People versus politicians: the political aftermath of the financial crisis in Iceland

Academic Article

Abstract: Iceland was one of the first victims of the 2008 financial crisis. The crisis tested the country’s political system and changed power relations between elected representatives and the public. What stands out is that as trust in politicians and parliament plummeted, support for direct democracy grew. Also, in the name of direct democracy, the power of the presidency grew, creating a counterweight to the parliamentary majority.

Iceland was one of the first victims of the 2008 financial crisis, which tested the country’s political system and changed power relations between elected representatives and the public. This article sheds light on the reasons for this situation by reviewing major political developments in Iceland from 2007 to 2013. What stands out is that trust in politicians and parliament plummeted. Yet, the outcome was not political apathy. Support for direct democracy grew as voters resisted government efforts to finalise an agreement with Britain and the Netherlands that would have made taxpayers responsible for debts incurred by private banks. The role of the presidency also was transformed, becoming a counterweight to the parliamentary majority. The following account is based on the author’s research and analysis of Icelandic politics.

The banking crisis

In October 2008, three of Iceland’s major private banks collapsed in the midst of the global financial crisis. Prior to 2008, over the course of only a few years, the Icelandic banks rapidly expanded, domestically and internationally. Easy access to loans in international financial markets enabled the expansion, but the flow of credit started slowing in autumn 2007. One year later, the credit crunch had escalated into an international banking crisis, which threatened the viability of highly leveraged banks in Iceland. In some countries, banks received state assistance to help them avert bankruptcies. But Iceland – with a population of only 320,000 – did not have the financial strength to save local banks that had accumulated debts nine times bigger than the national gross-domestic product.

In 2008, the value of the Icelandic currency dropped by about 50%. Inflation rose to over 20%. The debt burden on households and firms increased because loans either had been indexed against inflation or pegged to the value of foreign currencies. At the same time, the cost of living increased, the real estate market froze, private investments and spending dropped, and unemployment rose from almost zero to approximately 10%. Further, the cost of reviving the domestic banking system and the fall of some 25% in tax revenues meant that the public debt increased to about 111% of GDP in 2009, compared to 40% in 2006.

Thus, the economic shock presented government leaders with huge financial problems. On top of these, the government faced challenges of a political nature, because the crisis brought to the fore questions regarding political responsibility. Attempts to argue that global financial forces had triggered the crisis were seen as lame excuses by groups who started to organise meetings and rallies, demanding political accountability and a more-just and equal Iceland under the slogan such as “New Iceland”.

The pots-and-pans revolution

Iceland is a parliamentary democracy with a proportional electoral system. The government is controlled by a parliamentary majority. Cabinet ministers almost always are members of parliament (MPs) as well. And presidents – though popularly elected – have been figureheads. Party cohesion is a hallmark of parliamentary democracies, and Iceland has been no exception. For the past three decades, five to six political parties have been represented in parliament each term. Until 2009, the largest party was the centre-right Independence Party, followed by the Social Democratic Alliance, the centrist Progressive Party and the leftist Left-Green Movement. These four parties form the core of the Icelandic party system, while others have struggled to sustain long-term popular support.

The Independence Party returned to government in 1991 and led coalitions until 2009. For most of this period, it was in a coalition with the Progressive Party, but the 2007 parliamentary elections gave that combination only 32 seats out of 63. This prompted leaders of the Independence Party to ask the Social Democratic Alliance to replace the Progressive Party as coalition partner, creating a very-comfortable parliamentary majority. Iceland at the time was at the height of an economic boom, fueled by borrowed money and inflated asset prices. Many people assumed that this was the new norm, and government leaders credited their own policies for generating high economic growth. However, by 2008 the economic landscape had changed; the same political parties that had taken credit for the boom were now being blamed for the bust.

The Social Democratic Alliance tried to escape blame. Its leaders and supporters pointed the finger at the pre-2007 coalition, arguing that their own party had been in government for little over a year when the banks collapsed. They also put pressure on the Independence Party to apply for EU membership and replace the leadership of Iceland’s central bank. Since 2005, the chief director of the central bank had been the ex-prime minister and chairman of the Independence Party, Davíð Oddsson. The Independence Party, however, refused to force him out. Thus, in late January 2009, the Social Democrats started secret talks with leaders of the Left-Green-Movement. They were accompanied by the rhythmic beating of pots and pans by thousands of people who had gathered on the square before the small parliament building to demand a change in government.

