Case Questions
More than almost anything, Icelanders like a soak in hot water.
Reykjavik has more thermal spas per head than any other city in
the world. But lately, the North Atlantic nation has been feeling
more heat than it bargained for. On February 1st Fitch, a
rating agency, cut its outlook on Icelandic sovereign debt to
negative from stable, drawing attention to a current-account
deficit that ballooned to 15% of GDP in 2005 and fast-raising
foreign debt. With only 300,000 people and an economy onethird
the size of Luxembourg’s, Iceland’s troubles may sound
like the fabled headline, ‘‘Small earthquake: not many dead.’’
But dire warnings of contagion have flourished out of all proportion
to the country’s size.
‘‘Storm in a Hot Tub,’’ The Economist,
March 30, 2006
The last one or two years had been something of a
shock to the Icelandic people. Long used to being ignored
in the world, Iceland’s economic situation and its interest
rates—some of the highest in the world recently—had
suddenly garnered much international attention. Now, in
the spring of 2006, Iceland’s central bank and governmental
monetary authorities were wondering whether they
were seeing the dark underside of globalization and economic
growth. Is this what it felt like to be a small country
in a global market?
OVERHEATING
Iceland’s economy had been growing at record rates in recent
years. Gross domestic product had grown at just over
8 percent in 2004, 6 percent in 2005, and was expected to
be still above 4 percent by the end of the current year,
2006. While the average unemployment rate of the major
economic powers was roughly 6 percent, Iceland’s overheating
economy had only 3 percent unemployment. But
accompanying rapid economic growth in a small economy,
as happens frequently in economic history, inflation raises
its ugly head. And the requisite prescription for such an
ailment by monetary authorities is also well known: slowing
money supply growth to...