After a few years of indebted instability, Iceland’s economy is set to undergo a short sharp shock. We are in for a much more protracted downturn.
Exactly two years ago this weekend, this column focused on the strange and rapidly growing economy of Iceland. It seemed likely that, because the Icelandic economy was becoming rapidly indebted, it was becoming more unstable. Equally, as it did not have the protection of the European Economic and Monetary Union (EMU), its unsustainable debts were likely to lead to a financial crisis.
The mainstream financial markets rejected this view, spouting the usual mantra about Iceland’s fundamentals and so on. However, question marks remained. For the past two years, the Icelandic authorities have been doing their best to stave off the day of reckoning – but it appears that the predicted catastrophe is now upon them.
Every single financial measure in Iceland is now screaming ‘meltdown’. For example, interest rates on credit default swaps for Iceland’s main banks are now trading at 1,500 basis points. A credit default swap is an instrument that ensures against the risk of default. This means that if you are lending to an Icelandic bank and you want to ensure against the likelihood of a default, it will cost you €1.5 million to insure every €10 million loan you give it.
This is ten times the rate of the average European bank, implying that the market believes that a serious default is now only a matter of time. Banks simply can’t do business on these terms.
Meanwhile, the krona – Iceland’s currency – has fallen over 25 per cent this year, and is still in free-fall, despite recent hikes in interest rates.
It is clear that the Icelandic model is over. It was based on a bank-led boom, taking full advantage of financial liberalisation to borrow huge amounts of money and lend it to all takers. Icelandic banks expanded aggressively abroad – including in Ireland where Landisbanki bought stockbroker Merrion Capital and thought about bidding for Irish Nationwide.
Bjork may be Iceland’s most famous export, but the vast bulk of the wealth created in recent years has spun off from the banking sector, leveraging up and expanding. This was a country behaving like an out-of-control hedge fund, and it is suffering accordingly.
Iceland will recover, but it will experience large currency devaluation, one or two of the banks will possibly be nationalised to stave off bankruptcy and, like Norway and Finland in the early 1990s, it will probably have to issue a state-backed bank bond to pay off debts. As is happening in the US in the case of Bear Stearns, Iceland’s ordinary taxpayers will pay for the swashbuckling idiocy of its banking high-fliers.
However traumatic the experience, it will be swift and the turnaround is likely to be quick. Some people may be punished as dodgy practices are exposed and the country will start again. It is a world leader in hydrogen technology, at the cutting edge of genome research, and it will take more than a financial whirlwind to topple these Norsemen.
Most importantly, house prices will fall rapidly, to such an extent that within a year of two there will be great value in Iceland. Lessons will have been learned and the cycle will start all over again.
At the moment, Ireland can look north and thank our lucky stars that we are in the eurozone. Our banks have behaved in the same way as those in Iceland. If we still had the punt as an independent currency, we would look exactly like Iceland. For example, by late last year, only 50 per cent of Irish banks’ loans were covered by domestic deposits. So the banks here, like their Icelandic partners, were borrowing enormous amounts of money abroad to finance lending at home — which was almost exclusively going into property.
As a result of economic and monetary union and the creation of the euro, we won’t run out of money as a country. However, if the share prices of Irish banks are any indicator of future banking demand, we are in for a torrid time. Bank insiders have known this for awhile.
As far back as last summer, for example, some senior figures in private banking were advising their rich clients to get out of property, while telling the ordinary Joe Soap that there was never a better time to buy. So it’s not that the banks weren’t aware of the difficulties. It’s just that they chose to tell different stories to different people – one message for the rich and another for the not-so rich.
Now let’s try to read the tea leaves for a moment. We know that, in Iceland, the short sharp shock is already under way because it has its own currency. We, on the other hand, are going to suffer a much longer domestic slowdown. Ireland will experience what a US region experiences after a property/banking boom and bust, which is more akin to a slow puncture than a high-speed blow-out.
House prices will continue to fall, not rapidly, but progressively. Instead of prices collapsing, as happened in the early 1990s in Britain, Finland, Sweden and Norway, and now Iceland, we will go through what Massachusetts did in the late 1980s.The adjustment will take place on what is called the ‘‘real’’ side of the economy.
When I worked as a student in Boston in the late 1980s, there were loads of jobs and nowhere to live. By the early 1990s, there were loads of places to live and no jobs. People who had flooded into the New England area in the 1980swent back to the mid-west, Chicago and the South.
Immigration stopped. The region’s budgets went into deficit and the place felt a lot less crowded, congested and pricey. This process took time.
