SYMPOSIUM the icelandic economic collapse: how to overcome constraints associated with smallness? baldur thorhallsson Faculty of Political Science, School of Social Science, University of , 101 Reykjavı´k, Iceland. E-mails: [email protected]; www.uni.hi.is/baldurt/

doi:10.1057/eps.2012.37; published online 26 October 2012

Abstract The article identifies a number of fundamental flaws concerning the Icelandic government’s economic handling and administrative working practices, which contributed to the scale of the 2008 crash. At the same time, it argues that the authorities altogether failed to take account of the risk associated with the country’s small size during the Icelandic ‘out- vasion’. It claims that small-state studies need to move back to the basics and consider the original small-states literature, such as the small domestic market, the use of a small currency and the weaknesses associated with a small public administration, in order to fully understand the reasons for the Icelandic economic meltdown. A small state needs to acknowledge its limitations and take appropriate measures to compensate for them.

Keywords small states; economy; public administration; Iceland; size; alliance

INTRODUCTION EU and frameworks was exposed to the international financial crisis and celand’s economic crash provides an whether this status limited or facilitated ideal test case on whether the size of its responses to the crisis. I the economy and public administra- Iceland is the only state that experi- tion is more relevant than factors asso- enced a collapse of almost its entire finan- ciated with economic management and cial sector in connection with the 2008 administrative competence for under- financial crisis (the three main banks, standing how states are affected by, which collapsed, accounted for about and respond to, global economic turmoil. 85 per cent of the sector) (OECD, 2009). Also, it provides an interesting insight into Moreover, Iceland was the only OECD how a globalised small state outside the country to experience a currency crisis.

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(320–332) & 2013 European Consortium for Political Research. 1680-4333/13 www.palgrave-journals.com/eps/ In total, the Icelandic kro´na (ISK) depre- ‘One of the most ciated by around 48 per cent between y 2007 and 2009 (O´lafsson and Pe´tursson, important lessons 2010). In the autumn of 2008, the is the restricted Icelandic Central Bank only provided capacity of small foreign currency for the import of food, medicine and fuel (Central Bank of Ice- economies to engage land, 2008). Inflation rose from single in the international figures to 18 per cent and unemploy- global economy ment rose, from full employment, to 8 per cent. Household and corporate debt without a proper ally’ sky-rocketed; many homes and busi- nesses had borrowed in foreign currency Previously, most politicians had argued (IMF, 2009). Immediately, the Icelandic that full participation in the European government sought assistance from the project would impose severe constraints International Monetary Fund (IMF). In on Iceland’s economic and monetary 2009, GDP decreased by 6.8 per cent. policy, fisheries and agriculture. Member- This was the largest drop in GDP ever ship of the recorded since measurements began in (EEA) (1994) and the Schengen scheme 1945 (Statistics Iceland, 2010). (2001) was seen as serving Icelandic The economic crash soon created a interests adequately. The EU application political crisis, that is, violent protests on signalled a gradual geo-political transfor- the streets of Reykjavik, a collapse of mation. Iceland had slowly been directed the coalition government consisting of the towards its Eurasian Plate side after it conservative Independence Party and the had been sighted rather more on the North Social Democratic Alliance (SDA), a par- American Plate, politically speaking, dur- liamentary election and the subsequent ing the Cold War – under US protection. creation of the country’s first left of centre From the beginning, the focal points in government. The Conservatives were small-states literature have been the vari- thrown out of office after 18 years; for ables associated with states’ capabilities most of the time (1995–2007), they had (Neumann and Gsto¨hl, 2006) in terms of been in a coalition with the centrist numbers of inhabitants, the size of the agrarian Progressive Party. Immediately economy, military strength and territorial after gaining a parliamentary majority, size (Archer and Nugent, 2002). Further- the new government, consisting of the more, the influence of having a small Left Green Movement and the SDA, applied central bureaucracy and small diplomatic for membership of the corps was mentioned early in the devel- (EU) in the summer of 2009. The Social opment of the literature (Va¨yrynen, 1971) Democrats insisted on a speedy accession although this was never properly dealt process and the adoption of the Euro. with or taken fully into account. Their electoral success, despite the fact Small states were said to be more eco- that they were partly blamed for the nomically vulnerable due to the size of crash, had been achieved through these their GDP, their small domestic markets, promises. reliance on external trade and exposure Iceland, an island on the European to international economic fluctuations periphery in the North Atlantic, straddling (Katzenstein, 1984, 1985). Small entities the mid-Atlantic Ridge, with about 315 were even regarded as not being eco- thousand inhabitants, became the small- nomically sustainable or viable (Com- est state to apply for EU membership. monwealth Consultative Group, 1985).

