Edited by John Raymond LaBrosse, Rodrigo Olivares-Caminal and Dalvinder Singh
Chapter 8: Iceland’s Financial Disaster and its Fiscal Impact
Arnór Sighvatsson and Gunnar Gunnarsson 8.1. INTRODUCTION In October 2008, Iceland experienced a financial calamity of unprecedented scale. The sustainability of government finances immediately came into question. Overnight, after the implosion of all of its major banks, with massive losses to foreign creditors, Iceland became ostracized from international capital markets for an extended period of time. The sudden stop of international capital flows lead to the collapse of Iceland’s currency, which depreciated by 60 per cent from 1 September 2008 until capital controls were instated on 28 November 2008. Although the scale of the twin crisis was without precedence (see Figure 8.1), the build-up of unsustainable macroeconomic imbalances and misalignments in asset prices followed a typical pre-crisis pattern described in the literature.1 Lax risk management and low perceived risks based on optimism about the future prospects of the booming economy made the financial institutions and the private sector far too willing to assume imprudent risks. Financial institutions overextended themselves, not only domestically but particularly abroad. The large scale of the banks’ cross-border and cross-currency operations while their principal lender of last resort (LOLR), the Central Bank of Iceland (CBI), could by and large provide them with liquidity only in domestic currency made them particularly vulnerable to a run on their foreign liabilities.2 In a few years, the three major banks had become among the largest in the world relative to the home country economy. More specifically, they grew to more than ten times Iceland’s GDP. Not only were the...
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