An Almost American Attitude to Risk

There was not much warning. Some fifty staffers were summoned to their twelfth-floor offices overlooking Boston Common last week and told they were out of a job. Not yet a year old, BostonNow had been a promising giveaway newspaper for commuters, designed to compete with MetroBoston, the local affiliate (49 percent owned by The New York Times) of a global chain pioneered years ago by the late Jan Stenbeck, a Swedish forest products magnate.


But BostonNow’s backers were Icelandic entrepreneurs. With interest rates in their home country jacked up to withering 15.5 percent in hopes of quelling inflation and stemming a fiscal crisis, the investors scarcely tried to sell the fledgling paper, though it was expected to become profitable in another year. They just shut it down and sold the phones and furniture.


More fortunate was Carberry’s, a Boston-area bakery funded a dozen years ago by Icelandic bankers as a retail chain for under-employed Icelandic bakers – Iceland being said to consume more baked goods per capita than any other nation in the world. Today, Carberry’s is firmly established as a prosperous metropolitan wholesale and catering operation. Icelandic travelers arriving in Boston can find its pastries for sale at Logan Airport.


News, as they say, is what happens near an editor. In Boston, this was the human face of the Icelandic crisis of 2008.  One of the least-likely pockets of unconventional finance to have been exposed when the subprime lending crisis metamorphosed into a global credit crunch, Iceland’s economy has been the talk of financial markets for months, for fear that it might turn into a latter-day version of the Long Term Capital Management insolvency that rocked the world in 1998.


Since February, The Financial Times has been arguing that the little North Atlantic island, the smallest country in the world with an independent monetary policy, has been the target of a shadowy attempt by a syndicate of hedge funds to break its banks, thereby provoking a costly intervention by European central banks, risking global credit gridlock, all in hopes of reaping the benefits of massive short sales. Assuming that the nefarious gambit fails – an FT story Friday signaled that the Icelandic defense was working – then the next story is the little island economy itself.


Iceland ranks first in the United Nations Human Development Index, which takes into account longevity, literacy and education as well as money income. It ranks fifth among OECD nation in per capita income adjusted for purchasing power. Its democracy is flourishing, its institutions are strong, its citizens enjoy one of the world’s strongest government pension systems. And the number of non-residents working for Icelandic companies abroad nearly equals the population of 300,000 islanders.


The modern portion of the Icelandic saga began a quarter-century ago, as Iceland, like many other countries around the world, experienced a reawakening to the possibilities of market capitalism. For centuries, the country’s economy had relied mainly on fishing, a notoriously boom-and-bust business because there were no fixed boundaries and anyone with a boat could fish. After many bitter disputes, including three “cod wars” over its coastal limits with the United Kingdom (which in the 1970s Iceland finally won), the problem was solved. Iceland in the early 1990s devised a highly successful system of semiprivate property rights for its fish. Individual transferable quotas, or ITQ, solved the boom-and-bust problems of over-fishing, and, perhaps more important, since ITQs were bankable assets, created a pool of capital that could be invested in other opportunities. At the same time, Iceland privatized its banks and investment funds.


Before long, the always shrewd banks were staffed by up-and-comers, Icelandic men and women with MBAs who sensed opportunities all round. One such was in aluminum, an industry which requires enormous quantities of electricity to produce metal from ore. Electricity is as cheap in Iceland as anywhere in the world, thanks to its rivers and geothermal power; ocean transport of ore is cheap. In due course, half a dozen global companies began construction of huge smelters along its shores.


Another, greater opportunity was to be found in the record low interest rates of the last seven years – the global “savings glut.” Icelandic banks grew spectacularly, from 96 percent of GDP in 2000 to probably ten times GDP at the end of last year. Three Icelandic banks are among the hundred biggest in the world. How? By borrowing cheaply in foreign currencies, in order to build electricity capacity at home and invest in European and American markets. Strong successes led global investors in turn to borrow low-yielding dollars and euros to buy krona with which to invest in the Icelandic stock market – a strategy known since the nineteenth century as the “carry trade.” One expert told the FT’s Gillian Tett that Iceland had learned to operate its national economy like a hedge fund.


