Home The Washington Diplomat March 2009 Iceland Tries to Dig OutOf Its Financial Freefall

Iceland Tries to Dig OutOf Its Financial Freefall


Iceland’s new ambassador in Washington recently paused after he was asked whether his country’s currency was dying. Less than a month into the job, Hjálmar W. Hannesson explained that he wanted “to be diplomatic, but also to tell you I have a view on it.”

Then he flatly said, “I don’t know.”

The answer reflects a haunting reality that has loomed over Iceland since its banking sector and currency, the krona, collapsed last October.

Saddled with inflation-indexed loans and car payments in foreign currencies they can no longer afford, everyday Icelanders are in financial shambles. The construction boom that symbolized the small volcanic island’s white-hot prosperity has dried up, an unheard of 14,000 people are unemployed (the equivalent of 14 million Americans), and the government, forced to bail out its private banks, is drowning in a sea of inherited debt.

“The uniqueness of Iceland and the collapse of the banking sector is that the banking sector was so large as compared to Iceland’s economy,” explained Hannesson, who holds a master’s degree in political science from the University of North Carolina. “The liabilities of the three banks that were taken over by the government were over 10 times the GDP of Iceland. That is just huge.”

Now the mere possibility of the krona’s death is forcing the country of some 315,000 people to ask some very tough questions about their future — namely will the financial meltdown, and the likely policy changes to come, cut into the island’s independent spirit and proud Nordic culture.

With life savings and jobs wiped out, many Icelanders have also had to deal with the fact that the debt-driven lifestyles they enjoyed for roughly a decade — buying Land Rovers, Prada shoes and swanky homes — were an illusion built on blind trust in the system, poor governmental oversight, and the greed of a small number of bankers (some blame as few as 30 men and women).

Speaking at an October citizens meeting, Icelandic author Einar Mar Gudmundsson summed up the country’s disgust by comparing the crash culprits to cannibals.

“A cannibal is flying first class,” he said. “The stewardess brings a menu with several options. The cannibal is quite polite, as cannibals are upon first impression. The cannibal scans the menu and then says to the stewardess, ‘I don’t see anything appetizing on the menu. Would you be a dear and fetch the passenger list?’”

Cold Wakeup Call for Iceland It became clear to Hannesson, 62, that the financial hurricane gathering speed across the globe had hit Iceland’s shores after Prime Minister Geir Haarde left the 63rd session of the U.N. General Assembly early to return home — even as Iceland made its final pitch for a rotating seat on the U.N. Security Council. (Thanks in part to the financial mess, Iceland lost its bid for a Security Council seat.)

“We realized there were things happening that were unexpected and difficulties were ahead,” said the ambassador, who before coming to Washington served for five years as Iceland’s permanent representative to the United Nations in New York, where he was vice president of the 62nd General Assembly from 2007 to 2008.

Haarde’s swift departure back home didn’t save his job though. In fact, he became the first political casualty of the economic implosion. After violent protests that were uncharacteristic for this seemingly idyllic country, he resigned, citing health concerns.

On Feb. 1, Johanna Sigurdardottir was named head of Iceland’s new left-wing coalition government after her Social Democrats and the Left-Green Movement joined forces. The event was historic not only for Iceland but for the world. She became the country’s first woman prime minister and the world’s first openly gay head of government in modern time.

In hindsight, Haarde’s political — and the country’s economic — fate was decided years earlier when former Prime Minister Davíd Oddsson successfully pushed to deregulate the banking system. For him and his backers, Iceland’s economy was overly prone to inflation that was tied to periods of rapid growth. It was also dependent on a few key exports, including fish, which often fluctuated greatly year to year.

The move allowed the country’s three largest banks — Kaupthing, Landsbanki and Glitnir — to run wild. They invested at home and abroad, and it seemed the country moved from fishing to finance in a matter of days. For example, between 2000 and 2008, the Wall Street Journal reported that Kaupthing Bank, the largest of the three, saw its assets jump from 208 billion kronur to 6.6 trillion kronur.

Hannesson said the banks followed European banking rules and invested prudently, but when the world’s credit market dried up, they were unable to refinance loans. In a last ditch effort to stay afloat, they turned to the country’s Central Bank, now headed by Oddsson, only to learn it had failed to stockpile enough foreign reserves for such an emergency.

