34. What Bubbles in Iceland?
The Global Financial Crisis of 2008
Iceland is a country of rugged beauty, volcanic mountains, countless waterfalls and, well, ice. Its inhabitants are even more exotic; 54 per cent of Icelanders, for example, believe in elves – or say it’s possible that they exist. Travelling through the desolate landscape, one can easily imagine how such beliefs emerge: Iceland is a country with fewer than 400,000 residents. To put that in perspective, almost double the number of people live in the 33 square kilometres of Macau than in the 100,000 square kilometres of Iceland.
Iceland might seem like a strange place to start a story about the largest global financial crisis since the Great Depression. But Iceland exemplifies both the worst and best of the crisis. The story begins several years before 2008, when Iceland’s bank managers saw an opportunity: they could attract the savings of Europeans, mostly residents of England and the Netherlands, by offering interest rates higher than those of the banks of those countries. The scheme seemed to work. Money poured in to such an extent that the three biggest banks grew to ten times the size of the economy, and twenty times the size of the government’s budget. What did Iceland’s banks do with all this money? They reinvested it abroad, buying all kinds of things, from foreign companies to foreign real estate – even foreign football teams. They also purchased what had become known as collateralised debt obligations, or CDOs. Think of a CDO this way: it pools the mortgage payments of many different home owners together. The attractive thing for an investor is that by pooling the mortgage payments of people across the United States, for example, the risk of non-payment is spread across many home owners and territories. If one home owner defaults, perhaps because of poor financial decisions or poor economic prospects in their area, the result is not so bad, because there are many others who will continue paying their mortgages. For that reason, a CDO can have a better risk rating than the underlying assets.
So, Iceland’s banks invested their European clients’ savings in the American housing market. These investments were fine while house prices were on the rise. And this was indeed the case for much of the first half of the 2000s. In fact, house prices were not only rising – they were skyrocketing. To cash in on the housing bubble many Americans had taken on second mortgages, at sub-prime interest rates, and used that money to speculate in the housing market. They often borrowed this money not from banks, but from financial institutions known as sub-prime lenders.
Sub-prime lenders were part of what was known as the shadow banking system in the United States. The liberalisation of financial regulations in the 1990s allowed new types of financial institutions to develop. These pseudo-banks were not subject to the same regulatory oversight as traditional banks and therefore could create complex financial instruments, such as CDOs, that separated the risks from the returns. In short, the high-risk sub-prime mortgages were creatively repackaged and disguised as CDOs and sold to bigger banks in the United States and Europe, including those cash-flush bankers in Iceland.
By early 2006, however, it was increasingly obvious that what had become a housing bubble was about to burst. House prices flattened and then declined. Home owners, such as those who had bought a second property hoping to sell at a higher price, could not find any buyers. Some began to default on their mortgage payments, leaving sub-prime lenders in the lurch. During the first few months of 2007 more than twenty-five US sub-prime lenders filed for bankruptcy. This had other knock-on effects. By August 2007 it was clear that the financial market could not solve the sub-prime crisis. Because of the interconnectedness of the banking system, the situation quickly spilled over into Europe. By the end of 2007 major European banks had announced substantial losses from sub-prime-related investments.
The worst was yet to come. When banks realised that the CDOs and other complex financial instruments they had purchased were actually not so safe, it caused what was equivalent to a run on the shadow banking system. Basically, everyone wanted to sell their CDOs as soon as possible, but no one wanted to buy them. The shadow banking sector collapsed. On 15 September 2008 Lehman Brothers, a global financial services firm founded in 1847 and the fourth-largest investment bank in the USA, with about 25,000 employees worldwide, filed for bankruptcy. Just a week earlier Fannie Mae and Freddie Mac were placed into conservatorship by the US Treasury. Fannie Mae (the Federal National Mortgage Association) had been founded in the aftermath of the Great Depression as a way to help Americans finance their home loans. It was privatised in the 1960s. In 1970 the Federal Home Loan Mortgage Corporation (or Freddie Mac) was founded to expand the secondary market for mortgages. When the housing bubble burst, Fannie Mae and Freddie Mac owned or guaranteed a large proportion of all home loans in the United States. Both were deemed too big to fail by government, and received government support to survive.
