Let Banks Fail : Iceland’s plan looks to be working

Iceland let its banks fail in 2008 because they proved too big to save.

Now, the island is finding crisis-management decisions made half a decade ago have put it on a trajectory that’s turned 2% unemployment into a realistic goal.

The island’s sudden economic meltdown in October 2008 made international headlines as a debt-fueled banking boom ended in a matter of weeks when funding markets froze. Policy makers overseeing the $14 billion economy refused to back the banks, which subsequently defaulted on US$85 billion. The government’s decision to protect state finances left it with the means to continue social support programs that shielded Icelanders from penury during the worst financial crisis in six decades.

Successive Icelandic governments have forced banks to write off mortgage debts to help households. In February 2010, 16 months after Kaupthing Bank hf, Glitnir Bank hf and Landsbanki Islands hf failed, unemployment peaked at 9.3%. The rate was 4.2% in December, according to Statistics Iceland. In the euro area, unemployment held at a record 12.1% in November, Eurostat estimates.

The government’s 2014 budget sets aside about 43% of its spending for the Welfare Ministry, a level that is largely unchanged since before the crisis. According to Stefan Olafsson, a sociology professor at the University of Iceland, the nation’s focus on welfare has been key in restoring growth.

The economy will expand 2.7% this year, according to the Organization for Economic Cooperation and Development. That’s better than the average for the OECD-area as a whole, which will grow 2.3%, the Paris-based group estimates.

Still, Iceland’s efforts to resurrect its economy have been far from smooth, Olafsson said. Inflation, which peaked at 19% in January 2009, has hurt Iceland more than most other countries because most mortgages are linked to the consumer price index. Though the set-up protects investors, households see their debt burdens grow as prices rise. Inflation was 4.2% in December.

Most of Iceland’s inflation has come via the exchange rate, which has been protected by capital controls since plunging 80% offshore against the euro at the end of 2008. Gunnlaugsson says any efforts to scale back existing currency restrictions will only take place at a pace that safeguards krona stability.

“It is a problem that can be solved, and can be solved quite fast,” Gunnlaugsson said.

The krona has appreciated around 10% against the euro over the past 12 months. Still, today’s rate of about 157 per euro compares with an average of 88 in 2007, a year before the island’s financial collapse.

To support households, Gunnlaugsson in November unveiled a plan to provide as much as 7% of gross domestic product in mortgage debt relief. The government intends to finance the plan, which the OECD has criticized as being too blunt, partly by raising taxes on banks.

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