Iceland’s chilly lessons on the moral hazards of bailouts

Iceland’s chilly lessons on the moral hazards of bailouts

By paying off loans for consumers, forgiving homeowner debt (up to 110% of the property value), and throwing financial institution offenders in prison, Iceland was able to bounce back.

WASHINGTON, Sept. 2, 2015 – The United States actually has an official “too big to fail list.” Essentially, this is a list of companies that have been sanctioned by the government as getting a guaranteed pass, no matter how economically ruined they become.

According to the Treasury Department, that list includes MetLife, Inc., American International Group, Inc., General Electric Capital Corporation, Inc., Prudential Financial, Inc., and others.

Such a list, and bailouts, are a problem for several reasons.

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Up until 2008, no housing slump in any country had ever caused a worldwide financial crisis like the one experienced by the U.S. and much of the world since that year. Until mid-2008, the Federal Housing Administration offered loans that required just a 3 percent down payment. In spite of this low sum, many nonprofits sprang up (and funded by construction developers and home builders) to cover that cost.

An untold number of consumers “bought” homes with virtually no skin in the game, essentially making it a house of cards waiting to fall. Finally, the Wall Street disaster became even worse after Congress authorized the Treasury to spend billions of dollars “resolving” the financial crisis. Many rightly argue that the worst may be yet to come.

What if such institutions were not, in fact, “too big to fail”? What would happen if a country were to allow its largest businesses and financial institutions to simply succumb to the financial pressures they voluntarily put themselves under?

In the U.S., the prevailing theory is that if these companies were to allowed to fail, the nation itself would certainly go down with them.

Much of the world took the “too big to fail” approach after the economic crash of 2008. The result of those who have followed that perspective have seen global stagnant economic performance, chronic unemployment and little hope of serious economic improvement. The one exception to that was Iceland.

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Iceland, which was as hard hit as any country by the great crash of 2008, decided to take a completely different approach. This approach was built on the idea of high accountability and allowing companies to face the consequences of their behavior.

Forbes reported, “a country with a small population of roughly 320,000 citizens, Iceland’s entire banking structure ‘systemically failed’ in the early days of the 2008 recession. Despite the fact that Iceland is still on the road to recovery, the country ranks high as a politically and economically stable nation.”

In order to get the country back on track, it pursued a course that was radically different from the rest of the world. While most countries allowed their financial institutes to stay in their “sick state” or even replaced one economic illness (collapse) with another (artificially propping them up), Iceland chose to let its financial disease run the course, and the nation was certainly better off for its decision.

The Forbes piece goes on to say,

Instead of allowing the criminals responsible for bank fraud to run free as the years passed by, Iceland thought it might be wise to actually indict bankers who committed serious financial crimes that contributed to the collapse. By paying off loans for consumers, forgiving homeowner debt (up to 110% of the property value), and throwing the offenders in prison, Iceland was able to bounce back. Now, its economy is “recovered” and is growing faster than both the U.S. and European economies.

This part of the formula is the secret to Iceland’s success. The reinforcing of “moral hazard” sends a message to everyone that matters that, if you commit a crime, you will do time, regardless of your income bracket.

This tells investors in Iceland that there is a high accountability in that country for bad (or even illegal practices). In the U.S. we not only forgave such immoral behavior, but subsidized it with bailouts.

One does not have to be brilliant to know that there is a point coming where such an approach will simply not work. Very few people got rich by being stupid. That lack of a full and robust recovery in this country is linked to the sense that this country is a “house of cards” economically.

The United States, and the rest of the world of business, could learn a great deal from the people of Iceland. “Moral hazard” matters, and we could certainly use some of that in this country today.

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