February 17-Sally and I had a great chance to learn about the history and the nature of the modern Icelandic economy and its financial system today. While sitting in the staff and faculty lounge for coffee this morning, we started to talk to Hjalti about the home financing mechanisms in Iceland. The system over here is significantly different from the one we enjoy in the U.S. For starters, there is no such thing as a long-term fixed-rate loan. Instead, a borrower can choose one of two different types of loans: a three-year loan that automatically gets renegotiated at a new interest rate when it is due, or a long-term variable rate loan that is
pegged to the inflation rate.
Ian Watson, the American expat who teaches the Icelandic Culture and Language class in English on Fridays, came in and enlivened the conversation at that point, because he and Hjalti disagreed on a few points. Ian also gave a short history of Icelandic society and economy later in class that day, which tied in nicely to this discussion. For most of its history, Iceland has been an agrarian society. The Vistarband law passed in 1490 forced anyone whose wealth amounted to fewer than three cows to become indentured servants to a landed farmer for one year. Every year on the same date, everyone's wealth was reevaluated, and the poor had to find someone to serve again. This process kept the poor from becoming beggars, since they were always "employed" by some farmer, who was responsible for providing their servants with room and board. Of course, it also essentially
made the poor into slaves who were subject to other limitations as well. For example,
indentured servants were not allowed to marry. This restriction reduced the number of children born into destitution, although children could be and were occasionally born out of wedlock.
Farms, run by their owners, were the basis of local government and served as the center of social life for Icelanders. Consequently, towns did not exist in Iceland during this time. In the late 18th century, Icelanders began to take to the sea to fish and discovered that they could sell the fish and buy their way out of indentured servitued. Meeting places for fishermen sprang up on the coast, developed into harbors, and ultimately became
permanent urban settlements during the 19th century. As more people took to fishing, the farmers began to lose their labor and they fought these developments. Ultimately, they lost and in 1894 the Vistarband law was abolished. Meanwhile, fishing became Iceland's primary economic driver and remains vitally important today.
Iceland's economy and standard of living looked more medieval than modern well into the 20th century. Iceland essentially became independent of Denmark when the Germans invaded Denmark in 1940. The British moved in shortly thereafter to keep Iceland free of German submarines and to use Iceland's fjords as a layover point for trans-Atlantic convoys. Subsequently, Iceland's export of fish to Britain increased dramatically, resulting in a large influx of money. After the war, the fishing industry grew dramatically and fish exports rose steadily. An American base was also established at Keflavík and Americans with money to spend began arriving on the island. The government used the money it collected from taxes on fish exports to modernize the country's infrastructure and fishing fleets. During these boom time, there was essentially no unemployment. However, the financial system did not modernize simultaneously and remained tied to the peculiarities of Icelandic history. It was basically crony capitalism at its finest.
By the 1990's personal wealth had increased to such a degree that Icelandic banks were overflowing with money and they started buying up banks in other countries. These actions made the Icelandic financial system look strong, investors came calling, and the Icelandic króna strengthened considerably. Consequently, imports became artificially cheap and Icelanders went on personal spending sprees as well. Inflation has always been rather high in Iceland, so it made more sense to buy products sooner than later, when they would certainly be more expensive. Therefore, it also made sense to take out loans to finance the personal spending sprees. Foreigners watched the króna steadily increase in value and wanted in on the action, so they started buying the currency, further inflating its value. The Icelandic banks recognized this new market and advertised savings accounts, monetized in the steadily appreciating króna, aggressively in Europe.
In 2008, the whole system fell apart, practically overnight. As the global financial system grappled with ever-tightening credit, foreign depositors demanded that the Icelandic banks repay them with their native currencies. The sell-off of krónur caused the realilzation to spread that there was no foundation for the króna's value. Since bubbles are built on confidence and belief, the psychological support for the króna's value crumbled. Ultimately, the króna lost nearly 3/4 of its value against the dollar. All three of Iceland's major banks went bankrupt, personal savings were lost, and prices rose dramatically across Iceland as the inflaction rate soared. The repercussions are still being felt today.
While the situation has stabilized and the economy is actually slowly growing, Icelanders are still saddled by debt and the government has had to deal with greatly reduced budgets. Polictical discontent in the immediate aftermath of the crash brought down the government and the new government made sure that Icelanders' savings were reimbursed. However, foreign accounts have not yet been reimbursed and there is an ongoing debate as to whether they ever will be. The depositors in Denmark and Britain were reimbursed by their own
governments, which now demand to be repaid by the Icelandic government. These demands are currently playing a significant role as Iceland negotiates to join the EU.
The government has also imposed capital flow restrictions since the crash to force foreign investments in Iceland to remain here. Consequently, krónur may not be converted into foreign currency. The folks in the lounge pointed out that Iceland is the only country with a population of less than one million that has its own currency that is not tied to a foreign country's currency. They think that the króna is really just funny money and it is only a matter of time before Iceland is forced to adopt another currency, like the Euro or the Canadian dollar, or something similar. To make matters worse, Iceland is too small to be self-sufficient, so the strength of its economy is really dependent on the strength of the European and American economies. Obviously, that is not particularly reassuring right now, although the economic indicators are currently more positive than negative in Iceland.
Returning to the interesting way in which mortgages work in Iceland, the crash was obviously pretty hard on homeowners. Housing prices dropped, the net worth of homeowners was decimated by the króna's devaluation, and the interest rates jumped with a rise in inflation. Consequently, many people were suddenly underwater with their mortgages. Unlike in the United States, people here cannot simply walk away from their homes in these situations and turn them over to the lendors as collatoral. Nor are they allowed to sell the house to recover some of the money they need to repay the loan. And, until recently, lendors could indefinitely pursue litigation to recover the full loan amount from a lendee. There is a time limit on that now, but there is still no way for a person to declare bankruptcy and start over. This situation combined with the lack of usary laws and the excessive loans taken out by Icelanders before the crash has resulted in many people working their tails off just to keep paying interest on loans. Consequently, there is a controversial movement afoot in Iceland to have the government pay off portions of loans to get people back afloat. Others point out that warnings were sounded prior to the crash about the Iceland's precarious financial situation and that the people who chose to take the risks of high levels of indebtedness should now deal with the consequences of their bad decisions themselves.
To muddle matters even more, the Icelandic Supreme Court handed down a ruling on Wednesday about home loans made in both krónur and foreign currency before the crash. It was our discussion of the ruling that sparked the long discussion. After the crash, these loans were renegotiated and the foreign currency interest rates were increased to
compensate for the loss in value of the króna. The Supreme Court ruling disallowed this
interest rate change, forcing the banks to reimburse lendees the extra money that has been collected on the loans since they were reset. This ruling essentially rewarded the lendees for risky behavior and has really raised the ire of the people who chose the safer loans and are now getting the shaft. The expectation is that all of this will come to a head in the Parliament at some point in the near future, or it could cause the current government to fall.
All of this brought to mind the saying, "you don't know what you've got until it's gone." Compared to Iceland, we have some pretty good consumer and lender protection laws in the States and the Icelanders envied our home morgage system. I don't know what that says about smaller governments being more responsive to the populace and less so to special interests, but it is an interesting observation. Furthermore, the fact that legislative actions can cause changes to be made in contracts between private parties (lenders and lendees in this case) is also something that would be difficult to imagine in the U.S. Whereas much of our time here has been spent marveling at the similarites between the U.S. and Icleand, this is an instance where the differences are much more apparent.
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