Phases of the crisis – are we approaching the endgame?

Phase 1: Greenspan, the arch money crank

The Greenspan “put”, and the collective adoption by most central bankers of low interest rates after the dot-com bust and 9/11, caused one of the largest injections of bank credit in history. Since bank credit circulates as money, we can say public policy has created the largest amount of new money in history.

This should never be confused with creating new wealth. That is what entrepreneurs do when they use the existing factors of production — land, labour and capital — in better ways, to make new and better products. The money unit facilitates this exchange.

Now to a money crank.  He will assume that new money will raise prices simultaneously and proportionately, so the net effect of the economy is that all the ships rise with the tide at the same rate. He’ll say that money is neutral and does not have any effect on the workings of the economy.

One of the great insights of the older classical economists, and in particular the Austrian School, is that new money has to enter the economy somewhere.  Injected money causes a rise in the price levels associated with the industry, businesses, or people who are fortunate enough to be in receipt of the new money. Prices change and move relative to other prices. It is often quite easy to see where the new money enters into the economy by observing where the booms are.

Suppose a banker sells government bonds to another part of the government (as has been the case with UK QE policy).  For selling, say, £30bn of government debt to the Bank of England, he gets a staggering, eye-popping bonus. With his newly minted money, he buys a new £10m house in Chelsea, a £5m yacht in Southampton, some diamonds for the wife to keep her happy, and lives a happy and rich life. The estate agent spends his commission on a luxury car, and some more humdrum items that mere mortals buy.  At each point in time, the prices of the goods favoured by the recipients of new money are being bid up relative to what they are not spending on.  Eventually these distortions ripple through the economy, and the people furthest from the injection of new money — those on fixed income, pensioners, welfare recipients — end up paying inflated prices on the basic goods and services they buy. A real transfer of wealth takes place, from the poorest members of society to the richest. You could not make this up. I am no fan of the “progressive” income tax, but I certainly can’t support a regressive wealth transfer from the poor to the rich!

Even when the government was not creating new money itself, it was setting the interest rate, or the costs of loanable funds, well underneath what would naturally be agreed between savers and borrowers.  Bankers are exclusively endowed with the ability to loan money into existence, so they welcome the low rates and happily lend, charging massive fees to enrich themselves in the process.

After the dot-com bubble, it was property prices that went up and up.  Not only do we have the richer first recipients of new money benefiting at the expense of the poor, we have a massive mis-allocation of capital to “boom” industries that can only be sustained so long as we keep the new money creation growing.

Our present monetary system is both unethical and wasteful of scarce resources. We do not let counterfeiters lower our purchasing power, and we should not let governments and bankers do it.

Phase 2: Bush & Brown – private debt nationalised by the Sovereign

This flood of new money brought more marginal lending possibilities onto the horizon of the bankers.

They devised a range of exotic products whose names are now familiar: CDO, MBS, CDO-squared, Synthetic CDO, and many more — all created to get lower quality risk off the issuing bank’s balance sheet, and onto anyone’s but theirs!

In 2007/2008, bankers started to wake up to the fact that everyone’s balance sheets were stuffed with candyfloss money, at which point they suddenly got the jitters and refused to lend to each other.  As we know, bankers are the only people on the planet who do not have to provide for their current creditors; they can lend long and borrow short. Thus, the credit crunch happened when the demand for overnight money to pay short-term creditor obligations ran dry.

Our political masters then decided that we could not let our noble bankers go bust; we had instead to make them the largest welfare state recipients this world has ever known! Not the £60 per week and housing benefit kind for these characters, but billions of full-on state support to bail out their banks. They failed at their jobs and bankrupted many, but they kept their jobs with 6, 7, or 8 figure salaries!

Bush told us that massive state intervention was needed to save the free market. Brown said the same. We were told that there would be no cash in the ATMs and society would most certainly come to an end if heroic action was not taken to “save the world”, as Brown so memorably put it (though he seemed to think he had accomplished this feat singlehandedly). Thank God for Gordon!

Now in Iceland, a country I was trading with at the time, their banks did go bust; no one could bail them out. But within days the Krona had re-floated itself and payments continued; within weeks they had a functioning economy.

Within days the good assets of Lehman Bros had been re-allocated, sold to better capitalists than they.

