VoxEU Column Europe's nations and regions Global crisis

Currency is not destiny

Iceland and Ireland were both rocked by the fallout of the Global Crisis. This column argues that differences in currency arrangements affected the mechanisms of the boom and the collapse. Iceland’s banks collapsed because they did not have a lender of last resort in euros. Ireland did. But Iceland’s collapse and ensuing capital controls shifted the burden of debt restructuring onto foreign creditors to a much greater extent than in Ireland.

During the period before the crises, Iceland and Ireland embraced globalisation with the aim of improving economic performance and raising the standard of living of their populations. Ireland joined the EU in 1973, increased its attractiveness to foreign investors as highlighted by Honohan (2010), and Iceland adopted the European legal framework through European Economic Area membership in 1994.

For Ireland, the formula was to use tax incentives to attract foreign investments and multinational companies which eventually turned Ireland into an international financial hot spot. The resulting capital inflows in the 2000s had profound effects on the domestic economy fuelling runaway asset inflation in residential and commercial property markets raising debt across the board.

Iceland jumped straight in to the deep end of the financial pool with aggressive investment strategies abroad in the early 2000’s. The authorities decided at the beginning of the decade to foster the creation of an international financial centre through low taxes, light regulation and minimal supervision, in fact to emulate the Irish banking sector. Supported by newly privatised banks eager to test the limits of financial expansion for a small economy willing to play for high stakes, Iceland became more like a gigantic hedge-fund, as described by Benediktsdottir et al. (2011) and Johnsen (2014).

Ultimately, what sets Iceland and Ireland apart from other countries that managed to escape the recent crisis is a policy to profit from international capital flows through low taxes and lax regulation. The capital inflow into these countries and the domestic credit expansion then caused asset prices to boom – stock prices in Iceland and commercial and residential real estate prices in Ireland – fuelling growing euphoria in a Minskyian sense (Minsky 1986). There was a concentration of political end economic actors within a golden circle, coupled with what Regling and Watson (2010) describe as excessive groupthink.1 The state coffers benefited from rising revenues from tariffs and taxes. The banks inflated their capital by lending to buy own shares and lent extensively to related parties.

Collapsing in a global financial crisis

At the end of the day, the two island economies were both caught up in the whirlpool of excessive capital inflows and credit expansion way beyond what can be considered prudent or economically viable.

What sets the two countries apart is the mechanism of the capital inflow/outflow due to different currency arrangements. Ireland, being part of the Eurozone, enjoyed low interest rates, in fact too low to contain the booming construction sector. Borrowing to finance investment in housing was lucrative, higher house prices made further borrowing possible through increased collateral and so on until the bubble burst in 2010. The consequences have largely been borne by households, the government, and the non-financial corporate sector (see Kelly 2007, Kinsella 2012). Iceland used high interest rates to curb its own domestic credit but this magnified speculative inflows that made the currency appreciate even further while investors evaded the high interest rates by borrowing in foreign currencies – in fact taking part in the carry trade – ending in a sudden stop, an exchange rate collapse and mass insolvencies.

Similar macroeconomic trends

The macro stories in Ireland and Iceland are remarkably similar in spite of the different currency arrangements. Looking at GDP growth, (Figure 1) investment (Figure 2), unemployment (Figure 3) and the current account balance (Figure 4) since 1990, a similar growth and investment story emerges.2 Unemployment falls when investment and growth take off, although the level of unemployment in Ireland is higher throughout. In Iceland the depreciation of the currency made real wages fall, which made unemployment rise by less than in Ireland. Both countries experienced increased current account deficits during the boom years, even though the magnitude in Ireland seems small compared to Iceland where the exchange rate appreciation made the current account go deeper into negative territory. In the aftermath of the crisis, the current account has improved rapidly in both countries tilting the foreign balance into a positive territory. 

Did the currency regime matter?

It was due to Ireland’s membership of the Eurozone that the Irish banking system was saved in the fall of 2008. Saved in the sense that it was provided with enough liquidity not to default on its debt but it was left to the Irish taxpayer to recapitalise the banks. In contrast, the failure of Iceland’s banking system left the country without a functioning banking system and with the sovereign credit ratings badly affected, but passed losses on to foreign creditors.

Iceland not only had a collapsed banking system in 2008 but also most of its non-financial businesses were technically bankrupt because business debt was mostly denominated in foreign currencies. Moreover, capital controls were imposed that have not been relaxed in the almost seven years that have passed since their imposition. Much less noticed is the fact that the cost of the crisis to the Icelandic state appears to have been as great as the cost of the Irish crisis to the Irish state, 44% of GDP versus 41% according to Laeven and Valencia (2011)

The failure of the Icelandic banks and the insolvency of non-financial businesses made pervasive debt restructuring possible, as shown in Table 1 below, which has reduced the business debt to GDP ratio from 277% in 2009 to 111% in 2014.  Restructuring measures dictated by the government and the courts and also increased savings by households have reduced the household debt to GDP ratio from 122% to 91%.

