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This article was published 6/8/2010 (3821 days ago), so information in it may no longer be current.
WHAT happened to Iceland’s economy?
The shortest of explanations for the crash is that when Iceland privatized its banking system in 2002, its regulators weren't prepared for the creative ways the new bankers would devise to move capital around.
The longer explanation centres on inflation. Iceland has always been beset with inflation problems due to its small economy. In the 1980s, it even dropped a couple of zeroes from its currency just to bring the krona back down to earth.
So to hold down inflation, Iceland's central bank automatically raises interest rates when inflation goes up.
But higher interest rates attracted foreign investment into Iceland's banks. And the deregulated Iceland's banks became investment banks and started investing abroad -- madly.
They made highly leveraged acquisitions of foreign banks and companies such as a beer bottling firm in Russia, a telephone company in Bulgaria, the frozen food chain called Iceland in England, and England's Hamleys Toy Store, the biggest toy chain in the world. Their buying spree earned them the moniker "corporate Vikings."
The party was interrupted briefly in 2006 when bond raters, such as Moody's, criticized Iceland's three banks -- Glitnir, Kaupthing Bank, and Landsbanki -- for being so heavily financed by foreign capital, and not more from deposits by ordinary people.
Of course, Iceland doesn't have a large population. So the banks opened online deposit accounts in Great Britain and Holland, the most notorious being IceSave run by Landsbanki that guaranteed returns of five per cent per year.
British and Dutch people could transfer their savings into IceSave by themselves online. With that kind of interest rate and assurances that deposits were fully guaranteed, almost 300,000 people in Britain transferred savings worth more than C$10 billion into Icelandic accounts. People in Holland invested at levels almost as great.
(Recently, the Icelandic government hammered out a deal that will pay those countries about 20 per cent of the losses, out of bank foreign assets. In Britain, the government protected the mom-and-pop accounts up to about C$35,000 but not depositors such as organizations or local councils.)
How did the Icelandic online banks pay five per cent returns? From good investments, presumably. And if you believe that....
An independent commission said there was an inordinate amount of trading back and forth between the banks and a handful of individuals. John Lanchester, author of the book I.O.U. states it more bluntly: "A small group of rich and powerful people sold assets back and forth to one another and created a grotesque bubble of phoney wealth."
All the outside money pouring into Iceland caused its economy to overheat. So the central bank intervened with additional interest rate hikes to cool the economy.
And higher interest rates attracted more outside capital, including currency speculators.
"The whole economy became flooded with foreign capital," said Tomas Brynjolfsson, an employee with Landsbanki when it collapsed, who now works in Iceland's finance department.
The foreign capital caused Iceland's currency, the krona, to become overly strong. Because Iceland imports so many goods, the very strong krona made it cheaper to buy virtually everything.
"People felt much richer than they were," said Brynjolfsson.
Everyone was traveling and buying new cars. There was a scheme for that, too. People bought cars with loans indexed to currencies of countries with low interest rates, such as Japan and Switzerland. The interest rates were just three per cent. The indexed foreign currency loans were also used on some home mortgages.
At the time of the crash, more than 40,000 Icelanders had loans indexed to foreign currency. The size of their foreign loans averaged about C$50,000 each.