But with these notable exceptions, socialism was the order of the day. Bank’s inflated balance sheets were assumed by sovereign states. Like lager louts on a late night binge, after a Vindaloo as hot as hell itself, heads of government seemed to care little for the inevitable pain that would follow, as states tried to digest what they had so hastily ingested. Indeed, the failed organs of the nationalised banks survive only on life support, enjoying continuous subsidy through the overnight discount window.

But the sovereign governments, under various political colours, had a history of binging. In our case the Labour Party spent more than it could possibly ever raise off the people in open taxes, and the Tories offer “cuts” which in reality mean that the budgets of some departments will not increase as quickly as they were planned to.

Phase 3: King Canute, sovereign default

Default is the word that can’t be mentioned. In reality, we should embrace default. This debt is never going to be repaid. Never, that is, in purchasing power terms.

S&P ratings agency have hinted at this with the recent US rating downgrade. They know the American government can always mint up what it needs so long as it has a reserve currency. They also know that this is a soft default. In real terms, people seem likely to get back less than they put in.

Hard default should be embraced by the smaller nations like Greece and Ireland, so they can rid themselves of obligations they cant afford to pay. This will be good for taxpayers in the richer countries of Europe, as they will no longer be bailing out those who foolishly lent to these countries. It will be good, too, for the debtor nations, as they can remove themselves from the Euro and devalue until they are competitive again. They will, however, need to learn to live within their means. Honest politicians need to come to the fore to effect this.

Yes, this will be painful and the people who lent these profligate and feckless politicians the money will get burnt.

However, the FT has recently seen prominent advocates for a steady 4%-6% inflation target. This is the debtors’ choice and the creditors’ nightmare, with collateral damage for those on fixed or low incomes, for the reasons mentioned above. Should we let the Philosopher Kings have their way?

“Let all men know how empty and worthless is the power of kings. For there is none worthy of the name but God, whom heaven, earth and sea obey”.

So spoke King Canute the Great, the legend says, as waves lapped round his feet. Canute had learned that his flattering courtiers claimed he was “so great, he could command the tides of the sea to go back”. Now Canute was not only a religious man, but also a clever politician. He knew his limitations – even if his courtiers did not – so he had his throne carried to the seashore and sat on it as the tide came in, commanding the waves to advance no further. When they didn’t, he had made his point: though kings may appear ‘great’ in the minds of men, they are powerless against the fundamental laws of Nature.

King Canute, where are you today? We need honest politicians and brave men to step forward and point out the folly of trying paper over the cracks. Unless banks write off under-performing (or never-to-perform) securities from both the private sector and the public sector, we will progressively impoverish more and more people.

Let better business people buy the good assets of the bust banks, and let them provide essential banking services.

Let the sovereigns that can’t pay their way go bust and not impoverish us any further with on-going bailouts. In all my years in business, your first loss is always your best loss.

Yes, this will be painful. Politicians, fess up to the people: you do not have a magic bullet and you can’t offer sunshine today, tomorrow and forever.

I fear that if we do not do this, we approach the end game: the total destruction of paper money. Since August the 15th 1971, paper money has not been rooted in gold. It is the most extreme derivative product, entirely detatched from its underlying asset. Should the failure of this derivative come to pass, we will have to wait for the market to create something else. Will we be reduced to barter, as the German people were in the 20s?

A process of wipe out for all will be a hell of a lot harder than sensible action now.  It is still not too late.

Cobden Centre Radio

Cobden Centre Radio: Europe’s Deep Freeze of Debt

In this latest Cobden Centre Radio programme, I interview Professor David Howden, a member of our Advisory Board, about his new book, Deep Freeze: Iceland’s Economic Collapse, co-authored with Professor Philipp Bagus.

Amongst other subjects, we fly south from Iceland down to Ireland, then compare how these two North Atlantic islands are coping with their respective economic crises, before Howden considers Portugal, Greece, and Spain, and how the fate of these nations may be tied to the immediate fate of the Euro, by weighing up the latest evidence from an Austrian perspective:

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The Beauty of Being Iceland

Under the EU’s Markets in Financial Instruments Directive, the EU allowed the external countries of Iceland, Liechtenstein, and Norway to enter the ‘levelled’ EU financial markets, which Iceland took advantage of, to within an inch of its financial life.

When the Icelandic banks collapsed, the EU tried to make the Icelandic government impose ‘austerity’ upon the Icelandic people to ensure that EU banks were kept whole on their Icelandic investments.