baldur thorhallsson european political science: 12 2013 321 The small size of their administrations The economic success of small Western posed constraints on their international European states was found to be a behaviour, that is, they had less capacity result of their flexible democratic corpor- both to defend themselves diplomatically atism, based on the culture of consensus and to engage in international affairs (Katzenstein, 1984, 1985). The success (Handel, 1981). Importantly, doubt was of small states in regional and inter- even cast on small states’ ability to national organisations such as the UN govern themselves, that is, to run the and the EU has been seen as a result of necessary apparatus. It was argued that their administrative working practices in they had less capacity to manage their terms of prioritisation, informality, flex- exposure to risk due to the small size of ibility and the autonomy of their officials their bureaucracy (Reid, 1974) and less (Thorhallsson, 2000). Small states were margin for error, that is, they are more found to be notably influential in the multi- vulnerable to absolute loss of manpower, lateral arrangement of the international territory or economic infrastructure than system. most larger states (Barston, 1973). Accordingly, the small-states literature Small states were said to rely on larger gradually shifted its focus from the mere states for their internal and external vulnerability consequences of the size of policymaking. Moreover, they relied on the economy and the central bureaucracy their larger neighbours for basic survival to opportunities associated with small- and engagement with the outside world ness. However, the question that remains (Thorhallsson, 2006). Alliance formation unanswered is whether economic manage- was a must for their success (Keohane, ment and administrative competence are 1969). Their domestic affairs and foreign related to opportunities and constraints policy were under a strong influence from associated with smallness. The aim of this their protectors. Accordingly, the smallest article is to examine whether a small state European states – Liechtenstein, Andorra, like Iceland encounters, purely or partly, Monaco and San Marino – did not gain structural problems associated with its access to the League of Nations and its smallness, in the international system: successor the United Nations (UN) until Does Iceland’s small size in terms of the early 1990s. Their foreign policies its economy and bureaucracy provide were not seen as being independent from a better understanding of the economic those of their larger neighbouring states collapse and its responses to the crisis, (Duursma, 1996). than do factors regarding economic man- After many of these hypotheses had agement and administrative competence? been proven wrong (Katzenstein, 1984, Moreover, did the non-EU and Euro mem- 1985), small states began to be seen as bership matter in the lead-up to the crisis, economically and administratively smart, during the crisis itself, and in cleaning up salient, resilient and faster, and more fit after the event? Are small states more or to adjust to global competition and other less in need of an external shelter (an ally challenges (Briguglio et al, 2006). They or an alliance) in order to cope with the were no longer seen as being constrained new globalised economy? The article will by their small administrations and the address these concerns by examining a smallness of their economy. Instead, the number of independent analyses conducted informality and flexibility of their bureau- in order to understand the Icelandic eco- cracy and the small domestic market – nomic collapse. The aim is to apply the small community – were seen as provid- literature on small states, concerning ing them with opportunities, domestically the economy and administration, to these and internationally (Thorhallsson, 2000). findings to explain whether or not the size

