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Global Economies, Regulatory Failure, and Loose Money: Lessons for Regulating the Finance Sector from Iceland’S Financial Crisis

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Global Economies, Regulatory Failure, and Loose Money: Lessons for Regulating the Finance Sector from Iceland’S Financial Crisis 2 MORRISS PETURSSON 691 - 799 (DO NOT DELETE) 5/3/2012 1:26 PM GLOBAL ECONOMIES, REGULATORY FAILURE, AND LOOSE MONEY: LESSONS FOR REGULATING THE FINANCE SECTOR FROM ICELAND’S FINANCIAL CRISIS Birgir T. Petursson* & Andrew P. Morriss** ABSTRACT Iceland was the first developed economy to fall into crisis in 2008, with the collapse of its banking sector, currency value, and economy. The collapse threw Iceland into a political crisis and provoked a serious international dispute between Iceland and Britain and the Netherlands over responsibility for the failed banks. Prior to 2008, Iceland had been treated as the poster child for deregulation; since 2008, it has been held up as the poster child for the dangers of financial liberalization. Neither is accurate. Rather, Iceland presents a cautionary tale about the interrelationships between fiscal and monetary policy and regulatory measures. Excessive liquidity fostered by central banks around the world, expansionary fiscal policies in Iceland, and inadequate understanding of fundamental * Partner, Laekjargata Lawfirm, Reykjavik, Iceland & Co-Founder and Director, Centre for Social and Economic Research, Reykjavik, Iceland; Cand. jur., University of Iceland, 1998. The authors thank the University of Alabama School of Law, and Law and Economics and Business Law Programs at the University of Illinois College of Law for financial support that made their collaboration easier; Liberty Fund, Inc. and the Searle Center at Northwestern University facilitated the collaboration by assisting with Petursson’s travel in the United States in 2009; the Regulatory Studies Program at George Washington University hosted us in 2011 and participants at a seminar there provided helpful comments. Roger Meiners, Richard W. Rahn, and Timothy Ridley also provided helpful comments, as did participants in the business law workshop at American University’s Washington College of Law; and Matthew Brown (Illinois), Clifford Henson (Illinois), and Hunter Hill (Alabama) provided extraordinarily helpful research assistance. Stephanie Davidson and the staff at the University of Illinois Law Library provided exceptional support in the initial research and with keeping up with events in 2009 and 2010 while Morriss was on the faculty there; staff at the University of Alabama provided equally excellent support in 2011. Students in Morriss’s seminars on the financial crisis at the University of Alabama School of Law provided valuable insights through classroom discussions. Birgir T. Petursson can be reached at [email protected]. ** D. Paul Jones, Jr. & Charlene A. Jones Chairholder in Law and Professor of Business, University of Alabama; Research Scholar, Regulatory Studies Center, George Washington University; Senior Scholar at the Mercatus Center at George Mason University, and Senior Fellow, Property & Environment Research Center, Bozeman, Montana. A.B. Princeton University; J.D., M.Pub.Aff., University of Texas; Ph.D. (Economics) Massachusetts Institute of Technology. Andrew P. Morriss can be reached at [email protected]. 2 MORRISS PETURSSON 691 - 799 (DO NOT DELETE) 5/3/2012 1:26 PM 692 Alabama Law Review [Vol. 63:4:691 economic linkages created conditions under which capital flooded Iceland and overwhelmed its financial institutions. Regulatory failures at the EU and Icelandic levels meant regulatory measures such as central bank interventions and deposit insurance exacerbated problems rather than correcting them. This Article explores those relationships, uncovering connections made visible by both Iceland’s relatively small size and the comprehensive parliamentary investigation into the crisis. It concludes that regulators need to focus attention on enhancing market-feedback mechanisms rather than on attempting to steer economies if they are to avoid “the next Iceland.” ABSTRACT .................................................................................................. 691 I. THE INTERCONNECTEDNESS OF OPEN ECONOMIES ........................ 702 A. Free Movement of Capital ....................................................... 702 B. Loose, Active Monetary Policies ............................................. 711 C. Stimulative Fiscal Policies ...................................................... 715 D. Floating Exchange Rates ......................................................... 718 E. Lagging Regulatory Institutions .............................................. 721 F. The Impact of Context.............................................................. 723 II. THE ICELANDIC CRISIS ................................................................... 