The Icelandic economy came down like a house of cards in late year 2008. Few people saw the collapse coming and those who claim they knew something horrible was about to happen did not speak out loud. Why not? Those who held high positions (politicians, government officials and bank managers) and now claim that they actually knew what was just around the corner, or what might possibly happen, have said that if they would have spoken out loud about the bad state the banks and the economy as a whole, it might have triggered a negative spiral which might have resulted in a bank collapse. So instead of talking about facts and possible outcomes, government officials (of the Financial Supervisory Authority of Iceland and the Central Bank), politicians (both ministers and many members of parliament) and of course the bank managers of the three big Icelandic banks (Glitnir, Kaupthing and Landsbanki) rather spoke about the strengths of the Icelandic banking system and the strong fundamentals of the Icelandic economy.
The danger of triggering and setting off the negative spiral (i.e. run on the banks) may have been true but what does that tell us about how the banks were managed and the governmental supervision? The assets of the three big banks were about 11 times bigger than the GDP of Iceland just before the crash so it is understandable to a certain extent why so many people held their opinions to themselves.
Source: Economy of Iceland 2010, page 8. Seðlabanki Íslands [PDF]
Moral hazard
Moral hazard can be defined like this: an individual does not take the possible outcomes of his actions, or lack of actions, into consideration for he does not have to bear the responsibility of possible outcomes.
The lack of supervision and what seems to have been inefficient regulatory practices, especially in the financial sector, in Iceland in the years leading up to the crash might have encouraged the irresponsible behavior of the banks.
When I decided to write on the topic of moral hazard in relations to the financial meltdown of Iceland one story came directly to mind. Around Christmas time of 2007 it was reported that Landsbanki had given all ministers of the Icelandic government a bottle of red wine, Rioja Muga, Seleccion Especial (2003) to be exact. Kaupthing Bank did something similar. Kaupthing sent two bottles of red wine to some of the “key employees” of the Financial Supervisory Authority of Iceland (Sá kann ei gott að þiggja sem ei þakkar) (Landsbankinn gaf ráðherrum rauðvín í jólagjöf) (Fjármálaeftirlitið kann ei gott að þiggja).
Jóhanna Sigurðardóttir, who at the time was the minister of social affairs, said that gifts like these would definitely not influence the ministers at all. Björgvin G. Sigurðsson, who was the minister of business affairs at the time, said that gifts from companies were highly questionable. He said in an interview with DV that he would not take the bottle home for he didn’t drink alcohol (Ráðherra vill ekki vín).
Can gifts, like a bottle of red wine (worth €15), really influence people? They might and therefore, in my opinion, government employees should be banned from receiving gifts from private corporations.
Landsdómur
Landsdómur, i.e. the „Court of Impeachment“, a special Icelandic court which handles cases where Icelandic ministers are suspected of criminal behaviour, came together for the first time on March 5th 2012. The former Prime Minister of Iceland, Geir H. Haarde, is accused ofgross negligence in relations to the economic collapse of Iceland. Many former government officials, politicians and bank managers were called before the court as witnesses. I want to mention two examples, of what might be considered moral hazard, I noticed when following the hearings.
The first example is when Ingibjörg Sólrún Gísladóttir (Minister of Foreign Affairs in the years 2007-2009 and former leader of the Social Democratic Alliance (Samfylkingin)) came before the special court and testified that she had not trusted the words of the then Governor of the Central Bank of Iceland (Davíð Oddsson) in a meeting they had in February of 2008. Among topics of discussion were the directors of the Icelandic banks. Davíð, who was the Prime Minister of Iceland in the years 1991-2004 and the former leader of The Independence Party (Sjálfstæðisflokkurinn) has been a controversial political figure in Iceland. Ingibjörg said that since Davíð had previously voiced his subjective opinions on the Icelandic bankers and had had conflicts with the owners of Glitnir banki in the past she did not fully trust Davíð’s words.
Ingibjörg said that her conclusion of the meeting, that the banks were not in trouble, was influenced by Davíð’s subjective opinions. This raises a question, is it appropriate for former politicians to hold high government offices after their political careers? To avoid situations like these in the future I would think that it would be better if former politicians would be excluded from high offices like this (Ingibjörg treysti ekki orðum Davíðs).
The other example that came to mind when relating moral hazard to the “trial against” Geir Haarde was the testimony of Sigurjón Árnason, former director of Landsbanki. During his testimony he said that he had had numerous meetings on the stability of the Icelandic economy with Geir Haarde in the months following up to the collapse. Sigurjón said that at least two of the meetings had taken place in Geir’s home. One has to wonder if the arrangements of the meetings that took place in Geir’s own home is something that should be the norm or even allowed? Of course I don’t know what Geir and Sigurjón talked about during these meetings but what seems to be a close relation between the former director of Landsbanki and the then Primer Minister of Iceland is what has to be questioned. Did this relationship make it more difficult for the Prime Minister to act on behalf of the Icelandic government? I think it is safe to say that meetings like this should not be the norm.
Moral hazard and research
Lastly, I want to include a short video from the movie Inside Job, which was released in 2010. In this clip Frederic Mishkin, an American economist, is asked about a report he co-authored with Tryggvi Þór Herbertsson (who is now a member of the Icelandic Parliament). The report, titled Financial Stability in Iceland, came out in 2006. Mishkin got paid $124,000 for his work by the Icelandic Chamber of Commerce. The conclusion of the paper was that the fundamentals of the Icelandic economy were strong.
I don’t want to say too much about the clip but rather ask this question: is it possible for a researcher to reach an impartial conclusion when he is asked to write a report on matters like this and he gets paid a large sum of money from some one who would benefit from a certain result?
Conclusion
One of the best ways, in my opinion, to eliminate moral hazard is to have a strong regulatory framework (one that does not discriminate between large and small corporations, “regular people” and people in high positions etc.), transparency and a strong judicial system.
Is it possible to eliminate moral hazard from society? Most likely not, but it is important to hold government officials, regulators and supervisory authorities responsible when something that is/was preventable goes wrong. Only then can we limit the chance of another economic collapse which, of course, has terrible consequences for the general public.
New Institutional Economics 