Explaining Iceland’s Excessive Boom and Bust: a Political Economy Approach

We explain the Icelandic bubble economy and the financial crisis of 2008 with lessons from classical political economy theories (Keynes, Minsky, Kindleberger, Reinhart and Rogoff). We ask why and how the Icelandic bubble came about? Why it went so far off track? Who were the main actors? And why they did it? At the base of these developments were changes in the policy environment and institutional changes in finance and economy, which produced both new opportunities and new risks, as well as paving the way for new powers to rise in the society, not least with the full privatization of the state banks in 2003. An overextended belief in the virtues of the free market of the private sector led to a laissez-faire attitude towards the new risks, while the new opportunities were pursued with great efforts. This produced a classical but unusually large financial bubble, culminating in 2003-2008, with massive and risky growth of banks. The main characteristic of the Icelandic bubble was extensive business speculation with borrowed money. The consequence was excessive accumulation of foreign debt, which tends to be the ultimate cause of financial crises. The main actors were the top ten percent of income earners, who gained tremendously during the decade leading up to the collapse. Their incomes grew way beyond all others, not least their financial earnings, which sprang mainly from the activities of the unsustainable bubble economy.