US libertarians, and some of those who share their rhetoric on the right, are strong proponents of laissez-faire economics and limited government. However, in the case of Iceland and its banking crisis of 2008 we seem to have, on the face of it, a counterexample.

Iceland's banking sector was allowed to grow to a disproportionate size relative to Iceland's GDP, including by offering foreign currency savings accounts at attractive interest rates, which implicitly put the Icelandic government, and therefore the Icelandic people, on the hook for ultimately repaying other countries when Iceland's banking system collapsed and a systemic Icelandic bank run occurred. The whole sector was unsustainable.

Is there any coherent libertarian argument, that is consistent with the facts, for the proposition that Iceland imploded in 2008 due to "big government", rather than a lack of government regulation?

Alternatively, was there any argument based on libertarian principles for greater government regulation of banking in Iceland - and if so, why was it that no libertarian, and no generally-laissez-faire economist, made that argument before 2008? Indeed, quite the contrary. Before the banking crash, Iceland was pointed to as a shining example of free market economics gone right.

Note that it is difficult to make a coherent argument from a libertarian position that this was "just bad apples", because if the "bad bankers" of Iceland be merely "random" bad apples, they caused Iceland to have to reject basic principles of free market economics like "there should be no capital controls". In which case, free market economics can lead to its own downfall, at least in a small country like Iceland - and, by the law of averages, would be more and more likely to, the longer it went on.

  • I like this question. It's specific, aims at the libertarian wheelhouse, and is several intellectual steps above "But who will build the roads?" Jan 25, 2014 at 0:58
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    "However, in the case of Iceland and its banking crisis of 2008 we seem to have, on the face of it, a counterexample." Note that a person can be a libertarian either due to practical or moral reasons, or both. It is a common fallacy to present practical effects of libertarianism as if they refute libertarianism. For a morality-based libertarianism, that would like pointing out all the people who have died because of the lack of forced organ harvesting and then acting like this refutes all opposition to forced organ harvesting. Apr 27, 2018 at 18:24

2 Answers 2


Short answer: government policies that produced *artifically low interest rate loans on capital, and moral hazard.

*An interest rate is called "artificial" when the rate reflects a mismatch between the time preferences of borrowers and lenders. The artificial part usually occurs when the state central banks inject credit over and above the savings level into an economy.

Forward to the longer answer: You don't hear a lot of "bad apple" arguments from libertarian economists, whos mantra is more likely to be "there are macroeconomic problems, but only microeconomic causes".

Longer answer: The proximate cause of Iceland's banking crisis was the banks practice of using short-term borrowing to finance long-term investments. This normally risky practice was rendered almost risk-free by the CBI's explicit guarantee of the banks solvency. It would be as if I promised to cover all your losses at the betting table, so you felt no need to be prudent with your bets -- risk big and win, win big; risk big and lose, break even.

The short term funds for this gambling spree were provided in part by the CBI expansion of credit during this period, as well as by the Japanese central bank, which was expanding credit as well during this period, which the Icelandic banks were using in their risky game. Several IMF economists noted in 2007 "Foreign currency borrowing has been growing strongly ... and this could potentially become an important indirect credit risk for banks."

The long term investments that Icelandic banks engaged in were primarily in industries with longer maturities, naturally, such as construction and mining. Another consequence was the growth of a financial sector to manage all of the credit expansion. Suddenly banking looked more profitable than fishing for many Icelanders, leading to more house mortgages which had been made more attractive by the CBI lowering of long-term interest rates. The important thing to note here is that these are all distortions of the consumption/savings time preferences of the people of Iceland. Had all the people of Iceland decided to save all of their income, month after month, in 30 year bonds, all at once, it would have been a more natural development. However, since it was funded by central bank-fueled moral hazard, it was a house of cards ready to fall when bidding for resources from consumption goods started competing with the artificially demanded long-term investment, depleting the credit. Said using an analogy, Icelanders still wanted lots of fish, but all the fishermen were busy being investment bankers.

Prevention: Capitalism is a profit and loss system. The profits provide incentives. The losses provide prudence. The explicit guarantee of the banks against losses released them from any notion of prudence. Central bank credit expansion, disconnected from consumer time preference, both domestic and foreign, provided fuel to the fire it all started. Had neither occurred, Iceland would have been fine.

Predictions: There are some who predicted problems, however, not all libertarian economists are laissez-faire when it comes to central-banking, so I can understand how it can be confusing. There are many camps. Generally those who worry about the effects of interest rates on the real economy did see problems, although I don't know of any interest-rate-hawk economists from Iceland per se.

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    This could benefit from some references. CBI guarantee on losses. The Several IMF economists that predicted trouble in 2007. Good info, but we like to trust, but verify.
    – user1873
    Jan 22, 2014 at 6:10
  • Regarding CBI policy, see "May 2001: A new Act on the Central Bank of Iceland". Regarding names of IMF economists, see TOC on the doc itself: imf.org/external/pubs/ft/scr/2007/cr07296.pdf Jan 22, 2014 at 6:58
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    I don't know about the Icelandic problem in particular, but would suggest that a common problem is that situations where it is possible for people to place bets without being able to fully cover them, and the ability to welsh on bad bets shifts what would be a negative expected value to a positive one, invite disaster. It may be that in the absence of a program to cover certain kinds of losses, such losses would be unlikely to occur at all, and few people would suffer from them, but the existence of such programs can change both those facts.
    – supercat
    Nov 2, 2014 at 20:56
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    If sheltering people from losses would allow them to expect to profit by placing bad bets, many more people will place such bets than would do so without such protection; further, in many cases, the increase in the number of people placing such bets will increase the likelihood that they will go bad.
    – supercat
    Nov 2, 2014 at 20:59

Clearly if the private banking system is joined at the hip with the public sector, then if the banking system fails it represents a national risk. The libertarian argument therefore, is simply that the private banking system (a) should not be joined at the hip with public sector; and (b) if it fails, it should be allowed to fail

  • OP is asking for an extant libertarian argument. Can you show that some libertarian "in the wild" has used this line of thinking? Apr 27, 2018 at 21:01

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