322 european political science: 12 2013 the icelandic economic collapse of the economy and the public admin- own infrastructure’ (Althingi, 2010a: 1). istration played a part in the crash. The banks were suffering from a liquidity problem because they were suspected to be insolvent and no SIZE OF THE ECONOMY facilities could have saved them. Their VERSUS ECONOMIC wholesale funding had been very difficult MANAGEMENT from late 2006 and dried up completely in mid-2007 (Carey, 2011). In the years leading up to the crisis, there Nevertheless, there is a tendency to were several fundamental flaws in eco- overlook the inability of the Icelandic nomic management in Iceland, according state and its Central Bank to stand by its to the Special Investigation Commission banks. It may have been a major mis- (SIC) appointed to investigate the fall of take by the government to allow the the financial system (Althingi, 2010a). massive expansion of the financial sector, The government kept lowering taxes, and the fact that it had assets valued at changed lending guidelines at the Hous- over ten times Iceland’s GDP in the ing Financing Fund and decided to build a autumn of 2008 (, massive power station during an economic 2010) made it impossible for the govern- expansion period. It did not restrain ment to guarantee the payment of liabil- the budget, and the Icelandic Central ities to foreign creditors (for comparison, Bank was too late in raising interest rates. the Irish banking assets were three times Accordingly, the government failed to as big as the GDP of Ireland). It salvaged address economic fluctuations, over-ex- the domestic branches and their credi- pansion and growing imbalance in the tors, allowing their foreign operations to economy. This contributed significantly to collapse and leaving their creditors with- the hard landing of the economy (see also out any more than a promise of minimum OECD, 2009). compensation. O´lafsson’s and Pe´tursson’s (2010) ana- Already in early 2006, representatives lysis of forty-six medium-to-high income of the Icelandic Central Bank ‘had been countries indicate that the difference “spanked” in meetings with experts in in the way individual states experienced [y], for risk-taking and the the 2008 economic crisis had mainly relative size of the Icelandic banking to do with their economic management. system. It is iterated that the banks were States ‘that, in the run up to the crisis, close to bankruptcy in the “mini-crisis” in had higher inflation, larger current account early 2006’ (Althingi, 2010b: 140). Again, deficits, a more leveraged private sector, in the autumn of 2007, there were doubts greater output volatility, or a poorer fiscal about the capacity of the Central Bank of position tended to experience some com- Iceland to be the lender of last resort for bination of a deeper or more protracted the banks. During the first months of contraction in output or consumption, and 2008, it was clear, according to the SIC, were more likely to experience a systemic ‘that the enormous size of the Icelandic banking or currency crisis’ (O´lafsson and banking system relative to the Icelandic Pe´tursson, 2010: 25). economic system and the associated risk The SIC claims that the reasons for for the entire Icelandic economy if the the default of the banks ‘are first and banks were to run into difficulties, was an foremost to be found in their rapid expan- especially urgent threat given the circum- sion and their subsequent size. Their stances at the time’ (Althingi, 2010b: balance sheet and lending portfolios 137–138). In the spring, the IMF, credit- expanded beyond the capacity of their rating agencies and foreign central banks

baldur thorhallsson european political science: 12 2013 323 concluded that the banks had become far to the closure of Kaupthing, the only one too big relative to the size of the Icelandic out of the three large banks that was economy and the capacity of the Icelandic still functioning. Iceland encountered a government to rescue them. The other collapse of its entire financial sector, a Nordic Central Banks made currency currency crisis and a currency shortage. swap arrangements with the Icelandic The economic landing was hard. A modest Central Bank with the condition that the improvement only began 2 years later. Icelandic government would reduce the Furthermore, currency restrictions will size of the banking system (Althingi, remain a fact of life for Icelanders until 2010b: 137–138). The Bank of England 2015, according to the Icelandic Central declined to make a currency swap agree- Bank’s plan to ease currency controls ment with Iceland but instead offered its (Central Bank of Iceland, 2011). Three assistance to scale down the financial years after the depreciation, the ISK is sector. However, the Icelandic government still undervalued by about 25 per cent did not take any measures to achieve versus the euro, despite strict controls this objective (Althingi, 2010b: 138). (Danske Markets, 2011). There are The small size of the Icelandic economy still considerable uncertainties concerning made it impossible for it to stand by the the Icelandic funding situation (Danske financial sector. The government had no Markets, 2011; IMF, 2011). Forecasts choice on whether or not to save the differ on whether unemployment will fall banks since it did not have access to or rise; the IMF (2011) expects it to external funds to back them up. The small decline gradually to just over 3 per cent national currency made matters worse. in 2014; Danske Markets (2011) claims Its depreciation, earlier in the year, made that it will remain close to 10 per cent foreign borrowing so expensive that the until 2013 (i.e., to the end of its forecast Icelandic authorities hesitated to borrow period). There has been only a moderate abroad in order to strengthen the cur- increase in total exports despite the rency reserves (Althingi, 2010a). The banks obvious benefits of a favourable exchange found it increasingly difficult to find coun- rate for the export industries. Export terparties willing to buy the kro´na in increases are hampered by limited alu- exchange for foreign currencies (Carey, minium production capacity and fish 2011). Underestimated risk of foreign stocks. On the positive side, predictions currency shortage, and later lack of have been made of 2–4 per cent GDP access to foreign currency, significantly growth and low inflation (about or below undermined the Central Bank’s ability 2.5 per cent) in the coming 4 years, a to stand by the banks (Gujmundsson, large trade surplus, a largely balanced 2009). The Central Bank had not suffi- current account and stabilisation of the ciently bolstered its reserves despite the public finance situation (IMF, 2011; massive expansion of the banks (OECD, Danske Markets, 2011), much lower 2009). The banks’ domestic operations interest rates offered by the Central and foreign branches lacked lender of last Bank than in the previous years and resort facilities for their foreign lending the complete re-organisation of the (Carey, 2011). financial sector. Authorities in neighbouring states, as EU and Euro membership might not have well as the market, lost confidence in the hindered the collapse of the Icelandic Icelandic banks and the ability of the state banks and the economic downturn asso- to defend them. Moreover, Britain used its ciated with it (Carey, 2011). However, anti-terrorist laws to seize the assets of Iceland would not have experienced the Icelandic banks in London, which led the currency crisis that has substantially

