The road from Reykjavik’s sleek airport to the Icelandic capital passes through a landscape of black lava, rocky scabs from previous molten eruptions that go on for mile after wide-open mile. A cold wind blows in from the Atlantic Ocean and the strewn rock is bathed in a brooding, beautiful light. The capital is sophistication itself. Home to roughly half of Iceland’s population of 334,000 people, its buildings resemble little ski chalets or competition-winners from architectural magazines. Icelanders are fashionably dressed. Prosperous, liberal and chic, Reykjavik is the kind of place where the cafés serve toasted date and kale sandwiches (open-face on dark brown bread, of course) and play warbling Ethiopian jazz.2
Still, eight years after the financial crisis, the scars of one of the most dramatic banking collapses in modern times are as visible as the rocks scattered by the volcanic eruptions. Six months before I arrived in October 2016, Sigmundur David Gunnlaugsson, the prime minister, had resigned after revelations that he and his wife had owned an offshore investment trust with multimillion-dollar claims on Iceland’s failed banks. The scandal, the latest in a cavalcade of post-crash revelations, had helped give life to the Pirate Party, an anarchist-leaning group with roots in online activism which was now threatening to upend the island’s cosy politics. The party was Iceland’s version of the radical movements – from both left and right – that had sprung up across Europe in the aftermath of the 2008 financial meltdown. Its logo was a black pirate flag.
Elections triggered by Gunnlaugsson’s resignation were just a few days away. Twelve parties were jostling for control of Iceland’s ancient parliament, founded in AD 930. There was a palpable sense of anger over what people saw as betrayal by the country’s elites.
At sixty-two, Sigmunder Knutsson, a man who wore his scowl on his sleeve, described himself as a poet and an economist. Many Icelanders think of themselves as having twin vocations, and not a few, including Birgitta Jonsdottir, the leader of the Pirate Party, consider themselves poets. These days fewer admit to being economists.
‘When I think about politics in Iceland, it makes me want to vomit,’ Knutsson told a reporter from the New York Times, tucking into a plate of fermented shark, a local treat, in a small café with worn tables and bare walls. ‘It’s all about corruption among a very small elite,’ he said. ‘There is something that is not right. Something smells bad.’3
Arnan, a thirty-two-year-old former banker with shoulder-length blond hair, stopped in the street in front of the Hallgrimskirkja, a modern cathedral that looks like an about-to-blast-off space rocket, to voice much the same opinion. Iceland had traditionally been a farming country with an economy dominated by the big landowning families, he said. Those same families had used their wealth and influence to secure a monopoly over the island’s rich fishing quotas. In the latest iteration, he said, the self-same elite had taken over a banking sector that had expanded exponentially in the first years of this century.
The story of Iceland’s banking industry illustrates one of the messages of this book. Not all economic growth is good. Rapid growth comes in many flavours, and some of them are less appetising than others. In the 1990s David Oddsson, Iceland’s longest-serving prime minister, oversaw a Thatcherite orgy of deregulation that transformed Iceland from sleepy fishing nation to pioneer of turbocharged ‘Viking capitalism’.4 After the banks were privatised in 2002, three institutions, Glitnir, Kaupthing and Landsbanki, went on an incredible expansion binge fuelled by cheap borrowing from other cash-flush banks. They lent money to friends and to each other and set off on a madcap spending spree, picking up assets all across Europe, from English football teams to Danish airlines. Stefan Olafsson, an Icelandic professor, called it ‘probably the most rapid expansion of a banking system in the history of mankind’.
