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Icelandic Prime Minister Geir Haarde's resignation on January 23rd of this year marked the first political casualty of the current financial crisis. While the Icelandic situation has received scant attention relative to other calamities reverberating through the world's financial markets, the source of Iceland's woes can be found in many of the same locales. Unfortunately, while the events affecting Iceland's populace have been severe, the country's diminutive size — approximately 320,000 residents — has made it a target all too easy to miss. However, the repercussions on both the country's native Icelanders as well as global financial markets give reason to dedicate serious attention to the causes, and cures, of this unfortunate and wholly avoidable event.
Regrettably, the current focus on the causes of the crisis continually misidentifies its true source, resulting in prescribed cures that fall short of the necessary actions. Peter Gumbel writing for the December 4th, 2008, edition of Fortune reckons previous Prime Minister Davíð Oddsson's free-market reforms during his 1991–2004 years in office are what ultimately gave rise to the bust. Likewise, the IMF's mission chief sent to Iceland to survey the nature of the problem, Poul Thomsen, recently commented in an interview that the root problem in Iceland was an unregulated environment that allowed an oversized banking system to develop. Indeed, the post-privatization banking experienced in Iceland resulted in a banking sector that saw assets increase to over 1,400% of GDP!
What analysts and authors commonly miss is the reason the banking sector could expand so rapidly. Indeed, as we shall see, the incentive structure of the Icelandic economy was manipulated through government guarantees, artificially low interest rates, and monetary spigots opened wide, allowing liquidity to be flushed through the economy. In addition, Iceland's homeowners were offered tantalizingly low interest rates through the "Housing Financing Fund" (HFF), a state agency that enjoyed explicit government guarantees on its debt, resulting in reduced interest charges for homeowners. Interestingly, while the Fund's merely implicitly guaranteed American counterparts — Freddie Mac and Fannie Mae — have been the center of much controversy, the HFF has remained relatively unscathed.