Iceland

Settled by Norwegian and Celtic (Scottish and Irish) immigrants during the late 9th and 10th centuries A.D., Iceland boasts the world's oldest functioning legislative assembly, the Althing, established in 930. Independent for over 300 years, Iceland was subsequently ruled by Norway and Denmark. Fallout from the Askja volcano of 1875 devastated the Icelandic economy and caused widespread famine. Over the next quarter century, 20% of the island's population emigrated, mostly to Canada and the US. Limited home rule from Denmark was granted in 1874 and complete independence attained in 1944. The second half of the 20th century saw substantial economic growth driven primarily by the fishing industry. The economy diversified greatly after the country joined the European Economic Area in 1994, but Iceland was especially hard hit by the global financial crisis in the years following 2008. Literacy, longevity, and social cohesion are first rate by world standards.

Medieval Iceland and Anarchy
The Icelandic Commonwealth is often used as an example for anarchy. The settlement began, according to the Icelandic sources, about 870 A.D. Escaping the rule of king Harald Fairhair of Norway, the new settlers decided they could do very well without a king. They had chieftains, but one could choose a chieftain and could freely change allegiance. The government had one part-time employee (the Lawspeaker) and no executive branch.

Criminals were forced to pay fines. These fines did not go to the state, but were restitution. If the criminal could not pay the fine imposed on him, then he could go to his chieftain or a group of family and friends, or some other alliance, and have them pay the fine for him, or if no one would represent him, he could work the fine off via slavery. The poor were at no disadvantage. The poor could sell their right to justice to someone, such as a chieftain or another respected peer, who could collect or make right upon the victim. In this respect, the right to transfer restitution acted as an equalizer for the poor. If a criminal would not pay his fine or submit to slavery, he was either outlawed or would possibly lose the support of his peers, depending on the severity of the crime, eventually discrediting himself. Even in times of war, it was understood that every man that was killed had to be paid for. This kept feuds short, and both parties always had the incentive to compromise and make amends because sustained violence is costly in this type of institutional framework.

In the year 1000, Iceland was officially converted to Christianity, putting an end to a tradition of relative religious freedom. In the 990's, King Olaf I of Norway sent groups of militant Christian missionaries to proselytize through harassment and intimidation. Those who resisted the word of God were sometimes beaten or killed. Moreover, the King captured and held as hostages the relatives of prominent Icelanders visiting Norway; Olaf threatened to maim or kill these hostages unless Christianity was declared Iceland's official religion.

Iceland, a resource-poor country without an army, and for whom the powerful and wealthy Norway was an indispensable trading partner, had to take the King's threats seriously. But this catastrophe was averted in typical Icelandic fashion: the dispute was submitted to arbitration. It was decided in favor of the Christians, and so Christianity became the compulsory religion for all Icelanders.

In 1097 was a compulsory Christian tithe instituted. Those paying the tithe, however, had no choice about which church their money would go to; that was decided by the bishops. In other words, those who owned churches — generally Chieftains who had become Christian priests — got the money no matter what they did, and thus did not have to depend for their income on the good will of their clients. The fee, unlike the regular Chieftain fee, lacked the crucial element of accountability.

Over time, wealth and power began to be concentrated in the hands of a few families. Less competition meant that Chieftains could charge arbitrarily high prices for their services, often forcing their Assemblymen into the role of propertyless dependents. In the absence of the earlier competitive check on abuse of power, the chieftains grew so powerful during the Sturlung Period that they became able, for the first time in Iceland's history, to impose general taxation to directly support the governing elite, without the disguise of supporting Christianity. Contests over churches were more important than traditional contests over ordinary sorts of property; and disputes once settled through arbitration were settled on the battlefield.

Norwegian influence served to exacerbate the conflict. The shifting alliances and power plays further destabilized the Icelandic situation, as King Haakon of Norway eagerly encouraged conflict, dissension, mistrust, and confusion. Finally, in 1262, King Haakon graciously offered to come in and quell the conflict he had helped to create. A desperate Iceland, ravaged by civil war, accepted his offer, and submitted to Norwegian rule. The Icelandic Free Commonwealth, founded 332 years earlier by refugees from the tyranny of Norway's first monarch, fell at last under the yoke of a Norwegian King.