Being outside the EU and being one of the most freedom-loving peoples in the world, with a proud history of North Atlantic island independence and a record of cocking a snook at the powers of the world — including defeating the Royal Navy in 1976 — the Icelandic people refused to bow their collective knees to their feeble quisling government and their government’s would-be overlords at the EU; they defaulted instead on their banking system’s enormous debts, much to the anger of the technocrats in Belgium.

Since then, Iceland has recovered from a low recessionary point, with this growth accelerating.

Meanwhile, back within the hallowed holy borders of the EU, the overlords of the Holy Roman Empire of Brussels have insisted that the Irish people suck up austerity and stop complaining, because this will:

  • Help prevent a terminal crisis for the glorious Euro project
  • Help prevent German and French banks collapsing
  • Help their satrap quislings in Dublin and their divine overlords in Brussels keep living the high life

You’ll notice that there’s little in the above package for the actual Irish people themselves.

However, because they allowed themselves to get ruled over by some of the stupidest politicians and most Machiavellian bankers in global history (and let’s not even talk about corruption and greed), this means in the explicit EU view, that the Irish people deserve to take their imposed punishment of austerity.

But is this divinely-directed EU edict written in French on tablets of Lapis Lazuli and then copied out in triplicate in Danish, German, and Greek?  Or is it in any way modifiable?

Unfortunately for the EU, the Irish people also have a proud history of North Atlantic island independence, not unlike that of Iceland, which is also a lot closer to Ireland than it is to Belgium. This relative success of the Icelandic default, compared to the upcoming agony of austerity for the tax serfs of Ireland, is something that is also quite clearly visible from the north-western shores of County Donegal.

So in this latest King World News interview, Jim Rickards asks the question: What if the Irish people refuse to suck it up? What if they do what Iceland did and tell the EU and its tottering banks to take a hike? What happens next?

Personally, as Daniel Hannan reported, I think this is an unlikely outcome, because most people in Ireland still perhaps accept their political system — for its legion faults — and all of the politicians in Ireland still want to suck up to the EU, for whatever reason. But what if the Irish do default and overcome the selfish personal interests of their politicians?

We certainly do live in interesting times and that is perhaps an interesting question.

If you would like to listen to the interview, which also discusses the honest financial assessments of Mervyn King, plus the situation in the metals markets, then click through either of the links below.

The interview proper starts @ 30 seconds:


A Crisis of Illiquidity or Insolvency?

As Europe continues bailing out its troubled economies, a subtle point is sidestepped. Providing additional doses of liquidity has brought short-term relief to some of the most troubled countries. Greece’s €110bn bailout earlier this year allowed it to save its burgeoning government payroll from starving. Ireland’s drawing on the €750bn. European bailout fund to the tune of €85bn. has saved some privileged banks. The next country to get bailed out will likely also see its troubles sidestepped for another day.

But the problem that no one wants to answer relates to what type of crisis this really is. Providing additional injections of liquidity may be a good Band-Aid solution if we are faced with a liquidity crisis. By expanding its balance sheet over the last two years, the European Central Bank has provided ample liquidity to keep its Eurozone banking institutions from failing. And if the ECB’s liquidity facilities weren’t enough, America’s Federal Reserve has been on hand to make U.S. dollar funding available at request. Tuesday’s extension of its U.S. dollar liquidity swaps reinforced the Fed’s commitment to maintaining a European banking system awash in credit.

Yet in continually ratcheting up the provision of liquidity, the ECB and the Fed have been battling yesteryear’s fight. Today’s crisis is fundamentally not of liquidity. It is one of solvency.

For a decade European governments spent beyond their means. Indeed, the ECB was one of the prime culprits allowing the newly formed Eurozone to pursue such prolific sovereign deficit spending. By allowing government debt to be used as collateral for its refinancing operations, the ECB ensured that Eurozone governments, especially Southern Eurozone governments, had access to cheap credit. With artificially reduced interest rates on their sovereign debt, Europe’s PIIGS economies were able to partake on a spending binge, with little heed for the coming liquidity crunch. The ECB, after all, had its hand on the lever to keep the liquidity coming.

Implicitly the ECB has treated the whole of the last decade as a liquidity crisis. Instead of functioning in its traditional role of lender of last resort, the ECB became a lender of first resort.

