A Spending Spree

Summary

Iceland’s economic turbulence sounds like a familiar macroeconomic story — a credit expansion fuelled excessive borrowing and spending. But there are unfamiliar details — an unusually large banking sector and a central bank unable to serve as a credible lender of last resort — that raise concerns. Nevertheless, Iceland should be able to weather the current turmoil.

The recent economic turbulence in Iceland is in some ways familiar, while in others it is unique. The macroeconomics of current account deficits, inflation and asset price bubbles is the familiar part; the creation of a large banking sector in a country with no tradition of modern banking is the unique part. Both developments were driven by borrowing in the international credit market — the global savings glut has been the mover and the shaker of the Icelandic economy in recent years. While foreign borrowing to finance a domestic credit expansion explains a large part of the macroeconomic development, external borrowing to finance a credit expansion at home as well as abroad explains the expansion of the banking sector. And just as the two are joined in their cause, they are also joined in the distress caused by the current credit market turmoil. In a way, Iceland is testing the limits of small open economy macroeconomics by building a banking industry that by nature is dependent on foreign leverage while still maintaining an independent currency and a central bank whose possibilities to serve as lender of last resort are quite limited.