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When Iceland Totally Froze

Tags Booms and BustsGlobal EconomyOther Schools of Thought

04/06/2011David Howden

[Excerpted from chapter 1 of Deep Freeze (2011).]

Following the bankruptcy of the American investment bank Lehman Brothers in late 2008, credit markets all over the world seized up in a striking manifestation of the interconnectivity of the global economy. When the dust had settled, the crisis had wiped out trillions of dollars of investments, and the previously well-functioning credit markets had stalled. The most spectacular bankruptcy of the 2008 financial crisis was the collapse of Iceland's financial system. This collapse is especially intriguing as Iceland is not an underdeveloped country (it ranked third in the United Nations' 2009 Human Development Index).

During the several years leading up to the collapse, Iceland experienced an economic boom. The Icelandic financial system expanded considerably; a nation with a population only slightly larger than Pittsburgh, Pennsylvania and a physical size smaller than the American state of Kentucky erected a banking system whose total assets were ten times the size of the country's GDP. The prices of housing and stocks soared, and consequently so did Iceland's wealth.

The traditional fishing-based economy was altered dramatically. Financial engineering became the preferred career path of ambitious youth, instead of the traditional natural-resource management. Young men on the streets of Reykjavík were as likely to know the Black-Scholes formula as the yields from the day's salmon catch. People from all walks of life wanted to work in the banking industry. A general practitioner cited his experience in "communicating" with people daily as his key asset.[1] Young children, when asked what they wanted to grow up to be, innocently and unhesitatingly answered, "bankers."

The banking sector became so large that it was having trouble finding enough talented and, more importantly, experienced workers in such a tiny country. The best employees of more traditional Icelandic businesses were headhunted away to work in the growing financial sector.

Then, in the autumn of 2008, the dream of unlimited wealth ended suddenly with the bankruptcy of the Icelandic state. The exchange rate of the Icelandic króna collapsed, the three big Icelandic banks, Landsbanki, Kaupthing and Glitnir, were nationalized, the unemployment rate soared, and the rate of price inflation reached 18 percent by the end of 2008. In a few short months, Icelanders lost not only the wealth they had accumulated during the short-lived boom, but also a good portion of the savings they had worked diligently for many years to amass.

The stock market fell by 90 percent. Statistics Iceland reports that Reykjavík housing prices fell by over 9 percent during 2009.[2] What savings remained had changed in location and kind. Instead of depositing their money in banks, Icelanders preferred to hold foreign currency; they rid themselves of krónur at any chance they got. They started to hoard groceries and supplies.

With their government bankrupt, Icelanders might well have experienced physical hunger had it not been for foreign help. Foreign loans to secure essential food imports came primarily from sympathetic Scandinavian countries with close historical ties to Iceland. The government instituted exchange rate regulations and controls to limit the use of foreign exchange for purchasing newly precious imports such as food, drugs, and oil.

What made such a boom and bust possible? Common superficial analyses of Iceland's economic crisis have mirrored the analyses offered for the worldwide crisis. Analysts and journalists alike have blamed the worldwide crisis on the usual suspects: greedy bankers, inexperienced upstarts, a corrupt political elite, the deregulation of the financial system, or, more generally, the evils of capitalism. Likewise, some commentators and economists[3] have blamed Iceland's crisis on financial deregulation during the preceding decade. Gumbel contends that the free-market program of Davíð Oddsson, the prime minister from 1991 to 2004 and a self-proclaimed fan of Milton Friedman, caused the debacle.

"Recovery is not impossible, though it will require hardship and perseverance."

The problem with this explanation is that Iceland could not, by any stretch of language, be called a free market.[4] In 2007, before the crisis erupted, Icelandic taxes and contributions to social security were the ninth highest among nations in the OECD (41.1 percent of GDP).

Iceland's particular crisis, and the world's in general, was caused by the manipulations of central banks and intergovernmental organizations. Thus, in the final analysis, it was the actions of governments that brought about Iceland's financial collapse. While some point to the supposed independence of central banks from their nations' governments, few could argue that the Central Bank of Iceland, with two of its three governors direct political appointees, could be anything other than a cog in the political machine.[5] In short, the causes of Iceland's financial collapse are the same causes that explain the worldwide financial crisis of 2008. The main difference in Iceland's case is their magnitude. In Iceland, the economic distortions were extreme, making the country's financial structure particularly prone to collapse. Moreover, the Icelandic case contains a special ingredient that made an exceedingly rare event for a developed nation, sovereign bankruptcy, possible in the first place.

During the boom, Iceland's fiscal framework was ineffective at curtailing government expenditures.[6] Local and national governments routinely surpassed their budgets. Budget overruns became the norm in Iceland's parliament, the Althing, with few severe repercussions. This fiscal imbalance became a mainstay of the Icelandic public sector.

