Last week (March 5, 2010) Iceland held its first ever referendum in history. The issue was not on whether to extend religious freedoms, introduce legal representation for animals, or on joining the European Union. Instead, Icelanders were voting on whether they agree to the deal that Iceland made with the Netherlands and the UK on terms of reimbursement of these two governments for losses their citizens incurred by the bankruptcy of the Icelandic online retail bank Icesave. With a result of 93.2%[1], the citizens rejected the inter-governmental compensation deal.

This story is about commitments governments make to international institutions, and about how they clash with commitments made to their citizens. It is also a story about the deep sense of injustice that unfolded in the aftermath of the financial crisis with respect to the ‘socializing of financial risk’ – the fact that around the globe taxpayers bailed out reckless bankers and financial institutions in order to restore the financial system and prevent national economies from collapsing. In this sense it is not a story about Iceland, but about many countries faced with severe fiscal strain, like Greece, or several countries of East and Southeast Europe. However, in order to be able to appreciate the nuanced symbolism of this story, we need to start at the beginning. 

Setting the Scene

Iceland was proclaimed an independent republic in 1944, when it terminated its union with Denmark. It has a population of 313,376[2], which spreads over an area roughly comparable to the size of Ireland. In 2006, its GDP per capita was $35,748 (ibid.), and fishing is its most important industry, accounting for 70% of the country's exports[3]. In its 20th century past, Iceland boasts the world’s first popularly elected female head of state – Ms Vigdis Finnbogadottir – which was elected president in 1980, and re-elected in 1984, 1988 and 1992.

            The last regular parliamentary election was held in 2007, when a coalition was voted into office between the centre-right Independence Party and the Social Democrats. From October 2008 onwards the history of Iceland becomes well known: Iceland became the worst hit country in the world by the financial crisis[4]. The crisis led to the collapse and government nationalization of the country’s main banks, and was followed by the resignation of the government in January 2009. An interim government was formed, consisting of Social Democrats and the Left-Green Movement[5], and this government was confirmed at early elections held in April 2009.

Why was Iceland hit so hard?

            First of all, Iceland has had limited experience with international banking[6]. During the 20th century, its financial system was highly regulated and politicized, most of it government-owned and insulated from global financial flows[7]. This changed after 1994 when the European Economic Area came into force. As a member, Iceland adopted a new regulatory structure, the key novelty of which was that Icelandic banks could freely operate within the EU. However, according to Jon Danielsson, an expert on Iceland from the London School of Economics, both the banks and the government were seriously unprepared for deregulated operations.

The banks passed into hands of holding companies and soon significant parts of the economy were controlled by a few investment groups who were running financial institutions, non-financial businesses, the media, and had close connections to political parties. The banks were using borrowed funds to acquire assets, and in a short period of time the balance sheet of banks swelled to 10 times the GDP of Iceland[8]. One avenue of bank expansion was the setting up of internet branches and subsidiaries in Europe. In 2006 Landesbanki set up Icesave, a leading protagonist in this story, which started offering above market rates; soon it amassed £4.5 billion in the UK and €1.7 billion in deposits in the Netherlands.

According to Danielsson, the risk was there for everyone to see. As far back as 2005 the financial press in Scandinavia was issuing warning assessments about Icelandic banks, and in 2008 a British financial paper called Icelandic banks ‘the most unsafe in the developed world’. Therefore, it seems clear that the risks were appreciated way ahead but were ignored or at best underestimated.

In other words, while Landesbanki and the rest of the Icelandic financial system went bust in October 2008 in what seemed to be the consequence of a global financial crisis, actually the country’s financial system was a time-bomb which was set off by the global downturn. The Icelandic financial system, it could be argued, epitomizes in a small scale everything that was wrong with the global financial sector.

As a consequence, the banking system in Iceland has been nationalized[9], and by extension the debt that resulted from risky international financial undertakings became the responsibility of Iceland’s government and its people. The overall amount that Iceland must repay to the Dutch and British governments is around €3.9 billion, which, when divided up per citizen of Iceland, amounts to €13,000 per person[10], or more than 40% of Iceland’s GDP[11].

The president of Iceland, Mr. Grimsson, was quoted in the New York Times saying that ‘ordinary people, farmers and fisherman, taxpayers, doctors, nurses, teachers, are being asked to shoulder through their taxes a burden that was created by irresponsible greedy bankers.’[12] His refusal in January to sign the bill on repayment that was passed in Parliament triggered the national referendum. At the referendum held on March 5, the citizens rejected the repayment deal. Even though technically the referendum was only on the specifics of the proposed repayment plan, the vote acquired the symbolic rejection of the whole idea of citizens repaying bankers’ debts.

The EU dimension

Iceland has traditionally not wanted to become member of the EU, not least because of the key role fishing plays in its economy. Currently only Icelanders are allowed to fish in its waters, foreign ships have restricted access to Iceland’s ports and foreigners are only allowed to own a minority share in Iceland’s fishing companies[13]. However, after the political and economic shock that it suffered in mid-2008, Iceland applied for EU membership in July 2009[14].

