Global Economies, Regulatory Failure, & Loose Money: Lessons for Regulating the Finance Sector from Iceland's Financial Crisis

Abstract

Iceland was the first developed economy to fall into crisis in 2008, with the collapse of its banking sector, currency value, and economy. The collapse threw Iceland into a political crisis and provoked a serious international dispute between Iceland and Britain and the Netherlands over responsibility for the failed banks. Prior to 2008 Iceland had been treated as the poster child for deregulation; since 2008 it has been held up as the poster child for the dangers of financial liberalization. Neither is accurate. Rather, Iceland presents a cautionary tale about the inter-relationships between fiscal and monetary policy and regulatory measures. Excessive liquidity fostered by central banks around the world, expansionary fiscal policies in Iceland, and inadequate understanding of fundamental economic linkages created conditions under which capital flooded Iceland and overwhelmed its financial institutions. Regulatory failures at the EU and Icelandic levels meant regulatory measures such as central bank interventions and deposit insurance exacerbated problems rather than correcting them. This paper explores those relationships, uncovering connections made visible by both Iceland’s relatively small size and the comprehensive parliamentary investigation into the crisis. It concludes that regulators need to focus attention on enhancing market-feedback mechanisms rather than on attempting to steer economies if they are to avoid “the next Iceland.”

Keywords: Iceland, financial crisis, central banking, deposit insurance, monetary policy