Long maintains, that the Free Commonwealth's downfall was not that it was too anarchistic, but rather that it was not anarchistic enough. The total number of Chieftaincies had been fixed by law, so new Chieftains were not able to arise and challenge the emerging ruling class. The number of churches was also limited.

According to Friedman, during more than fifty years of what the Icelanders themselves perceived as intolerably violent civil war, leading to the collapse of the traditional system, the average number of people killed or executed each year appears, on a per capita basis, to be roughly equal to the current rate of murder and nonnegligent manslaughter in the United States. The legal system worked sufficiently well to survive for over three hundred years.

Financial crisis
Icelandic banks, as many other banks, heavily engaged in the practice of maturity mismatching. They issued short-term liabilities in order to invest in long-term assets. The banking system had to continuously roll over (renew) their short-term liabilities until their long-term assets fully matured. If the banks failed to find new borrowers to continue rolling over their liabilities, they could face a liquidity crisis and spark the collapse of the Icelandic financial system; recent events have borne out this exact scenario.

Why did Icelandic banks engage in such a risky practice in the first place? Maturity mismatching can be a very profitable business, involving a basic interest arbitrage. Normally, long-term interest rates are higher than their corresponding short-term rates. A bank may then profit the difference — the spread between short- and long-term rates — through these transactions. This practice is also very risky as the short-term debts require continual reinvestment (i.e., a continual "rollover" must occur).

As in other countries, Icelandic banks enjoyed guarantees by the government to bail them out should their bets on the market turn erroneous. However, while this guarantee was merely implicit in most developed economies, the Central Bank of Iceland (CBI) committed to it explicitly. The CBI effectively functioned as the "roller-over of last resort," providing fresh short-term debt as the market required it. Indeed, the three main Icelandic banks — Kaupthing, Glitnir, and Landsbanki — were so big that they could regard themselves as too big to fail. This led to moral hazard problems.

In Iceland, the central bank itself is the provider of deposit insurance. In many other countries this role is not given to the monetary authority, but is rather undertaken by the fiscal authority. (In the United States, the Federal Deposit Insurance Corporation (FDIC) is a government corporation. In the eurozone, it is not the European Central Bank that provides deposit insurance but the national governments comprising the monetary union.)

The government is under a budget constraint (at least in theory) whereby if it needs to fund its insurance scheme it must do so from taxes or debt issuance. In contrast, the central bank has the ability to monetize its own insurance funds as the need arises. The second difference of Iceland's deposit insurance scheme is that it guarantees not only domestic Icelandic krónur deposits, but also those denominated in foreign currencies.

Besides problems with moral hazard, an even more important effect of excessive levels of maturity-mismatched loans is that it leads to distortions in the real economy by distorting the capital structure, as demonstrated by Austrian Business Cycle Theory. Maturity mismatching deceives both investors and entrepreneurs about the available amount of real long-term savings. Long-term interest rates are artificially reduced. Entrepreneurs think that more long-term savings are available than really exist and accordingly engage in malinvestments that must be liquidated, once it becomes obvious that there are not enough real savings to sustain them to completion.

In the Icelandic case, the malinvestments were made mainly in the aluminum and construction industries. Both aluminum mines and residential and commercial housing represent long-term investment projects that were financed by short-term funds and not by savings of an equal term. Another consequence was that resources were drawn into the financial sector, which expanded enormously. Fishermen became investment bankers to meet the insatiable demands of the newly profitable financial sector and Iceland became an exporter of financial services and an importer of goods. This distorted structure of production threatened to "starve" the population during the currency breakdown when Iceland had problems obtaining foreign exchange to pay for the imports the country had become so reliant on consuming.

