One of the fundamental concepts in insurance is that of moral hazard. Whenever a party is insulated from the adverse consequences of his actions, he will tend to engage in more risky behavior than he would do otherwise.
We see aspects of moral hazard around us every day. Politicians make public spending decisions based on information that is much less than they would require for their personal spending decisions, since the money does not belong to them. Investment advisors push stocks on their customers that they would never buy themselves, because they're too risky. Drivers talk on cell phones and text while driving, knowing that any resulting accident will be covered by insurance.
As Iceland's economic collapse has unraveled, it has become clear that many of the current problems now facing Icelanders are the result of moral hazards present in traditional Iceland culture, amplified by the neo-liberal philosophy that dominated our politics until the banks failed in late 2008. Until the conditions that permitted individuals and commercial entities to avoid personal liability for their errors are eliminated, we will be doomed to endless cycles of boom and bust.
Because of its small size (Iceland's population is currently around 310,000), there has always been a very close link between the elite and the dispensation of justice. During the time of the sagas, the goði (chieftains) were not only the wealthiest individuals, but they controlled their warriors and served as the judges at the annual meeting of clans in Þingvellir. Disputes were resolved as much by the force as by any agreed-upon law.
Our colonial overlords maintained a similar system, in which they used their monopolies over commerce and the use of force to ensure that justice favored the colonizers, rather than the natives. When we finally achieved our independence from Denmark in 1944, the families that had grown fat under foreign rule were the only ones with the experience or wealth required to build a modern state.
They maintained a stranglehold on all aspects of Icelandic society--media, fishing, banking, commerce, travel, politics--until they were forced to broaden their numbers as more Icelanders earned university educations and obtained commercial experience, and as the working classes exercised their new-found right to vote, but they ceded control reluctantly, step-by-step.
The new members of Iceland's elite included a group of young libertarian ideologues, led by Davíð Oddsson, Geir H. Haarde and Hannes Hólmsteinn Gissurarson, who took control of the dominant Independence Party and made Iceland into testing ground for the free market ideas of Friedrich Hayek, James M. Buchanan and Milton Friedman. Taxes were slashed and public resources were privatized.
Unfortunately, the privatization process was highly politicized, and the fisheries and the banks ended up in the hands of the ruling parties' patrons, generally for free or for greatly reduced prices. The banks immediately financed a massive spending spree that regulators had neither the expertise nor the resources to effectively oversee.
Not to worry, said the government, the market will regulate itself, and if worse comes to worst, the Central Bank will be there.
If the government had awarded these valuable resources in public sales to the best qualified parties, maybe. However, there was a fundamental imbalance of information. The government did not have the means or the will to conduct a fair sale; it had no way of knowing whether one bidder was better qualified than another. All the politicians knew was that their friends wanted the banks, and would spread some of the wealth their way.
The Icelandic public was largely left out of the decision-making process. There was no transparency: independent expert assessments of the ability of the new owners and their plans were never made public (if they were ever conducted). Politicians were never asked to report family ties to the banks, and were never required to recuse themselves from voting on measures that benefitted them personally.
The beneficiaries of the state's largesse created extremely elaborate corporate structures to mask control and to shield themselves from potential personal liability. Until Merrill Lynch went public in 1971, investment banks were private partnerships in which each partners was personally liable for any losses caused by the partnership. These partnerships' transformation into public corporations was the single most important factor in the banks' risk-taking behavior in the 2000s. As Daniel Gross recently wrote in Slate, "The shift to public ownership ... replaced the accountability of partnerships--when there are no profits, there are no partner bonuses--with the dangerous fecklessness of public boards."
In a partnership, it was in the partners' interest to ensure that junior employees did not take excessive risk. However, as Jón Daníelsson and Con Keating observe, "When proprietary trading forms a significant share of total profits in limited liability institutions, it impedes effective risk monitoring as senior management generally does not have the appropriate incentives to restrict risk-taking activities."
When the banks failed, the shareholders were wiped out, but the employees and officers who had been paid outrageous salaries and unconscionable bonuses did not have to return them, even though the collapse was the direct result of their ineptitude. If the banks had been private entities, it would have been the partners who would have been wiped out.
What is especially disheartening in Iceland is that, not only did the banks' leaders get to retain their compensation; they continue to draw salaries from their new positions of authority in the new banks and in the government, at a time when most Icelanders are being buffeted on all sides by inflation, debt, and unemployment.
Now that the bankers see that their risk-taking did not cause them any personal damage, what chance is there that they will modify their behavior?