“The vulnerability of Iceland’s financial system was to be found in its enormous size relative to gross domestic product; the poisonous mix of [foreign exchange]-linked debt with revenues in local currency; its volatile small national currency; and the unpardonable neglect of the central bank to build up currency reserves,” Arsaell Valfells explained in Forbes Magazine.

In front of a stunned world, the banks subsequently toppled like dominoes within the space of a few days. The last to go, Kaupthing, fell after British Prime Minister Gordon Brown used the Anti-terrorism, Crime and Security Act of 2001 to freeze assets in the United Kingdom in order to recover the deposits of thousands of people who had invested in Icelandic banks.

Brown’s decision to invoke anti-terrorism laws insulted Icelanders and killed any last-ditch efforts to save Kaupthing. “We think there was a good chance Kaupthing would have survived,” Hannesson said. “But nobody knows of course.”

By the end of October, the government had taken over all three banks, inheriting massive debts. Following unanswered calls for financial help around the globe, Iceland agreed to the terms of a loan from the International Monetary Fund, including a provision that guaranteed 20,000 euros of insurance per depositor to Landsbanki’s Web-operated IceSave in Britain.

Catch-22 Aside from being a slap in the face, Brown’s decision to put Iceland in the same company as al-Qaeda, coupled with Iceland’s attempts — albeit legal — to avoid repaying British depositors, opened old feelings of distrust that had existed between the two countries during the so-called “Cod Wars” over fishing rights in the North Atlantic in 1958, 1972 and 1975.

The combination of distrust in other countries and national pride are part of the reason many Icelanders are balking at the idea of adopting the euro, a move that requires the country to join the European Union and surrender control of its fishing industry to Brussels, which has a poor track record of conservation.

Still, Prime Minister Sigurdardottir — a veteran of politics and social causes who’s been nicknamed Saint Johanna — has suggested that joining the EU and the euro zone might be the best option to salvage Iceland’s sinking economy. So far though, the government has only called for reports to examine the prospect. “I don’t see it as an option because [fishing] is a key element to the economy,” Sigurdur Sverrisson, of the Federation of Icelandic Fishing Vessel Owners, told The Washington Diplomat. “Fishing has been a key element to our society for decades, even centuries.”

The county’s “inbred notion of independence,” Sverrisson said, is “interwoven with our idea of fisheries.”

“It is kind of our symbol of nationalism and independence.”

But others suggest that the crash proves it’s time to retire the krona and adopt the euro to make a fresh start. “This [fishing] industry has had to previously cope with a monetary policy that was not directly aimed at their interest,” explained Olafur Isleifsson, of the Reykjavik University School of Business and onetime central bank official. “Of course one can understand that the fisheries industries have expressed worry about being locked into a currency that we don’t have much power over. But we did not have much control over the krona either.”

Asked whether the krona is on its deathbed, Isleifsson said, “For the time being, it does not look good.”

New Spring? Any debate over joining the EU would occur after the election scheduled for April 25 and after a constitutional court convenes later this year to discuss reforms and possible referenda questions, Hannesson said. “I underline this is an interim government,” stressed the veteran diplomat, who has served as ambassador to Canada, China, the Holy See and Germany.

Like many of his fellow countrymen, Hannesson remains optimistic about Iceland’s ability to climb out of this hole and adjust to its new economic role. Iceland’s clean energy, marine resources, strong infrastructure and well-educated workforce provide a solid basis to overcome the current economic difficulties and implement needed reforms, he said. “The basics remain strong.”

From Washington, this father of three also sees an opportunity to work with the Obama administration on developing clean energy plans that benefit both countries. “There are great possibilities of greater geothermal use in this country, where Iceland know-how could speed up that process,” Hannesson said. “We know this can’t be a one-way street.”

That bilateral philosophy, the ambassador suggested, will be a major part of the overarching goal of helping Iceland regain its national pride and international stature. “The Foreign Service of Iceland needs to be especially energetic in re-establishing the fine image of Iceland,” he said. “Diplomat work has never been as important as now.”

About the Author

Seth McLaughlin is a contributing writer for The Washington Diplomat.