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When I used to think of Iceland, thoughts of a plucky nation that fought off the curse of the bankers, and runs everything on renewable energy, would come to the fore. As usual, the reality is somewhat more mixed than the superficial appearance. The country has recovered better than many others from the 2008 financial collapse, but is still heavily indebted and requires capital controls to stop “trapped” investors from pulling their money out of the country. In addition, much of its recovery has been based on rapidly expanding a tourist industry heavily dependent upon cheap oil and the successful functioning of the global economy. Another major area of economic activity, aluminum smelting using Iceland’s cheap energy, is also tightly integrated with the global economy. It is also heavily dependent upon the Icelandic government socializing much of the exchange rate and aluminum price risks.

The Financial Bubble And Collapse

This section is heavily based upon the book “Bringing down the banking system: Lessons from Iceland”, by Gudrun Johnsen[1]

Prior to the deregulation and privatization of the banking system, Iceland had negligible government debt and an excellent credit rating. During the 1990’s, the Icelandic government was carried along with the general wave of privatization and deregulation, and decided to privatize its government-owned banks. In 1999 the government finalized the sale of FBA (later called Glitnir), and completed the privatization of the other two state-owned banks between 2002 and 2003. What the government didn’t know was that the final part of the sale of the latter bank had been financed by loans from the banks to the purchasers. Landsbanki lent money to the purchasers of Bunadarbanki (later merged with the investment brokerage Kaupthing), and Bunadarbanki lent money to the purchasers of Landsbanki. No new capital had been injected into the Icelandic banking system, contrary to the beliefs of the Icelandic government.

From 1998 to 2003, the three privatized banks expanded their balance sheets from 4.5 to 16 billion Euros. In the following four years, the three banks grew their balance sheets seven-fold, mostly financed by bonds issued outside Iceland, creating a world record for the growth rate of credit within an economy. Making things much worse was the fact that a large amount of the lending was to the owners of the banks, and other related parties, hidden by an extremely complex set of front companies. Much of this lending was also collateralized against shares in the very same banks, greatly reducing the real equity of the bank (although this fact was not reported by the banks). The combined assets of the three banks before their collapse was 115 billion Euros (US$180 billion), ten times the size of the Icelandic economy. The folly of privatizing and deregulating a banking system, in a country with no real experience of regulating a highly complex private banking system, should have been evident to anyone. Unfortunately, the short term leaps in financial wealth and purchasing ability created by this massive increase credit creation blinded many to the reality. The pride that many Icelanders felt in the new reputation of their country also made a realistic assessment difficult.

As wholesale funding for the banks dried up in 2007, they did not pull back. Instead, they took deposits from ill-informed retail savers in the United Kingdom, Holland and other European countries by offering high interest rates on retail deposits. This funding approach was very successful and at the time of their collapse Landsbanki had 7.2 billion euros of Icesave online deposits, and Kaupthing had 5.3 billion euros in its Edge online deposits. Just these foreign deposits were equal to the size of the Icelandic economy. After the collapse, these foreign deposits became the subject of a major crisis between Iceland and the governments of UK and Holland. The Icelandic government would only make good Icelandic deposits covered by its domestic deposit insurance, not the foreign deposits. That decision was later validated by an international court.

Incredibly, the Icelandic banks were also able to borrow 9.3 billion euros from the Icelandic and European Central Banks (ECB). A significant amount of this central bank lending was collateralized against assets which had been manufactured by, and exchanged between, the Icelandic banks for the sole purpose of creating the required collateral (which would be essentially worthless if the Icelandic banks collapsed). In 2008, the Icelandic banks increased their lending from the ECB by 3.5 billion euros in just a six-month period. After the collapse, the Icelandic central bank required an injection of USD 5.7 billion due to its losses on such lending.