Today the use of liquidity has already largely been exhausted. The prolific spending of the past has created a solvency crisis. The governments of the Eurozone, aided by the excessive liquidity provided by the ECB during the last decade, have partaken on spending paths far overreaching any semblance of sustainability. An imbalance created in the past is now becoming apparent as these countries’ past debts come due.

In fact, the today’s recession is at its core not the result of “tight credit conditions”, “debt contagions”, or any other frivolous explanation. At its core we are faced with the realization that the previous fiscal state of affairs was unsustainable. By the time entrepreneurs realized that we were living in an unsustainable situation, it was already too late.

Of course, once you realize that the crisis is one of insolvencies the question that must be raised is what the best course of action is to get these insolvent situations solvent again. If we were indeed in the midst of a liquidity crisis, keeping the credit channels open may (and we must use the word cautiously) aid affected businesses.

An insolvency crisis implies one of two things. Either institutions are unable to pay off their debts as they are falling due, or, institutions have negative assets – liabilities in excess of assets.

The former seems to accurately describe the sovereign debt situation in Europe. Bond auctions are increasingly dismal. National governments are having difficulties raising the capital to meet their operating expenses. Normally capital is raised primarily through the financial markets – banks, mutual funds, insurance companies and the like purchase government debt as a “safe” asset for their portfolio.

The problem today is that this group of financial companies that typically funds government debts is under the second form of insolvency. The banking system in particular functions in an insolvent position as a normal state of its business affairs. Liabilities are always issued in excess of the assets available to pay them off – this is the fundamental basis of the fractional reserve banking system we are bound to today. As loans are issued in excess of deposits, a ballooning set of liabilities is permitted to be issued against a dwindling balance of assets.

The ECB allows the Eurozone domiciled banking system to issue up to 50 times the liabilities than assets are available to fund them. The Bank of England pursues an even more extreme path. With a reserve ratio on demand deposits set at zero, an unlimited amount of banking sector liabilities can be pyramided off an inexistent base of assets.

An insolvent financial system is unable to purchase additional amounts of government debt. Consequently, the sovereign debt crisis is unable to continue. The ECB pumping additional liabilities into the financial system cannot change the unalterable fact that assets cannot be created from thin air. Insolvency crises require a different exit plan than their less troublesome illiquidity counterparts.

Lacking a quick and easy method to create assets, the only solution to an insolvency crisis is to allow insolvent institutions to fail. Purging the bad debts from today’s financial system is an essential step in creating a sound foundation for recovery. Iceland, over the course of the past two years, has witnessed the bankruptcy of an insolvent banking system – one which had three large banks dominate the economy with liabilities amounting to 1100% of GDP. One would think that permitting such a dominant and centralized part of the economy to “fail” would cause undue hardship.

The purge of insolvent assets from Iceland’s financial landscape allowed for a fresh start. Government spending was forced to be cut as revenues were sharply curtailed. Talk of austerity measures that Britain and the Eurozone only hesitantly discuss became quick reality for Icelanders. An unsustainable situation came to an end, and Icelanders have commenced rebuilding with knowledge of the flaws of their past.

If the Eurozone could realize the same fate it too could have a quick exit. Past mistakes have been made, and insolvent institutions have been created. Allowing them to flourish further will do nothing but prolong the current economic malaise.


Iceland and the Western Banking System

Gordon Kerr’s second address this year at the European Parliament was at a meeting of the European Enterprise Institute.  The meeting was chaired by Diego Feio MEP and the meeting organised by Christopher Pichonnier.   The platform was shared with Tryggvi Thor Herbertsson (MP, Iceland) and Rok Spruk, a Lithuania based economist. This speech was originally published on 4 March 2010.

1. Introduction

Mr Feio, Mr Pichonnier, ladies and gentlemen, thankyou for inviting me to address you today.  We are here to explain and hopefully start to resolve the Icelandic banking collapse.

By way of brief personal introduction I am a banker.  In my 29 year career I have experienced several banking crises.  In the early 80’s I worked on Paris Club restructurings for Latin American sovereign defaulters.

Later in the 80’s I travelled frequently to the US in connection with the Savings and Loan crisis.  In the early 90’s I worked mainly in Stockholm on mortgage backed transactions during the Swedish banking collapse.

A few years later I designed instruments that would in turn play a small but significant role in precipitating the collapse of the Western banking system.  These instruments were called synthetic capital structures. They  created the appearance of an increase in capital on bank balance sheets when in reality the economic risk and return positions of the banks concerned were essentially the same after the transactions as before.

