Warnings from Iceland

When I arrived this summer at Keflavik International Airport, about 30 miles west of Reykjavik, the capital, I expected to see a devastated country. Iceland's three major banks had all failed and been taken over by the government. The art collections that the banks once owned were given to the National Museum, so the public could derive some benefit from the only bank assets that still had real value. Iceland's currency, the kroner, had collapsed, declining more than 40% in value. The government itself had to go begging: securing the promise of a $2.1 billion loan from the International Monetary Fund (IMF) and a further $2.5 billion in aid from its European neighbors. For a while, even credit cards issued by Iceland's banks were cut off.

Despite the economic collapse, what I found was mostly business as usual. My plane was full, and there were long lines at immigration. Covering just 39,769 square miles, Iceland is slightly smaller than Kentucky, and has a population of 319,000, just a little larger than Pittsburgh's. Nearly two-thirds of all Icelanders live in the Reykjavik area. And every one of them, it seemed, was either shopping or relaxing in a coffee bar when I arrived.

When the banks fail and the currency collapses, you are supposed to see bread lines and shanty towns, similar to the Hoovervilles that sprang up in the U.S. during the Great Depression. I saw nothing but a clean and thriving capital. But appearances can be deceiving. While Reykjavik is a beehive of activity, not unusual in the political capital even of a country under great stress, the country is living on borrowed time.

Leveraged-Buyout SpreeDaniel Drezner of Tufts University provides an excellent crash course on what went wrong in an August Wall Street Journal review of a book by Asgeir Jonsson, former chief economist at Kaupthing, one of Iceland's big-three banks prior to the collapse. Drezner explains: "To help liberalize its financial sector, Iceland privatized its largest banks roughly six years ago and then allowed them to go on a leveraged-buyout spree across Scandinavia and Great Britain. When Iceland's central bank raised interest rates, the country became an epicenter of the 'carry trade,' in which money managers borrow from one country with a low interest rate and place deposits in a country with a higher one."

In the span of just three years, Drezner explained, "Iceland's per-capita income tripled, and its stock market capitalization increased by a factor of eight. Then the credit bubble burst. Iceland's overvalued currency plummeted, and there was a run on the country's banks… By October 2008, the financial sector had racked up debts equivalent to eight times the country's gross domestic product." Through it all, he notes, "Iceland's politicians seemed almost clueless."

A ticking time bombIn some ways, the recent bust represents a return to normalcy in Iceland. Despite the swaggering prosperity and meteoric rise in per-capita gross domestic product during the boom, Iceland historically has not had one of the world's "go-go" economies. The people were frugal and hard-working, but not worldly sophisticates. As late as the 1950s, many Icelanders didn't normally carry cash with them; they bartered for their needs. Credit cards were all but unheard of. Even now, according to the CIA World Factbook, 70% of Iceland's exports and 40% of its export earnings come from fishing and fish processing, which employ more than 5% of the entire workforce.

Despite the appearances of business as usual in bustling Reykjavik, the situation in Iceland remains grim. For now, people are enjoying themselves, and life goes on, as they use their income and savings to make payments on their debts. But this can't go on indefinitely, since many Icelanders borrowed in euros, while their income and savings are in the devalued kroner. When thifty Icelanders purchased homes and cars during the boom years, they typically made down payments that were way above average by U.S. standards—borrowing 20 million kroner (worth about €225,000 or $300,000 three years ago) to purchase a 30 million house kroner—a very conservative one-third down payment. Since interest rates on the local currency were in the neighborhood of 14% at the time, many borrowers were convinced to take out their loans in euros, since the interest rate was closer to 4%.

Then the bottom fell out. The value of that 30 million kroner fell 25%, to 22 million. Even with the major home price decline, the home would not be under water if the loan were in kroner. However, because the currency lost more than 50% of its value when converted to euros, the €225,000 loan became 41 million kroner. Many Icelanders find themselves in such situations, with the value of their assets deep under water and having to make monthly payments double the size of what they were expecting.

This is a ticking time bomb there's no way to defuse. Unlike the U.S., Iceland has no personal bankruptcy option, giving borrowers an opportunity to make a fresh start. In Iceland, debt follows you forever, forcing some Icelanders to flee the country to try to escape the debt they cannot repay.

Unless something changes radically, there will be massive defaults, engulfing Iceland in a new crisis. Beneath the surface, anger is growing. Businessman Sveinbjorn Arnason told me he expects the worst, possibly even riots, when people reach the breaking point later this year, or early next, when they can no longer make their mortgage payments and pay their other bills.

What can we learn from this mess? The first lesson is that in the modern global economy, intelligent, tech-savvy people can change the ground rules and manipulate financial instruments far faster than government regulators can keep up with their manipulations. While deregulation per se is not a bad thing, deregulation in the absence of competent and effective oversight is a terrible thing—an invitation for disaster and abuse.

We saw this in the U.S. with the securitization of subprime mortgages, and we are seeing it in Iceland and elsewhere. The promise of "making quick money" triggered a massive boom, with a corresponding massive rise in housing prices, cost of living and apparent prosperity. The boom was, unfortunately, a bubble—and bubbles always burst.

Nobody wants an economy that goes through wild booms and bust cycles. Even most proponents of a free market concede that some regulation is necessary. The argument is over the nature and degree of that regulation, the amount of authority to be granted to the regulatory bureaucracy, and who, if anyone, will keep an eye on the regulators.

The one thing about which most of us can now agree is that the pendulum swung too far in one direction. There was too little oversight. The second thing we can learn is that without steady, long-term economic growth, the debt time bomb eventually will catch up with us. That "us" includes nations as well as companies and individuals.

For the vast majority of Americans, everything seems normal today, as it seems in Reykjavik. The banks haven't collapsed and are even reporting profits. The residential real estate market appears to be stabilizing. And while nearly one of every 10 workers is currently out of a job, life is basically the same for the other 90%, though they are being more cautious with their money, saving more and spending less.

Behind this seeming calm, however, the U.S. is also awash in debt. Home values have dropped by 30%-40% and more in some locations, and we have massive levels of high-interest credit card debt. Commercial real estate, according to the Massachusetts Institute of Technology's Center for Real Estate, also has experienced a sharp decline in value, foreshadowing, some believe, a new round of problems. Bankruptcy laws can give people a fresh start, but a long, slow "jobless" recovery could force many more people to walk away from their obligations bt declaring bankruptcy, triggering more foreclosures, another housing price decline, and a second downward spiral.

America's false sense of invincibility Until this trip, I thought such a "lightning bolt" scenario highly unlikely; now I'm not so sure. The message from Iceland is that we should make sure we are doing everything we can to defuse the debt bomb before it can go off.

The U.S,, because of our inherent wealth, the stability of our political institutions and the underlying strength of our economy, is blessed—and can get away with a lot that would put other countries under. We have the largest economy in the world. We can print dollars and at least for now people throughout the world will take them—especially in a time of uncertainty.

But we shouldn't be lulled into a false sense of invincibility. The "Great Recession" that began in December 2007, should serve as a reminder that we're not too big to fail. We need to get our house in order.

There is calm and quiet in Iceland today. All seems well. But the "house of credit cards" could soon collapse. Let that be a lesson for the U.S.: The world is too complicated for anything-goes capitalism. A free market is important. But the ability to exploit such a market—and the ready willingness of some people to do so—requires checks and balances.

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