Iceland nearly goes bankrupt -- Could the U.S. be next?

October 18, 2008

In early October, Iceland nationalized its three largest banks - Kaupthing Bank, Landsbanki and Glitner Bank - which had begun defaulting on $62 billion of foreign debt. As a result of the banks' collapse, foreign investors fled Iceland, prompting the value of its currency, the krona, to drop 50% in one week.

Iceland's banks used $100 billion in debt to finance foreign acquisitions, dwarfing Iceland's GDP of $14 billion. When the credit crisis shut down lending, these banks' financial collapse brought down the country's economy. (Source: AP, Iceland teeters on the brink of bankruptcy, October 7, 2008)

Therefore, Iceland is appealing to neighbors Luxembourg, Belgium, and the UK to insure bank deposits of the branches in their countries. Iceland is approaching Russia and the IMF for loans to bail out their economy so they can insure bank deposits. (Source: Guardian, Iceland sees IMF decision with a week, October 16, 2008)

Iceland's economic collapse affects the rest of Europe, since Iceland's banks both expanded their retail services in Europe and heavily invested in foreign companies. Iceland's Baugur is the largest private company in Great Britain. Icesave, the online arm of Landsbanki, froze withdrawals during the crisis, affecting depositors throughout Europe.

Before the crisis, both inflation and interest rates were in the double digits. This caused many Icelanders to add second mortgages using foreign currencies, since interest rates were lower. Now that the krona has dropped, they are suddenly facing mortgage costs that are double the price in krona at the same time housing prices are falling. (Source: IHT, Iceland is all but officially bankrupt, October 9, 2008)

Since the government has been unable to maintain the value of the krona, many have suggested Iceland join the EU and adopt the euro as its currency. Iceland is already a member of the European Economic Area, a trade association that follows many EU rules. However, Iceland's fishing industry is opposed, since it has clashed with European countries over fishing rights.

What Iceland's bankruptcy means:

The U.S. government has invested a total of $5.1 trillion in stemming the banking crisis. This is more than one-third of annual production and, if left unfunded, would substantially raise the U.S. debt, currently at about $9 trillion. Furthermore, it is still unclear if the amount invested will be enough.

Although this is not as bad as Iceland's situation, it will have similar effects on the U.S. economy - a declining dollar, less trust in U.S. financial markets, and a much slower-growing economy for decades to come. (Source: IHT, U.S. consolidates financial risk-taking in Washington, October 18, 2008)

Action steps:
Consider a vacation in Iceland...prices are half what they were a month ago.

Read more articles on the European economy in European Union and Economic Evolution, a WorldMoneyWatch Top Ten Trend.

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