I am a member of the Advisory Board of a London based banking educational charity – The Cobden Centre, and I work for a small investment banking firm in London.

My message to you today is simple.  There is nothing specific about the way the Icelandic authorities managed its economy or its banking system that caused this massive failure.  The root of the problem lies within the very essence of the banking system itself.  Iceland, as a very small country with an aggressive banking industry, was just at the tipping point when the system itself failed, and has therefore suffered to a disproportionately greater extent than others.

2.  Were the Western Governments correct to bail out the banks?

Imagine the feeling of going to see a doctor with a puzzling medical condition, having both legs amputated, and three months later experiencing a recurrence of the symptoms.  You are admitted to hospital again, but this time the doctor who greets you post examination is far more sombre.

He explains that you have had a pancreatic tumour all along.  Had it been correctly diagnosed on first consultation the tumour would have been annulled, but now it is out of control and certain to kill you.

This, I believe, is a fair parallel with the way in which banks in the UK and many other European countries have been rescued.  I believe the bailouts are having the opposite effect to that which was intended.  They are not helping to re-stimulate lending to small and medium sized businesses – the engines of these economies.

A smarter observer than I has compared the UK solution to the actions of an alcoholic, accepting with equanimity inevitable long term pain as the consequence of his inability to resist the temptation of one more short term, fuzzy high.

There is a danger that solutions presently proposed could accidentally cut the legs off Iceland and condemn its economy to years of stasis, instead of helping to cure its crippled banking condition.

Let us look now at the banking system itself.  The legal rules which allow banks to gamble depositors’ demand funds on long term investments have simply created a liquidity pyramid scheme which, enhanced by various other banking developments, have boosted a variety of assets to unsustainable price levels that cannot be supported by the wealth of the relevant underlying economy.  Iceland, being both part of this system and a tiny country with its own currency, simply sits at the pinnacle of this Western banking system crisis.

3. Iceland and the Global Collapse.

I urge you to resist the temptation of embracing  the political exculpation  of  ‘global credit crunch’.  Although the crisis was truly global this simple linguistic term seeks if anything to discourage serious analysis of what went wrong.

Many papers and speeches I have read  are good quality diarised timelines of events in Iceland, without presenting credible cures or accurate analyses of the cause.

Iceland’s collapse was clearly related to the global failure, but each country does not necessarily need a global solution.  Indeed, whenever I hear of a problem that can only be solved by global accord I cannot avoid the conclusion that such a problem is being expressed as intractable.  The climate change issue is but one other example of a problem looking for a global solution.

Before addressing Iceland’s unique challenges, may I present some of the “banking developments” to which I referred earlier.  I am about to set out just some of the features of permitted banking activity which have combined to create an unsustainable pyramid of asset prices which Western liquidity may struggle to support.

Most of the features I am about to describe do not appear on the radar screen of the press or blissfully ignorant politicians. For brevity I will set out only five such features:

a)     The circular effect whereby asset prices are inflated merely by the creation of loans provided by banks to finance the purchase of such assets.  I have many times witnessed competitive bidding wars between two purchasers wherein the independent valuer has simply up valued the assets each time one side or the other’s bank has issued   a larger loan offer.  It is essentially the case that the size of the loan  determines the asset price, not the other way around.  Therefore it is impossible to divorce the independent valuation of assets from the quantity of debt which banks are willing to issue against the assets.

b)    Under EU fractional reserve regulations banks are required to maintain a minimum of say 8% “fraction” of their exposures as capital.  Since the bulk of European banks are shareholder owned, market forces virtually compel them to push fractional reserve regulation to the limit.  It is very difficult for the CEO of a major bank to keep his job if he is not fully leveraged in supposedly stable market conditions.

c)     The absurd accounting regime that encourages banks to transfer as much exposure as possible into derivative format.  The derivatives accounting regime  presents two important benefits to banks: 1) the front ending of multi year’s hoped for income as Day 1 “profit”, and 2) the ability of a bank to leverage its capital not 12 times (the reciprocal of the 8% basic capital ratio) but up to 200 times (the reciprocal of 1/16 of the basic capital ratio).  The 200 times leverage rule has historically been the starting point for calculating the capital to be reserved against derivative exposures, and now, under  Basel 2 rules, this higher level of leverage is permitted against any AAA rated assets even in non-derivative format provided the bank concerned is regarded as sufficiently sophisticated).