Iceland changed from a country into what one writer called a giant hedge fund.5 Its gung-ho young business titans swallowed whole the economic philosophy they had learned at American business schools. Together with normally sober Icelandic citizens they participated in a bout of collective madness. It wasn’t long before most Icelanders discovered the trick of borrowing cheaply in foreign currencies abroad and pumping the money into the local stock market, which increased in value nine times between 2003 and 2007. They invested in local property, whose value also went up and up and up, confirming their secret suspicion that they were investment geniuses. Consumption went wild. It became fashionable to hire helicopters to pop over to the other side of the island for picnics. One particularly exuberant Icelander paid $1 million to hear Elton John sing two songs for his birthday. By my reckoning, that’s $500,000 a song.6
What ordinarily sober citizens did, the banks did on steroids. The business of banking is credit creation, and Iceland’s institutions took their job seriously. At the peak of the insanity, the three main banks’ assets were worth 14.4 trillion krona, or an astonishing ten times Iceland’s national income. Not everything that was being done was, shall we say, legal. Michael Lewis, a financial author, quotes one hedge fund manager as describing some of the transactions between Iceland’s banks. ‘You have a dog, and I have a cat. We agree that each is worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners, but Icelandic banks with a billion dollars in new assets.’7
As banks’ activity expanded, so did their apparent contribution to the economy. While the fishing industry’s share of output dropped from 16 per cent of GDP in 1980 to 6 per cent in 2006, the share of finance, insurance and real estate went rapidly in the other direction. In the eight years to 2006, it rose from 17 per cent of economic output to 26 per cent.8 From the perspective of national accounting, bank expansion was a wonderful thing. It brought growth and yet more growth. Indeed, per-capita income exploded, reaching around $45,000 a head in 2006, making Iceland the sixth-richest country on earth. Kaupthing, the largest privatised bank, went on a binge of buying, merging and deal-making. It opened up an Internet bank, Kaupthing Edge, with branches in ten European countries, in a valiant effort to hoover up retail savings. Iceland had almost no track record in global finance, yet within a few years, according to one banker, Kaupthing began to think of itself as ‘the Goldman Sachs of the Arctic’.9
Then – and you probably guessed this was coming – it all went horribly wrong. And I mean horribly. When Lehman Brothers went bust in September 2008, trust in the entire global financial system vanished overnight. Banks stopped lending to each other, unsure whether their counterparties were good for the money or whether their balance sheets too were riddled with toxic assets. For Icelandic banks, leveraged up to the hilt, it was the end of the road.
Within ten days, Glitnir, the third largest, asked for a government bailout. As the krona plummeted and news spread that the financial system was insolvent, Icelanders started removing cash from banks by the bag-load. Many were left with huge debts in foreign currency, which they had to repay with a sinking krona. Within a few weeks all the banks had been nationalised. In Britain, where 300,000 people and some local councils had put money in Icelandic banks, Gordon Brown, the prime minister, invoked anti-terrorism laws to try to recoup lost savings. Geir Haarde, Iceland’s prime minister at the time, was not exactly sugar-coating his words when he said, ‘The danger is real that the Icelandic economy would be sucked, along with banks, under the waves and the nation would become bankrupt.’10
By the end of October, Iceland, just months previously an apparently roaring success, had gone cap in hand to the International Monetary Fund for a bailout. The stock market fell 85 per cent and every Icelandic man, woman and child was on the hook for their $330,000 share of the $100 billion in losses racked up by reckless banks.
I strolled over to the annexe of Iceland’s parliament, a modestly proportioned building that resembles a modern art gallery, to see Birgir Armannsson. A neatly dressed man in a soft grey suit, Armannsson is a senior member of the centre-right Independence Party, which was part of the ruling coalition when Iceland was leaping, lemming-like, off the financial cliff. As a young lawyer in the 1990s, he had noticed attitudes to finance change. ‘Icelandic business people became richer than ever before and started to lose all connection with the Icelandic people, with the Icelandic community,’ he said. In the following decade it got worse. ‘They became international billionaires instead of being rather well-off local business people. They started to buy private jets and yachts, something we had never before seen in Iceland. Before, it was good, maybe, to have two cars.’
