Icelandic government falls – will Europe learn from Haarde lesson?

Demonstrators gather to celebrate the government's resignation in Reykjavik on January 26, 2009 (AFP Photo / Halldor Kolbeins)
The tiny, North Atlantic island of Iceland, whose economy already lies in tatters, was plunged into further crisis on Monday as the coalition government collapsed amid violent protests on the streets.

Prime Minister Geir Haarde announced that a breakdown in talks between the coalition partners – made up of Haarde's Independence Party and the Social Democrats – had brought down the government that had only been elected in May 2007.

Mr. Haarde had called for early elections just last week, saying he would not lead his Independence Party into the new elections because he needed treatment for throat cancer. However, he was forced to disband the government yesterday after he was unwilling to meet the demands of his coalition partners who insisted on choosing a new prime minister in exchange for keeping the coalition intact.

“I really regret that we could not continue with this coalition, I believe that that would have been the best result,” Haarde told reporters.

Riches to rags

Iceland had until recently been hailed as an economic miracle. The country with a population of just 320,000 was ranked as the fourth most productive country per capita in the world two years ago and was an unlikely big player on the global financial stage. In 2007, Iceland was ranked as the most developed country in the world by the UN's Human Development Index, but Iceland had built its extraordinary wealth on the back of the worldwide credit boom and now the credit crunch has brought it to its knees. It is a rags-to-riches-and-back-again story that has the rest of the world paying close attention.

The Icelandic fairytale ended with the collapse of its banks in September and October of 2008 due to massive debts of around €14 billion – six times Iceland's annual GDP. Its currency, the krona, plummeted and Icelanders took to the streets to voice their anger at the mismanagement of the country's once booming economy.

In recent days the daily protests have become more violent. The police were forced to use tear gas last week for the first time since 1949. Following the violent clashes, Mr. Haarde had called for early elections, but his plan, along with the economy, now lies in ruins.

Where did it go wrong?

How did a country as small as Iceland get into a situation like this? According to Robert Wade of the London School of Economics, Iceland paid the price for financial excess. They were importing more than they were exporting and the amount of money that they owed in the short term was 15 times what they had in foreign currencies. It was currency speculation on a massive scale and it backfired.

“The external deficit was 25 per cent of GDP in 2006 and 17 per cent in 2007. Gross short-term foreign debt amounted to 15 times the value of the central bank's foreign exchange reserves at the end of 2007, or roughly 200 per cent of GDP. Those imbalances in the Icelandic economy had been bigger than almost anywhere else in the world, and that was especially dangerous at a time when the entire world economy was entering a severe slowdown,” explains Wade, who is one of the ‘50 most influential economists in the world’ according to the Financial Times.

However, not everyone agrees that the experiment failed. Hannes Hólmsteinn Gissurarson is a professor of Political Science at the University of Iceland. He is known for his controversial support for the ‘free market’ and has close ties with Haarde's Independent Party and David Oddsson, previously Iceland's longest-serving prime minister, architect of the economic overhaul over the past decade and currently the Central Bank chief.

Neither Haarde nor Oddsson are popular figures with the protesting masses, but Gissurarson refuses to criticise them: “It's not fair to say the experiment failed. The liberalisation of the Icelandic economy 1991-2004 was a great success. Tax cuts generated more tax revenue. Privatisation unleashed a lot of energy and individual initiative. Iceland, in 2004, was one of the richest countries in the world. Nevertheless, distribution of income was rather even, and poverty was negligible. There was practically no unemployment. But something went wrong in the years 2004-2008, no doubt. I think it was that the Icelandic oligarchs got too much power. There was nothing to counterbalance them. There were not enough balances and checks in the system. Capitalism only works if the capitalists use their energy in satisfying the needs of the customers, but do not rule everything.”

If the government is not to blame, who is?

“The government did not mismanage its finances,” says Gissurarson. “The government paid off its public debt. You can argue however that the banks grew too big for Iceland, but they were not too big for the EEA (European Economic Area). The main cause of the collapse of the banks was a system error in the EEA, namely that there was not a provision for an integrated lender of last resort in the EEA.”

“The Icelandic banks are however not blameless. They were in the hands of oligarchs who lent to themselves and took too many risks.”

What does the future have in store?

Regardless of the arguments, to the people on the streets in Reykjavík the gamble has failed to pay off. Now, without a government – for the interim at least – their plight has temporarily worsened. What is next for the small country that is left counting the cost of the economic miracle that backfired?

“It's difficult to tell,” says Professor Wade. “The situation here is fascinating as Iceland is the first case of a modern developed economy that suddenly has no banking system. To my knowledge that has never happened before and it certainly has not happened before in the context of a global crisis. My prediction is at some stage in the next several months there will be another tipping point. Pension funds have not yet collapsed and mass unemployment has yet to happen, so the real problems are coming. The worst is still to come.”

Although equally pessimistic, Professor Gissurarson has some thoughts on the way forward: “I cannot predict the future, but I am pessimistic. We have to stimulate the economy by tax cuts and also to go further in developing our natural resources, including the fish stocks, our hot springs and our waterfalls. But for this we need economic freedom and political stability, and unfortunately it does not look like we are going to get it now.”

Fears for rest of Europe

The events in Iceland will be of particular notice to the rest of the world. Icelanders have experienced the worst economic crash of any country in peacetime and its government has paid the price of denying responsibility. A wave of similar protest has spread throughout Europe. The Latvian and Lithuanian governments faced violent riots recently when it introduced pay cuts and tax hikes to deal with the financial pressure. In Spain, thousands have voiced their anger at soaring unemployment while in Greece they are still coming to terms with widespread student protests.

Iceland, and its government, is the first real victim of the global financial crisis – but they certainly won't be the last.

Ciaran Walsh for RT