As the financial markets entered the crisis of 2008 to 2009, liquidity started to dry up as lenders and depositors became increasingly concerned about the riskiness of the overall financial system. In addition, the central banks became aware of their increasing problems within the Icelandic banks, together with some of the issues with the collateral pledged to them. The collapse of such highly leveraged organizations, dependent upon short term funding, was assured. Once Lehman Brothers went bankrupt in mid-September 2008, and liquidity in the financial markets vanished, the three Icelandic banks rapidly collapsed.

The end result of the deregulation of the Icelandic financial system was to turn a country with little external debt and a high credit rating into one with large debts and dependence upon a rescue package from the International Monetary Fund and Scandinavian Central banks. The refusal to bailout out the European retail depositors saved the average Icelander from decades of debt penury, but did not remove the other huge costs of bailing out the financial system.

For the average Icelander, the large depreciation of the Icelandic currency caused severe problems. It both increased the Icelandic Krona amount of foreign-currency denominated debts, and greatly increased the rate of inflation. The latter affected the large number of inflation-linked mortgages. For many, the amount of their debts increased as the value of their property fell.[2]

Using Iceland As A Low Cost Base For Energy Intensive Industries

With fishing limited by the need to sustainably manage the Icelandic fisheries, the country turned to leveraging its extensive available renewable energy sources to attract the energy-intensive aluminum industry. After rapid growth in this area over the past couple of decades, the Icelandic economy is now heavily dependent upon an industry dominated by large, foreign, firms. In 2008, the aluminum industry exceeded the fishing industry to become the single largest source of exports (39% of all exports and 17.5% of GDP, offset by alumina imports representing 5.6% of GDP)[3]. Both aluminum smelters, and the supplying hydroelectric dams (owned by a government utility), are extremely large capital projects, which last for decades.

Given a large fixed cost, the cost of production is highly sensitive to volumes, and therefore the building of an aluminum facility requires a belief in ongoing demand over many decades. The Icelandic government has taken on much of the exchange rate and aluminum price risks, through the structure of its power contracts with the aluminum producers. Therefore, any falls in aluminum prices, or adverse exchange rate risks, will impact government finances. The current Icelandic government is pushing forward with another major aluminum plant, irrespective of concerns about the environmental impacts and increases to Iceland’s exposure to the aluminum industry[4].

There have been some successes in bringing other energy intensive industries to Iceland, such as ferrosilicon production[5] and computer data centres[6]. The major issue that these share with the aluminum industry is foreign ownership and control, together with tight integration with the highly fragile global economy. In a future of climate change and energy shocks the incredibly complex and integrated global economy will be severely impacted. In the extreme case, Iceland may be left with unused production facilities and hydroelectric dams with no customers.

Supplying Low Cost Energy To Europe

Instead of bringing the energy-intensive industries to Iceland by offering very low cost electricity and taking on much of the risk, perhaps Iceland could simply sell the electricity to other European countries? Iceland’s geothermal and hydropower electricity generating plants offer the stability and immediacy of production required by countries expanding their intermittent renewable energy generation. Iceland could become part of the standby “battery” required by countries such as Germany. The problem is that Iceland is a long way away from Europe, and even a cable to the United Kingdom would be the world’s “longest subsea power cable”[7]. If the technical challenges could be overcome though, it would provide Iceland with a reliable income as part of an integrated European power system.

Growth Of The Tourism Industry

One advantage that Iceland had over many of the other European nations is that it had its own currency, which devalued by nearly 50% following the collapse of the Icelandic financial system. While causing high inflation for Icelanders, this did greatly benefit the tourism industry. Reykjavik is once again a city of cranes, this time building new tourist hotels and apartments.

The number of foreign visitors to Iceland increased by over 50% between 2010 and 2013, and increased by a further 25% in the first half of 2014 (with an annualized number of visitors of over 1 million, compared to a population of 320,000).[8] Numbers are projected to grow to at least 1.5 million by 2023[9], and the new right-wing government wants to grow that figure to 3 million yearly visitors (a vision which is attracting a lot of resistance from Icelanders)[10]. There is a serious concern that such tourist numbers, together with the ecological despoilment created by more aluminum smelters, will eventually impact the tourism industry by degrading many of the natural attractions[11].