Nor were Iceland’s overseas ventures limited to bakery and newspaper startups. In the UK, Icelandic companies purchased the House of Fraser, a retailer; Whittard, a tea supplier; and even the West Ham United Football Club. Properties acquired in Scandinavia and Germany were no less iconic. Earlier this year, the FT’s David Ibison described the expansion this way: “Icelandic entrepreneurs have developed a reputation for aggressiveness, snapping up assets in the UK and shocking their consensus-driven Nordic neighbors with an almost American attitude to acquisitions and risk.  For a country that was more than 500 years under the control of Denmark, these developments have unleashed a dormant sense of national pride.”


The getting and spending led to powerful imbalances:  Iceland’s current-account deficit soared (all that borrowed money) and its inflation rate routinely exceeded the central bank’s target. In 2006, the krona depreciated by 25 percent and share prices fell to the same extent when confidence in the banks was impaired  The crisis was quickly enough defused by the banks, which countered investors’ fears by expanding their deposit base, adjusting the maturities of their holdings and eliminating the cross-holdings that had made their balance sheets difficult to parse. The boom continued as before.


But last year, sensing trouble, the Iceland Chamber of Commerce asked Richard Portes, professor at London Business School, head of Europe’s Center for Economic Policy Research, perhaps the leading policy economist in Europe, to take a look. Portes’ report, The Internationalization of Iceland’s Financial Sector, made few headlines when it was published last autumn. But it did focus attention on the difficulty of operating so highly leveraged an economy with an independent currency.


That was the situation in January, when rumors began to circulate in London that Iceland’s big banks were in trouble. This was not long after similar fears about solvency had fanned a run on Britain’s Northern Rock bank; not long before balance sheet doubts would force the distress sale of Bear Stearns. October had been fretful in capital markets; December had been worse. January produced white knuckles.


This time there was something different:  rumors swirled among market participants that currency traders and hedge fund operators were working in concert to drive down the krona and the Icelandic stock market through strategic selling and cunning manipulation of the news, driving up the price of the newfangled derivative instrument known as credit default swaps (CDS). Headlines proliferated in the London press: “Is Iceland headed for meltdown?” “Iceland shows cracks as the krona crashes.” Portes was warned that he was risking his reputation defending a nation whose situation was more dire than he understood. Behind the scenes, urgent questions were posed about who, in a pinch, would serve as lender of last resort.  How deep were the Icelanders’ pockets?  How trustworthy were assurances that Nordic central banks would come to their aid?


Since then, the Icelandic authorities have mounted a spirited defense, issuing bonds to bolster their foreign exchange reserves, tightening their lines of communication with the Nordic banks, making clear their determination to defend their currency, their stock market and their banks whatever the cost. “Iceland fends off hedge fund attacks,” headlined the FT Friday, concluding that the counterattack “seems to be working.”  The credit rating agencies have belatedly been marking down various Icelandic securities.  But the all-important CDS markets have been marking them up, with the price of insurance against default falling sharply since the first of the month. In London, Portes reiterated his recommendation: join the European Union and adopt the Euro in the long term, and hang tough against the speculators for now. The Icelandic economy, he said, was strong enough to take high interest rates and the resulting macroeconomic correction.


So that’s what happened to those BostonNow jobs – and, presumably, not a few other similar ventures around the world. Less-pressed owners would have tried harder to sell the newspaper as a going concern. But then the atmosphere in Reykjavik banking circles these last few weeks has been anything but open-handed. Much rested on the Icelandic response.  If the speculators had beaten Iceland, which carry-trade economy would have been next? Hungary, Turkey and New Zealand all have high current-account deficits, high interest rates and capital inflows. A spiral of lost confidence could have set the world on a path to make the global financial crisis of the late 1990s, when when the Asian crisis spread to Russia and Brazil, look like a qualifying round.


As a defeat that didn’t happen, the Icelandic saga hasn’t interested most of the rest of the world. But, especially in the United States, it is worth remembering that even if there is a recession, most Icelanders will still have their jobs. Their high living standards and generous pensions will remain intact. (The same can’t be said for the US workers who lost their jobs.) The Icelanders will retain their position at the top of the UN’s Human Development Report, ahead of oil-rich Norway. (The US stands twelfth in the rankings, the UK sixteenth.) In a less highly leveraged future, those venturesome Icelandic bankers will trim their appetite for risk. And fans of government everywhere will recognize that Iceland’s economy remains as well-managed as any in the world.