Meltdown in Iceland

Small countries in Europe and the world are being rocked politically as the volatility of the continuing global financial crisis overwhelms their relatively modest national economies. The case of Iceland was the first to achieve high visibility last autumn, but since then contagion has spread.

The particular case of Iceland illuminates the phenomenon as it manifests in other European countries that have recently experienced popular unrest. From there the broader contours of the phenomenon become evident, with differential effects in Africa and Latin America. The situation in Asia likewise differs, but with the huge and dynamic economies of China and India, could hold the key to the worldwide resolution - or aggravation - of the trend.

The Icelandic saga

As recently as 20 years ago, Iceland’s economy was based on fishing and the country had no functioning stock market. In the mid-1990s, it joined the free-trade zone European Economic Area and deregulated the national banking sector, which had until then dominated by the state. In 2001, the krona was freed from being fixed against a basket of international currencies and floated instead on the international markets. After the banks were fully privatized in 2002, for five years the country luxuriated in an annual growth rate of over 5 percent, one of the strongest in Europe.

In autumn last year, a nationwide financial crisis revealed the debt load of Iceland’s banks, unable to obtain short-term financing, to be equivalent to roughly to six times the country's GDP. Iceland's high standard of living turned out to be based largely on the banking sector of the economy, which had expanded by drawing money into the country from foreign depositors, including a large number from the UK.

Last October, trading in shares was suspended for Iceland’s six largest financial institutions. In order to be able to seize the UK holdings of Kaupthing, the largest bank, in defense of British depositors, the British government declared Iceland a “terrorist state.” Within two days the government in Reykjavik had taken control of the country's three largest banks.

In late November, the annual rate of inflation leapt to over 17 percent, and Iceland became the first Western European state in over three decades to receive a loan from the International Monetary Fund (IMF). A decline of nearly 10 percent in the economy is foreseen for 2009 with no growth in 2010. Following popular protests and mass demonstrations, a “red-green” coalition (Social Democratic Alliance and Left-Green Movement) took power at the end of January to form an interim government until the general election now set for 25 April.

Inflation estimates for 2009 vary with an average of 10 percent. Unemployment will double if not triple, and the current 18 percent interest rates will continue to rise. While there has not been massive destruction of property, there have been regular mass street demonstrations. Extra-parliamentary political upheaval has been limited to egg-throwing at the Central Bank. The significance, however, is that such protests have not been limited to Iceland.

The European contagion

The economic problems and popular unrest in Europe at large are not the result of the events in Iceland. However, these have had a certain “demonstration effect,” particularly among the smaller members of the EU, whose modest national ships of state are likewise buffeted by the gale-force winds of generalized economic bad weather.

The case of Latvia is most notable since it has, along with Hungary, been forced to seek help from the IMF. In mid-January, a demonstration in Riga of over 10,000 led to over 100 arrests during an ensuing riot; not far away in Vilnius, a demonstration of 7,000 led to a riot with 86 arrests. Latvia's agricultural minister has been forced to resign. The external page IMF report on Latvia explicitly anticipates a “prolonged recession” and cautions that the program “will only succeed if the financial sector stabilizes.”

The IMF stepped away from imposing a devaluation of the national currency (the lat) partly as a result of the government’s resistance and partly as a result of its own fear of a domino effect throughout Eastern Europe. Such a move would put the other two Baltic states, Lithuania and Estonia, under pressure to follow suit, and moreover influence international risk perceptions for the whole of Eastern Europe.

Yet Business New Europe reports the increasingly prevalent opinion that even the €7.5 billion rescue program for Latvia may not be sufficient and cites the prediction of external page Torbjorn Becker, director of the Stockholm Institute of Transition Economics, that a Latvian devaluation is inevitable “at some stage” before it joins the Eurozone as planned in 2012-13.

Local catalysts to unrest differ, but the unrest itself reflects generally shared discontent. From external page Irelandto external page Slovenia and beyond, hardly a single government is unaffected. Thus farmers not only in Latvia but also in Greece and Bulgaria have mounted unruly protests as the price of agricultural products has begun to collapse. Nor is this discontent limited to smaller or newer members. In France, a general strike set off by a proposed education policy reform received support from over two-thirds of the population.

Nor is it only in Europe that the political effects on government stability from the continuing global financial crisis will be felt.

The World Bank external page projects that growth in sub-Saharan Africa will be under 5 percent in 2009 as lower commodity prices and decreased foreign demand will lead to a worsening of the region's economic situation. The Latin America regional head of the UN Development Program, external page Rebeca Grynspan, has projected that poverty in Latin America could increase as much as 15 percent in 2009, with 2.4 million job losses. The smaller countries, she added, might not be able to cope with such a shock.

Breaking even

As for Asia, it has generally been agreed that the Chinese economy needs a minimum 8 percent growth rate to maintain levels of production sufficient to prevent unemployment (and attendant social unrest) from increasing. But in late January, the Chinese government released statistics showing that during the last quarter of 2008 the country's economy grew at an annualized rate of 6.8 percent, the slowest pace in seven years. This is the sixth consecutive quarter of decline, but as external page NYU Professor Nouriel Roubini has pointed out, the real growth rate is probably closer to zero, if not zero itself, due to the idiosyncratic manner in which the national authorities calculate and report these statistics.

Despite all the wishful thinking in 2006 and 2007 about Asian markets “decoupling” from the Euro-Atlantic area, it is hard to avoid the material reality that the Chinese economy will not grow faster until it exports more the US and Europe, where consumers will not have more money to buy more Chinese imports until some sort of economic recovery looks like taking hold. The optimistic forecast today for that event is 2011, as 2009 will be down year and, if luck is good, 2010 will break even.

In such an extended scenario, the structure of the Icelandic saga could become the generative grammar for the breakdown of other, still more significant national economic systems. As external page Der Spiegel recently explained, quoting former consultant to the Bank of England Willem Buiter, it is not out of the question that even so key an economy as the UK’s goes bankrupt, to “become a second Iceland.”

The UK does not use the Euro, but the possibility of such a major bankruptcy raises the question of the Euro’s viability.

Indeed, a division is emerging between those members of the Eurozone who look to Eurobonds to save their banking systems and those who insist that each state must employ national means for that purpose. It is no longer unthinkable that countries having entered the Eurozone may find themselves compelled to leave it and take up again their respective national currencies, with devastating economic consequences. That being the case, it is remarkable that the new caretaker government in Iceland has commissioned a parliamentary report on the advisability of the country’s adoption of the European currency.