From Iceland to Switzerland?

Isolated, proud people, European but not Euro-pean, if you know what I mean. OK, so one has lots of mountains and safe deposit boxes, and the other has tundra and a bank with a high-savings arm called Icesave that — wait for it — melted away.

Iceland has been called the first casualty of the credit crunch. How did Iceland fall apart?

– Interest rates were jacked up to target inflation, leading to

– “hot money” (foreign funds looking for the best return) flowing into Iceland, and

– Icelanders taking out loans abroad, in foreign currencies, to reduce their borrowing costs.

Spotting an opportunity to make money off “hot money”, Iceland also offered offshore high-interest savings accounts to other Europeans.

The more money that flowed into Iceland, the higher the currency became, the higher interest rates were raised to tame inflation. With the currency completely divorced from actual economic activity in the country, it was bound to depreciate, and did, dragging the banks and consumers down with it. Now, in other countries with desperately overburdened consumers and failing banks, the government just throws some guarantees their way and bob’s your uncle. But, in Iceland, the banks had become so much larger than the country as a whole that it just wasn’t possible. How much bigger? well, according to estimates, about 10 times the GDP of Iceland — before the crash. GDP has fallen by 65% since then.

The UK and the Netherlands want Iceland to make good on all losses of high-interest account holders at Icesave, which was not registered as a bank outside of Iceland and thus was not covered by the same deposit insurance schemes. However, as the VoxEU article on Iceland’s crisis observes:

The total losses to Icesave may therefore exceed the Icelandic GDP. While the amount being claimed by the UK and the Netherlands governments is unclear, it may approximate 100% of the Icelandic GDP. By comparison, the total amount of reparations payments demanded of Germany following World War I was around 85% of GDP.

And Switzerland? Isn’t it safe as houses (which were once, perhaps, considered to be safe)? Wouldn’t the Swiss government bail out the banking sector if it came to that? Consider this calculation, courtesy of Conde Nast Portfolio:

At the end of 2007, Credit Suisse was levered by more than 40 times; UBS was levered by more than 64 times. A 16% fall in UBS’s assets would wipe out not only all of its equity but 100% of Swiss GDP on top.