Armannsson watched the process unfold at close hand. ‘Icelandic banks got cheap loans all over the world and they were pumping money into local companies. The stock market rose dramatically and nobody thought it would ever go into reverse.’ Were there no warning signs? I asked. Didn’t the sudden rise in living standards and the massive paper gains look too good to be true? ‘Well into 2008, the outlook looked good. That was what parliamentarians thought, including myself. In retrospect we should have been quicker to respond to the rising problems,’ he said. ‘It has also come to light since the crisis that Icelandic bankers were manipulating the market and were deeply involved in insider trading. A lot of it was just a bubble.’
I asked whether he thought conventional accounting had overstated the contribution of banks to the economy. ‘It would take someone with more expertise than me,’ he said. ‘This is a complicated issue.’ Then he added, as if it might be of some comfort, ‘I think we have limited possibility of the same crisis. Probably the next financial crisis will be a little bit different.’
Just to be absolutely clear. The 2008 banking crisis, whose effects were still rippling through the world nearly a decade later, cannot be blamed on the way we account for financial services in our national accounts. The crisis had its roots in race-to-the-bottom deregulation, naive faith in the capacity of markets to self-correct and a perverse ‘shareholder-value’ ideology that allowed a few thousand masters-of-the-universe bankers to ransack their own institutions while simultaneously feeling good about themselves. There were many other factors, from the hugely increased (and unnecessary) mathematical complexity of financial instruments to the inherently corrupt relationship between the ratings agencies and the clients who paid them. The rampant fad of securitisation was another ticking time bomb. This was the practice of dicing and slicing different revenue streams and smushing them together into a tradable asset, a practice that severed the traditional link between lender and borrower. After a while people were happily trading bits of paper – all triple-A rated, naturally – blissfully unaware of what the underlying assets actually contained. As we now know, much of it was mortgage debt on homes taken out by people who could not afford to make their payments.
Yet the banking crisis was linked to national accounting in two important ways. The first is as much psychological as anything else. This is what you might call the danger of the circular argument, one that goes like this: ‘We all know growth is good. Growth is measured by GDP. So when GDP is going up that must be good. Giving free rein to banks to do their thing is a recipe for higher GDP. Ergo giving free rein to banks must be good.’
That led ambitious governments around the world, including Iceland’s, to ape the Anglo-Saxon model, one that involved liberalisation, deregulation and privatisation. Really anything with a ‘tion’ on end of it would do. Banks were allowed to get on with the business of ‘wealth creation’ – which mostly meant shuffling bits of paper among themselves, lending recklessly and paying themselves fat bonuses. The global cheerleaders for these policies were the US and the UK, where Ronald Reagan and Margaret Thatcher had set the deregulation agenda in motion and where Wall Street and the City of London were rampant. Not only was it obvious how much money bankers were making – you only had to look at the cars they were driving to see that – but they also spent formidable amounts of money lobbying governments to make life yet easier for them.
Banking became a bigger and bigger part of the US and UK economies. The ‘contribution’ of the financial sector to national income grew enormously. In the 1950s, when banks were banks rather than ‘great vampire squids’, they contributed about 2 per cent to the US economy.11 By 2008, that had quadrupled.12 Similar things happened in Britain. Until 1978 financial intermediation accounted for around 1.5 per cent of whole economy profits. By 2008, that ratio had risen to about 15 per cent.
The perceived success of financial deregulation in generating economic dynamism encouraged other countries to do the same. New Zealand, Australia, Ireland, Spain, Russia and even little Iceland were seduced by the Anglo-Saxon model. The financial industry exploded all over the world. For the year to April 2008, the largest 1,000 banks reported aggregate pre-tax profits of almost $800 billion.13 Countries that adopted these policies, including ones that gave freer and freer rein to their ‘wealth-creating’ banks, did well, while others appeared to lag. The way we think of economic growth tends to tell you one thing: the bigger the banks grow the better.