324 european political science: 12 2013 the icelandic economic collapse increased inflation and mortgages and state’s economy is restricted due to other loans taken in foreign currency, limited state back-up. These restrictions, and also loans in ISK due to them being identified in the literature, may be over- price-indexed. For instance, food prices come by a decisive back-up from a more rose by nearly 40 per cent in the 2-year powerful ally or alliance formation, such period from early 2009 (Icelandic as the EU. Iceland was protected politi- National Broadcasting Service, 2011). cally and economically by the United Also, Icelanders would not have been States during the cold war, before which faced with currency controls, which it had been part of the Danish Kingdom severely hamper the business community for centuries. In the early 1990s, the and foreign investment. Moreover, Ice- Icelandic government failed to adapt to land would have been assigned rescue the new international environment and packages just like other EU and Euro to seek much-needed external shelter members in economic difficulties. There within the EU. would have been fewer concerns about Businesses in a small state may engage Iceland’s future funding situation due to in massive ‘outvasion’ and create enor- the back-up from the European Central mous wealth, but this is a very risky tactic, Bank. Iceland would have had access since greater economic vulnerability is to the EU’s Structural Funds and the bound to follow. It ought to be a part of European Investment Bank (the latter good economic management to take has refused or hesitated to loan Iceland account of the limitations imposed by a since the crash), which, for instance, have small domestic economy in order to find provided important support for the Baltic a balance between sustainable growth states during the recession. and risk taking. This awareness was Accordingly, Iceland, as part of an altogether lacking in Iceland’s case. alliance (the EU), would have been shel- tered by its institutional framework. Iceland’s problems would have become SIZE OF THE PUBLIC the EU’s problems and the Union would ADMINISTRATION VERSUS have been compelled to come to its ADMINISTRATIVE rescue. Iceland, like other hard-hit small COMPETENCE European states, had to seek external assistance in dealing with the crisis and in A small public administration, like Ice- cleaning up after the event. The IMF was land’s, cannot be expected to prepare for Iceland’s only alternative, while belea- policymaking and legislation as decisively guered countries in the Union received as larger bureaucracies, or to have the joint EU and IMF rescue packages. In fact, manpower to efficiently supervise large Iceland’s IMF assistance was, on several financial institutions engaging in massive occasions, delayed by IMF members, foreign expansion. For instance, in 2008, particularly Britain and the , there were only 56 people working due to the unresolved Icesave dispute in the Icelandic Financial Supervisory (Strauss-Kahn, 2009). Authority (FME) (IMF, 2008) compared Iceland’s economic outlook is improving with 246 employees in the Financial but several uncertainties stand in the way Supervisory Authority in in 2010 of full recovery. Membership of the EU and (Norwegian Ministry of Finance, 2010) the adoption of the Euro would ease the and 1,830 in in 2011 (German way forward (Carey, 2011; O´lafsson and Federal Financial Supervisory Authority, Pe´tursson, 2010), particularly as regards 2011). Interestingly, the IMF in August currency and funding difficulties. A small 2008 still welcomed that ‘the budget and