There was no crisis, no single event or catastrophe. On the contrary, there was a slow realisation that the game had changed. There were still dollars in the banks, but people simply slowed down, re-examined their credit card bills and tried to hold onto their jobs. House price fell for six years.
However, on the upside, the technology hubs around Cambridge, MIT and Harvard thrived. They could attract the best people because Boston was no longer prohibitively expensive. Cash that had been diverted into the fool’s gold of property now was available for real investment, and the high-tech hub boomed.
Ireland is likely to experience the first part of this Massachusetts story. It is already happening and will get much worse. The big challenge for all of us is to make sure that the second part of the Boston story is repeated here over the coming years.
Oddly, even though the EMU gives us an element of protection, it also anaesthetises us to the severity of our difficulties. Like Iceland, our problems started in the banking system, and it would not be surprising if over the course of the next few months we get more bad news from this sector. However, unlike Iceland, which will go through the mill, we are likely to experience something much more protracted.
How can we get a real debate going about the possibility of moving on from the euro to stave of a very long recession in Ireland ? Exiting the euro must be considered now as a real option for the Irish economy if the government is to be able to fund the public service from decreasing tax revenues and not having to borrow massive amounts in the years ahead. We could convert personal debt to the new ‘punt’ when revalued by the financial market ? As you have said in the past if we had our currency the ‘Jugglers’ could… Read more »
Johnny, are you crazy? Exiting from the Euro would shoot interest rates way up again, give us exchange rate fluctuations etc. We have enough to worry about so let’s ride this one out and hope it is slow and protracted.
There are plenty of ‘Jugglers’ in the country but they are too busy juggling their own money dodging tax etc. The entrepreneurial spirit here is all about cute hoorism, that’s all, and the government are a bunch of muppits.
Ireland would become “Icelandic” if we bailed out of the Euro now. Our intrest rates would shoot up overnight to ensure that the “new punt” didnt experience Zimbabwe like devaluation. (OK a slight exageration..) At the moment it is a difficult time to be in the Euro Zone because of our trading partners (ie UK and USA). That will change in time. The US$ and Sterling will come back in time. I hope it is not too late for our multinationals and Ireland Inc. It may well be. The US$ will be in the hole until the US financial mess… Read more »
Agreed that we need to get used to work, innovate and create knowledge as the sustainable way forward but “our multinationals” – it’s a bit of a stretch that they will help pull us out of any longer term downturn. In fact, the more concerning pressures on those companies are not the exchange rates but the more durable and sustained pressures of lower cost in Eastern regions. Its great to see innovators rewarded for their work and fair play to the lads from Limerick last week – but there is a worrying sign in all of this when they got… Read more »
Exiting the euro may sound ‘crazy’ but all options should be debated thoroughly by those politicians, economists and busness people in the ‘know’ Lots of things sound crazy until something ‘suddenly’ changes and it’ too late – consider this much talked about multi national scenario. Currently the GDP in Ireland is a whopping €180 billion which must be nearly the highest in the world per capita considering we have just 2.1 million in the workforce. That’s about €85k a head, nearly 3 times the average industrial wage. How have we pulled off this trick ? Well it helps when we… Read more »
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Johnny,opting out of the Euro and allowing the debt to be revalued to the “new punt” is a non-starter due to one of the facts that David mentioned in this same article; 50% of the loans that Irish banks make are not covered by the domestic market. The banks will not be able to get those international loans revalued into the “new punt” so if they revalued their domestic loans for customers they would end up with a huge exposure to currency risk. We all know how much the banks like risk in the current climate.
