“The Icelandic crisis started well before the world collapsed in 2008″, Árni Páll Árnason (from now on APA) says. APA was an Icelander Social Democrat MP at the time. He only became Minister of Social Affairs and Social Security in the Spring of 2009, following a general election where citizens voiced their discontent by sending home the then ruling conservative government and electing a leftist coalition to power.
Within his party’s success, APA had his own success, with a strong personal showing. People listened and liked the message this young politician was proposing. I myself was drawn to look for him after listening to his 2011 speech, as Minister of the Economy, in front of IMF delegates and experts, recounting why Iceland was right and everybody else wrong in dealing with the triple crisis (banking, economic and currency crisis) the way it did. He convinced me. So I looked for him and had the pleasure to interview him. What follows is based on our talk and also from his speech. What you read in italics is taken from his speech that I recommend you also watch on the linked video (to watch it, scroll down the page to the Conference Program and click on Welcoming Program, Webcast. After the speech of the Prime Minister, at the ninth (9th) minute you will listen to him) .
In September 2010 APA became the Economic Manager of the country, the Minister of the Economy. But the experience during the crisis in the Ministry of Social Affairs, he recalls, was fundamental to learn about how to deal with tough economic issues, inevitable cuts and rising unemployment at the same time.
But let’s go back to before the crisis. The krona currency was a major factor in getting us into trouble in the first place. The banking crisis was preceded by a currency crisis. The (independent) Icelandic Central bank raised interest rates to stem inflation. High interest rates in an open economy attracted carry-trade and an endlessly appreciating krona encouraged unsustainable foreign borrowing by households and the corporate sector. The krona had therefore placed us in an economic strait-jacket, well before the events of 2008.
There was a lack of tools to deal with such a difficult situation, he recalls, especially macro prudential tools, but also some inevitability to it: Iceland being a very very open economy with a very very small currency could do little to defend itself from a world crisis and its repercussions.
On top of that, we had a banking crisis that here, as everywhere else, was the result of reckless banking practices and systemic undervaluation of risk. Huge leverage, trading in their own shares, all practices that were not illegal then, by the 3 largest banks mainly, representing 85% of the market, APA continues. Banks which were upgraded by the ratings agencies before the crisis, being considered strategically important and strong. The rating agencies correctly saw that the banks were too big to fail and thus granted them the AAA rating enjoyed by the Sovereign. What they should have done is to see that the three big banks were so huge in relation to the Sovereign that they were in fact too big to rescue. The banks used the AAA rating to borrow at very cheap rates. The Sovereign was virtually free of debt and the banks benefited from that, he recalls. This all started to fall apart when funding became more difficult and costly in late 2007 and during 2008, with the crisis, access to funding became much more difficult. It started for those banks as a cost of funding problem, not finding cheap money. Their whole business model was based on cheap funding and when that dried up their value started to depreciate quickly, he concludes.
Then came the Government recation. Emergency Legislation came as a natural solution for the Government. We could have considered guaranteeing activities of the banks, like the Irish did. A very difficult alternative …. Where would it have led us? The banking sector was huge, 10 time the Icelandic GDP.
It was not a nationalization. Banks could not operate anymore, they went bankrupt and the State created new banks with domestic payment systems in them. We refinanced the new banks. Creditors and shareholders of the old banks lost everything. First, deposit holders were given priority to the bond holders of the banks. Second, all domestic assets were transferred, along with deposits, to new banks at a “fair” value. Insurance for deposits in the Fund amounted to 18 bn IK and there were 1800 bn IK deposits. No insurance system could sustain every single bank.
I think it is safe to say that bondholders of banks were angry at that decision, he recalls.
It was not only an issue of deposit vs bond holders, but also an international issue of Dutch and British foreign currency deposit holders of one of the banks that had considerable deposits in the UK and Holland. Emergency Legislation gave priority to all deposit holders, but we moved deposits in local Icelandic branches into the new banks. Since we did not have enough FX it was impossible for us to move deposits in foreign branches into the new banks. Depositors in UK and Netherlands branches are now being paid out from the estate of the foreign bank and they will all be paid out. 30% of their claim has already been paid out (Iceland has been taken to court by the EFTA Surveillance Authority, which monitors the operation of the EEA-Agreement in a similar manner as the EU Commission does with regard to the EU Treaty, claiming that Dutch and British depositors were discriminated against).
After that, 2 of the 3 banks were fully financed by the old creditors. 1 bank is still owned by the State, because the creditors with priority claims are the Dutch and British government.*
But we also had a drastic downturn which was an unavoidable consequence of the overheating of the economy in the years before. Contrary to the criticism levelled at the IMF in the 1990´s, fiscal adjustment was effectively delayed as the Icelandic IMF plan foresaw us making full use of the automatic stabilisers – the unemployment and welfare benefits – for the first year of the program. It helped us to deal with the situation much more effectively than otherwise would have been the case and helped to avoid a much more severe downturn.
He writes: The Icelanders were unable to smooth their way out of crisis with near-zero interest rate and quantitative easing, like larger currency areas were able to, the macroeconomic adjustment was both rapid and painful led by sharp depreciation in Icelandic krona. The average Icelandic household has seen a 30% reduction in purchasing power since 2008 and the country is now running a merchandise trade surplus of 10% of GDP.
