Iceland is known for its (free) geothermal energy. Even this gift of nature was unable to save the country form the decennia of mismanagement by the Authorities and Banks.

Stunned Icelanders Struggle After Economy’s Fall

For the USA and the EU, this small island has become a example which is a lot closer than Zimbabwe.

The key factor in Iceland's failure has been the monetary policy pursued by its Central Bank, in particular inflation targeting, similar to the UK, Hungary, the EU and the USA.

The Financial times, November 13, 2009: Eva Joly, a 65-year-old Norwegian-born French lawyer, has none of the swagger that attended the deals made in Iceland’s heyday. Yet it is precisely because of high finance that Joly is in Reykjavik. As one of only a handful of investigators with any record of bringing corporate criminals to justice, she has been asked by the Icelandic authorities to help establish what role white-collar crime might have played in the island’s boom and bust...

Just as the Elf case revealed a rot at the heart of the French political system, Joly believes her latest project will illuminate the darkest recesses of global finance. In the years before the crash, Iceland transformed itself into an international financial centre. The inquiry is focused on whether market manipulation was involved in pumping up Icelandic banks’ balance sheets until they reached 10 times the size of the country’s gross domestic product, while the clique who ran them doled out cheap credit to some of their biggest shareholders and to favoured foreign clients. Although the main suspects are believed to be Icelandic, Joly makes clear that ultimate responsibility lies as much with the culture of greed imported from Wall Street and the City of London....click here for the article

Iceland is the live proof that it is impossible to control Inflation by raising and lowering interest rates. This method simply doesn't work. Monetary Inflation and the resulting price inflation are the direct result of the Money supply. Interest rates have absolutely no impact on the resulting price inflation. They rather are a consequence of the level of monetary inflation.

Central Banks targeting inflation by raising interest rates if inflation is above the target, and lowering them if inflation is below target are either run by idiots or crooks.

Interest rates are a consequence of and not the origin of a monetary policy. Interaction by the authorities will sooner or later always lead to accidents.

In Iceland, interest rates exceeded at times 15%. In a small economy like Iceland high interest rates both encourage domestic firms and households to borrow in foreign currency, and also attracted currency speculators. However, other factors (deleveraging and repatriation of funds like we have in the USA) can result in exactly the same situation.

This leads to large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth.

The end result was an exchange rate which was increasingly out of touch with economic fundamentals. As a result, in the end a rapid depreciation of the currency became inevitable.

The Icelandic banks had foreign assets worth around 10 times the Icelandic GDP, with debts to match. Similar and worse conditions exist(ed) in the EU and the USA. (CDO Subprime). As long as the economy was expanding, there was no problem as the leverage worked in favor of the Banks. However, because of Fractional Reserve Banking, Fiat Money, the Credit Crunch and the resulting deleveraging of the balance sheets of the Banks, the mechanism started to work in a negative way: as a result the Icelandic banks became insolvent!

The relative size of the Icelandic banking system and the monstrous leverage made it for the government impossible to guarantee the banks.

This effect was further escalated and the collapse brought forward by the failure of the central bank to extend its foreign currency reserves. (The day comes, the Federal Reserve will be confronted by a similar situation)

The final collapse was brought on by the bankruptcy of the entire Icelandic banking system.

As a result we see the same symptoms Zimbabwe has:

At the moment, the Icelandic economy has come to a standstill,

Imports of goods have become impossible: shelves are empty, the car sales have halted.

The Icelandic currency keeps on falling due to the currency speculators running for shelter.

Icelandic households see there payments on loans increased by up to 50%.

Inflation may reach 30% or more (60%) this year (hyperinflation)

Wages are frozen.
We have mass layoffs.

In the USA we have a similar situation as Iceland had before the crisis started. The Dollar which has been rising because of the Credit Crunch and deleveraging is resulting in exactly the same situation as Iceland was in before it all started to happen. The total size of the Derivatives (800% of World GNP) and the trillions of freshly created money will result into a similar situation. Ironically, interest rates in the USA are historically LOW and this will over time prove it is impossible to control Monetary Inflation and the resulting price inflation by adjusting the Interest Rates.