The total debt of households, the central government and businesses gives a ratio of debt to GDP of 493% in Iceland in 2009, which has fallen to 298% in 2014, while debt was 330% in Ireland in 2009 and 403% in 2013. Total debt has fallen by about twice the GDP of Iceland during these years, while it has increased by 73% in Ireland.

Unconventional measures

While debt relief was undertaken in both countries, what sets the countries apart was that foreign creditors were trapped behind capital controls imposed in Iceland as part of the IMF programme. The capital controls had the somewhat surprising and unintended consequence of allowing the government to transfer resources out of the estates of the failed banks to households and the government.

Following elections in the spring of 2013 a new government in Iceland imposed a tax amounting to around 4% of GDP on the estates of the failed banks. The tax receipts were then used to finance universal household debt relief.

A few weeks ago the government of Iceland passed legislation that imposed a tax of 31% on the estates of the failed banks allowing the creditors to walk away with what remains. Creditors are given until the end of the year to reach a settlement with the resolution committees and make a contribution to the government, somewhat smaller than the amount of the tax (see Danielsson and Kristjánsdóttir 2015). The anticipated receipts amount to around 80% of the value of local currency asset in the estates and thus prevent a balance of payments problem from arising. As a side effect the central government’s debt may fall by as much as 30% of GDP. The net investment position of Iceland will also improve and end up being no worse than in 2003 when the banks were privatised.

The story of Iceland and Ireland

The story of Iceland and Ireland in the first decade of the century offers some rather obvious lessons. The entry of global finance into a small open economy, especially if invited by the government through low taxes, regulation and supervision, can bring great riches in the short run but at a substantial cost. The real economy is distorted in an unsustainable way; ethics in both the business as well as the public sector suffer; white collar crimes arise; and the balance sheets of not only the private sector but also the public sector are put at risk when a crisis hits the world of global finance or traders become concerned about a particular country.

Differences in currency arrangements affected the mechanisms of the boom and the collapse; the current account deficit during the boom was greater in Iceland, real wages fell more in Iceland when the currency depreciated but unemployment rose less. Iceland’s banks collapsed because they did not have a lender of last resort in euros as did the Irish banks, but their collapse and the ensuing capital controls shifted the burden of debt restructuring onto foreign creditors to a much greater extent than in Ireland.

Figures 1-4.

Sources: Eurostat, OECD, Central Bank of Iceland.
Note: Irish debt numbers from 2013, for Iceland numbers are for Q4 2014.

Table 1. Private and public debt as a ratio to GDP


Benediktsdottir, S, J Danielsson and G Zoega (2011), “Lessons from a collapse of a financial system”, Economic Policy 26 (66): 183-235.

Danielsson, J and Á Kristjánsdóttir (2015), “Why Iceland can now remove capital controls”, VoxEU,org, 11 June.

Honohan, P (2010), “The Irish banking crisis, regulatory and financial stability policy 2003–2008”, report, Central Bank of Ireland.

Hreinsson, P, T Gunnarsson and S Benediktsdóttir (2011), “Causes of the collapse of the Icelandic banks – Responsibility, mistakes and negligence”, report prepared by the Icelandic Special Investigation Commission, SIC, 9.

Johnsen, G (2014), Bringing Down the Banking System: Lessons from Iceland, Palgrave Macmillan.

Morgan, K (2007), “On the likely extent of falls in irish house prices,” ESRI Quarterly Economic Commentary 2: 42–54, Summer.

Kinsella, S (2012), “Is ireland really the role model for austerity?”, Cambridge Journal of Economics 36 (1): 223–235.

Laeven, L and F Valencia (2011), “Systemic Banking Crises Data base: An Update,” IMF Working Paper WP/12/163.

Raza, H, B R Gudmundsson, S Kinsella, and G Zoega (2015), “Two thorns of experience: financialisation in Iceland and Ireland,” manuscript.

Regling, K and M Watson (2010), Preliminary report on the sources of Ireland’s banking crisis, technical report, Central Bank of Ireland.


1 Hreinsson et al. (2011) found a very close relationship between politicians and bankers in Iceland and significant borrowing by politicians from the banks, pre-crisis.  

2 The difference consists of the trough in 2002 in Iceland following the bursting of the dot-com bubble and the exceptional peak in 2006 when one of a large number of aluminium smelting projects was ongoing.

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