In February this year the European Commission officially recommended to member states that negotiations for Iceland’s membership could start. On that occasion, several leading newspapers quoted EU Enlargement Commissioner, Mr Füle, as saying that Iceland was a strategic gateway to the Arctic with its rich mineral resources. It is also a stable and advanced democracy, which should make its accession to the Union smooth and much faster than was the case with Eastern enlargements.

On the other hand, the EU is blocking the initiation of a $10 billion rescue programme with the IMF[15] on behalf of its member states the Netherlands and the UK over the Icesave dispute. Postponing the IMF loan is jeopardising the still precarious financial situation of the country, which is already probably the most indebted country in the world, with government debt to GDP at around 140%[16].

Apart from that, the EU appears to be signalling to Iceland that its membership application is conditional upon settlement of this dispute. At this point readers familiar with Croatia’s accession journey to the EU will remember that a recent bilateral territorial dispute with Slovenia blocked its negotiation process with the EU. Another country that is using the EU card in bilateral disputes is Greece, which is blocking the accession of FYR Macedonia. While in academic literature the EU is usually portrayed as Janus-faced, with an intergovernmental and a supra-governmental side, when it comes to crucial interests of member states, it repeatedly fails the test of unity.

Greece of course figures in this story in another important way. Greece faces €23 billion in debt repayments in April and May[17]. In order to finance its deficit and refinance its debt, it needs to borrow more than 50 billion euro by the end of this year[18]. The problem is that currently the interest offered is around 4% higher than the interest paid by for instance the German government for its bonds. The 16 members of the Euro-zone have a pragmatic reason to help Greece because its default would destabilize the currency.

However, there is another reason to help Greece, and this one sounds awfully similar to the situation in Iceland. According to Ole Ryborg, Danish journalist and commentator[19], while it is clearly Greek government’s fault to have run deficits, increased debts and lied about the size of its deficit, other members of the Euro group share part of the responsibility by not intervening and making demands on the Greek economy long before. Ryborg argues that the finance ministers and officials from the Euro group have collectively turned a blind eye and refrained from handling the Greek economy as they should have done a long time ago.

Lessons and Parallels

One striking parallel between the Greek and the Icelandic story is a strong sense that, since the key parties to the process were in the know, the current crises and their burden on ordinary citizens could have been avoided. The finance ministers and government heads, key financial institutions, as well as the relevant coordination bodies of the EU knew that, in the Icelandic case, the financial sector was overstretched and that it grew through a high-risk model. In the case of Greece, they knew that the government was overspending and over-borrowing. Instead of using the appropriate institutional venues to arrest exposure to high risk, they seemed to prefer turning a blind eye[20].

Since the advent of the phenomenon of globalisation, one of the pet topics of political scientists has been the double-bind that governments have found themselves in. On the one hand, the integrated financial markets make it paramount to play according to set rules of fiscal prudence and to heed warnings issued by international credit institutions and credit-rating agencies. This is a prerequisite in order to be able to borrow, and borrowing is in turn prerequisite for running a government.

This international finance dictate however puts governments at odds with their citizens, who typically care most about their living standards and job prospects, and who want to see public spending for the tax money they put in. The bond markets v. citizens dilemma is less apparent in times of economic growth, but in times of economic recession it becomes acute. In order to kick-start their economies, governments must borrow money and increase public expenditure; but in order to borrow at reasonable rates, they must first cut what is deemed excess public spending, creating a further recessionary spiral.  

While at first glance the examples of Iceland and Greece might seem to corroborate this dilemma, the morale of the story is quite different. What I have tried to argue is that the financial predicaments of these countries could have been avoided precisely because of the international nature of the financial sector. The institutions were there, but they were not doing their job. It was through choices made by those involved that the risks were downplayed, and their potential implications ignored.

What were probably numerous individual under-assessments of risks, in the aggregate created grave consequences for entire states and their populations. In this context, the Icelandic people’s ‘no’ at the referendum is a frustrated cry against a game which is rigged. Andrew Ward from the Financial Times wonders in a recent commentary whether lessons will be drawn by people elsewhere in Europe from this tiny nation’s ‘defying the will of powerful creditors’[21]. Unfortunately, this is fanciful. Just like the Greeks will have to endure severe cuts in public spending, Icelanders will be forced to repay the British and the Dutch governments.

March 12, 2010

Danijela Dolenec has been a PhD candidate at CIS - ETH Zurich since the spring of 2009. After completing her first degree in 2002 at the University of Zagreb, she studied political science at the London School of Economics, where she received her MSc in public policy and administration in 2005. In summer 2007 she completed a Master's in European studies at the University of Zagreb and during the academic year 2007/08 she was awarded a Fulbright Scholarship to study at Harvard University. There she studied comparative politics of old and new European democracies under the supervision of prof. Peter A. Hall and prof. Grzegorz Ekiert at Harvard’s Minda de Gunzburg Center for European studies.

Her main research interest lies in the field of post-communist democratization processes. Apart from that she is interested in Europeanization and globalization, European political institutions, political economy and public policies, especially social and education policy. She is currently working on her PhD thesis ‘The role of political party systems in the democratization of post-communist Europe’.

For more details and publications: http://www.eup.ethz.ch/people/dolenecd
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