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Iceland Economy: How they got in this Mess

By: CaraTan Date: 6 February 2009

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Reykjavik, 6 Feb. What was once one of the world’s most prosperous nations, Iceland is now struggling from the shocks of the financial collapse, and many are wondering how in the world this could have happened.

Since its independence in 1944, Iceland’s economy prospered on its healthy fishing industry, quickly moving the tiny nation into one of the most successful post-war economies. As the fishing industry slowly shrank, focus was placed on the nation’s financial sectors.

Huge amounts of foreign funds were injected into the country’s banks, giving rise to even more growth, until Iceland’s foreign assets were worth around US $200 billion. This might not sound like a lot, but it is 10 times its GDP.

So when 2008’s global financial crisis hit, Iceland was especially susceptible given that it was so reliant on banking

. In October of that year, the government made an attempt to prevent further collapse by taking over the three main banks. Just after this, Iceland applied for IMF help. This is the first such appeal to the IMF from a developed country in more than 30 years.

When the financial crisis struck Iceland, all foreign currency there became frozen. And considering the fact that the small nation of just over 300,000 relies on imports and exports to survive, no further international trade

was possible. So the businesses selling goods overseas cannot bring their profits back into Iceland, and those importing cannot obtain foreign currencies to buy goods.

But how did it all happen? Many believe that Iceland’s central bank pursued the wrong monetary policy. It adopted an inflation targeting strategy which involves dropping rates if inflation is below a certain target, and raising them if it is above. And it did a lot of raising.

The inflation rate rose and rose, which meant the central bank kept increasing the interest rate. It even reached 15% or more. What this was designed to do was prevent more loans and thus restrict the amount of borrowing, effectively making money more valuable.

However, with such a high interest rate, it only encouraged firms and individuals to borrow from overseas, where the interest rates were much lower. Some even engaged in the carry trade, which is borrowing cheap money (like from Japan) and selling it where interest rates are high (like back home in Iceland). It’s often been said that the carry trade is like picking up pennies in front of a steamroller, but if you’re a wealthy housewife buying yen at zero percent and selling it for 14% back home, it makes sense.

The result was tremendous amounts of foreign funds being introduced to the nation which created large exchange rate differences, making the Icelanders feel even richer than they already were. As this prevailed and was profitable for many, it therefore continued, until a bubble was created, and the Icelandic króna was overvalued. A collapse was imminent.

In early 2008, the króna was worth 90 euro. By October 2008 it dropped to 340, and in now it has started correcting to around 145.

A senior government official in Icelandic recently said, "The króna is dead. We need a new currency. The only serious option is the euro."

Vladamir Gonzalez, EconomyWatch.com