Iceland’s circumstances were extreme, but there are other countries suffering from milder versions of the same fundamental inconsistent – or at least vulnerable - quartet:
(1) A small country with (2) a large, internationally exposed banking sector, (3) its own currency and (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap.

Countries that come to mind are:

Switzerland,
Denmark,
Sweden
the UK, although it is significantly larger than the others and has a minor-league legacy reserve currency.

Iceland: downfall of 'a foolish little nation' Neil Tweedie - 06 Feb 2009

The shockwaves from the country's economic implosion are being felt in Britain, but the effects are far worse at home.

Iceland's humiliation begins at Heathrow. Try buying the currency, the krona, at Travelex and you will discover it is no longer held. "And whatever you do," says the woman at the counter, "don't bring any back." The words "failed state" bring to mind ungovernable Third World hell-holes, but Iceland is a new kind of failed state, a financially failed one. Without cash from the International Monetary Fund it would be as near to bankrupt as a country can be.

The latest aftershock was felt in Britain this week when the holding company Baugur, with stakes in a string of British high street chains, went into administration. The group, which has major shareholdings in House of Fraser, Iceland, Hamleys, and Mappin & Webb, collapsed with debts of more than £1 billion. The future of 3,500 stores and some 50,000 jobs is in doubt.

However, the turmoil engulfing Iceland's economy is far from evident on arriving at Keflavik airport, 40 minutes' drive from the capital, Reykjavik. The air is clean, the roads good and the houses that dot the stark volcanic landscape well maintained. The cars are big, too: four-wheel drives and high-end marques. But then the stories begin. The taxi driver on the Keflavik run was in his sixties, respectable, softly-spoken and, to all intents and purposes, bankrupt.

"I keep on working and pay what I can. The bank knows I can't do more. There is no point in shutting me down."

His tale is similar to thousands of others. He had needed a new car and went to his bank for a loan – Icelanders, for so long a frugal people dependent on fish and agriculture, have become as addicted to debt as the British. His lender suggested using a "currency basket", made up of different strong currencies, to buy a secondhand Cadillac from America because the krona was weak. The little currency had suffered from volatility in the past but no one predicted what came next. In October, the banking system imploded under the weight of an enormous mountain of debt. The three big banks had boasted assets many times the size of the country's GDP, but their liabilities were of a similar order. When the government nationalized the banks, it was left with liabilities in excess of $60 billion (£40 billion), more than three times GDP. The krona nose-dived and borrowers like the taxi driver woke up one cloudy morning to discover that, in krona terms, their loans had doubled in size. With the krona effectively dead, the country has been forced to seek the shelter of a bigger currency – probably the euro.

There were other shocks in store. Inflation soared as import prices rose, hitting the many mortgages in Iceland that are index-linked. Repayments went through the roof and the overheated housing market collapsed. Unemployment soared towards 10 per cent. The construction industry seized up. Now, lifeless cranes dominate the skyline of Reykjavik, monuments to hubris.

The banks had done something else besides lending money they did not have. Thousands of Icelanders had been persuaded to swap bank deposits for what were effectively stakes in the banks themselves. For them, the banking collapse threatened personal ruin. "Many people who live in beautiful houses and drive beautiful cars are completely broke," says political commentator Egill Helgason. "None of it can be sold, they have lost their jobs. People look wealthy, but worry about the next meal."

Iceland's fall from grace has been swift. In 2005, it was ranked in the top 10 in the world in terms of GDP per head, and between 1996 and 2006 its economy grew by 50 per cent. It has routinely figured near the top of the human development index, which combines economic and social measures. Now, interest rates are 18 per cent and inflation 20 per cent; and each man, woman and child could owe as much as $250,000 to foreign creditors.

Tear gas had been used in Iceland only twice before last month – in 1949, during protests against Iceland's membership of Nato, and in 1959, when a dance in a remote fishing town in the north turned into a riot.