* We screwed up! * We pissed away a 10 year boom on domestic and internation property to the benefit of a minority of the ‘barbara striesland’ generation. * Nobody else is to blame. Switching currencies is not a tactical decision like our juggler friends who switch credit cards in order to borrow more. * It takes years to plan and execute even with goodwill on all sides. * At a time when trust is a very precious commodity in banking circles, does anyone seriously think a short term tactical refloating of the punt would work? We dont need to… Read more »
To David Wolfgang Munchau on “ft.com” had an interesting view (30/3’08) on Iceland’s economy. He doesn’t think Icelands economy is “melting down”, but he admits. It is suffering from huge macro economic imbalances; high inflation, current account deficit and imbalance between foreign debts and assets. He explains the high increase in credit to Fort insurance. (Which you mention in your article.) as being due to a speculative attack by international financial speculators. He makes the point that only one of the three giant Icelandic banks have any exposure to toxic mortgage derivatives, and he quotes university level research showing that… Read more »
Agreed. Let’s forget about blaming those outside of Ireland for our troubles. We are locked in to Europe and we have a role to play. Let’s find that role as mature adults. The last thing we want is a credit crunch caused as a result of petulent attitude to our euro neighbours. Also, bear in mind that your euro neighbours are not that well off either. Start reading the international papers! This is a global crisis which is not just economically driven. I just came back from Britanny and the economy and job situation is not good at all –… Read more »
“We cannot all be knowledge workers.” In any case being a “knowledge worker” is a mugs game, since IT is easily outsourced, and immigrants are plentifully available. For that reason the West has seen long term decline in the numbers of IT since the dot com boom, and the very people who complain about the reduction in the number of people who take IT degrees ( IBEC etc.) run courses on outsourcing ( A hint to IBEC. If you are going to complain that the best leaving cert graduates in science and mathematics are not going into IT you should… Read more »
Funny thing is that whiskey or ‘uisce beatha’ is an Irish product, made its way to Scotland, got famous there and the Scots market it way more successfully than we do (attributed to US Navy/army drinking it during 2nd WW?). Anyway Irish whiskey, taste wise, is way up with the Scotch and beats any of that American rubbish hands down. Next point, for example who has heard of Redbreast? An excellent Irish whiskey that nobody really drinks and has heard of. These products should be marketed along with our excellent agricultural produce. My father is from a farm and laughs… Read more »
Iceland is a fascinating test of ‘The Will of the Nation State’ versus the Market. The Market will win. I wonder why a ‘house-price boom’ ever occurred in Iceland! It”s not exactly short of space to build. Bit like Ireland… And England – once that whole M25 ‘green belt’ N.I.M.B.Y. nonsense is sorted. Perhaps Iceland could even become an affordable tourist destination if this carries on! Like Ireland: http://www.irishabroad.com/news/irish-voice/news/Articles/Dollar-for-Euro-at-Irish-Hotels290308.aspx Still, if there’s no Yanks or Brits kissing the Blarney Stone this year: I’m sure there’ll be enough credulous Krauts to fill the gap. Sorry…was that tasteless? I’ll be taking my… Read more »
There seems to be good ideas and suggestions coming through on how the economy could prosper…. I suppose those who appreciated David Mc William’s views on this blog have already understood we’re in trouble and are prepared to address the issues. That’s maybe what a ‘knowledge economy’ is all about, people sharing innovative ideas – but all the knowledge (and R&D) in the world is no use for future incomes without applying it to real commercial use and generating revenues. Maybe, that’s what we should be doing — transferring the innovations from the likes of China, India etc and using… Read more »
You have to admit that most do not believe the place exists. For if they do it is more in the realm of Narnia than the real world. But the property binge, world wide, was at it’s genesis a response to the dot-com bust and continued for as long as it did because there was nothing much around which excited. Renewables had and to some extent still have there possibilities, but were starved for want of realistic vision and caught between the nimby and the stone-age green.
I much prefer the provision of solutions, good suggestion Johnny Dunne – more optimistic and proactive. Indeed, it seems it is not all bad. I read an article recently by a guy called Anthony King, in the New Scientist that outlined the perspectives of professors, scientists, students and entrepreneurs about “How Ireland is Building its Research Capital” (New Scientist; 13/10/2007, Vol. 196 Issue 2625, p58-61) – by this account, Ireland is one of the best funded regions in the world when it comes to research. As with all initiatives such as this, it takes time for them to bear fruit… Read more »
“most people will not be or even will aspire to being millionaires and will seek to gain fulfillment by being able to use their education to its fullest extent” Dont be naive GOM. It is clear from the points system that the smartest students follow the money, this isn’t a matter of becoming a millionaire ( not that they would be opposed to that) but making money to get into the real middle classes. Not the cubiclised jobs-could-be-lost-to-outsourcing- two-hours-to-work middleclass, but the one that lives on the Southside and has no idea how the other 90 percent lives. You cant… Read more »
eugene, I accept the arguments made but let me respond with some data I uncovered in studying the area. I also want to point out that I accept that the word “most” in my phrase probably stretched it and I my thought process was in trying to relate the fact that because of the property boom some people believe that the value of their houses being above a million Euro makes them a millionaire – that is a perception that definitely needs correction. One more point, there is a slight contradiction in your point – “It is not just about… Read more »
I just saw this http://www.breakingnews.ie/business/mhojojgbkfau/rss2/ and wondered what it meant in terms of motivations for a) the lenders and b) the potential borrowers, i.e., is this just another creative way to get another sector into debt or a good way for a small business owner to go. Typically the sector of small business owners is populated with relatively optimistic people so no surprises on the sentiment in the article but it would be worrisome if this was a way for banks to make up for the declining credit markets elsewhere.