A Probable Future

Although Iceland has greatly reduced its level of debt, to a significant extent through debt write-offs, it is still a relatively heavily indebted country, which requires capital controls to stop large amounts of capital from leaving the country. Taking into account the remaining liabilities of the collapsed banks, which are implicitly owned by the Icelandic state, government debt is 221% of Icelandic GDP.[12] Before capital controls can be removed, a significant reduction in those remaining bank liabilities will be required. Otherwise, capital flight would trigger an immediate economic crisis. The best solution for Iceland’s population would be to repudiate these remaining liabilities, but such actions are constrained by Iceland’s reliance on the global economy and the graces of the International Monetary Fund (IMF). In late 2013, the government announced a new mortgage debt-reduction scheme, which will “forgive” a significant chunk of mortgage debt. Even after this though, household debt will be about 100% of GDP, still a high level, and the debt reduction may simply exchange consumer debt for government debt[13] [14].

Global tourism is a bubble made possible by the availability of cheap fossil fuels, both to fuel the aircraft and to generate the levels of affluence required to afford trips to a relatively remote country. Given the distance of Iceland from even the closest highly populated countries, it is more exposed to a downturn in the global tourism industry than most. The market for aluminum is also heavily dependent upon the functioning of the global economy. Any breakdown, whether due to financial crash, energy constraint, or ecological impact, will severely impact demand for the aluminum that Iceland produces.

At some point global tourism and global trade will break down under the weight of the problems created by humanity’s continued growth. At that point Iceland will have to revert to fishing and agriculture, the latter perhaps made easier by a warmer climate. The folly of massively expanding such industries as tourism and aluminum smelting in an age of ecological and energy limits, will then be shown by the empty hotels, industrial buildings, and airports. The mismatch of a still large debt-based financial system with an age of limits will also be apparent. Iceland’s fate will still be much better than most though.

[1] Gudrun Johnsen (2014), Bringing Down The Banking System: Lessons From Iceland, Palgrave MacMillan

[2] Joe Lynam (2013), Iceland’s ‘tenacity’ lifts economy out of crisis, BBC. Accessed at

[3] Daniel Grande (2011), Rethinking Aluminum In Iceland’s Economy: Balancing Risk & Reward, Perspectives on Business & Economics Volume 29, 2011 – Martindale Centre Le High University. Accessed at

[4] Lowana Veal (2013), Iceland Renews Push for Aluminum Plant, Inter Press Service. Accessed at

[5] Geir Olafsson (2014), Iceland Ferrosilicon Plant in Chinese Ownership, Iceland Review. Accessed at

[6] Frank Ohlhorst (2013), Inside Iceland’s Newest Data Centre, Information Week Network Computing. Accessed at

[7] Nerijus Adomaitis (2013), Iceland revives plan for worlds longest subsea power cable, The Globe And Mail. Accessed at

[8] n/a (2014), Number of Foreign Visitors, Icelandic Tourist Board. Accessed at

[9] n/a (2013), Northern Sights: the future of tourism in Iceland, Boston Consulting Group. Accessed at

[10]Julia Vol (2014), The Wheels of Greed Are Spinning in Iceland, Saving Iceland. Accessed at

[11]Larissa Kyzer (2014), Fit For Print – Did The New York Times Get It Wrong?, Saving Iceland. Accessed at

[12] Gillian Tet (2014), The darker side of Iceland’s showcase recovery, The Financial Times. Accessed at

[13] Omar R. Valdimarsson (2013), IMF Says Iceland’s Debt Relief Risks Housing Fund: Nordic Credit, Business Week. Accessed at

[14] Olafur Margeirsson (2013), The Icelandic Debt Relief, Icelandic Economics. Accessed at


Photo credit: Wikipedia/Dieter Schweizer/CC BY-SA 3.0