Iceland is now well on its way in achieving an export based recovery. It is therefore easy from the outside to make the case for the Icelandic krona and see only the benefits brought by the floating exchange rate for the economic recovery. That is however only one side of the story. The fall of the krona also exacerbated the problem of overindebtedness of the private sector. With 70% of all corporate lending in foreign currency almost all for anemic investment and growth equity in the corporate sector has been wiped out. This is the biggest single reason: Overindebted companies do not invest. Similary, with the household sector overindebted and nearly the entire stock of mortgages linked to inflation, mortages have increased by more than 30% and interest payments as a share of total disposable income have risen from 20% in 2008 to over 30% in 2010. How are households to smooth consumption over time and make plans for the future when they face such uncertainties? The fall of the exchange rate may therefore have eased the shock in the labour market, but the position of the household and corporate sector has been dire nonetheless due to these severe balance sheet effects.
But, what was seen as a disaster for Iceland three years ago is increasingly being seen as good fortune with the passing of time. Icelanders may have lost their financial system but instead they were spared the burden of nationalizing private debt. Although the banking system defaulted, the Sovereign of Iceland has never defaulted and remains solvent with debt levels close to the European average of between 80% and 90% of GDP. The Icelandic emergency measures in early October 2008 and subsequent policy is founded on a single principle, namely that we cannot accept the socialization of losses.
This approach, he claims, did not draw many supporters. The IMF was, as were others, hesitant towards this approach. The common wisdom at the time – and still is to certain extent, was that governments should, at all costs, prevent banks from failing. Our approach – defining the strategically vital operations of a bank and refinancing those – was widely considered heresy back in 2008. But it is now reflected and recognized in one way or the other in recent reform proposals in most countries.
APA is, I think, a man of vision, which sees reforms as the only way forward for Western societies. But, to him, reforms must point toward one intertwined goal: greater opportunities through greater social cohesion.
All over the western world questions are being asked about the sustainability of the financial system. Most of our countries have for a long time been on an unsustainable path in terms of debt levels and growth prospects. Can we address our problems only through the traditional means of austerity and more borrowing – one or the other? I don’t think so. The longer term success – both economic and democratic – will depend on the level of structural reforms undertaken. We cannot thrive in societies lacking social cohesion. The social contract stands for both an active safety net and equal opportunities for all. We now see groups within society and even entire generations having little hope of meaningful employment and finding themselves excluded, while others enjoy relative job security. Some workers have to make do with the basic pension while others enjoy more generous provisions. These examples are endless. Structural reforms, taking on vested interests and empowering people may be difficult but they are absolutely essential.
We cannot base prosperity on the participation of the few and disillusionment of the many. I am often asked what lessons can be drawn from the Icelandic experience for the wider world. It has certainly been a difficult journey but we have used this experience as an opportunity. Maybe that is the lesson to be drawn: Difficulties provide opportunities. They force you to focus on your relative strenght and enable you to deal with weaknesses, in spite of the general resistance to change. That opportunity needs to be seised by responsible government, in time of crisis.
When the interview is over, he sends me a final mail. That I need to quote from. “I am increasingly fascinated by the challenge facing our societies and my sister (center-left, I think he means, GP) parties in Europe. 100 years ago the social-democratic movement had as its principal purpose to speak for the disillusioned and powerless against those who wanted to preserve their acquired rights. Now, in Greece and Spain at least and maybe also to some extent in Italy, the social-democratic movement is defending the rights of members of trade unions while a new generation grows up disillusioned and powerless, with no realistic prospect of ever holding a job (youth unemployment in Spain is now 46%). It will be an enormous challenge for social-democrats to speak for the outsiders this time around. And if they do not, who will?”
At the end of the interview we spoke about Europe. APA said: now, this leads us to the more existential question about whether Iceland can continue to be a part of the European single market with its own very small national currency. I favored Iceland’s entry in the European Union, he says, for which we have applied for. I still do, even though Icelanders are divided and a referendum in a few years will solve that.
That the euro area is in a state of a crisis does not scare APA. He does not seem a man to be easily scared. After facing the IMF, he faced his government running for re-election in 2013 and made sure everyone knew that he was not going to allow a spending binge for that occasion. He asked for continued fiscal discipline. After all making tough cuts in 2009 as Minister of Social Affairs must have been harder. But the political consequences of his acts were hard. For him. Just a few weeks ago he was replaced within the context of a larger coalition re-shuffling. He leaves an economy that in the second semester of 2011 grew at an admirable 4% rate, also thanks to the performance of exports and domestic consumption.
I ask him what he will do next. “I am an MP and many things need to be addressed and I will just do that as an MP and we will see what happens”. Are you very popular? He laughs when I ask him that. “Well, being kicked-out was very helpful for my popularity. A considerable number of people recognize that I was probably right about putting doubts on the fiscal binge”.
I have a sense that we will hear from him again. I tell him I see bright future for him. He laughs and say “I hope so”. I know he will. If only for the fact that when I asked him via mail to discuss with me on the phone he responded 20 minutes later with a yes. In Italy, I think, it would have taken 20 years for a former Minister of the Economy to show up.