These events, later called the pots-and-pan revolution, resulted in the formation of a minority government that took office on February 1st 2009. It was supported by the Progressive Party in return for a promise of early elections, scheduled for April 2009. As soon as the minority government took office, it announced a series of political reforms. The directors of the central bank and the leadership of the financial-surveillance authority were replaced, and a new office of a special prosecutor of economic crimes was established to investigate claims of illegal activities behind the economic crash. As soon as the new government was announced, demonstrations ceased and opinion polls showed that the new officials enjoyed broad support. This was confirmed by the parliamentary elections in April, when the Social Democratic Alliance and the Left-Green-Movement won a parliamentary majority.

The critical factor in this victory was the surge in popularity of the Left-Green-Movement. It increased its share of the national vote from 15% in 2007 to almost 22% in 2009, while the Social Democratic Alliance managed to keep its 30% of the votes. Previously, left-of-centre governments always had needed the support of the Progressive Party to rule, so the victory was historic in giving the two left-of-centre parties their first opportunity to form a coalition alone.

The two winning parties interpreted the electoral swing to the left as a mandate to push through the economic and political changes that they had long advocated. These included changing the system of individual transferable quotas used to manage fisheries, emphasising environmental sustainability over investment in heavy industries and applying for European Union membership. However, only the Social Democratic Alliance was keen to join the EU. The Left-Greens viewed the application as a price for being in government and never committed itself to accepting membership.

The challenge of governing

Among other things, the new government wanted to create a social partnership with labour unions and employers on issues related to incomes, employment and taxes. Both sides saw the need to get the economy back on track and meet the goals of an International Monetary Fund program that Iceland had signed up for in November 2008. Since the 1990s, unions and employers often had participated in social pacts designed to promote economic growth and control inflation. Thus, in the summer of 2009, the government signed a stability pact with the unions and employers. When new collective wage agreements applying to most of the labour market were signed in 2011, the government became involved in a tripartite social pact between the unions and employers as well…

However, in the second half of the government’s term, from 2009 to 2013, relations with the unions and employers deteriorated. Interest groups in the fishing sector also fiercely criticised the government for its plans to nationalise individual fishing quotas, which fishermen had been buying and renting from each other for three decades. The fishing sector is vital to the national economy because it provides half of Iceland’s export earnings. To prevent overfishing, the minister of the fisheries determines how much can be caught from the stock of most species. Quotas then are used to determine the share of the total catch. They can be bought and sold but only by those who own ships or boats, making fishing capital-intensive and profit-driven. Thus, threats of partial or complete nationalisation brought about strong opposition from pro-business groups. Among other things, it was argued that changes in the system would reduce productivity at a critical time for the overall economy as well as endanger the new banks created after the collapse of the old ones.

The public also grew restless over the inability of the government to sort out the debt crisis facing families and firms. Polls show that, since the end of 2009, the government has never enjoyed the support of more than one-third of the electorate. They also show that trust in parliament dropped to 13% in 2009 and remained unchanged in 2010. In 2011, it declined to 11%, and in early 2012 only 10% of respondents said they trusted parliament.

The government also was weakened by in-fighting within the Left-Green-Movement. The 2009 elections had given the coalition 34 seats out of 63. In 2011 and 2012, however, four members of parliament left the Left-Green-Movement, and one member left the Social Democratic Alliance. This turned the government into a minority government, and since 2012 it has relied on the informal support of the small Citizens Movement party and the Bright Future party.

The issue that proved most damaging to the government’s credibility concerned an agreement reached soon after it took office, in 2009, with the British and Dutch governments regarding the online-savings operation Icesave. The agreement obliged the Icelandic state to pay €5 billion to the British and the Dutch, at relatively high interest, to reimburse these governments for money they paid to holders of the Icesave deposit accounts, set up in their countries by Landsbanki, a failed Icelandic bank. At the time of the crash, when depositors found themselves unable to access their money, the governments decided to refund them quickly in order to calm fears and avert a run on banks in their own countries. They then demanded a refund from Iceland.

The money involved presented a huge financial burden for a small state already heavily in debt. Many in Iceland also questioned whether the relevant EU directive – applying to Iceland as part of the European Economic Area – actually committed member states to refund depositors if national depositor insurance schemes, financed by the banks, were unable to do so. Although the Icelandic government gave in to pressure from Britain and the Netherlands and agreed to guarantee the full repayment with interest, it nevertheless insisted that the legal obligation to do so was unclear. Its decision reflected a calculation that it was in Iceland’s best interest to maintain friendly relations with the two governments. There was also the fact that an agreement was a condition for help from the International Monetary Fund.

