Iceland's Economic and Financial Crisis: Causes, Consequences and Implications

Spruk, Rok (2010): Iceland's Economic and Financial Crisis: Causes, Consequences and Implications. Published in: EEI Policy Paper , Vol. 1, No. 2010 (23 February 2010)

Abstract

Iceland experienced a significant financial meltdown and subsequent economic downturn after the 2008/2009 financial crisis struck the country. It had been the worst crisis ever experienced by a small country from the late 20th century onwards. Since 1980s, Iceland's macroeconomic stability had been constantly deteriorated by the most volatile annual CPI and asset-price inflation dynamics in the OECD. More than a decade of robust growth dynamics left behind an internationally over-exposed banking sector which exceeded the size of country's GDP by nearly 10 times. The failure of Lehman Brothers and a global credit crunch, in turn, raised CDS rates on Icelandic banks which immediately declared insolvency after the global interbank lending froze. The paper provides a comprehensive analysis of the macroeconomic, banking and financial background of the crisis. It also provides a short-term analysis of Iceland's macroeconomic outlook. The main findings of the article conclude that the depth of financial crisis is attributed to the recent decade of unadjusted monetary policy which failed to prevent sharp appreciation of the krona and thus created sufficient conditions for significant asset-price inflation, high interest rate differential and the largest banking collapse in small and open economies. As the size of the banking sector was several times the country's GDP, Icelandic central bank failed to act as a lender of the last resort. The paper concludes that, to prevent future crises of similar proportions, it is impossible for a small country to have a large international banking sector, its own currency and an independent monetary policy.

• Item Type: MPRA Paper
• Language: English
• Keywords: Iceland, Financial Crisis, Financial Macroeconomics, International Finance, Monetary Policy, Currency Crisis
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; G - Financial Economics > G0 - General > G01 - Financial Crises; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

Abritti, Mirko & Mueller Andreas (2007), “Asymmetric labor market institutions in the EMU: positive and normative implications” Central Bank of Iceland Working Paper No. 37

Buiter, Willem & Sibert, Anne (2008), “The Icelandic banking crisis and what to do about it: The lender of the last resort theory of optimum currency area” CEPR Policy Insight No. 26

Buiter, Willem & Sibert, Anne (2008), Iceland’s banking collapse: the predictable end of the non-viable business model, Voxeu, October 30th

Danielsson, Asgeir, Guðmundsson, Haraldsdottir, Svava J., Olafsson, Thorvardur T., Petursdottir, Asgerður, Petursson, Thorarinn & Sveinsdottir, Rosa (2009), “QMM: A quarterly macroeconomic model of the Icelandic economy” Central Bank of Iceland Working Paper No. 41, February

Danielsson, Jon (2008), How bad could the crisis get: Lessons from Iceland, Voxeu, November 12th

Glitnir Bank (2006), Icelandic krona: Highlights and forecast summary, December, Reykjavik, Iceland

Herbertsson, Tryggvi T. & Mishkin, Frederic S. (2006), Financial Stability in Iceland, Iceland Chamber of Commerce, Reykjavik

Holden, Steinar & Wulfsberg, Fredrik (2007), “Are real wages rigid downwards?” Norges Bank Working Paper No. 2007/01

Jackson, James K. (2008), Iceland’s Financial Crisis, Congressional Research Service, November 20th

Jonsson, Asgeir (2006), Icelandic Economic Miracle: Where does the money come from?, Kaupthing Bank, March

Lane, Phillip (2008), Iceland: The future is in the EU, Voxeu, November 6th

Mitchell, Daniel J. & Gissurarsson, Hannes (2007), “The Icelandic tax system: Key features and lessons for policymakers, Prosperitas” Vol. 7, No. 5, Center for Freedom and Prosperity

Mitchell, Daniel J. (2007), Iceland joins the flat tax club, Tax & Budget Bulletin, No. 43, February

Mongelli, Francesco Paolo (2002), “New views on the optimum currency area: What is the EMU telling us?” ECB Working Paper No. 138, European Central Bank

Oddsson, David (2004), Iceland’s economic performance, Address to the American Enterprise Institute, June 14

Øygard, Svein Harald (2009), The recovery of the Icelandic economy, Morgunbladid, April 1

Portes, Richard (2008), The shocking errors behind Iceland’s meltdown, Financial Times, October 13

The Economist (2008), Kreppanomics, October 8

Tulip, Peter (2007), “Financial markets in Iceland” OECD Economics Department Working Paper No. 549

Valgren, Carsten, Christensen, Lars, Andersen, Peter Passing & Kallestrup, Rene (2006), Iceland: Geyser crisis, Danske bank, March 22