Moral hazard also distorts other aspects of the banks' decision-making.
Iceland's Central Bank created moral hazard by implicitly promising to act as the lender of last resort for the banks as they expanded to about ten times the size of the entire domestic economy. To minimize the danger of excessive risk-taking the Central Bank should have closely regulated and supervised the banks, but it was singularly incapable of doing so.
For one thing, the office was seen as a political position. Davíð Oddsson, who had orchestrated the privatization of the banks when he was Prime Minister, had appointed himself as head of the Central Bank, despite his lack of training or experience (he considers himself to be a poet). For another, the high interest rates maintained by the Central Bank in an unsuccessful attempt to control inflation led numerous consumers to take out foreign loans and encouraged massive foreign speculation, apparently to the tune of 50% of GDP. Finally, the Central Bank made no real effort to acquire foreign reserves to prevent the exchange rate appreciation and to prepare for any crisis.
Before the collapse, the banks had every incentive to take crazy risks. The Central Bank did not impose any discipline, but pretended to be a backstop if some pitches were wild. The bubble's inflationary period led to extravagance and decadence that would have shamed Caligula. The Icelanders saw themselves as innately superior businessmen destined to lord over Europe, just as Europe had lorded over Iceland for so long. They weren't tied down by archaic concepts, such as generally accepted accounting principles (GAAP), independent boards, or lending standards, and could be more nimble in seizing opportunities.
Of course, gravity never goes away, and, as Daníelsson has noted, "If the banks become too big to save, their failure becomes a self-fulfilling prophecy." The banks' sheer size relative to Iceland's economy and Central Bank inevitably pulled them down to size.
One consequence of this imbalance is that the Icelandic state has itself become the ultimate insurer of the banks' losses. The IceSave matter that currently dominates domestic debate is a direct result of Landsbanki's desperate attempt to raise capital once its liquidity had evaporated, and some intemperate remarks from Oddsson and Haarde to British authorities.
Rather than swallowing this bitter pill, it appears that the coming national referendum will reject the compromise hammered out by the current government. There are many voices telling Icelandic voters that they have no obligation to reimburse the British and Dutch depositors under international law, that others are primarily to blame (the depositors should have known better, the British and the Dutch should have regulated Landsbanki better, etc.), that they can walk away with impunity.
Most likely, though, the British and the Dutch recognize the moral hazard in letting Iceland off the hook. If a country is unable or unwilling to create institutions capable of regulating complex international transactions or to punish individuals who take outsized risks, then the country itself must suffer, or other countries will duplicate its behavior. If you forgive Iceland, why not Spain, Greece, Ireland, the Baltic States, and all the other countries currently going through economic hell. How can you expect them to forgive Iceland when Iceland has done nothing to punish the individuals who furthered the IceSave fraud? And how would you force them to adopt and enforce prudent banking regulations if there is no downside?
In Iceland's case, reforms that would be necessary to ensure a return to the global economy must include much tighter control of the banks by knowledgeable independent regulators and directors, which will almost certainly have to be foreign. Elimination of the corporate form for investment banks would ensure much more prudent lending standards. Increased transparency is called for throughout our government, but especially here.
Unfortunately, the party just plays on. The individuals and institutions responsible for the kreppa keep giving one another second and third and fourth chances. For example, when Arion Banki (the former Kaupþing) recently decided to list the reorganized retail chain Hagar on the Reykjavik stock exchange as a public listed company, it insisted that the company's founder, Jóhannes Jónsson, keep ten percent of the stock and remain as chairman of the board. Never mind that Jónsson and his son, Jón Ásgeir Jóhannesson, represented the paradigm of the Icelandic irresponsibility. Never mind that Arion is looking to sell 85% of the company's stock without giving investors control over its direction. Never mind that there are, in Iceland, competent, responsible, experienced businessmen with records of running their companies in a financially prudent manner who could have been brought in.
The former Landsbanki employee responsible for marketing the IceSave accounts, Erla Ósk Ásgeirsdóttir, was recently given a seat in Iceland's parliament--the Althingi--by the Independence Party. Since the IP is currently the single most popular political party in Iceland, despite its central role in the financial bubble, it is very possible that she will be setting policy for the country in short order.
Until Iceland makes serious structural changes, and demonstrates to the world that it can punish incompetent and crooked individuals, it is simply not realistic to expect mercy. Icelanders have succumbed to every moral hazard that has come our way, and we cannot expect to be asked to rejoin the global economic community until we accept responsibility in a demonstrable fashion.