Iceland’s Meltdown

Nigel Holmes and Megan McArdle
The Atlantic
December 12, 2008

“All financial innovation involves … the creation of debt secured in greater or lesser adequacy by real assets,” wrote the economist John Kenneth Galbraith in 1993. And “all crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”

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Iceland’s neophyte bankers no doubt wish they’d paid more attention to this warning. In the past two months, many countries have seen their banks brought low by excess leverage, but none has been punished so thoroughly as Iceland, where the currency and the government’s credit rating have joined the banking system on the ash heap of history. “Too big to fail” turned into “too big to save”—the banks’ holdings were so large relative to Iceland’s economy that the government had no credibility as a lender of last resort. The economy looks likely to shrink by 10 percent this year, and future growth may not be enough to cover the interest on the massive foreign loans that Iceland needs simply to keep functioning.

Notably, Iceland’s financial industry had little exposure to American subprime mortgages. In this, Iceland serves as an important reminder: ultimately, leverage, more than houses, is to blame for the severity of the international financial crisis. And leverage is what regulators worldwide will need to tackle as we seek to clean up the mess.

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This article was posted: Friday, December 12, 2008 at 3:01 pm

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