In the ten years leading up to Iceland's financial collapse, there were fantastic liberalizations in the world economy as globalization swept the planet. Benefits of these changes were widespread, with few people unaffected. However, the liberalizations were accompanied by several salient interventions that compounded their effects.

Immediately following Iceland's financial collapse in late 2008, the International Monetary Fund's Icelandic mission chief, Poul Thomsen, was asked, "What went wrong in Iceland?" He reckoned that the root cause was that a very oversized banking system was allowed to develop.[7] Thomsen went on to note that, after Icelandic government completed the privatization of the banking sector in 2003, banks increased their assets from 100 percent of Icelandic GDP to over 1,000 percent. Though he blamed the current situation on this perceived unsustainable situation, Thomsen did not raise the question of why the banks could expand so rapidly.

The real reasons for Iceland's collapse lie in state institutions and in the intrusions by the state into the workings of the economy, coupled with the interventionist institutions of the national and international monetary systems. Iceland's crisis is the result of two banking practices that, in combination, proved to be explosive: excessive maturity mismatching and currency mismatching. While these two activities, especially maturity mismatching, are ubiquitous in modern finance, they were carried to more extreme lengths in Iceland than in other countries, making the Icelandic financial system especially fragile.

Corporate debt levels exceeded 300 percent of GDP in Iceland in 2007, more than four times the level in the United States (see Table 1). The Icelandic banking sector financed roughly two-thirds of this debt, and 70 percent of it was denominated in foreign currency. Over 60 percent of Iceland's external indebtedness was of short-term durations, and 98 percent of this was on account of the banking sector. While this foreign-denominated debt was mostly used to finance foreign investments, Icelandic companies with no foreign operations owed a large and growing share of this debt.[8]

Table 1: Corporate Debt (percentage of GDP)



Euro area[9]


UK [10]




Source: Caruanna and Chopra (2008)

The system was further weakened by the existence of an institution that serves to bail out sovereign nations on an international level, the International Monetary Fund (IMF). The implicit assurance of support by the Fund reduced the risk premium and volatility of exchange rates, and this, in turn, induced people around the world to increase funding in foreign currency. The króna enjoyed the dubious benefit of being one of the more stabilized currencies that investors turned to. Consequently, the Icelandic banks shifted from denominating their debts in krónur to undertaking foreign liabilities sponsored by the international credit expansion.

The consequences of this dual arbitrage of maturities and foreign currency risk would prove to be lethal. Malinvestment and an accompanying shift of resources into the financial sector set the stage for a collapse. An increased amount of foreign-denominated financing bred malinvestments that the monetary authority could not unwind. The international liquidity squeeze of the fall of 2008 burst the financial bubble. The Central Bank of Iceland and the government tried to act as lenders of last resort, and they failed. The economy collapsed.

Despite the hardships of the past two years, there are green shoots that could grow and flourish. Recovery is not impossible, though it will require hardship and perseverance. At the end of this book, we outline a route to recovery.


[1] Armann Thorvaldsson, Frozen Assets: How I Lived Iceland's Boom and Bust (Chichester, U.K.: John Wiley and Sons, 2009), p. 147.

[2] Statistics Iceland.

[3] Peter Gumbel, "Iceland: The Country That Became a Hedge Fund," CNN Money (December 4, 2008); and Paul Krugman, "The Icelandic Post-Crisis Miracle," The New York Times (June 30, 2010).

[4] Philipp Bagus and David Howden, "Iceland's Banking Crisis: The Meltdown of an Interventionist Financial system," Ludwig von Mises Institute, Daily Article (June 9, 2009).

[5] Roger Boyes, Meltdown Iceland: Lessons on the World Financial Crisis from a Small Bankrupt Island (New York, Berlin, London: Bloomsbury USA: 2009), p. 114.

[6] Robert Tchaidze, Anthony Annett, and Li Lian Ong, "Iceland: Selected Issues," IMF Country Report no. 07/296. (2007), p. 15.Download PDF

[7] Camilla Andersen, "Iceland Gets Help to Recover from Historic Crisis," IMF Survey Magazine 37, no. 12 (December 2, 2008).

[8] Jaime Caruanna and Ajai Chopra, "Iceland: Financial System Stability Assessment-Update," IMF country Report no. 03/368 (2008), pp. 9–10.Download PDF

[9] Data is for 2005.

[10] Financial liabilities.


Contact David Howden

Dr. David Howden is Chair of the Department of Business and Economics, and professor of economics, at Saint Louis University at its Madrid campus. A Fellow of the Mises Institute, he is the author of over 50 scholarly articles and books. His research focuses on the business cycle and fractional-reserve banking.