Iceland Economy: Its Bankruptcy and the Financial Crisis

How a Volcanic Eruption Helped Iceland Recover

Icelandic volcano eruption
Eyjafjoell volcano rise in the distance above a farm on May 17, 2010. Photo: Ingoacutelfur Bjargmundsson/Getty Images

Iceland's economy successfully survived a sovereign bankruptcy and government collapse. But an economic rebound fueled by tourism could be overheating the economy once again. That's because the small island economy is vulnerable to boom and bust cycles.

In 2016, Iceland's gross domestic product was $16.5 billion. Since the country only has 336,000 people, that translate to a wealthy $48,100 GDP per capita.

That's lower than the United States' ($57,300) but higher than Canada's ($46,200).

Iceland's GDP growth rate was a robust 4.9 percent. That's much faster than the healthy 2-3 percent growth rate

Iceland's economy has always relied on fishing and aluminum smelting. The fishing industry provides 12 percent of GDP. It is vulnerable to declining global fish stocks, itself caused by overfishing and climate change.

Tourism became a large contributor to the economy after the 2010 eruption of the Eyjafjallajökull volcano. In 2016, the number of tourists was 4.5 times the country's population. (Source: "Iceland's Economy," The CIA World Factbook.)

Iceland Financial Crisis and Its Causes

In October 2008, Iceland nationalized its three largest banks. Kaupthing Bank, Landsbanki, and Glitnir Bank had defaulted on $62 billion of foreign debt. The banks' collapse sent foreign investors out of Iceland. That sent the krona down 50 percent in one week.

The stock market fell 95 percent. Almost every business in Iceland went bankrupt. Housing prices fell, while mortgage costs doubled. (Source: "Iceland Is All But Officially Bankrupt," International Herald Tribune, October 9, 2008.)(Source: "How Iceland Emerged From Its Deep Freeze," The Wall Street Journal, July 5, 2015.)

Here's how Iceland's banks created the crisis. First, they lured deposits from the Netherlands and the United Kingdom by offering 15 percent interest rates. They could offer these rates because the value of Iceland's currency, the krona, was high. It had become a major trading currency. That drove its value up 900 percent between 1994 and 2008. 

That also created inflation.  Housing prices rose. Between 2003 and 2004, the Iceland stock market skyrocketed 900 percent. By 2006, the average Icelander was 300 percent wealthier than in 2003. Many Icelanders added second mortgages using cheap foreign currencies. (Source: Roger Boyes, Meltdown Iceland. Bloomsbury USA, 2009.)

The banks used $100 billion in deposits to invest in foreign companies, real estate and even soccer teams. That amount dwarfed Iceland's 2008 GDP of $14 billion. 

Then the 2008 global financial crisis shut down bank lending. Like U.S. banks Bear Stearns and Washington Mutual, Iceland's banks went bankrupt. The government couldn't bail them out because it didn't have the money. Instead of being too big to fail, they were too big to save. As a result, these banks' financial collapse brought down the country's economy. (Source: "Iceland Teeters on the Brink of Bankruptcy," Associated Press, October 7, 2008.)

Prime Minister Geir Haarde and Foreign Minister Ingibjorg Gialadottir negotiated a $2.1 billion bailout from the International Monetary Fund to keep the government afloat. Iceland asked its neighbors Luxembourg, Belgium and the UK to insure bank deposits of its branches in their countries. (Source: "Iceland Sees IMF Decision Within a Week," The Guardian, October 16, 2008.)

The Government Collapsed

Iceland's nearly bankrupt economy caused the government to collapse in January 2009. The failure occurred because Prime Minister Haarde resigned due to cancer. The minority party insisted that one of its members fill the position. Haarde asked that Gialadottir take the post. Commerce Secretary Bjorgvin Sigurdsson resigned due to bankruptcy-related stress.Protesters took to the streets in response to soaring unemployment and rising prices caused by the bankruptcy.

(Source: "Iceland's Government Topples Amid Financial Mess," Associated Press, January 26, 2009.)

Impact on the Global Financial Crisis

Iceland's economic collapse affected the rest of Europe. That's because Iceland's banks had expanded their retail services in Europe. They had also and invested in foreign companies. Iceland's Baugur was the largest private company in Great Britain. Icesave, the online arm of Landsbanki, froze withdrawals during the crisis. That affected depositors throughout Europe.

Since the government was unable to maintain the value of the krona, many suggested Iceland join the EU and adopt the euro as its currency. Iceland is already a member of the European Economic Area, a trade association that follows many EU rules. But Iceland's fishing industry is opposed. It clashed with European countries over fishing rights.

How Iceland Recovered

In February 2009, voters elected Johanna Sigurdardottir and her coalition. She barred capital from leaving the country. She raised taxes. But she also kept social services and provided debt relief to mortgage holders. She prohibited citizens from buying foreign currency or foreign stocks. (Source: "How Iceland Emerged from Its Deep Freeze," The New York Times, July 3, 2015.)

As a result, people invested in local businesses, including real estate and private equity.  Tourism boomed when local prices fell thanks to the low currency exchange rate. It increased further after both the 2010 and 2011 volcanic eruptions. (Source: "Icelandic Caretaker Government Wins General Election," The Guardian, April 26, 2009.)