“Besides just throwing money at the problem in the form of tax incentives etc. I also believe our education system can be improved by introducing elements of business education to our science and engineering programmes, e.g., a course on how to start a business or intellectual property licensing and management. Many scientists and engineers don’t know how to practically set up a business and opt for the “soft option” of going to work in the MNCs…consequently we end up with MSc and PhD level people doing work that they are overqualified for so we need to break that cycle to… Read more »
http://news.bbc.co.uk/2/hi/uk_news/politics/7322825.stm – No or of Little Benefit
I found this on the BBC and find this remarkable what was announced and what Gordon Browns response was without suprise.
It appears that we can be successful by only being more motivated ourselves to starve off a long-term recesssion, any ideas about what next?
“There is little use, though, talking about entrepreneurialism unless we acknowledge the money motive. People want to become millionaires in Ireland because that is the only way to a decent living, really. And if entrepreneurs when successful were only as successful, in money terms, as a civil servant no-one would do it.” Successful entrepreneurs don’t start out thinking about money – it will come eventually with success and only passion can drive success in the real world. Our points system, while being fair, is not the best when it comes to producing star performers in any area. Crammers can sail… Read more »
VincentH said: “the property binge, world wide, was at it’s genesis a response to the dot-com bust and continued for as long as it did because there was nothing much around which excited. Renewables had and to some extent still have there possibilities, but were starved for want of realistic vision and caught between the nimby and the stone-age green.” VincentH: You might enjoy this article which suggests that ‘a new bubble’ will emerge around sustainable energy technologies, a bubble to avoid the possible meltdown as envisaged in this article: http://www.harpers.org/archive/2008/02/0081908 Maybe ‘wave-power’ in Donegal means more than the latest… Read more »
Ed – fair point about the scientists and engineers being the ones to learn new skills – the points I raised were logical progressions from where I started earlier and the New Scientist article. Still, and this is not a point to raise the hackles of business grads, science and engineering grads can do an MBA but there is no route for a business grad to do a masters or PhD in science or engineering so combining a technical primary degree, which is where the basis of understanding science and technology originates, with a business degree is more practical for… Read more »
Typo …in the last post….”grants in the UK” should read “grants in the EU”
On the discussion of entrepreneurs… I have the priviledge to view business proposals for start-ups on a monthly basis and most of what I see are me-too proposals. That is not necessarily “bad”, i.e. copying others, just indicative of a low level of genuine innovation.
Related is the likes of Peter Sutherland pontiicating about the “Knowledge Economy” / University R&D Funding today in the Irish Times – “It will be a hollow achievement indeed to have 176,000 students in higher education by 2016 if our brightest and best continue in increasing numbers to leave these shores to study at the best universities abroad”. Strange…showing how out of touch with ‘commercial’ reality in Ireland the so called ‘establishment’, most have never been involved in building a sustainable business. The Dept of Education will spend circa €10 billion this year, much of this increase in spend is… Read more »
“I have the priviledge to view business proposals for start-ups on a monthly basis and most of what I see are me-too proposals.”
innovation can be in implementation: facebook came after myspace, and google after alta vista.
Followers also provide validation of the reality of a space – would you turn down a proposal because it had a competitor or consider that at least the proposer is not a lone lunatic? Would you consider Microsoft a leader or a follower? This is a very difficult area and I don’t envy the job of having to turn down proposals…bit like not placing a bet on a potential winner.
[…] had an interesting post a couple of days ago about the sad state of Iceland’s economy. Yes, that’s Iceland with a ‘c’. Not a country you hear very much about. It […]
The German bankers are the bedrock of the euro. I would leave the country immediately if the Republic withdrew from the Euro. This island will return to its normal condition for the next 20 years and unless it develops substantial alternative energy systems, the economy will decline substantially as the American big earners withdraw to lower wage and regulation economies. The party is over, learn to wear insulated underwear for six months and become self-sufficient in essentials. The housing stock has been built, there are more than enough places for people to live together, efficiently sharing heated space, rather than… Read more »
Leaving the eurozone would trigger the Doomsday machine from Dr Strangelove, or at least the “mother of all financial crises”. Even preparing to leave would destroy the market in government bonds – the state would go bankrupt and cease to exist, to be succeeded by god knows what kind of hybrid legal entity. Not gonna happen:
http://www.voxeu.org/index.php?q=node/729