As Iceland Goes…

, Allie Winegar Duzett, Leave a comment

“The Icelandic Meltdown,” by Philipp Bagus and David Howden, published in the August 2009 edition of The Free Market newsletter, takes an in-depth look at Iceland’s current financial crisis. The thesis: that contrary to popular belief, the free market was not the cause of the financial meltdown—indeed, the free market may be the key to resurrecting Iceland’s economy. Is it possible that by looking at what went wrong there, we could get an idea of how larger country’s economies collapsed, such as America’s?

Bagus and Howden begin by examining the claims of the opposition. They note that multiple writers and government officials have blamed the current crisis on “an unregulated environment,” and “free market reforms” that took place from 1991 to 2004. These reforms, critics Poul Thomsen and Peter Gumbel say, caused the development of an “oversized” banking system.

The authors, however, are quick to interject that the reason for the rapid banking growth was not the free market, but government intervention in the form of government guarantees and “artificially low interest rates” through the Housing Financing Fund (HFF). This artificial security, according to Bagus and Howden, allowed “liquidity to be flushed through the economy.”

The authors go on to explain how all countries that are currently struggling with financial crises like Iceland’s have one thing in common: banking systems that “issued short-term liabilities in order to invest in long-term assets,” or “maturity mismatching.” This kind of system requires the constant rolling over of short-term liabilities, which in turn requires a constant flow of borrowers. And when the borrowers stopped, the problems started. The writers ask why Iceland would do something so risky. Well, Bagus and Howden admit, the strategy Icelandic bankers employed can be extremely profitable.

Still, maturity mismatching leads to many problems, as they discuss. There are moral problems: when the mismatching fails, someone has to come to the rescue with the bailout—but whom? And there are financial problems: too many mismatched-maturity loans “[lead] to distortions in the real economy.” Maturity mismatching “deceives both investors and entrepreneurs about the availability of real long-term savings,” Bagus and Howden write.

Bagus and Howden do not blame all of Iceland’s financial crisis on maturity mismatching, however; they also note that Iceland’s banking system relies heavily on funding in foreign currencies, including Japanese yen which were attainable with very little interest. This foreign borrowing coupled with the fact that Iceland’s mortgage assistance programs had no system of “[discriminating] between those who should receive assistance and those who should not.” These two factors, Bagus and Howden explain, made it nearly impossible for Iceland’s private banks to compete with those run by the state. In order to compete at all, the private banks “reduced the quality of the collateral posted on their mortgages.”

Bagus and Howden draw a connection between the collapse of Lehman Brothers and the Icelandic collapse, stating that once Lehman Brothers had bankrupted, Iceland found itself “in a squeeze to roll over the necessary funds to maintain liquidity.” When that happened, the Icelandic currency drastically lost value.

As Bagus and Howden write, “In the end, a banking system once thought to be ‘too big to fail’ [turned out to be] ‘too big to bail.’” According to these writers, the problem never was the free market.

Allie Winegar Duzett is an intern at the American Journalism Center, a training program run by Accuracy in Media and Accuracy in Academia.