social Democratic Alliance and the Left-Green Movement filled the vacuum and the same coalition emerged victorious in the April voting. “To date, Iceland’s remains the only government to have resigned as a result of the global financial crisis. It is also the only country to have shifted distinctly to the left in the aftermath of September 2008.”27

Iceland’s progressive government took a series of policy actions over the following years that were quite different from those of other European governments. Most importantly, rather than try to resuscitate existing structures and patterns of economic activity through austerity measures, it actively intervened in financial, currency, and housing markets, as well as strengthened targeted social programs that protected majority interests. The results, as the editors of Bloomberg View describe, have been impressive:

Few countries blew up more spectacularly than Iceland in the 2008 financial crisis…. Since then, Iceland has turned in a pretty impressive performance. It has repaid International Monetary Fund rescue loans ahead of schedule. Growth this year [2012] will be about 2.5 percent, better than most developed economies. Unemployment has fallen by half. In February, Fitch Ratings restored the country’s investment-grade status, approvingly citing its “unorthodox crisis policy response.”28

Although far from radical, the Icelandic government’s response to the country’s crisis was indeed unconventional. It was also more successful in promoting economic recovery and protecting majority well-being than the more conventional responses of other European governments.

Financial Policy

One Icelandic analyst explained the core differences between the Icelandic government’s financial policy and those of other European countries as follows:

Unlike other badly “Kreppa”-hit countries like Ireland, Greece and now Spain…Iceland didn’t save its failed banks.29 The credo of the European Central Bank and the European Commission has been that no bank must fail in the Euro zone and no bondholders must suffer losses, so as not to undermine the faith in the euro…. Another concerted action that set Iceland apart from other European countries in recession is the widespread and extensive write-down of loans, both for companies and individuals.30

Glitnir and Landsbanki were nationalized on October 7, 2008. Kaupthing was taken over the next day. Each of the three banks was divided into two, a new and old bank. The new state-owned banks were given all the mortgages, other bank loans, and deposits of the old banks, with only international obligations remaining at the old banks. To ensure the viability of the new banks, loans held by the old banks were often transferred to the new banks at a steep discount.

In response to an IMF directive, the government privatized two of the newly created banks; it is in the process of increasing the private ownership share of the third, the new Landsbanki. Creditors of the old banks eventually reinvested in the new banks. All three new banks were “recapitalised with strong capital ratios—in excess of 16 percent of all assets—and are 90 percent funded with deposits. Most smaller savings banks were also restructured. During the whole process, all deposits in Iceland (both of residents and non-residents) were guaranteed in full.”31

The government also took steps directly to reduce the debt burden on households and non-financial businesses. In June 2010, the Supreme Court ruled foreign-currency-linked motor-vehicle loans invalid. In December 2010, the Parliament made a similar ruling for mortgage loans. In June 2011, the Supreme Court included loans to corporations. All these loans “were converted into domestic currency loans, whereby the outstanding principles of the loans were reduced considerably, and the interest rates were also recalculated (retroactively as well) using the lowest non-indexed interest rate published by the Central Bank of Iceland.”32

These developments had nothing to do with Icesave and demands by the governments of the United Kingdom and the Netherland for repayment. Finally, in October 2009, under pressure from the European Community, the Icelandic government presented the Icelandic parliament with the terms of a negotiated agreement in which it committed to pay the two governments 5.5 billion euros (approximately 50 percent of Iceland’s GDP) over an eight year period, from 2016 to 2023. The parliament reluctantly approved the agreement in December, but the President of Iceland announced that he would not sign it without a national referendum. In March 2010, the voters rejected the agreement with 93 percent of the votes in opposition. A new agreement was negotiated, one that extended the payout period and lowered the interest rate. A new referendum was held in April 2011; this time 66 percent of the voters said no.

