There was the short story, and the longer more complex story. Iceland had seen both. And what was the moral of the story? Was the moral that its better to be a big fish in a little pond, or was it once burned twice shy, or something else?Iceland was a country of only 300,000 people. It was relatively geographically isolated, but its culture and economy were heavily intertwined with that of Europe, specifically northern Europe and Scandinavia.A former property of Denmark, it considered itself both independent and yet Danish. Icelands economy was historically driven by fishing and natural resource development. Although not flashy by any sense of the word, they had proven to be solid and lasting industries, and in recent years, increasingly profitable.At least that was until Iceland discovered banking.

Icelands economy had grown very rapidly in the 2000 to 2008 period. Growth was so strong and so rapid that inflationan ill of the past in most of the economic worldwas a growing problem. As a small, industrialized and open economy, capital was allowed to flow into and out of Iceland with economic change.As inflationary pressures rose, the Central Bank of Iceland had tightened monetary policy, interest rates rose.Higher interest rates attracted capital from outside Iceland, primarily European capital, and the banking system was flooded with capital.The banks in turn invested heavily in everything from real estate to Land Rovers (or Game Oversas they became known).

Then September of 2008 happened. The global financial crisis, largely originating in the United States and its real estate-securitized-mortgage-debt-credit-default-swap crisis brought much of the international financial system and major industrial economies to a halt.Investments failedin the U.S., in Europe, in Iceland. Loans to finance those bad investments fell delinquent.The Icelandic economy and its currencythe kronacollapsed. As illustrated in Exhibit A, the Krona fell more than 40% against the euro in roughly 30 days, more than 50% in 90 days. Companies failed, banks failed, unemployment grew, and inflation boomed.A long, slow, and painful recovery began.

QUESTIONS

1-How does the Iceland story fit with our understanding of the Impossible Trinity? In your opinion, which of the three elements of the Trinity should Iceland have taken steps to control more?

2-In the case of Iceland, the country was able to sustain a large current account deficit for several years, and at the same time have ever-rising interest rates and a stronger and stronger currency. Then one day, it all changed. How does that happen?