Iceland Sours on Austerity as Pre-Crisis Parties Close on Power

Icelanders, burdened by more than four years of hardship, are poised to oust the government and return to power the parties that steered the island through a banking-led boom that ended in economic ruin 2008.

Voters in the 322,000-people North Atlantic island nation head to the polls today, with a preliminary result expected after the voting ends at 10 p.m. local time.

“No government that’s forced to raise taxes enormously and cut all services down to the bone will become popular,” Eirikur Bergmann, a political science professor at Bifrost University, said this week in an interview. “The current government is headed for the greatest defeat in Iceland’s history.”

Polls show voters have abandoned the Social Democratic Alliance and the Left Green Party coalition, which took over after street protests ousted an Independence Party-led government in 2009. Independence and its pro-deregulation ally, the Progressive Party, are now set for a comeback, tapping voter fatigue as the nation struggles to dig itself out of the collapse triggered by the failure of its three-largest banks.

The government will win only 25.6 percent of the votes combined, according to the latest poll. Support for the Progressive and Independence Parties was 25.4 percent and 22.9 percent, respectively, according to Frettabladid and Stod 2 poll released on April 26.

Debt Burdened

While Social Democratic Prime Minister Johanna Sigurdardottir has won praise from the International Monetary Fund and debt rating companies for her handling of the crisis, voters are burdened by excessive mortgage debt and an unemployment rate that’s still more than double pre-crisis levels. Unemployment was 6.8 percent in March, up from below 2 percent in 2007, according to a monthly survey from the Statistics Office.

The government has made close to 300 changes to the tax system, including raising income, value-added and corporate taxes. The government dropped a 37 percent flat tax, raising the highest marginal tax rate to 46.2 percent and also introduced a 1.5 percent wealth tax on fortunes above 75 million kronur ($638,000). New taxes have also been levied on natural resources and the tourist industry, as well as bank employees.

The parties have been outbidding each other with promises of debt writedowns and tax cuts, measures they say will be paid for by the creditors of the failed banks.

Debt Writedowns

The Progressive Party, one of the pre-crisis architects of financial deregulation, has pledged to writedown mortgages by as much as 20 percent, which in part will be financed by the 450 billion kronur of domestic-currency assets held by creditors in the failed Kaupthing Bank hf, Glitnir Bank hf and Landsbanki Islands hf.

The Independence Party, a potential government partner with the Progressives, has pledged cutting taxes to ease the financial pain of consumers and corporations.

“In most matters it will be pretty easy for the Progressive Party and the Independence Party to reach an agreement, which can be the basis of them forming a government,” said Olafur Hardarson, a professor in political science at the University of Iceland, in an interview this week. “However, the promises of the Progressives to write down mortgages and abolish the inflation indexation of consumer loans may be a bit tricky.”

Seizing Assets

As forced writedown of creditor claims may also backfire on Iceland’s economic resurrection, according to Lars Christensen, Danske Bank A/S’s chief emerging markets economists and one of the first to predict 2008 collapse.

While there’s a need to ease household debt, “paying for that by seizing the assets of foreign investors such as the creditors of the failed banks isn’t the way,” Christensen said in an interview this month. “If their assets are seized, the international investor community won’t soon forget that.”

Iceland emerged from a $4.6 billion IMF-backed rescue program in 2011 and has since returned to global capital markets with two U.S. dollar bond sales. In January, it won a court battle against the U.K. and the Netherlands, freeing it from as much as $2.6 billion in damages for not honoring depositor claims stemming from failed Landsbanki.

Since 2008, Iceland has relied on capital controls now blocking as much as $8 billion in offshore kronur holdings from being offloaded. The government and central bank have yet to design a road map for exiting the controls as they try to avoid a new crisis. The turmoil in 2008 sent the krona plunging as much as 80 percent against the euro in the offshore market. Even the official onshore rate dropped close to 50 percent.

Can’t Refuse

Inflation spurred by krona losses has crippled households. With more than 80 percent of private debt linked to consumer prices, Icelanders are more vulnerable to currency swings than borrowers elsewhere. Households owe domestic lenders about 1.43 trillion kronur ($11.3 billion) in loans indexed to inflation. They’ve struggled to keep up debt payments as price gains hover close to 4 percent.

“After a term which has been very difficult financially for many voters, the Progressives and the Independence Party have promised solutions which are designed to do away with people’s financial misery,” said Bergmann. “It’s like making people an offer they can’t refuse.”