As the idea that an unbridled banking industry led to a strong economy took hold, governments did all they could to foster the growth of the financial sector. For the most part, that meant getting out of the way. From the mid-1980s, states rolled back banking industry regulations, many of them put in place after the 1929 Wall Street crash. In America the separation of investment from commercial banking was steadily eroded until it was abandoned altogether with the repeal of the Glass-Steagall Act in 1999. In the mid-1980s London had its Big Bang, which swept away regulations and paved the way for huge financial conglomerates. As in Iceland, banks that had once relied on steady retail depositors for their capital took to the wholesale markets, sucking up and recycling first petro-dollars from the Middle East and then the surplus savings of workers and peasants in booming China.14
A process now known by the hideously ugly term ‘financialisation’ took hold. Anonymous capital markets replaced the once-simple relationship between borrower and lender. New products sprang up to fill this new market, including complex derivatives, or bets on the future movement of prices. Soon banks were talking a new language of forward exchange rates, credit default swaps and collateralised debt obligations. The less ordinary people understood about what was really going on the better. I remember in the mid-2000s being lectured by senior bankers who explained to me condescendingly how derivatives were making the world a safer place by spreading risk to the four corners of the earth. But like Easter eggs hidden in sundry parts of the garden, it wasn’t long before everyone forgot where they were hidden – or precisely what colour or shape the eggs were. Just for good measure, in keeping with those buccaneering times, the market in derivatives was not regulated at all.
Banks’ biggest customers were each other in an insane shuffling of paper that added virtually nothing to real economic activity (properly measured). The vast bulk of bank assets were actually claims on other banks. In Britain actual lending to businesses and individuals engaged in productive activity amounted to about 3 per cent of total assets.15 That left the other 97 per cent. What’s more, banks were horribly incentivised to keep up the game of pass the parcel. From the bankers’ perspective, there was no downside. If a bet came off, they would be rich beyond imagination – and praised as wealth-creating geniuses to boot. And if it didn’t come off, well what was the worst that could happen?
It turned out that the worst was the near-collapse of the entire financial system, a meltdown arrested only by taxpayer bailouts worth hundreds of billions of dollars. Banking, as has been said by more than one person, is socialism for the wealthy and capitalism for everyone else.
Throughout the whole hideous expansion, conventional economics was sending but one signal. Bigger is better. Banking’s apparent contribution to the economy had seduced politicians for decades. When the industry blew up, the debt was transferred from private banks to the public purse. A whole generation was saddled with the bill, both in higher taxes and in lost economic opportunity. One report put the cost of the financial crisis at between one and five times annual world output.16
That brings us to the second, slightly more technical, matter of the way we account for banking activity in our national accounts. The system that has evolved is perverse. It stems from the fact that banks do not charge fees for many of their activities. If a bank lends you money, it may charge a one-off fee. But the bulk of its revenue comes from what is called the spread – the difference between the interest rate it charges you and the interest rate at which the bank itself can obtain money.
To measure the supposed economic value generated by this interest-rate spread, a new accounting concept was introduced in the 1993 update to the UN System of National Accounts, the holy book of GDP. The concept is called financial intermediation services indirectly measured, or FISIM for short. Without going into technical details, the upshot is that the wider the spread the more value is judged to have been created. That is back to front. In banking, spreads increase when risk rises. If a banker judges you quite unlikely to repay a loan, she will raise the interest rate charged to reflect the higher risk of default. So, from an accounting point of view, the riskier the portfolio of loans the greater the contribution to growth. Put another way, the more catastrophically irresponsible bankers are, the more we judge them to be helping the economy to grow. It is as if a driving instructor rated your proficiency solely on the basis of your maximum speed.
As one report into the UK financial crisis put it, with the sort of understatement only the British can muster, ‘This can lead to some surprising outcomes.’17 In the fourth quarter of 2008, after Lehman Brothers went bust and the international financial system seized up, from the perspective of UK national income things had never looked better. Just as the economy was about to go into free-fall, the report said, ‘the nominal gross value-added of the financial sector in the UK grew at the fastest pace on record’.