Icelanders are not given to public demonstrations, but last month a mob pelted eggs at the car of the prime minister, Geir Haarde. Out came the tear gas and out went Haarde's Right-leaning coalition government. The Left-wing coalition now serving as a caretaker government, until elections in April, is headed by 66-year-old Johanna Sigurdardottir.

Respected rather than loved, she is a traditional Left-winger. Except for a few traditionalists in the backwoods, no one cares that she is a lesbian, having swapped the father of her children for her current partner. What matters is that she harks back to another world, before the rise of Iceland's mini-oligarchs, the group of 30 or so men and women who, from the mid-Nineties, took an isolated, conservative society and transformed it into a freewheeling outpost of capitalism. Some are well known in Britain. Jón Ásgeir Jóhannesson, 41, typified the new elite, the so-called Viking Conquerors. He set up a supermarket chain which blossomed into Baugur. As his wealth grew, so did his ambition. He acquired a yacht, a house with a bullet-proof panic room and a beautiful wife, Ingibjörg Pálmadóttir. Her customised Mercedes is known in Reykjavik as the "white pearl". A conviction for false accounting did him little harm, but the banking collapse did.

The other big Icelandic name in Britain is Björgólfur Gudmundsson, who snapped up West Ham United. His son Thor was the original Icelandic success story, making millions from a brewing venture in post-Soviet Russia.

The "Vikings" thrived because of the intimacy of society. The political and financial worlds in Reykjavik are intertwined – it is said in Iceland that by the age of 50 you will have met half of the 320,000-strong population. When the three main banks were privatized in 2002, the business elite assumed control, turning them from sober institutions into aggressive vehicles for venture capitalism. The banks were used to financing foreign acquisitions and the domestic companies of their main shareholders. Iceland's financial supervisory system was primitive and the media silent – most of it having been bought up by the Vikings. No one asked where the money was coming from. The seemingly unlimited amounts of cash led to suggestions that they were drawing on "funny money" from Russia. The allegations, so far, have not been substantiated.

'The madness started with privatization of the banks in 2002 and their transfer to the cronies of the political parties," says Helgason. "The true worth of the banks and the companies they were feeding with loans became obscured. Anything and everything was used to boost balance sheets.

"There is a market for cod fishing quotas," adds Helgason. "A kilo of cod was sold for 4,000 krona in this market. If you went to a shop you could buy it for 1,200 krona. So the cod swimming in the sea was worth more than cod that had been caught – madness."

The madness threatened dire consequences for British savers when Landsbanki, one of the three big banks, set up the internet operation Icesave, offering very competitive interest rates to European savers, including many individuals, councils and charities. When it collapsed, Gordon Brown used anti-terror legislation to freeze the UK assets of Landsbanki and another Icelandic bank, Kaupthing.

For Icelanders, the classifying of their banks with organisations suspected of funding al-Qaeda was an insult too far.

Iceland's foreign minister Ossur Skarphedinsson is still shocked by Brown's actions. "Iceland has always looked on Britain as a helping hand, except during the cod wars. In your darkest hour in the Second World War, we offered you the use of our country. No one in Britain knows that Iceland lost proportionally the same number of people as America in the war. [Many lives were lost on Icelandic ships after its occupation by British and, later, American troops.] To suffer the humiliation of having a friendly country stigmatising you as terrorists was terrible. It was a disgusting thing to do."

A special prosecutor has been appointed to investigate the banking collapse. One of his jobs will be to discover the fate of assets thought to have been transferred to off-shore accounts by some businessmen shortly before the crisis. Rumours abound in the still chic bars of Reykjavik's small centre about billions salted away overseas.

Icelanders are a stoic lot, though, and the feeling in the hot pools where people congregate, is that the nation will, as always, pull through – helped by cheap geothermal energy, healthy fish stocks and a beautiful, if forbidding, landscape, attractive to tourists.

However, the days of hubris, of the Icelandic David taking on the Goliath of international finance, are over. "People don't want blood, but they want the truth," says Helgason. "In the end, we were a foolish little nation who thought we had found some new way of making money. We hadn't."

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