Iceland Crisis and Causes Led to the Crisis

Topics: Bank, Iceland, Investment Pages: 5 (1484 words) Published: November 20, 2012
Iceland and the rest of the world reeling. In retrospect Iceland was essentially operatinglike a firm with a highly unviable growth model. However, the political relationship between Iceland and Britain also greatly added to the economic downturn and financialcrisis. Britain’s use of anti-terrorism laws, in an attempt to protect their economicinvestments in Iceland, essentially labeled Iceland as a terrorist state which onlycontinued to stagnate the inflow of foreign capital. Although without a doubt the primarycause of the Icelandic financial crisis was economic, political factors such as therelationship and interdependence between Iceland and Britain exacerbated the alreadydire situation.Iceland began as an isolated, fairly impoverished country whose survival was based largely on its fishing trade. 1

However, in recent years Iceland had been successfulat establishing itself as a premier offshore banking hub. At one point Icelanders wereecstatic and celebrated the fact that their tiny country of about 300,000 people had 3 banks in the worlds largest 300 banks. 2

The Icelandic government was able to enticeforeign investors by setting interest rates very high, which encouraged foreigners toinvest largely in financial assets. The large inflow of foreign capital associated with suchmass foreign investment caused the krona to greatly appreciate. Since the krona wasgreatly overvalued it made all imports in both goods and services very inexpensive for Icelanders; the overvalued krona also made it a lot easier for Icelanders to borrow moneyfrom abroad. 3

The high interest rates, gargantuan capital inflow, and an appreciatedcurrency all aided in creating the economic boom that Iceland enjoyed for many years  
This economic boom encouraged Icelanders to borrow from abroad and many failed toforesee that such economic prosperity was limited and that a bust is inevitably going tofollow a boom.The lack of government oversight on the banking system also was an economicfactor that led to the financial crisis. One large problem with the Icelandic banking sector is that the banks became so large that the Icelandic government was unable to operate asa lender-of-last-resort simply because Iceland with its mere 300,000 people has a verysmall tax base. 4

At the end of 2006 the total assets of its banks grew to be nine times aslarge as the countries GDP. 5
It would have been less of a problem for the banks to be solarge if they had not remained domiciled in Iceland. It was perhaps too large and ideal of a goal for such a small country like Iceland to become an international financial center.Iceland was essentially acting like a firm when indeed they should have been lookingafter the economic stability of their whole country. The Icelandic government simplylacked the ability to financially sustain their banks in times of economic crisis. If some of the banks in Iceland had foreign lenders-of-last-resort they might have been able toweather out the economic storm.Iceland’s economic growth model was mainly built upon foreigninvestors being able and willing to keep on giving. However, due to the global economiccrisis foreign capital ceased coming in and when it did the myriad of public and privatedebt became quite evident.  

Some analysts argue that problems with the krona have prevented Iceland from being able to control the financial crisis. Since Iceland does not have an effectual currency to manipulate they are largely unable to support the banks andhave no practical ways to bring down the inflation and interest rates, which have beenstaying in the double digits. 7

This is just one of the many economic situations currentlyaffecting Iceland.Without a doubt the prime cause for Iceland’s financial crisis is largely theeconomic circumstances previously discussed. However, political factors such asIceland’s relationship with Britain also played a role in exacerbating the crisis and preventing Iceland from any chance it might have had of...
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