baldur thorhallsson european political science: 12 2013 325 the staff of the FME have increased other banks in the EU/EEA (OECD, 2009). significantly over the last years’ and that Although financial regulations were mostly ‘all stakeholders, including the govern- transposed through the EEA, ‘Iceland’s ment and the supervised parties recog- supervisors were unable to keep up with nise the need for the FME to grow in line the complexity and size of the system as with the expansion of financial under- it grew rapidly and applied rules in an takings’ (IMF, 2008: 27). Moreover, in excessively legalistic manner’ (OECD, 2001, 150 people were employed in the 2009: 11). Also, the fact that the number Foreign Service in Iceland, compared with of departments in the Icelandic central 1,150 in Norway, 1,642 in and public administration was one-third of 5,500 in Britain (Foreign Ministries of that in the Norwegian administration Iceland, Norway, Finland and the United affected its behaviour. Icelandic depart- Kingdom, 2001). ments have broader responsibilities and The substantial lack of supervision of specialisations. As a consequence, they the banks, the inability to deal with their are forced to prioritise in order to cope expansion, the passive response to can- with their burden. Officials are granted did criticism of their behaviour and the official autonomy and flexibility. For chaotic reaction to the crisis event signifi- instance, Icelandic officials have greater cantly contributed to the economic crash autonomy in dealing with EU/EEA cases (Althingi, 2010a). These factors can in than their counterparts in the other turn be explained by the small-staff Nordic states (Lægreid et al, 2004). complements and lack of expertise in Furthermore, responsibility for handling the financial sector and the demanding EEA/EU relations in Iceland is mainly in tasks associated with it. At the same the hands of public servants (not politi- time, the lack of administrative compe- cians), due to the structure of the EEA tence and the background political reality, agreement. This absence of domestic poli- that is, the unwillingness of the govern- ticians within the EEA decision-making ment to curb the financial sector and its processes has created a reactive approach firm belief in the neo-liberal agenda, have in implementing the EEA rules, that is, to be taken into account in evaluating the the Icelandic authorities simply apply the cause of the crisis. rules without taking any notice of the The criticisms raised by the SIC and domestic reality such as the country’s committee of experts small size. appointed by the prime minister to address Historically, the Icelandic administra- the implications of the commission’s con- tion has outsourced its policymaking in clusions for the public administration the important fisheries and agrarian sec- point to a fundamental failure by the tors. This is in line with the sectoral bureaucracy regarding policymaking and corporatism that exists in the country supervision. They identify a lack of pro- and was later extended to the aluminium fessional competence due to political industry and the financial sector. Out- interference, small-staff size, reliance on sourcing of projects has further wea- personal connections and limited empha- kened the administration’s capacity to sis on best practice. The smallness of the build up knowledge and engage in deci- administration and its lack of expertise sive policymaking. Moreover, it has made not only made it unable to supervise the small bureaucracy particularly vul- the financial sector properly; it permitted nerable to powerful pressure groups ‘the bankers largely to regulate them- (Thorhallsson, 2010). This was the case selves’ (Althingi, 2010c). The banks were in the relations between the administra- thought to be less closely supervised than tion and banks (Althingi, 2010a).

326 european political science: 12 2013 the icelandic economic collapse The government’s first mistake in the ‘y[the] first mistake y privatisation process of the state-run banks was to sell them to political sup- was to sell [the banks] to porters who did not have any experience political supporters y’ in running financial institutions and had major expansion plans (OECD, 2009: 11). The government did not follow the Ice- the bureaucracy is a fundamental fact landic Financial Supervisory Authority’s and cannot be changed. On the other (FME) advice in the process and the hand, there is a considerable room for authority was given insufficient resources improvement within the administration, to carry out its duties (Althingi, 2010a). since there is little emphasis on compre- In addition, politicians were suspicious hensive policymaking processes with- of the administration’s effort to regulate in the administration itself and by poli- the banks since it might constrain their ticians. The smallness creates particular expansion. Politicians praised the bankers challenges for the administration. These for massive expansions; they were are related to the organisational struc- regarded as the new Viking explorers ture and working practices, on the one who knew how to take risks and succeed. hand, and emphases concerning rela- This was due to the natural, innate, talent tions with domestic and external actors, of the Viking race and informal and on the other. flexible decision making (President of First, close personal connections (char- Iceland, 2006; Althingi, 2010b). The acterised either by friendly or antagonis- Icelandic ‘outvasion’ seemed a great suc- tic relations), due to the small community cess. The administration was expected to size, had considerable influence on the engage in informal and flexible decision scenario leading to the crisis and the crisis making in order to make things easy for response. These connections did not lead the bankers. Comprehensive policymaking to efficient policymaking; instead, they has always been sidelined by emphases created suspicion and conflict. Close per- on informality and flexibility within the sonal connections may also have played administration (Prime Minister’s Office, a part in the failure to supervise the 2010). Politicians reacted fiercely to financial institutions. The committee external criticism of the banks and did recommended that these weaknesses be not take any measures to scale down met with measures such as highlighting their expansion plans; Icelandic banks comprehensive policymaking processes, were expected to base their headquarters closer coordination between different at home and were, in fact, praised for actors, the creation of larger units and doing so (Althingi, 2010a) – despite the institutions, clearer accountability and massive risk for the Icelandic state and unitary leadership of senior executives the economy associated with their opera- (Prime Minister’s Office, 2010) tions abroad. Second, despite its smallness and close- The committee of independent experts ness to the other Nordic states, Iceland’s argues that the ability of the Icelandic political system is not characterised by administration to prepare legislation is consensus politics, but rather by conflict inevitably limited due to its small size and rhetorical debates in which the truth (Prime Minister’s Office, 2010). Accord- of statements has little value (Althingi, ingly, it is unrealistic to assume that pre- 2010c). There is a strong tradition of paration for policymaking and legisla- majority rule. This could be modified by tion can always be as detailed as in the adopting the small European states’ cor- neighbouring states. The small size of poratism, which is characterised by con-

