Sixteen years ago, one of us (Passell) wrote an article for The New York Times explaining how Iceland defied common sense and conventional analysis by managing a highly productive, diversified economy just one-one-thousandth the size of the U.S. economy in the middle of the ocean. The country’s strategy amounted to economic jujitsu, doing what it did best (think, fish, exploit geothermal power), grabbing freebees where it could (an ultra-modern all-weather airport, courtesy of NATO) and never challenging the big guys where economies of scale or geography made the battles almost unwinnable. That formula worked well for a very long time: In 2007, the country’s per capita income, expressed in purchasing power terms, exceeded that of Germany or Britain or Japan.
Today, of course, the bloom is off the rose: No economy (with the possible exception of Russia) has done as badly as Iceland’s in the global recession. The currency collapsed in 2008 and living standards, which had been tracking those of Scandinavia pretty well since the 1980’s, fell to just two-thirds that of Denmark and Sweden. Moreover, no end to what amounts to a depression is in sight: real output fell almost 7 percent in 2009, and nobody’s predicting a vigorous recovery anytime soon. Indeed, the financial mess seems likely to undermine economic growth for the indefinite future.
The story of Iceland’s ejection from the garden is a familiar one by now. Landsbanki, the country’s largest bank, dove blindfolded head first into the global securities bubble, largely financing its expansion by offering savings accounts denominated in other currencies (but insured by the Government of Iceland) to some 400,000 Europeans. When the bank went belly up, the British and Dutch governments bailed out the Icesave account holders (whose numbers exceeded the entire population of Iceland) and presented a bill to the Icelandic government roughly equal to half a year’s national income. Iceland’s not about to pay it – and as a result may sacrifice its deal with IMF to provide the foreign exchange the country needs to function efficiently in global markets.
So what happened? Thorvaldur Gylfason, Iceland’s highest-profile economist, explains here and in a recent Milken Institute Review article [Download Here] in terms of the soft corruption of interest group politics and the subsequent evaporation of effective financial regulation in Iceland. Can’t dispute that. But the magnitude of the catastrophe also has much to do with Iceland’s failure to respect the inherent limitations of its small size.
Iceland succeeded in part by ignoring size where it didn’t matter – for example, by running an airline through the island that largely served other countries’ residents, and by manufacturing specialized, energy-intensive chemicals whose market was elsewhere. However, no matter how high the living standard, small economies can’t allow their banks to act like big-economy banks by taking massive unhedged positions in foreign currencies.
Seems that, in the end, the little economy that could, didn’t.