The collapse of a large part of the financial sector inevitably affected other parts of the economy too. Although the United States formally entered a recession in December 2007, during 2008 and 2009 the recession spread across the globe, becoming the Great Recession. International trade declined by 22 per cent in US dollar terms, commodity prices fell sharply, and unemployment increased. In 2009 global GDP declined for the first time since the Great Depression of the 1930s.
How did policymakers respond to the enveloping crisis? To sum it up: they told a story. In his presidential speech to the Economic History Association in 2012 the economist Barry Eichengreen explained that policymakers during the crisis had three options.1 They could use deductive reasoning in deciding how to respond. This implied that they would use their macroeconomic models to determine their response. The problem with this approach is that there is much debate over which macroeconomic models best explain the economy, and, as a consequence, what to do when a crisis hits. Put very simplistically, the saltwater school (so named because all the major universities that support this approach are based next to the US east or west coast) would propose active monetary and fiscal policy intervention, while the freshwater school (notably the University of Chicago, which is based next to a lake) would propose limited government intervention.
A second approach was to use inductive reasoning. This would require one to collect as much evidence as possible about what was happening, and then respond in a pragmatic way. This is an approach attractive to many social scientists, yet it has one major limitation in a crisis: it takes time to collect accurate information about the state of the economy. It can easily take three months to devise an accurate estimate of GDP. By that time the policy response that would have been appropriate three months previously might no longer be relevant.
Eichengreen argued that during a crisis, such as the Great Recession of 2008, policymakers follow a third approach: they use analogical reasoning. And during the Great Recession, he said, they used the Great Depression of the 1930s as their analogy. They chose this approach to tell a story about what had gone wrong during the Great Depression and how we should ‘learn from history’. This approach made sense for a couple of reasons. It was easy to get public support for something that most people could relate to. We all like to tell stories – and it is much easier to be convinced by a story than by a mathematical model or statistical evidence. Second, it is much easier to rely on a story when we disagree on theory, as was the case with the saltwater and freshwater economists. Third, it allows policymakers to move quickly.
As we discussed in Chapter 22, policymakers during the Great Depression were initially hesitant to intervene, hoping that the issue would solve itself. They believed that there was no need for fiscal or monetary policy, that in time the economy would revert to equilibrium. When this did not happen, Roosevelt introduced his New Deal. But it came four years after the initial Wall Street crash.
The crisis of 2008 was different. Ben Bernanke, who wrote his doctoral dissertation on the Great Depression while he was a student at MIT, was chair of the Federal Reserve, the central bank of the United States. He quickly realised that to avoid the same economic calamity as the Great Depression, he needed to act. In March 2009 the Federal Reserve quickly and resolutely adopted a policy of quantitative easing – the process of buying government bonds to inject money into the economy.
Monetary policy was not enough. A relatively unknown senator from Illinois, Barack Obama, had been elected president of the United States in the midst of the crisis. He, too, had learned from the past. He realised that if the banks and the companies that they serviced were allowed to fail, it would devastate the American economy. To counteract this he adopted a fiscal stimulus package to bail out insolvent banks and other companies. The combined effect of expansionary monetary and fiscal policy ensured that the crisis, although severe, was short-lived. The US economy shrank by 2.5 per cent in 2009. In stark contrast to the Great Depression, when negative economic growth persisted for several years, GDP growth bounced back the very next year, in 2010, recording a positive growth rate of 2.6 per cent.
Not all countries suffered equally from the fall-out. South Africa, for example, escaped much of the initial bank crisis. There was good reason for this. Only a few years earlier, in 2002, South Africa had experienced a ‘small bank crisis’, with several small banks, notably Saambou, filing for bankruptcy.2 One consequence of this crisis was that the authorities imposed stricter banking regulations. South African banks were therefore far less exposed to the instruments issued by the sub-prime lenders in the United States. This does not mean that the country was unaffected. When America sneezes, the world catches a cold. During the crisis, the Johannesburg Stock Exchange contracted by 40 per cent. Lower commodity prices and a decline in global demand hurt South African exports substantially. GDP declined by 1.5 per cent in 2009, and unemployment and poverty increased, setting South Africa, as we will see in Chapter 36, on course for a decade of poor performance.
