February 03, 2009

Why Iceland melted

Regarding Kevin?s DeAnna?s latest, many have wondered why Iceland, that little ethnically homogenous island that used to have one of the highest living standards in the world, was the first country to suffer a total meltdown?economic, social, and political. After all, wasn?t it those rich Icelanders who not too long ago were buying up all the commercial property in London? Well, to paraphrase Tolstoy, while all happy economies are the same?high savings, high production?all unhappy economies collapse in their own peculiar way. And while the U.S. of A. will soon be crushed under its unfathomably large public and private debt obligations, Iceland?s problems derived from the so-called ?carry trade.?

The inimitable Max Keiser discussed it all in a series for al-Jazeera English?which aired in the spring of ?07, by the way, well before any mainstream politician or public intellectual was talking about a crash.

Basically, carry trading is an act of arbitrage, currency speculation, that?s highly remunerative but has got to be the most unproductive use of capital ever devised. There?s no ownership or real investment; instead carry traders are simply playing the exchange rates and collecting interest on borrowed money. First, a carry trader goes to a country with a very high savings rate (that is, they have money to lend) and very low interest rates. Japan is the ideal place as its people, being far more dedicated to the Protestant Work Ethic than decadent Americans and Europeans, save tons, and for the past 15 years, the Japanese Central Bank has been forcing down interest rates in a vane attempt to ?stimulate lending? (sound familiar.) The carry trader then takes this money to a place where the interest rates are very high, Iceland for instance, and simply puts its in a bank and collects a high rate of return.

The unintended consequence is that in the country where the money is invested, an illusion of wealth arises, a buble. Icelanders haven?t actually increased their productive capacity, and they aren?t actually saving more than they used to, but the banks have become flush with capital. And sooner or later, they soon start to lend? and lend and lend and lend?all the easy money.

With the stock market crash in the U.S., all those carry traders had to meet margin calls and quickly de-leverage, and they thus pulled tons of money out of Iceland, creating a kind of run on the Icelandic banks. The rest is history. 


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