Legal Commentary

Why Don't We Bail Out Iceland?

By Professor University of Miami School of Law

Here’s a serious question: Iceland has long been a strong ally and a NATO member, despite having no armed forces. As we all know, the Icelandic economy is suffering from a virulent case toxic shock.

Iceland’s economy is not, by US standards, particularly big, clocking in at about US $12bn GDP. A bailout would, I presume, take only a fraction of that? And their troubles are really not their fault:

So how did Iceland get in so much trouble? That’s the odd part of the story: it isn’t because its banks gambled on the worthless subprime securities that helped undo Bear Stearns and so many others. Iceland’s banks prudently avoided the subprime market, even as they embarked on a lending boom at home and expanded abroad. What got Iceland in trouble was something more subtle: its banks got their money primarily from international investors, making the Icelandic miracle heavily dependent on foreign capital.

In normal times, this might not have mattered, given the country’s solid economic fundamentals. But these aren’t normal times. The subprime crisis, in which investors realized that they had greatly underestimated the risks of lending to people with bad credit, has spawned a wider credit crunch: investors now suspect disaster behind every door, and even seemingly solid borrowers find credit much harder to come by. The subprime crisis was an earthquake that caused a tsunami: the quake has done plenty of damage on its own, but the tsunami looks set to do even more.

Iceland has been swamped by that tsunami because it trusted in the availability of global credit in time for that credit to evaporate.

So why not bail them out? There is of course no legal duty to do so; I’ll even stipulate that there is no moral duty to do so. It’s just a way, quite cheap in the grand scheme of things, to make friends abroad and mitigate a global crisis. The Icelandic people would, I would think, be grateful for a generation. And other people around the world might see in this willingness to help out a sign of hope, which might help combat some the psychological aspects of the current crisis.

So, how much would we have to make available as a special loan facility to bail out Iceland? Any arguments against this other than it might invite other governments to ask for bailouts too and we can’t afford them all?

Full post as published by Discourse.net on November 16, 2008 (boomark / email).