Who bombed Iceland?

November 3, 2008 from the Daily Princetonian

Last year I made huge waves in Iceland by suggesting in a column for the Daily Princetonian, purely in jest, that the United States bomb Iceland instead of Iran because it would be so much more convenient. I wrote the piece to satirize the American penchant for viewing the bombing of other nations as a substitute for frustration on the diplomatic front.

The column triggered a storm of protest from Iceland, whose inhabitants apparently read the piece long before most Princeton students got around to it. Many readers in Iceland apparently took the column seriously. Fortunately, in a flood of e-mails following the earlier flood of irate ones, all was forgiven after I had explained, in Iceland’s major daily newspaper and on Iceland’s national radio, that I was only jesting.

Alas, in the intervening months Iceland has been bombed, not by the United States, nor by a nutty professor from Princeton, but by Iceland’s own bankers. They have done to that country what 1,000 American bombers most likely could not have done: They drove Iceland’s economy to the brink of bankruptcy.

Iceland’s problem, like that of the rest of the world, is rooted in the unquestioned belief in the free market doctrine that swept the world during the past two decades, especially after the fall of the Soviet Union. According to the axioms underlying that credo – and a pure credo it is – free markets are self-regulating, because they are dominated by rational decision makers who are well informed and smart. In such a world, rational bank executives are unlikely to finance the acquisition of risky assets with debt, unless they have a large enough equity cushion to absorb even substantial declines in the value of the assets they bought. And on that credo, Iceland’s liberal government thought it was safe to let the island’s bankers loose in a global market of debt and asset financing.

Though Iceland’s economy basically relies on a few staples, its bankers discovered during the ’90s that the island of some 300,000 inhabitants could be converted into the analogue of a highly leveraged hedge fund. Such funds scour the earth for low-cost credit – usually available in Asia – and then scour the world for investments with higher yields. They live on the spread between the higher returns on their assets and the lower interest rates they pay on debt. In the jargon of finance, this was called the “carry trade.” Eventually, Iceland’s bankers pushed the carry trade to a point where the amount of money they owed mainly to foreign lenders and depositors amounted to almost 10 times Iceland’s gross domestic product (GDP). And unlike the legendary prudent banker, they had only skimpy equity cushions to absorb any decline in the value of the assets they bought.

It appears that, unlike their colleagues on Wall Street, Iceland’s bankers did not invest heavily in the dodgy mortgage-backed securities based on subprime mortgages, which have brought down so many banks in the United States. Instead, they were heavily involved in financing entrepreneurs in Europe and elsewhere. But caught in the global credit squeeze, they found it impossible to roll over their huge short-term debt, while the looming recession impairs the value of the loans made to enterprises.

Thus, one by one, Iceland’s banks had to be taken over by Iceland’s government, whose resources are plainly insufficient to guarantee the enormous debts Iceland’s bankers put on their books. As The New York Times reported, under European regulations, Iceland is obliged to pay 20,000 euros to each individual foreign depositor in Icelandic banks. In toto, however, that guarantee alone amounts to 60 percent of Iceland’s GDP.

Students interested in economics and finance should closely follow this new Iceland saga, for it is the most dramatic story yet to illustrate how reckless bankers let loose in a free market can destroy entire economies. Professional economists should follow the saga, too, to extract from it lessons for rewriting their stale textbooks, whose content has hardly changed at all in more than half a century. It is, after all, remarkable how – with the exception of Princeton’s Paul Krugman and a handful of other economists – the bulk of the economics profession slept right through to the middle of the current financial crisis. As Yale economist Robert Shiller observes in “Challenging the Crowd,” “a taxi driver seemed to sense what economists didn’t.”  Even former Federal Reserve Chairman Alan Greenspan, a faithful Ayn Rand disciple and truly a true believer in the self-healing powers of free markets, ruefully admitted in congressional testimony last week that he had made an error in his belief that free markets are self-regulating. And a costly error it was.

Uwe E. Reinhardt is the James Madison Professor of Political Economy and a professor in the Wilson School. He can be reached at reinhardt@princeton.edu.

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