The Icelandic story

The Icelandic financial crisis is instructive for its own sake but it may also serve as a summary of the Asian crises in the 1990s, since Iceland committed exactly the same errors as the Asian countries had done 10 years earlier and at twice the scale (in relationship to the size of the economy). While the Asian crisis cost between 32 percent of GDP in Korea and 57 percent of GDP in Indonesia, the Icelandic crisis was originally estimated by the IMF to cost 80 percent of GDP. This was later (2012) lowered to an actual gross cost of 44 percent of GDP, beating even Ireland at 41 percent of GDP, the topic of the next chapter.

On the macroeconomic plane, Iceland grew faster than surrounding countries in the first years of the new century, or by 4–8 percent per year. See Figure 23a. The focus of the government was aimed at achieving a better diversification of the economy, where the fishing industry still accounted for 20 percent of exports and 8 percent of employment. On the industrial side, Iceland wanted to utilize its cheap hydroelectric and geothermal energy for such energy-demanding industries as aluminum production. Service sectors such as tourism and banking were also in focus. The investment ratio in GDP was almost 30 percent and investments grew by over 20 percent annually.

The economic program was on the surface a spectacular success. Unemployment was negligible and Iceland rose in the “rich man's league” (measured by GDP per capita) to ninth position in the world, well ahead of countries such as Sweden, Denmark or the United Kingdom. But the high growth rate had its drawbacks. Just like in Asia, the deficit in the current account skyrocketed, to −25 percent of GDP in 2006, only to fall back somewhat to −15.5 percent in 2007. See Figure 23b. The reason for the improvement was increased exports, not least by the financial sector. Also just like in Asia, capital imports led to increases in house prices which more than doubled between 2001 and 2007, rising 35 percent in individual years.

The high growth rate had the additional advantage that the budget showed a surplus of 5–6 percent of GDP just before the crisis.