I have a second confession to make.    I was involved in designing the early forms of credit derivatives.  I have written articles about this activity on the Cobden Centre website and I am grateful to its founder, Toby Baxendale, for inviting me to write about this.  Let me clarify for the record one frequently confused point.  The motivation behind the emergence of credit derivatives was not the enabling of banks to distribute loans to non-banks.  That activity was operating perfectly well before the advent of credit derivatives via other financial instruments.

The overriding motive behind the emergence of credit derivatives was in the accounting rules.  Credit derivatives allow banks to book multi-year profits, subject to supposedly conservative reserves, before they have been realised or earned in a sense that would satisfy an accountant in any industry other than banking.

d)    I referred earlier to the liquidity pyramid that results from the legal relationship between banks and depositors.  Depositors’ money belongs in law to the bank, not depositors.  The EU seems aware of this concern and some proposed new regulations talk about inhibiting banks’ future ability to mismatch the maturities of assets and liabilities.  This mismatching has, I believe, been a major contributor to the crisis in a very simple way:

  • Person ‘A’ deposits £100 of cash into his instant-access bank account and receives a promise to return the cash on demand.
  • The bank retains a small reserve (say £3), and lends out £97 to Person ‘B’.
  • Person B purchases £97 worth of goods from person C who in turn redeposits the money in the bank.
  • Both ‘A’ and ‘C’ both have a claim to instant access on this money.
  • In three steps, the bank has turned £100 into £197 of useable money.

e) The use of the ECB discount window to finance banks purchase of assets post crisis.  There has, in the last 10 months, been a gradual rise in the prices of large volumes of the very type of banking assets that many UK commentators have termed “alphabet soup”.  Less kind commentators have termed some of these assets a “Liverpudlian Stew” – a rather unpleasant menu item, even by British culinary standards.  It is  in essence an attempt to present undigestible left over food as attractively as possible. (On behalf of Liverpool may I thank the EU for ordaining it as European City of Culture in 2008).

These price rises seem inconsistent with present reduced liquidity within the banking system. The only explanation I can reach is that some financial institutions have been able to fund their purchases of such assets via the central bank discounting windows such as the ECB itself.  Banks are then, as rational players in a regulated industry, motivated to make money by the monetisation of unrealised future profits by entering into synthetic arrangements on these same assets.  If true this effect will dash all our hopes that we may be coming out of the crisis.


Let us look at Iceland more specifically.  The root of the problem lay not in the failure of Iceland’s specific regulators or its national regulation system per se, but in the simple combination of three factors:

  1. i.         Its small size and status as a country;
  2. ii.         Its banks seeking aggressive growth;
  3. iii.         Its acceptance of the Western bank regulatory regime.

The scale of the problem measured against Iceland’s GDP was simply incredible.  The country effectively staked its economic future on international banking, raising capital internationally and lending it out in highly leveraged packages relying on rating agencies and more experienced capital markets arrangers.

The deposit base which lay at the root of the banks’ efforts to prop up the pyramid should have collapsed before the problems became quite so bad, but thanks to Iceland’s status as a sovereign state and international conventions whereby one country’s banks can be “passported” to raise deposits in another, Iceland’s banks succeeded in raising considerable sums of demand deposits from other countries’ savers, in particular the UK and the Netherlands.  Those savers looked only to their own national regulators who, under passporting rules, in capital markets parlance simply “wrapped” the Icelandic Central Bank.’’

Ironically the taxpayers of countries such as the UK and Netherlands in effect wrote credit default protection on Iceland, and now, having been called on this protection, seek to exercise rights of subrogation against the Icelandic taxpaying citizenry.  But if the Icelandic people did not understand what was going on, are these actions not akin to luring the demented old lady next door into leaving you her house in her will and thereby disinheriting her children?

Icelanders who had saved in its major banks, supervised by its national regulators, were effectively performing the function of a junior mezzanine investor (ie just above the shareholders) in the capital structure of a typical “alphabet soup” investment whose fragility was almost impossible for the ordinary taxpayer to understand.

And so, the pyramid inflated further until September 29 2008.  On that date Glitnir, on seeing its credit lines withdrawn following the collapse of Lehman, knew it was unable to raise funds to satisfy a €750 million payment due on October 15th and approached the Central Bank of Iceland for an emergency loan.  The loan request was turned down and instead Glitnir was forced to accept €600m from the central bank in return for a 75% stake.  Its shareholders were practically wiped out[i].

