Thursday, October 27, 2011

The Icelandic lesson

In an international conference held on October 27 in Reykjavik, Iceland's experience in addressing the global financial crisis was reviewed. In the light of the achievements and challenges still ahead, there are some interesting lessons to learn in order to inform the wider economic issues for  the eurozone countries.

Iceland suffered the largest banking collapse in economic history. In 2008, the Icelandic financial crisis  led to the collapse of the three main banks, whose assets were much larger than the country's external debt. The national currency (krona) fell sharply (more than 35% against the euro) which led to capital account restrictions; the market value of  the stock exchange fell by more than 90%. This led to a severe economic recession, with a drop in GDP of 10,2% in 2009-2010. According to certain estimates, the cost of the crisis can be evaluated in  at least 75% of the country's GDP. But the external consequence was also dramatic as millions of  bank deposits were frozen and foreign banks had to face significant losses.

The government decided to nationalize the banking sector - which was deregulated in 2001 - (after that the UK decided to nationalize Bradford & Bringley, one of the banks involved in the financial crisis) since banks were unable to refinance their debts. Banks were restructured  and subordinated to stricter financial supervision; businessmen involved were subject to intense scrutiny; criminal investigations were launched on financial fraud. Eventually, the government resigned in 2009 after massive protests .

Since the crash, the country has improved its financial position and the economic recession was halted at the end of 2010. The emergency legislation which allowed the State to take control of the financial sector helped resolve the financial crisis.In fact, the country was not affected by Europe's sovereign debt crisis. Despite contention with Britain and the Netherlands over the question of a state guarantee on the deposits of an Icelandic bank (Landsbanki) in these countries, credit default swaps on its sovereign debt have steadily declined and are now much lower than Ireland . Furthermore, the decision of the government to apply for the euro membership has also helped to enhance credibility on international financial markets. 

But the most important fact is that a country on the verge of financial collapse has managed to resolve the financial crisis with a strong fiscal adjustment under an IMF programme while using the social welfare  system to maintain real wages. Welfare expenditure in the form of transfers to households and social protection increased significantly between 2007 to 2010 to soften the impact of the crisis. Child benefits were also increased and  targeted  at lower income groups. As a result the inequality trend was scaled back, with a Gini coefficient declining from 0,43, its maximum level in 2007 to 0,29. 

 European leaders should draw lessons from this country, in the way it managed to overcome the financial crisis with a sense of equity and justice. In comparison, the eurozone crisis requires urgent action on a much wider scale, including with non-European partners, and bolder measures to strengthen fiscal integration and the creation of eurobonds.

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