baldur thorhallsson european political science: 12 2013 327 sensual decision making by all the main international economy due to its pre- actors in society (Prime Minister’s Office, dominant reliance on marine product 2010). exports. Nevertheless, participation in Third, Iceland’s foreign policy needs the free movement of capital within the to take account of the smallness of the EEA, without attention given to the con- country. Globalisation and close engage- sequences for the small economy and the ment with external actors pose several state’s liability for its banks operating challenges for a small entity. The EEA within the common market, made the regulatory framework makes no distinc- country more than ever exposed to ex- tion between whether a financial entity in ternal risk. In Iceland, as in many other a small country is opening branches in a Western countries, the state was heavily small or large market/country and makes influenced by financial interests and this the small entity responsible to investors is an important factor in explaining the regardless of the size of the country and crisis. However, our analysis indicates itscapacitytoshouldertheresponsibilties that the smallness of Iceland contributed (Althingi, 2010d: 132). The Icelandic significantly to the problems of a state authorities did not use the flexibility of captured by financial interests. Small the EEA agreement to implement regu- states encounter a structural problem lations concerning the financial sector associated with their smallness. according to the small size of its economy. One of the most important lessons to be They could have adopted measures to learned from the crash is the restricted hinder the banks’ expansion abroad and capacity of small economies to engage in thereby limit the risk associated with the the international global economy without opportunities, which the financial sector a proper ally. We have come back to the was granted by membership of the EEA original findings of the small-states litera- (Prime Minister’s Office, 2010). ture, that a small state needs to align Compared with larger states, small itself with more powerful states, or the states have to tackle difficulties asso- protecting framework of regional or inter- ciated with their more limited resources national institutions, in order to limit the concerning information gathering and risk exposure involved in engagement comprehensive policymaking (Prime Min- with the international economy. The case ister’s Office, 2010: 48–49). A small of Iceland indicates that the importance state has to acknowledge its limitations of shelter has never been as salient as at and accept that it may not have sufficient present, with the growing reliance of manpower to engage in decisive policy- small states on the international financial making concerning the financial sector system. and the supervision of international Small states can overcome many of the banks. Hence, it may have to relinquish obstacles associated with the small size of its right to take independent decisions, their economy and public administration. domestically, and join regional or inter- The key to success is sound economic national organisations in order to limit the management and administrative compe- vulnerability associated with the new tence. Small states need to acknowledge globalised economy. their limitations and take notice of it in their economic planning and the struc- turing of their public administration. CONCLUSION Constraints imposed by having limited personnel and small domestic markets The small economy of Iceland has always may be compensated for by a closer been vulnerable to fluctuations in the engagement with relevant international

