Wharton's Philip Nichols and University of Iceland's Thorvaldur Gylfason discuss Iceland's economic recovery.

In an art museum in Reykjavik stands a mural that looks, from a distance, like a pointillist painting. Those who venture closer discover that the work – a creation of artist Ragna Robertsdottir – is fashioned from tiny fragments of volcanic rock and ash from Mt. Katla, long considered one of Iceland’s most ferocious volcanoes. The mural offers a glimpse of Iceland’s genius in taking a powerful destructive force, such as a volcanic eruption, and transforming it through ingenuity and effort into art of breathtaking beauty. Robertsdottir’s creation could well serve as a metaphor for the country’s financial debacle, ten years ago this week, and its revival during the decade that has followed.

What Caused the Iceland Financial Crisis?

During the early 2000s, Iceland saw an unprecedented boom led primarily by its banks. The country’s top three financial institutions — Glitnir, Kaupthing and Landsbanki — rapidly built their international operations, attracting torrents of cash from around the world. By the end of 2007, the banking triumvirate had morphed into global giants whose assets were nine times the size of the country’s GDP. But the good times ended in the fall of 2008. At that time, Lehman Brothers was collapsing in the U.S. and the Great Recession was wreaking havoc worldwide. Unlike the U.S., which treated major financial institutions as being “too big to fail,” Iceland treated its banks as being “too big to save.” All three banks collapsed. Iceland’s currency, the krona, lost 50% of its value between 2007 and 2010. The country plunged into a meltdown of volcanic proportions.

Now, a decade later, Iceland has risen from the wreckage of the banking crisis. Tourism has emerged as the primary source of foreign exchange earnings. For a country whose population in 2017 was 340,000 — 5% of New Jersey’s — Iceland attracts massive numbers of tourists, more than 2.2 million a year, or seven for each domestic resident. The GDP growth rate exceeds 7%, among the highest in the world; the World Bank Group notes that GDP has bounced back from a 2009 low of $12.9 billion to more than $20 billion today. Employment is at an all-time high. Still, while the country’s economic recovery has been strong, it continues to face political and judicial challenges, according to experts from Wharton and elsewhere. Philip Nichols, a Wharton professor of legal studies and business ethics, and Thorvaldur Gylfason, an economist at the University of Iceland, believe that Iceland’s experience holds key lessons for other countries about how to deal with a financial downturn and bounce back. (Listen to the podcast – based on a conversation on the Wharton Business Daily radio show on SiriusXM — at the top of this page.)

Gylfason attributes the origin of the troubles to mistakes that Iceland made when the country opted to privatize its banks during the 1990s. Instead of inviting international bankers who had expertise in privatization, Iceland’s government – led by Prime Minister David Oddsson — “botched privatization … [and] handed the banks on a silver platter to local cronies. [It took them] only a few short years to drive the banks into the ground. That is why Icelandic banks collapsed. It had little to do with Lehman Brothers…. That was just the spark that lit the fire.”

Cows in Spring

Iceland’s bankers were inexperienced, and they went on a global borrowing spree. “They kicked up their heels, like cows in spring, as if there were no tomorrow and as if there were no financial supervision in Iceland, which was pretty close to being the case,” Gylfason notes. As a result, in the fall of 2008, all three banks – which among them accounted for more than 90% of Iceland’s financial system – fell “like a house of cards.” The government had little choice but to summon the International Monetary Fund to the rescue. As The Washington Post reported later, Iceland desperately needed cash to “protect domestic deposits, cushion the economy’s free fall, and keep the … krona from crashing much more. In all, Iceland got $4.6 billion — $2.1 billion from the IMF and $2.5 billion from its Scandinavian neighbors.”

The collapse of banks in Iceland “had little to do with Lehman Brothers…. That was just the spark that lit the fire.” –Thorvaldur Gylfason

Following the bailout, the IMF orchestrated a cleanup operation to revive the banks. The rescue came at the expense of international creditors, who were “left without being paid to the tune of four times of Iceland’s GDP. When you run away from private debts of four times your GDP, it makes it that much easier to make an economic recovery,” says Gylfason. “That is what Iceland has done. Our national economic output and purchasing power were restored by 2016 – nine years after the [financial] crash. Nine years is about what it takes to recover from a crisis – if you look at hundreds of years of economic history. Iceland was a textbook case.”

Wharton’s Nichols agrees that any country going through a financial crisis would benefit if it adopts a strategy in which it refuses to pay its creditors. He also offers other reasons why Iceland could be considered a poster child for understanding the banking crisis. “That is one of the insights we got through the Panama Papers,” he says, referring to a leak of millions of documents in 2016 outlining secret dealings of global political leaders. Following those revelations, Iceland launched criminal investigations into those considered culpable for the meltdown.

Gylfason believes that when a country goes through a major economic shock, in addition to getting its financial house in order – which Iceland successfully accomplished at the behest of the IMF — it also needs to clean up its act in the judicial and political realms. “We have a mixed picture here,” he says. “Thirty-nine bankers were awarded prison sentences by the Supreme Court of Iceland, to the tune of 2.5 years on average. This means the amount of prison time in man-years that the Supreme Court handed out is close to 100.” He admits some critics have alleged that “the small fry were sentenced, while the big fish got away. This raises sensitive questions about equality before the law. But we will know more once the Supreme Court hands out its last sentences in 2019.”