After this second vote, the European Free Trade Association Surveillance Authority sued Iceland in the European Free Trade Association’s court. The case was finally decided in January 2013. The court, surprising many, announced that Iceland was under no obligation to compensate the two governments since the regulations on cross-border deposit insurance did not apply in the face of “a systemic bank failure of the magnitude experienced in Iceland.” Regardless, Iceland has already repaid more than 90 percent of the minimum deposit guarantees required by EEA membership from money raised selling Landsbanki assets.33

Currency Policy

Iceland’s currency remained strong during the country’s pre-crisis expansionary period in spite of its enormous current-account deficit because of the large inflow of foreign funds. With the collapse of the banking system, that inflow stopped and the krona went into free fall. The decline intensified the country’s economic problems. Many households and businesses held foreign-currency indexed debts that exploded in domestic cost. As noted above, the government worked to minimize the economic harm from this development by forcing banks to restructure their loans in domestic currency.

At the same time, there was a positive side to the currency decline. In particular, it enabled the country quickly to regain its international competitiveness and economic traction. Iceland recorded a current account surplus in 2009, which was achieved in part thanks to a recovery of exports. “Among the thirty-four countries for which Eurostat publishes constant price data on exports of goods and services, Iceland was the only country where there was a growth in 2009 compared to 2008.”34 In addition, the higher import prices also stimulated a revival in the country’s import substitution industries.

Iceland’s crisis experience is often compared to those of Ireland and Latvia. All three countries relied heavily on foreign borrowing and debt bubbles to drive growth, and all three suffered major economic collapses for roughly the same reason. Ireland and Latvia suffered greater economic declines than did Iceland, and their recoveries have been far weaker and more punitive.35

One reason for this outcome is that neither Ireland nor Latvia changed their respective currency values; the former uses the euro for its currency and the latter remains committed to a fixed rate of exchange with the euro. As a result, both Ireland and Latvia were forced to pursue international stability through what is called an “internal devaluation.” Said differently, they relied on slashing domestic wages and prices to boost their respective economic competitiveness.

Iceland’s currency policy also includes the use of strict capital controls which make most transnational capital movements illegal.36 These controls have blocked an estimated $8 billion, roughly equal to 50 percent of Iceland’s GDP, from leaving the country. Had the government not taken action, the resulting outflow would no doubt have led to a complete currency meltdown. Thanks to the controls, the krona, although lightly traded, soon strengthened and then stabilized.

Housing Policy

The government took strong steps to minimize the threat to household finances caused by the collapse of the housing bubble and to restore stability to the housing market. As the IMF explains, the government quickly implemented a number of measures “to ensure that families did not lose their homes owing to temporary problems and to prevent a spike in foreclosures leading to a housing market meltdown.” Those measures included:

a moratorium on foreclosures, a temporary suspension of debt service for exchange-rate-and CPI-indexed loans, and rescheduling (payment smoothing) of these loans. About half the households with eligible loans took advantage of payment smoothing, which reduced current debt service payments by 15 to 20 percent and 30 to 40 percent for CPI-indexed and foreign-exchange-indexed loans, respectively.37

The government then introduced several new initiatives designed to provide more long term relief. These lowered household debt and mortgage interest payments as well as provided support for housing alternatives and renters. For example, the government first pursued a strategy of encouraging householders to directly negotiate write-downs with their lenders, often with the assistance of an ombudsman. Given the slow progress, the government introduced a debt-forgiveness plan that wrote down underwater mortgages to 110 percent of a household’s assets. To ensure that working people were the main beneficiaries of the plan, the amount of relief was tied to the value of a modest house and family size. More detailed financial examinations were available for households in especially serious financial trouble, with the possibility of greater write-downs.38

As noted above, the government ruled mortgage loans indexed to foreign currencies illegal, which meant that households no longer saw payments rise due to the depreciation of the currency. It also offered means-tested, mortgage-interest-rate tax rebates and special subsidies to help homeowners in difficult circumstances meet their interest obligations; these were financed through a special tax on financial institutions and pension funds.39