As several huge banks in Britain were about to go under, the financial system made up a record 9 per cent of total economic activity. Worse, after much of the financial system was nationalised, its ‘contribution’ rose yet again, this time to an all-time high of 10.4 per cent, within a whisker of all British manufacturing.18 ‘At a time when people believed banks were contributing the least to the economy since the 1930s, the national accounts indicated the financial sector was contributing the most since the mid-1980s,’ the report notes. ‘How do we begin to square this circle?’19 How indeed?
In the US the story was every bit as catastrophic. Taxpayers injected hundreds of billions of dollars to bail out some of the biggest names in banking, including Citigroup and American International Group, the world’s biggest insurer. Merrill Lynch was folded into Bank of America, Washington Mutual was sold to JP Morgan and Lehman Brothers – well, you remember Lehman Brothers. Even Goldman Sachs and Morgan Stanley, the last two independent investment banks left standing, had to agree to become bank holding companies, which subjected them to greater regulation. In October 2008 $700 billion of taxpayer money was pumped into the Troubled Asset Relief Program, but not before Congress had rejected it once, prompting the biggest points fall in the history of the Dow Jones Industrial Average. As the financial crisis spread to the real economy, General Motors and Chrysler came knocking on the government’s door for relief.
Nearly a decade after these events, the US economy still had not recovered its pre-crisis growth rate. That was probably, in large part, due to the fact that much of that growth had been little more than fiction.
The conversation about how we should account for banking activity quickly leads to a discussion about what banks are for. It is worth a tiny digression. Banks fulfil two broad functions. One is to store and transfer money. The other is to allocate risk. Somewhere along the way, these functions got badly scrambled.
I went to discuss this with Gavyn Davies, a former partner at Goldman Sachs. Davies said I should think of banks as being in two categories: cloakrooms and casinos. Cloakroom banks are boring. They are essentially utilities, places to house your money. ‘People give you the money; you put it in a cupboard, and when they come and get it, you give it back.’ Another metaphor sometimes used for this kind of bank is the economy’s plumbing or pipework. That’s because banks, even boring ones, transfer money along a network of pipes, for example if I want to send cash from my account to pay a utility bill or to my grandma back home in Wichita.
The other, more interesting – yet potentially more dangerous – function of a bank is to allocate capital. That means allocating risk. It requires a bank to make decisions about the creditworthiness and potential profitability of those to whom it lends money. At its most simple, the bank chooses between two widget companies that both need working capital. The bank lends to the better widget company and starves the inferior widget company of funds. Society benefits through better widgets. ‘Now, you’re going to measure that not necessarily through the banking system,’ Davies said. ‘You’re going to measure it through the productivity and production of the widget manufacturer.’ If the bank is doing its job right, everyone benefits.
But if the bank’s capital allocation is measured in the real economy, why do we have to measure it separately as if it were useful in itself? We pick up the contribution of banks to the economy in the production of excellent widgets and in the production of all the other businesses helped by having access to excellent widgets. Measuring capital allocation as a stand-alone activity smacks of double counting, like measuring the flour in bread or the electricity in the production of marijuana. Accountants used to think so too. In the 1950s finance was treated as an unproductive activity, and banking made a only small positive – or even a negative – contribution to national income. Interest-rate flows were ‘treated as an intermediate input’ and netted out of the final value-added contribution to GDP.20 Only with FISIM did we become obsessed about measuring what the banks were up to themselves.
Davies thought about the issue slightly differently. ‘When I used to have existential crises about what am I doing wasting my life in the banking system,’ he said, a colleague would assure him that banks played a vital economic role. ‘What we’re doing is actually the most important function of all. We’re allocating capital in the right way.’
Davies said this always made him feel better. ‘Then 2008 happens and it’s obvious that we’ve allocated capital in totally the wrong way for the previous decade,’ he said. ‘Those two activities – allocating capital in the right way and allocating it in the wrong way – are measured the same.’ They both count towards economic growth, which is to say they’re really not being measured at all.