From 2001 to 2008, there was a 2,300 percent increase in foreign liabilities that occurred over the seven-year period. Domestic liabilities, in contrast, also saw a significant 600 percent increase — the result of low nominal interest rates, which hovered near zero when factored for inflation. An extremely accommodating monetary policy — both domestically and internationally — made ample quantities of liquidity available to be borrowed and invested. In Iceland’s specific case, broad-based monetary aggregates such as M1, grew at a rate of 20–30 percent per annum every year between 2002 and 2007. As long as the liquidity remained high, Icelandic banks faced no problem continually obtaining new short-term funding. However, as the interbank lending markets dried up last year after the collapse of Lehman Brothers, Icelandic banks found themselves unable to cover the shortfall.

A decade of highly inflationary monetary policy had left the Icelandic economy awash with credit. Money flowed into the stock market, consumers’ goods, housing and, eventually, foreign investments. Secured by an explicit bailout guarantee from the Central Bank of Iceland, the domestic banking industry soon ballooned to 1,100 percent of 2008 GDP. Activity was centralized in a mere three banks, which together controlled 80 percent of total Icelandic banking assets. Secured by a stable krona exchange rate, banks, entrepreneurs, and individuals increasingly borrowed in foreign-denominated debts – primarily Swiss Franc and Japanese Yen. Eventually 80 percent of total consumer borrowing was concentrated in these two currencies.

Recovery
The Central Bank of Iceland lacked the ability to inflate in any currency other than the domestic króna; as a result, Iceland's banking sector — which was heavily indebted in foreign liabilities (primarily Japanese yen and Swiss francs) — succumbed to insolvency.

The central bank tried to be the lender of last resort, but it was left with few options. It lacked foreign-denominated assets with which to fund the struggling financial sector. In the end, the system required currency swaps and lines of credit by friendly nations to stave off a devastating financial collapse. As a result, the Central Bank of Iceland became the first central bank of a developed country in the twenty-first century to become insolvent.

By choosing the bankruptcy path rather than continued bailouts, the Icelandic economy fell into a deep immediate decline. Within months of Iceland’s "bankruptcy", its stock market had fallen more than 95 percent from its 2007 highs. The krona depreciated by 60 percent against the euro. While such drastic adjustments were devastating for the short-run, they were necessary to provide entrepreneurs with the essential signals to aid economic recalculation, and to promote coordination. The decline in the krona exchange rate provided domestic producers the necessary cost advantages to recommence becoming exporters to the world. At one point Iceland, a country with no domestic automotive production facilities became a net exporter of autos as the devalued krona made export of the surplus stock of vehicles profitable.

The combination of a general unease to lend to the Icelandic government and a devalued exchange rate made it increasingly difficult for the Icelandic government to continue running budget deficits. Austerity measures that other countries have discussed, but lack the commitment to enact came into place.

Real wages, started showing positive growth in Iceland in 2010. As inflation has stabilized in Iceland, the country is showing strong signs of recovery. A significantly devalued krona has allowed the country to return to competitiveness, with commensurate growth in its GDP.

Economical characteristics

 * Currency: Icelandic króna (ISO code: ISK)
 * Central bank discount rate: 11.5% (31 December 2009)
 * Commercial banks lending rate: NA% (31 December 2008)
 * Stock of money (M1): $4.83 billion (30 September 2009)
 * Quasi money (with M1 makes M2): $3.44 billion (31 December 2008)

Notable events:

 * Banking crisis: 1985-1986, 1993
 * Years in inflation: 25% (share of years 1918-2009 with annual inflation above 20 per cent per annum)
 * Public default: 2007-2010 (external)

Links

 * Central bank of Iceland
 * BBC country profile
 * Iceland aims to become an offshore haven for journalists and leakers by Jonathan Stray, February 2010
 * After banking bust, Iceland turns to free-market innovation by Ben Quinn, March 2010
 * Iceland's Banking Crisis: The Meltdown of an Interventionist Financial System by Philipp Bagus and David Howden, June 2009
 * Iceland’s Big Thaw by Lars Tunbjork, May 2011
 * A Bruised Iceland Heals Amid Europe’s Malaise by Sarah Lyall, July 2012