328 european political science: 12 2013 the icelandic economic collapse and regional organisations. These may ‘y we cannot y provide not only a larger market with its potential economic benefits, but also an underestimate the important economic and administrative failure of the Icelandic shelter. Having an ally will not system- government to take atically limit risks posed by reliance on international trade, and economic crises notice of weaknesses will continue to occur; however, having associated with its recourse to protection may ease economic small economy and burdens and provide important economic and political assistance in times of need. administration’. Accordingly, we cannot simply explain Iceland’s economic crash with the inter- national financial crisis that would greatly The entire focus, by most politicians, underestimate the failure of the Icelandic public servants, researchers and the government to take notice of weaknesses media, was on how to further boost the associated with its small economy and ‘outvasion’. Our findings also indicate that administration. The government’s firm we need to consider the original small- belief in the free market and limited states literature regarding the small size interference in its operations – including of the public administration and the eco- those of the banks – was manifested in nomy in order to fully understand the the official and unofficial pressure by reasons for Iceland’s economic meltdown. politicians not to restrain the ‘outvasion’. First, small administrations encounter Iceland’s economic management had structural problems. Accordingly, Ice- fundamental flaws that contributed to land’s small administration did not have the scale of the downturn. The govern- the resources needed to engage fully in ment fuelled the economic boom instead comprehensive policymaking and legisla- of addressing its overheating; it failed to tion concerning the financial sector. More- curb the massive expansion of the banks, over, the size of staff and lack of expertise which further exposed the small economy within the administration led to a funda- to high risk. The Icelandic authorities mental lack of supervision of the financial did not take any notice of the possible sector and an underestimation of the risks danger entailed in closer engagement in entailed in its expansion for the small the international financial system. Hence, community. The small bureaucracy was the public administration was given unable to deal properly with the complex- insufficient resources to deal with the ity of the massive expansion of the banks; demanding task of supervising the banks. their operations in the new globalised Moreover, the absence of Icelandic politi- international economy were too demand- cians from the EEA/EU decision-making ing. A small administration cannot be processes concerning financial rules left expected to engage in policy formation in them unaware of their implications for the as decisive a manner as larger admin- small economy and capacity of the small- istrations. Icelandic policymakers need to state entity. Furthermore, traditional fea- take an account of the fact that the scope tures of the administration, such as little of the Icelandic administration will always emphasis on long-term policymaking, a be more limited than that of most other general lack of professionalism, outsour- administrations in Europe. This has to be cing of projects and political interference compensated for by seeking advice and led to insouciance about the threat posed assistance from the others and by close by the ‘outvasion’ to state and society. engagement with supervisory bodies

baldur thorhallsson european political science: 12 2013 329 such as the EFTA Surveillance Authority tance. The fall in the and, (ESA) and its sister organisation, the later, the currency shortage further weak- European Commission. Instead of expres- ened the system, that is, the ability of sing annoyance over alleged interference the banks to continue their operations by ESA, Icelandic politicians and public and the ability of the state to respond to bodies should have welcomed its efforts their difficulties. The whole economy at supervision. collapsed when the international finan- Second, the small size of Iceland’s cial crisis hit with full force and Iceland economy is a structural problem in itself. was left without an ally in responding to The small domestic market, the small- the crisis. state budget and the small national cur- To conclude, a small state encounters rency could not sustain the ‘outvasion’. structural problems associated with its The financial sector outgrew the state’s smallness in the international system. capacity to defend it. The Icelandic autho- The new globalised international econo- rities did not have any unrestricted ex- my, characterised by the free flow of ternal back-up such as they had enjoyed capital, has made it more difficult for during the cold war, from the United small states to cope with its fluctuation. States, and, previously, under the Danish The case of Iceland indicates that policy- umbrella. Economic size did not pose any makers in small societies need to recog- constraints during the economic boom; nise this new reality and look for shelter. however, size constraints that gradually That said, the problem that small states emerged as the warning signals about the encounter in the new world economy is state’s capacity to stand by its banks not purely structural. External shelter started to pile up. The market lost trust needs to be coupled with good economic in the economic system and the banks management and administrative compe- and the state did not have access to tence. Policymakers in Iceland failed on overseas loans or other forms of assis- all these accounts.

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About the Author

Baldur Thorhallsson is a Professor of Political Science and Jean Monnet Chair in European Studies at the Faculty of Political Science at the University of Iceland. He founded the Centre for Small State Studies within the Icelandic Institute of International Affairs in 2002 and was the Chair of the Board of both until 2011, and remains on the Board. His research focus is primarily on small-state studies, European integration and Iceland’s domestic and foreign policy. He has published extensively in international journals. He has contributed to several academic books and written two books on small states in Europe: Iceland and European Integration: On the Edge and The Role of Small States in the European Union. He holds a Ph.D. and an MA degree in Political Science from the University of Essex in the United Kingdom.

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