Iceland’s deep freeze

The Financial Page

By James Surowiecki

updated 7:13 a.m. ET April 15, 2008

By now, we’re all familiar with the major victims of the subprime meltdown: greedy mortgage brokers, overleveraged hedge funds, feckless banks and brokerages, incautious homeowners and so on. But the crisis is also wreaking havoc in places that, on the surface, might seem to have nothing to do with the price of foreclosed homes in Miami. Places, that is, like Iceland.

Insofar as Americans think about Iceland at all, it’s as a land whose remoteness belies a vibrant cultural scene featuring hipster titans, like Björk and Sigur Rós, and exceptional social conditions—it’s the top-rated country in the U.N.’s most recent human-development index. But in the financial world Iceland is now a hot topic of discussion for a different reason: Many people suggest that it could become the “first national casualty” of the ongoing credit crunch.

Until last year, Iceland’s economic track record in this decade had been phenomenal—its annual growth rate averaged close to 4 percent over the past decade, and its per-capita gross national income is now higher than that of the U.S. This year, though, the country’s currency, the króna, has fallen 22 percent against the euro; the economy has stagnated; and a global rating agency has put the nation’s three major banks on a credit watch. Now analysts are wondering whether the new Nordic Tiger will end up, instead, as “the Bear Stearns of the North Atlantic.”

So how did Iceland get in so much trouble? That’s the odd part of the story: It isn’t because its banks gambled on the worthless subprime securities that helped undo Bear Stearns and so many others. Iceland’s banks prudently avoided the subprime market, even as they embarked on a lending boom at home and expanded abroad.

What got Iceland in trouble was something more subtle: Its banks got their money primarily from international investors, making the Icelandic miracle heavily dependent on foreign capital. In normal times, this might not have mattered, given the country’s solid economic fundamentals. But these aren’t normal times. The subprime crisis, in which investors realized that they had greatly underestimated the risks of lending to people with bad credit, has spawned a wider credit crunch: Investors now suspect disaster behind every door, and even seemingly solid borrowers find credit much harder to come by.

The subprime crisis was an earthquake that caused a tsunami: The quake has done plenty of damage on its own, but the tsunami looks set to do even more. Iceland has been swamped by that tsunami because it trusted in the availability of global credit in time for that credit to evaporate. And the fact that Iceland has been so dependent on foreign investors makes those investors even more skittish about investing there: In markets, weakness often begets weakness.

Further, the country’s troubles have made it a potential target for speculators seeking to drive down the value of its currency and perhaps cause a run on the banks. In 1998, hedge funds purportedly worked together to attack Hong Kong’s currency and its stock market, an attack that was foiled only when the government bought up a sizable chunk of the stock market. It’s not clear that a similar cabal is gunning for Iceland—the governor of its central bank insists that one is—but the notion is certainly plausible: With a population the size of Pittsburgh and a central bank whose total reserves are less than $5 billion, the country makes an easy target for hedge funds flush with cash.

Iceland’s current woes teach a useful lesson about the interconnectedness of global markets: Trouble can come from anywhere. Homeowners default on mortgages in San Diego, and suddenly people in Reykjavík are paying more for gasoline and wondering if their bank deposits are safe. That doesn’t mean that Iceland is an innocent victim. The country went overboard with spending and borrowing—between 2000 and 2007, domestic credit in the Icelandic banking system more than quadrupled as a share of GDP. And relying on foreign money to fuel that kind of frenzy is foolish, since it puts you at the mercy of fickle foreign investors.

But Icelanders can be forgiven for wondering if they’ve really been any more reckless than many other countries—most obviously the U.S., which relies heavily on foreign capital to fund home buying and profligate consumption, and whose banking system is rife with reckless lending.

And that’s the second lesson of Iceland’s plight: Even in a flat world, there are different rules for different players. In order to prop up the króna, and keep foreign capital from fleeing, Iceland’s central bank has had to raise interest rates to an astounding 15 percent, a move that will slow the economy to a crawl. By contrast, the dollar, while weak, has evaded the króna’s precipitous fall; the Federal Reserve, far from raising interest rates, has slashed them; and Congress is borrowing a $152 billion to hand out tax rebates. Iceland’s government has been forced to inflict pain; the U.S. is doing everything possible to avoid it.

If Iceland were to attempt to emulate America’s approach, its currency would be demolished, and foreign investors would almost certainly head for the exits. The U.S., by contrast, remains the beneficiary of the world’s generosity—no matter how bad our financial situation looks, countries like China and Japan keep pouring hundreds of billions of dollars into U.S. securities.

They’re doing this not out of kindness, of course, but because the U.S. is a colossal market and they need us to keep buying stuff. The world can’t afford to have the U.S. fail, and so we are able to get away with behavior that would wreck smaller countries. Great for us, but when we look at Iceland’s predicament we should say that there but for the grace of China go we.

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