Iceland therefore suffered like no other country, and at a rapacious rate.  At less than 6% of GDP, government debt was tiny at the beginning of 2008.  Under an FRB system that mirrored that of all major European countries its banking system was quickly destroyed and its people burdened with unimaginable levels of debt.

5. What Should Iceland Do?

We have just heard from Dr. Tryggvi Thor Herbertsson MP that there is great doubt as to whether it will join the Euro.  Even if the Eurozone states can fund the PIGS and other bailouts presently planned, should Iceland ask for an EU bailout?

The short term appeal is obvious, is the longer term outlook as rosy?  What of the concerns of abandonment of control over fiscal and monetary policy?  Are these measures consistent with the Icelandic character and way of doing things?

Let us consider Greece very briefly.  The calm 2 weeks  ago when the Greek bailout was announced has been replaced by concern.  The austerity measures the EU would impose will be as unpopular in Iceland as they are in Greece.

There is clearly a gulf between the positions of the bailor and  the bailee.   As I prepare this speech I read in February 25th Daily Telegraph the following report by Ambrose Evans Pritchard:

“Hans-Werner Sinn, head of Germany’s IFO economic institute, said Athens was holding Euroland to ransom, threatening to set off mayhem if there is no bail-out. “Greece should never have entered the euro zone because they did not qualify and they are now blackmailing other European countries via the euro. It’s not for the EU to help Greece. We have an institution that is very experienced in bailing-out activities: the IMF,” he said.

Otmar Issing, former doyen of the European Central Bank, echoed this view in Germany’s Bundestag last Wednesday, warning that a Greek rescue would “open the floodgates” for serial bail-outs and destroy EMU discipline. “The crisis is made in Greece. It is the result of bad policy, not outside forces like an earthquake.” “

Does this rhetoric imply that life under the EU will be much better for Icelanders?  That is clearly a decision for Iceland’s Government and people.

If Iceland joins the EU then I would urge the EU to reform its own regulatory regime fundamentally to protect Iceland from further catastrophe.  Relying on rating agencies as the basis of regulation, rather than markets, makes little sense.

It is not impossible to devise a fractional reserve regulatory system that will work if its practitioners are expert bankers and fully appraised of everything that its banks are engaged in post reform.  But this is fraught with risks.

A far easier solution for Iceland is to make one simple law change.  Grant depositors title to their deposits, stipulate that the state and taxpayers will never again bail out the banks, and allow free market forces to create a safe and transparent banking system.  A ban on the maturity mismatching of assets, combined with a clear policy of NOT bailing out the banks in future, will enable free markets to flourish.

Do not blame the bankers, they were merely acting like rational capitalist players in a wrongly regulated system.  If we are to allocate blame then look to yourselves right here in the Brussels Parliament.  It is you rulemakers who have made the mistakes.  You should have worked this out.

6. Conclusion

The way forward for Iceland should be to look to itself.  Tryggvi, your people have a powerful sense of identity.  You have a wonderful natural economy, a well educated population and a well documented strength of character.  You can fix your problems yourselves, but maybe with a little help from my firm! The detail of implementation needs to be set in the context of modern banking.  A restructured banking system as proposed today would ensure:

1)   Depositors could NEVER AGAIN lose their money;

2)   Credit would resume flowing from savers to entrepreneurs;

3)   The reopening of the international capital markets to Iceland

Without these measures I fear it will be back to the operating theatre in a year or two, with little prospect of a speedy recovery.

Mr Feio, Mr Pichonnier, ladies and gentlemen, thank you for your time.


Gordon Kerr  – March 2nd 2010

EU Parliament, Brussels

[i] What the Icelandic Collapse has Taught Us, February 2009, Tryggvi Thor Herbertsson

Further Reading


Iceland’s krona proves the magic wand as Europe ails – Telegraph

Via Iceland’s krona proves the magic wand as Europe ails – Telegraph:

Out in Iceland’s Eastern fjords, Alcoa has raised aluminium production to record levels – and metal matters as much as fish for exports.

“The smelters are running full speed,” said the new-broom finance minister, Steingrimur Sigfusson. So is Mr Sigfusson himself. Last week he launched three new banks on the ruins of the old. Normality is returning. “We are going to get through this better than feared. We’re feeling real activity in the economy, and much of this comes from a favourable exchange rate,” said Mr Sigfusson.