725 A. Before the Boom ...................................................................... 725 B. The Reform .............................................................................. 732 C. The Boom ................................................................................. 740 D. The Geysir Crisis ..................................................................... 753 E. The Meltdown .......................................................................... 758 F. Aftermath ................................................................................. 764 III. LESSONS .......................................................................................... 775 A. Monetary and Fiscal Policy Links to Financial Regulation .... 778 B. Moving Beyond the Regulation/Deregulation Dichotomy ....... 783 C. Financial Surveillance ............................................................. 786 D. Jurisdictionally-Based Regulation .......................................... 792 E. The Politics of Crises ............................................................... 795 IV. CONCLUSION ................................................................................... 797 2 MORRISS PETURSSON 691 - 799 (DO NOT DELETE) 5/3/2012 1:26 PM 2012] Global Economies, Regulatory Failure, and Loose Money 693 Beginning in 1990, a series of economic reforms in Iceland transformed its economy from stagnant and statist to thriving and free.1 By 2004, the Icelandic economy appeared as strong as any in the world, Iceland was widely touted as an example of how a small open economy could succeed,2 and Iceland was the sixth wealthiest country in the world as measured by GDP per capita.3 A new generation of Icelandic businessmen and bankers, sometimes colorfully referred to as “Viking raiders,” were beginning to buy assets across Europe, including financial institutions in Scandinavia; real-estate in the Baltic; beverage production in Russia; telecom in eastern Europe; pharmaceuticals in the Mediterranean; and retail, food manufacturing, and banking in the United Kingdom.4 The Icelandic currency (the krona or ISK) gained over 40% against the dollar, 30% against the yen, and 17% against the pound between the end of 2001 1. James McLean, Deregulation Brings Boom Time to Iceland, TIMES (London), Nov. 29, 2007, http://business.timesonline.co.uk/tol/business/markets/europe/article2963336.ece (“The catalyst for a dramatic turnaround was the deregulation of the formerly state-controlled financial sector.”); William Underhill, The Icemen Cometh, NEWSWEEK, May 23, 2005, http://www.newsweek.com/ id/51773/page/1 (“Since the mid-’90s, the country’s center-right government has pushed free-market reforms” producing an economy that “outstrips most of Europe.”); Hannes H. Gissurarson, Miracle on Iceland, WALL ST. J., Jan. 29, 2004, http://online.wsj.com/article/0,,SB1075331821538144 98,00.html (“[A]fter a radical and comprehensive course of liberalization that mirrors similar reforms in Thatcher’s Britain, New Zealand and Chile, Iceland has emerged as one of the world’s most prosperous countries.”); see also JAMES GWARTNEY & ROBERT LAWSON, ECONOMIC FREEDOM OF THE WORLD: 2006 ANNUAL REPORT 99 (2006), available at http://www.cato.org/pubs/ efw/efw2006/efw2006-3-a- k.pdf (showing that Iceland’s economic freedom score placed them twenty-fourth in the world in 1990, seventeenth in 1995, twelfth in 2000, and ninth in 2004); JAMES GWARTNEY, ROBERT LAWSON, & JOSHUA HALL, ECONOMIC FREEDOM OF THE WORLD: 2011 ANNUAL REPORT 84 (2011), available at http://www.freetheworld.com/ 2011/reports/world/EFW2011_complete.pdf (showing that Iceland’s economic freedom score placed them sixty-third in the world in 2009). 2. McLean, supra note 1 (noting that the IMD World Competitiveness Report rated Iceland the most competitive economy in Europe in 2004); Hannes Gissurarson & Daniel J. Mitchell, The Iceland Tax System – Key Features and Lessons for Policy Makers, VII PROSPERITAS, no. V, Aug. 2007, available at http://archive.freedomandprosperity.org/Papers/iceland/iceland.pdf. 3. Iceland’s GDP per capita on a purchasing power parity basis in 2004 was $34,117.756, behind Luxembourg ($56,620.563), the United States ($39,771.787), Norway ($39,587.452), Ireland ($36,218.044), and Switzerland ($34,163.155). WORLD BANK, World Development Indicators and Global Development Finance, http://databank.worldbank.org/data/home.aspx. Iceland is, of course, a small economy in absolute terms—the total population was only 317,000 in 2008. WORLD BANK, 2010 WORLD DEVELOPMENT INDICATORS 50 (2010), available at http://data.worldbank.org/sites/default/ files/wdi-final.pdf. For comparison, the least populated American state, Wyoming, has 563,626. U.S. CENSUS, 2010 RESIDENT POPULATION DATA (2010), http://2010.census.gov/2010census/data/ apportionment-pop-text.php. 4. See Ian Griffiths, Next-Generation Viking Invasion, GUARDIAN
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