Iceland’s experience during the Great Financial Crisis is another particularly useful example in probing Sovereign Exceptionalism. Iceland entered into the crisis in 2008 with low inflation and a fiscal budget surplus. Similar to other crises we have examined, Iceland also experienced significant capital inflows in the lead-up to the crisis, particularly Nordic, British and Dutch investors buying deposits from Iceland’s major financial institutions. Somewhat unique to the Icelandic crisis, however, was the disproportionate size of the Icelandic financial institutions relative to its sovereign. On the eve of the crisis, Iceland’s external debt had peaked at nearly seven times GDP, while the assets of the three largest Icelandic financial institutions sat at eleven-times GDP. This enormous disparity made it clear that the Icelandic sovereign could not hope to guarantee or cover these obligations in the event of a crisis.
The rationale behind the collapse of the Icelandic krona is fairly self-evident: at a time when nearly every major financial institution was recognizing large losses requiring state aid to cover, Iceland’s financial institutions were holding liabilities that would vastly surpass the government’s ability to redeem them. Many of these liabilities were denominated in pounds or euros, and very quickly the demand to redeem krona deposits for foreign currencies would fully deplete Iceland’s currency reserves and swap agreements. Once investors came to this realization, the market for krona froze almost entirely, as even Icelandic citizens were attempting to sell krona in order to cover their own euro and pound denominated liabilities.
The depreciation of the Icelandic Krona started in September 2007, moving from roughly 85 ISK/EUR to approximately 125 ISK/EUR by August of 2008 (a roughly 30% devaluation). Then, with the collapse of Lehman Brothers in September 2008 and the ensuing tightening in the interbank markets, the major Icelandic banks began to wobble and international investors began to seek redemptions in earnest. On October 7, 2008, the Icelandic central bank attempted to peg the krona to 131 ISK/EUR — but that effort lasted less than 24 hours before the central bank conceded defeat and reversed itself. In the aftermath, the central bank introduced capital controls to restrict the pace of redemptions, leaving the on-shore exchange rate around 180 ISK/EUR, while the offshore rate exploded to 390 ISK/EUR — a nearly 80% depreciation from a year earlier. Despite its intermittent quotes, the krona effectively ceased trading outside of Iceland. For all intents and purposes, the Icelandic sovereign had lost any ability to finance itself through further issuance of krona.
The financial crisis Iceland is an interesting case due to both its onset and progression, but also due to its subsequent governmental response. Unlike other nations, including sovereign issuers like the US, Iceland decided not to bail out its financial institutions and to instead pursue asset preservation and debt relief for its citizens. While letting its major banks collapse, Iceland determined to impose full losses on foreign depositors — protecting on-shore depositors by transferring their liabilities to new “Good Bank” entities. They went on to speedily resolve local bankruptcy’s, most caused by exploding real costs of foreign denominated debts, and to provide mortgage relief for homeowners facing similar strains after the krona’s devaluation. However, they also determined to raise taxes in order to pay for continued social services while maintaining a balanced budget.
The results have been better than nearly anyone would have hoped: the decline in real wages has made Iceland’s tourist industry particularly attractive for US and European consumers, while the strict capital controls forced local individual and institutional investors to find domestic investment opportunities. In 2014, Iceland’s GDP surpassed its 2007 peak; and by September 2017 the krona had recovered to approximately 120 ISK/EUR — still 30% below its 2007 value, but far better than the depths of October 2008. In October 2015, the IMF announced that Iceland had fully repaid its emergency loan — nearly a year ahead of schedule. Finally, in March 2017 Iceland formally lifted its capital controls by reaching an agreement to purchase 90B ISK of offshore krona assets at a rate of 137.5 ISK/EUR. Nearly ten years on from the crisis and Iceland is recovered and seemingly stronger than ever.
As with other sovereign crises, the situation in Iceland begs serious questions of MMT’s assertion of Sovereign Exceptionalism. In addition to contradicting the notion of unlimited self-financing, the case in Iceland also questions the MMT policy prescription of funding spending through monetization, rather than through balanced taxation. From 2008 through 2016, Iceland actually ran a cumulative primary budget surplus, while unemployment dropped over the same time period from nearly 8% to 3%. So what can we take away from the crisis and response in Iceland?
First, it is clear that Iceland could not simply have issued additional krona to spend its way out of the crisis. This is not because the Icelandic sovereign had some ill-conceived currency peg or because it had leveraged itself with foreign-denominated indebtedness, but rather because the market dynamics had turned massively against the desirability of holding the krona. The loss of faith in the creditworthiness of the Icelandic banks, as well as the Icelandic consumers themselves, precipitated a very rational run on the ISK. If the Icelandic central bank were to attempt to issue and spend additional krona at this point, it would have certainly led to continued devaluation and hyper inflation. Instead, to stabilize the situation Iceland took steps that seemingly directly contradict MMT doctrine: they took a foreign loan from the IMF, disavowed or wrote-down most private debt, and then began running a balanced budget with a primary surplus.
The key takeaway from the Icelandic crisis is that Sovereign Exceptionalism is, unsurprisingly, not the silver bullet that MMT would have us believe. Iceland was forced to resort to traditional financial mechanisms — borrowing and repaying in real terms — rather than relying on the money-printing policies of MMT. More importantly, Iceland demonstrates that running a balanced budget, and even a surplus, are often beneficial for an economic nation — so long as the budgetary actions are directed towards domestic accountability and not towards repaying foreign creditors. More than anything, Iceland shows that the true benefit of sovereignty resides in the ability for domestic courts to protect its citizens and soak foreigners in times of financial strain. It was the repudiation of the banking sector and the write-down of private debts that revitalized Iceland — it had relatively little to do with its monetary policy.