Monetary Reform: Part 1 – Iceland Eyes Master Reset Button

Series: Iceland monetary reform

After a near death experience of its banking industry during the 2008 global financial meltdown, Iceland looks hard at the root causes of the crisis and contemplates the reset button to its monetary system, a system which shares the same characteristics and ills with the ones used by all major economies.

A recent report commissioned by the prime minister of Iceland lays bare in laymans’ terms the root causes of the 2008 collapse of the country’s banking system, the same set of core problems which permeate the rest of the monetary and banking systems of the world.

The possible outcomes to the monetary end game and the subsequent reset range from tolerably painful to devastating hardship and chaos. Part 3 of this series examines one which sits on the hit-me-gently end of possible monetary reset scenarios championed by a most unexpected tiny island nation of Iceland.

Hit by the global banking crisis in 2008, Iceland took a drastically different path from the rest of the Western economies captured by banking interests. Six years later the country stands to show the world what success looks like by doing the right thing.

Six years after Iceland suffered a near death experience triggered by the 2008 US subprime mortgage crisis which saw its largest banks facing bankruptcy and subsequently put under state control and after which capital control was introduced which remains in place to this day, the island state, despite its tiny size both in real estate and economic terms, is looking into a new way to radically reform its monetary system, a way which might serve as a template for much larger world economies.

Named  “Monetary Reform – A better monetary system for Iceland” , a report commissioned by Prime Minister Sigmundur Davíð Gunnlaugsson and authored by Frosti Sigurjonsson, a lawmaker from the ruling Progress Party, and foreworded by Lord Adair Turner, former chairman of the UK Financial Services Authority and chair of the policy development committee of the international Financial Stability Board, clearly pinpoints the fundamental problems with our current monetary system and outlines a new proposal which will restrict the power of commercial banks and repatriate the responsibility of money creation back to the state.

If implemented, the effects of this reform would be far reaching and the resulting new construct will serve as a sharp contrast to and dramatic departure from the dominant (rather, only), and broken, monetary system designed by and for the financial industry, a system which mainstream economists, banking interests and regulators in the US, EU, Japan and pretty much the rest of the world, are, through sheer incompetence or self interest, have been unwilling to reform.

The Context

With a population of only 320,000, the relatively small economy of Iceland consists primarily of fish products, aluminum and to some extent tourism. Exports account for 57% of GDP.

The recent monetary history of Iceland has been a turbulent one. Currency control in the 1920s to the 1950s was followed by chronic inflation in the 1970s to the 1980s, with an annual inflation reaching 83% in 1983. The Icelandic Krona (ISK) had to be re-denominated 100:1 in 1981. Since the establishment of the Central Bank of Iceland in 1961 with a stated goal of price stability, the Krona lost 99.7% of its purchasing power in the ensuing five decades.

 Iceland annual inflation

Iceland annual inflation since 1962 (source: Statistics Iceland)

 

The adoption of its regulatory framework after becoming a member of the European Economic Area in 1994 provided a sudden liberalization of the Icelandic financial sector. Following the privatization of the country’s two largest banks, the banking sector and capital markets, which had been very small in relation to the country’s overall economy, began to expand their financial loan portfolios rapidly, and, in the process, expanded Iceland’s money supply by seven-fold between the spring of 2003 and fall of 2008, an average increase of around 40% per year.

The high interest rate set by the central bank to combat inflation also attracted many depositors from outside the country, notably the British and the Dutch, to put money into the oversea branches of the large Icelandic banks.

The assets of the large banks continued to expand unabated until the global financial crisis was triggered by the Lehman Brothers collapse in the wake of the US subprime mortgage crisis. By the time the crisis hit, the banks had managed to balloon their assets to roughly 10 times the size of the country’s GDP.

Which brings us to the Iceland banking crisis.

The Iceland Banking Crisis

Here’s a brief timetable of the banking crisis which swept the country in the fall of 2008.

  • September 2008 – In the wake of exploding sour loans and frozen money markets triggered by the Lehman Brothers’ bankruptcy, Glitnir Bank, Iceland’s third largest bank, went into severe shock and was subsequently taken over by the Iceland government.
  • October 2008 – as fear spread, bank-runs occurred and the banks started to collapse under massive deposit withdrawals. By the end of the month, all three largest banks were taken over by the government. With the tiny amount of deposit insurance quickly running out, the Iceland government had to issue an unlimited guarantee for all domestic (but not foreign) bank deposits.
  • October 2008 – some 340,000 British and Dutch savers who had deposited about $5 billion into Icesave’s (subsidiary of the failed Landsbankinn Bank) were caught holding the bag as the deposit insurance ran out. The British and Dutch government bailed out their own respective citizen depositors and demanded the Iceland government to foot the bill. When Iceland waivered, the UK government invoked anti-terrorism legislation to freeze Icelandic banks’ assets in the UK.
  • January 2010 – Against overwhelming public opinion, then prime minister Johanna Sigurdardottir negotiated a deal promising to repay more than $5.3bn to Britain and the Netherlands for the lost deposits. The bill, if passed, would have meant a per capita cost of $42,000 for every Iceland household and would make Icelanders debt slaves for decades. In an unprecedented move, Olafur Grimsson, the country’s president, vetoed the bill and forced a referendum on the unpopular legislation. (The Guardian)
  • March 2010 – the referendum was rejected by Icelanders by a massive 93% majority. As if that no wasn’t resounding enough, the prime minister proceeded to renegotiate a new deal with the UK and Dutch governments, calling the bill in the just defeated referendum “obsolete” in  Sigurdardottir’s words. (Bloomberg)
  • April 2011 – a second attempt by the prime minister to push an amended bill with better terms through parliament was again vetoed by president Grimsson, sending the matter to a national referendum for a second time. (WSJ)
  • April 2011 – still angered for having to pay for the mistakes made by the bankers, the voters again rejected the bill by a 60 to 40 margin. (AP)
  • May 2011 – sensing that the negotiation was going nowhere, the British and Dutch governments took the case to the European Free Trade Association (EFTA) through the European Free Trade Surveillance Authority (ESA).
  • Jan 2013 – the EFTA court rejected all claims by the ESA, and ordered it to pay all legal costs. (Morgunnbladid, Google translated)
  • Feb 2015 – Iceland’s Supreme Court upheld convictions of market manipulation for four former executives of the failed Kaupthing bank, and sentenced them to between four and five and a half years in jail. Since the crisis, the Supreme Court has upheld six of the seven criminal cases brought before it, with five more due to be heard and another 14 cases awaiting possible prosecution. (Reuters)

Through this ordeal, the Krona dropped 50% in one year, and capital control was introduced which remains in force to this day six years after the crisis first erupted.

Part 2 of the series will explore the fundamental causes of the country’s banking crisis.

Part 3 of the series will explore the framework of the proposed monetary system reform.

 

Reference

 

 

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