With about 320,000 people, Iceland has only about as many inhabitants as an average German city. Nevertheless, the island republic is among the richest nations in the world with one of the highest living standards. Iceland is a member of the United Nations, NATO and the European Economic Area, as well as many other international organizations. “Is the banking industry responsible for the economic disaster of Iceland?”
Until the 80’s, Iceland was a more regulated economy with many interventions by the state. Since then, the Icelandic economy has been unbundled and increasingly liberalized. Since 1991, many state enterprises were successfully privatized. With the establishment of the European Economic Area between Iceland and other member countries, free movement of goods, services, capital and persons become a common part of economy of Iceland.
GDP per capita in Iceland is, however, above average. GDP is calculated at 1,700 € per head, or 6.7 per cent higher than in Germany. A striking feature of the Icelandic data is high economic growth and low unemployment. However, major issues in the economy are a high foreign trade deficit and a high rate of inflation. (Jonsson & Asgeir, Pp. 42-48)
Permanent deficits in the public sector and the burden of foreign debt were major structural problems facing the Icelandic economy in the nineties, but both problems were mitigated with some degree of success. Although most Icelandic businesses have always been private, the economy was clearly centrally controlled until mid-1980, with state control over pricing, a comprehensive indexing, the protection of certain sectors, the distribution of loans with political interests and control over foreign investments and cash flows in and out of the country. However, by the early 1990's, all the major economic and commercial activities had been liberalized, with the advent of the principles of free trade in goods and services and the free movement of capital, which covered the structure of the European Economic Community.
Iceland's economic crisis shares a common bond with those that have infected other developed economies recently: all have banking systems heavily engaged in the practice of maturity mismatching. In other words, Icelandic banks issued short-term liabilities in order to invest in long-term assets, a practice which created funding gaps (i.e., liabilities less assets) of a given maturity for the three largest Icelandic banks -- Kaupthing, Glitnir, and Landsbanki.
Thus, the banking system had to continuously roll over (renew) their short-term liabilities until their long-term assets fully matured. If an event arose whereby Icelandic banks failed to find new borrowers to continue rolling over their liabilities, they could face a liquidity crisis and, more importantly, spark the collapse of the Icelandic financial system; recent events have borne out this exact scenario.
The Icelandic banking collapse resulted from two major causes: inadequate...