ICELAND SHOWS THE DANGERS AHEAD FOR US ALL / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Iceland shows the dangers ahead for us all

By Robert Wade

Published: August 26 2009 19:53

In the build-up to the global crisis of 2008, tiny Iceland was a canary in the mine, a leading indicator of wider vulnerabilities. Now, amid growing optimism about global recovery, Iceland may again be a leading indicator of trouble ahead.

In the space of a few days last October Iceland’s whole banking system collapsed and was taken into public ownership, including the three banks which went from nowhere in 2002 to rank among the world’s 300 biggest by 2007. These three now make it into a less glorious league – Moody’s list of the 11 biggest financial bankruptcies in history. The country’s average income fell from 160 per cent of the US’s in 2007 to 80 per cent this year.

Yet, walking around Reykjavik and other cities this summer, one sees no signs of economic distress. The country looks amazingly prosperous. Traffic density has fallen a little, but only to 2005 levels. Unemployment has risen to 8 to 9 per cent, nearly twice the previous postwar record – but is still below that of several other high-income countries. Applications for free food from charities have increased, but numbers remain small. Four out of five households have been affected only at the margins.

The government of Social Democrats and Left-Greens elected in April 2009 has got into gear after a slow start. Progress is being made on some of the most difficult issues, including the Icesave agreement on treatment of foreign depositors, the creation of new banks from the wreckage of the old ones, and the prosecution of financial wrongdoing. The paralysis that gripped the country for six months after September 2008 is over.

However, appearances are deceiving. This is a postponed crisis. When the government brought in the International Monetary Fund in late 2008 the IMF prescribed deferring the pain for a year. Now the pain is coming.

First, the freeze on mortgage repayments is due to end in November. The fifth of mortgages that are in yen or Swiss francs face a doubling of payments. Krona mortgages also face big increases in payments because they are tied to the consumer price index, which has shot up with the krona’s collapse. House prices are down 20 to 30 per cent, leaving many with houses worth only half the mortgage. The government asked the nationalised banks to show leniency, but repossessions will probably jump after mortgage payments are unfrozen.

Second, government spending, sustained so far by heavy borrowing, is due to be cut 20 to 30 per cent later this year, affecting health, education, social security and infrastructure. A wide range of taxes will be raised to try to eliminate the budget deficit by 2013. If the government accepts British and Dutch terms, Iceland’s taxpayers will take on an Icesave debt equal to half the country’s 2008 GDP.

Third, the capital controls that have protected against capital flight are to be eased as part of the process of financial reintegration; but at the cost of high interest rates, currently 12 per cent, which choke investment.

The government coalition is fragile. The Social Democrats are committed to joining the eurozone and the European Union. The Left-Greens are almost equally committed to staying out of both. The Social Democratic prime minister is popular as a symbol of rare integrity, but she retreats from foreign leaders and even from the local media. The Left-Green leader, the finance minister, is articulate and effective, but is a passionate nationalist and hostile to EU membership. He may be about to become the most unpopular politician in the land as tax increases and spending cuts bite.

As the summer tourists go home commerce will slow and unemployment rise. Deep resentments will again boil to the surface, as with the citizens movement whose protests brought down the previous government in January. The resentments are now doubly charged by the tension between those who want help with excessive debts and those who were careful, yet face tax rises. It is quite possible that the government could fall within six months. The only plausible alternative involves the two conservative parties which presided over the build-up to crisis.

The economic and political tipping points vary from place to place. But the news from the canary in the mine suggests people in other vulnerable economies in America and Europe should enjoy the good economic news while they can. There are good reasons to think it may not last.

The writer is professor of political economy at the London School of Economics and author of Governing the Market

Copyright The Financial Times Limited 2009