“We cannot imagine the equivalent of 6% of the U.S. population throwing snowballs at anyone.” –Philip Nichols

The way Iceland dealt with its financial crisis had a strong political aspect, notes Gylfason. “One way of describing what happened is that the politicians and the bankers were in bed together — big time. Basically, it was under the weight of this corrupt arrangement that Iceland collapsed.” As these facts became widely known, political protests rocked the country. People took to the streets, banging pots and pans, demanding reforms. “Politicians were up against the wall. They were visibly shaken and afraid. They resolved unanimously in parliament that criticism of Iceland’s political culture needed to be taken seriously. But then the IMF program was so successful, it worked wonders even more than the [Fund] had dared hope. Politicians thought that perhaps there wasn’t a need for them to clean up their act.”

Fallout From the Icelandic Banking Crisis

Popular anger exploded in full force in 2016. According to Nichols, some 6% of Iceland’s population took to the streets, throwing snowballs at politicians. “We cannot imagine the equivalent of 6% of the U.S. population throwing snowballs at anyone.” Gylfason says it turned out that Iceland had 600 names in the Panama Papers. By way of comparison, Ukraine had 20. “Iceland had by far the most names in the Panama Papers, per capita, of any country. There were five Cabinet ministers in all of Europe whose names appeared in the Panama Papers. Of those, three were from Iceland. And one of them is still finance minister. This is a clear sign that the political and judicial aspect of the recovery was less ambitious and less successful than the economic recovery.”

To appease popular discontent, a constitutional reform process was set in motion. A constituent assembly was set up to draft a post-crash constitution for Iceland; Gylfason served as a member. Once again, though, political barriers emerged. Despite being endorsed by a national referendum in which some 67% of voters expressed support for the new constitution, “Parliament put the new constitution on ice,” Gylfason notes. “It has refused to ratify it. That is a sign of Iceland’s fraying social capital.”

International observers seem to have noticed these maneuvers. Freedom House, an independent watchdog organization that advocates for democracy and freedom around the world, used to award Iceland a full score of 100 points like Sweden, Denmark and Norway. In recent years, Iceland’s score has dropped to 95, Gylfason notes. “Freedom House … realized that things [in Iceland] are not the way they are supposed to be in a Northern European democracy.”

“[The] political and judicial aspect of the recovery was less ambitious and less successful than the economic recovery.” –Thorvaldur Gylfason

Despite the half-hearted commitment to political reform, why has Iceland’s economic recovery worked so well? Gylfason believes one factor that might have contributed was that the country – unlike Ireland, which also fell upon hard times during the downturn – was not part of the Eurozone. As a result, Iceland could let its currency depreciate by 50%. This, in turn, created the conditions for an influx of tourists, who discovered they could enjoy Iceland’s rugged natural beauty with its volcanoes, geysers, waterfalls and lagoons – at a fraction of the cost of traveling to other exotic destinations. “That is what helped revamp the economy,” Gylfason says. “This is something that the Irish could not do, because they were part of the Eurozone.” (He adds, however, that in recent years Ireland has made a stronger economic recovery than Iceland, which may mean that being outside the Eurozone and letting the krona depreciate may not have helped Iceland as much as was originally thought.)

Fickle as Fish

Even so, as the krona lost half its value following the banking crash, tourism surged. “Tourists started flocking to Iceland,” says Gylfason. Tourism is now the most important source of foreign exchange earnings for Iceland, outstripping the fishing industry, which was previously No. 1. That, he believes, is good news for two reasons. First, foreign exchange is “nice to have” to pay for imports. Second, ownership of Iceland’s fishing industry is concentrated, “dominated by a few oligarchs who like to throw their weight around in the political arena.” In contrast, tourism is diversified, with many small-scale operators. Some observers hope that the diversion of foreign exchange earnings away from fisheries to tourism will help ease the political influence of the fishing industry’s oligarchs. Still, “tourists are a bit like fish; they can be fickle, and you never know if the current wave of tourists will be replaced by other waves in the future,” Gylfason says.

Millions of tourists continue to travel to Iceland although the krona has now again reached pre-crash levels, making the country one of the most expensive destinations in Europe. While tourism numbers declined a bit in response to a strengthening currency, the fall has been modest, says Gylfason. Nichols, who has traveled to Iceland a few times, notes that the country can be “brutally expensive” but it is gorgeous. The country has a minimal tourism infrastructure because the tourist season is short. In addition to a favorable exchange rate, access has played a role in boosting Icelandic tourism, he says. Both Icelandair and WOW air – the country’s main carriers — have implemented low-cost strategies. These make it relatively inexpensive for tourists to travel to Iceland from destinations around the world – and also to fly via Reykjavik between destinations. “It’s more than just the cheap krona that led to the tourism boom,” Nichols says. The tech industry, while it is smaller than tourism, offers more promising prospects for strengthening Iceland’s economy in the future. “That is where Iceland could focus if it wants to build long-term, sustainable growth.”

“It’s more than just the cheap krona that led to the tourism boom.” –Philip Nichols

What is the most important lesson other countries could learn from Iceland’s experience in dealing with its financial crisis? According to Gylfason, the key is for countries to realize that they should focus not just on the economic recovery but also on the judicial and political aspects. “One needs a two-pronged recovery from a deep crash of the type we experienced in Iceland,” he says. “I don’t think we would have had Brexit or President Trump if there had been more prosecutions in the U.S.”

As the clash between economics and politics in Iceland continues, the country will continue to witness eruptions. But it will survive. After all, Icelanders have been dealing with volcanoes like Mt. Katla for a long time.