Meltdown 2.0?

Cyrus Sanati’s article, “Iceland is Europe’s Ticking Time Bomb–Again,” published yesterday in Fortune, has been making its rounds on the interwebs and generally sowing gloom and doom. Says Sanati:

The inevitable unmasking of Iceland’s dubious economic recovery could have severe consequences for the rest of Europe. Since 2008, the small island nation has been able to avoid an all-out economic meltdown thanks largely to government-imposed capital controls that have kept its currency from imploding. At the same time, the nation’s zombie banks have managed to avoid total collapse thanks to delay tactics that have allowed them to avoid settling with their creditors.

But the walls the government and its banks erected to shield its population from the outside elements have finally started to crumble. Unfortunately, there is not much Iceland can do to save itself at this point; it will need to face the music eventually.

Iceland’s economy appears as if it has rebounded, growing faster than most of its European cousins. Unemployment has fallen sharply from a peak of 8% in 2009 to around half that today. At the same time, consumer confidence in the country is growing, as is tourism, which is one of the two major industries in Iceland, the other being fishing. All in all it seems that Iceland has recovered, at least that is what most economists and even the IMF say.

But hang on: Iceland has made little, if any, real progress in tackling its economic issues. The government and its banks have simply employed measures designed to delay the pain, not cure the disease. Capital controls imposed by the government in 2008 are still in effect, forcing its citizens, and, more importantly, the nation’s massive pension fund, to invest mainly in Iceland. At the same time, Icelandic consumers still find it hard to buy foreign goods, forcing them to buy less-desirable local equivalents, giving an artificial boost to the domestic economy. Meanwhile, high interest rates have made borrowing expensive. A moot point, considering Iceland’s now-zombie banks aren’t really lending; they are too busy dealing with fallout from the billions of krona worth of bad loans on their books.

celanders, frustrated with the slowdown in economic growth, voted in a new government coalition in May, the same that was in power during the boom years. The new government promised during the campaign to lift the capital controls and to force banks to cut people’s mortgage principals. This has understandably shaken the rating agencies. S&P lowered its outlook on Iceland to negative in June on concern that the new government will go through with its plans. The IMF has expressed similar reservations.

Iceland has few good options. If it keeps the capital controls in place its economy will continue to shrink; lift them and asset values will fall as Icelanders ship their cash out of the country. The new government says that foreign direct investment will make up for the capital outflows, but they are either extremely optimistic or completely misguided. The lifting of capital controls will cause housing prices and other Icelandic assets to fall dramatically leading to yet another bank panic. In the wake of this chaos the Icelandic government believes foreign investors will come strolling in?

Grim, to say the least.

Not being remotely qualified to speak on the financial outlooks of Iceland, I can’t honestly say if Sanati’s forecasted Meltdown 2.0 seems likely or not. Economic recovery is a long and difficult process, of course, and there are a whole lot of variables to consider in the case of Iceland (not the least of which are the measures that Iceland’s recently elected coalition government has said it will take to aid recovery, which Sanati discusses in his article). But the article has gained a lot of attention, not least from Gylfi Magnússon, Iceland’s former Minister of Finance and Commerce, who told the news oulet Visir that the story is “mostly baloney.” Per The Reykjavík Grapevine:

Gylfi said that Sanati’s presumptions were wrong and that he cited statistics incorrectly. “Furthermore, he doesn’t make a distinction between the old and the new banks and doesn’t seem to know anything about how things are.”

“Perhaps this tells us that we need to put forth clearer messages to the outside world about the situation in Iceland, to prevent such rubbish being published again and again.”

Gylfi also stated that within the economy sector, people who have actually studied the circumstances think that Iceland’s progress is rather good and that the country is on the right track towards restoration.

I hope Gylfi is right, of course, but will be watching the news with interest.


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