One question that has intrigued economists is how a future financial crisis can be averted. One clue is that these crises typically emerge because of some asset bubble: the Great Depression was preceded by massive speculation on the Dow Jones, and the Great Recession, as we have seen, was the result of a housing bubble.
Asset bubbles are, of course, not new events. One of the first and most famous bubbles was Tulipmania, which swept Holland in 1636. Tulipmania saw the price of rare tulips inflate in one year only to collapse by 90 per cent the following year, which devastated many tulip investors. Another was the South Sea Bubble of company stocks (including that of the South Sea Company) in the United Kingdom in 1720. And yet another was Bicycle Mania in 1895, which saw the rapid price appreciation of bicycle companies. Perhaps more familiar to us is the dot-com bubble of 2001, a stock-market bubble caused by excessive speculation in internet-related companies.
Financial historians William Quinn and John Turner explain that for a bubble to emerge, three things are necessary.3 The first is marketability, or the ease with which an asset can be freely bought and sold. The second is low interest rates on traditional safe assets, which can force investors to ‘reach for yield’ in new asset classes. The third is speculation, the practice of buying an asset with the sole motivation of selling it later at a higher price. Although there is always speculation, Quinn and Turner note that during a bubble large numbers of novice investors join in as speculators.
The best recent example of how all three of these factors combine is the 2017–18 Bitcoin bubble. Bitcoin is a decentralised cryptocurrency that uses sophisticated blockchain technology to allow payments without the need for an intermediary. Bitcoin not only eases payments but is often also used as a store of value in countries that experience rapid currency depreciation. The bubble was brief but memorable. At the start of 2017 the price of one Bitcoin was below $1,000. By the end of that year it had reached almost $20,000. But the bubble burst, and it did so spectacularly in 2018. By the end of 2018 it had lost 72 per cent of its value.
This is not the end for Bitcoin and other cryptocurrencies, however. In March 2021 the price of one Bitcoin soared to above $60,000. Eighteen months later it fell below $20,000 before again increasing steadily to rise above $60,000 by May 2024. It is entirely plausible to expect it to reach $100,000 or even $1 million a year or two from now – or be worthless. Who knows?
Which brings us back to Iceland. Volcanoes and ice not only provide beautiful vistas, but are also a source of cheap energy and cold temperatures, a perfect combination for mining Bitcoin. As one journalist put it in 2018, ‘effectively, a bunch of computers engage in a race to burn through the most electricity possible and, every 10 minutes, one wins a prize of 12.5 bitcoin for the effort’.4 The cold Arctic air also reduces the need to invest in expensive air-conditioning for server rooms. In 2023, Bloomberg reported that ‘Iceland has become a refuge for Bitcoin miners as energy costs soar and regulatory pressure on cryptocurrency operations mount in the US and other countries’.5 As cryptocurrencies become more commonplace, competing with and perhaps even displacing national currencies and allowing new types of transactions, Iceland may soon be at the forefront of global financial developments yet again.
B. Eichengreen, Economic history and economic policy, Journal of Economic History, 72 (2), 2012, 289–307.↩︎
R. Havemann, The South African small banks’ crisis of 2002/3, Economic History of Developing Regions, 36 (2), 2021, 313–38.↩︎
W. Quinn and J. D. Turner, Boom and Bust: A Global History of Financial Bubbles (Cambridge: Cambridge University Press, 2020).↩︎
A. Hern, How Iceland became the bitcoin miners’ paradise, The Guardian, 13 February 2018, www.theguardian.com/world/2018/feb/13/how-iceland-became-the-bitcoin-miners-paradise.↩︎
D. Pan and M. Goldman. 2023. Bitcoin Miners Draw From Iceland’s Surplus of Renewable Energy. Bloomberg, 30 August, https://www.bloomberg.com/news/articles/2023-08-30/bitcoin-btc-miners-like-bit-digital-draw-from-iceland-s-renewable-energy-surplus↩︎