Deep Freeze

Bagus and Howden, both economists working in the Austrian tradition, wrote an analysis of the Icelandic banking collapse from that theoretical perspective.

Their account applies Austrian business cycle theory to the case. Credit expansion not backed by real saving distorts the structure of production by making long-duration investments appear profitable at artificially low interest rates. In Iceland the expansion was funded externally rather than domestically: the banks borrowed short-term in foreign wholesale markets and lent long-term, which they treat as a maturity mismatch that is the defining feature of fractional reserve banking and the source of its instability.

They add a currency dimension. The banks' liabilities were in foreign currency while a central bank can only supply its own, which meant no lender of last resort existed for the actual exposure. They argue this makes the Icelandic case a clean demonstration that maturity mismatch rather than any particular asset choice is what destroys banks.

The policy analysis attacks the deposit insurance and implicit guarantee arrangements, arguing that they permitted risk-taking depositors would otherwise have restrained, and attacks the European Economic Area framework that let Icelandic banks take deposits across Europe while home supervision remained with a regulator that could not possibly support them.

Their prescription is full reserve banking, meaning that demand deposits should be backed one for one and that maturity transformation should be confined to instruments where holders accept the risk explicitly.

The Austrian framework is heterodox and its central claims are not accepted by most economists. The specific observation, that a banking system with foreign currency liabilities has no lender of last resort, is correct and is accepted independently of the theory. Johnsen's account, also in this reference, covers the same collapse from the investigation record without the theoretical commitment.