We will not pay bankers’ debts

Parliament had to approve the Icesave agreement. That, however, proved difficult. Not only did the opposition oppose the deal, a number of Left-Green MPs had doubts too. After weeks of heated parliamentary debates in the summer of 2009, the impasse was broken when the government majority agreed to ask for easier repayment terms from Britain and Holland. This was pointless because the two governments were unwilling to change much from the original agreement. With minor amendments, the agreement returned to parliament as Icesave 2 and was passed with a slim majority in December 2009.

Polls showed that the public was as strongly opposed to the second Icesave agreement as it was to the first one. They also showed that government was losing popular support. A known refrain was that taxpayers should not pay debts incurred by private banks. Nationalism also influenced the public’s mood. Generally, Icelanders felt that they had been bullied and let down by the government for folding to unfair demands.

After parliament passed the Icesave agreement, more than 56,000 people within a few days signed a petition to the president asking him to refuse to sign the law. This number translated into nearly 25% of the electorate. The Icelandic constitution requires all legislation passed by parliament to be signed by the president. If he or she refuses, a referendum is called to decide whether the law should take effect. This constitutional clause was not originally meant to give the president power over legislation. The intent was to circumscribe the president’s power. In this instance, however, the provision gave an opportunity to opponents of the Icesave deal. They already had called in parliament for a referendum on the issue and had been defeated by only one vote, the same night that the Icesave 2 law was passed. If the president could be convinced not to sign, a referendum would be guaranteed.

Weakening of parliament

When Ólafur Ragnar Grímsson was elected president in 1996, he had had a long career as an MP and as a former leader of the socialist People’s Alliance. In 2004 he broke with tradition when he became the first president to refuse to sign a piece of legislation passed by parliament. That time, a referendum was not held because the parliament majority repealed the law. Grímsson never refused again to sign laws until he received the anti-Icesave petition. In early January 2010, he issued a statement in which he argued that a large divide between parliament and the public had emerged on the issue. He backed up this claim by pointing to polls that showed that a large majority opposed the Icesave 2 law and that trust in parliament had evaporated.

The result of the referendum, held in March 2010, was a blow to the government. A full 93% of voters rejected the law. Following this, the government put together a new team of negotiators who reached a new agreement – Icesave 3. This agreement sailed through parliament because most of the MPs of the Independence Party supported it, along with government MPs. Again the president intervened, arguing that voters should have the last word. His main reasons were that a new parliament had not been elected, trust in parliament remained low and voters supported a referendum.

The second referendum on Icesave was held in April 2011. Despite strong parliamentary support, Icesave 3 was rejected by 60% of voters. Britain and the Netherlands then decided to take the dispute to the court of the European Free Trade Agreement. Finally, in February 2013, the court reached the verdict that the EU directive in question did not obligate states to refund deposits in private banks even when national insurance schemes failed. This was good news for Icelanders, but it hardly helped to restore the credibility of the government, which had fought to pass three Icesave agreements through parliament. By 2012 it had also become clear that the estate of the failed Landsbanki would be able to repay British and Dutch account-holders in full.

Among the political consequences of the Icesave saga, the most important was the notion that parliament should not make laws alone. Support for direct democracy grew, and most people seemed to like the idea of a presidency that could act as a counterweight to the parliamentary majority.

Citizens´ constitution

When the new government came to office in February 2009, it announced plans to revise the constitution to ensure the establishment of a new and more-just Iceland. The new constitution was to be written by common people rather than the political elite. In November 2010, national elections were held to choose 25 people tasked with drafting a new constitution. In comparison to the Icesave referendums, turnout was low: 34% compared to over 60%. Shortly before the constitutional assembly was to convene for the first time, Iceland’s high court annulled the election on the grounds that rules securing secret balloting had not been observed properly. This was yet another setback for a government that had already suffered two referendum defeats.

The solution was to create a constitutional council and appoint the same people to sit on it. None of the council members were constitutional experts. Most had university degrees and lived in the Reykjavik metropolitan area. Only two had backgrounds as politicians. All of them, however, were well-known – which helped them in a race that involved 522 candidates. Strangely, given the lack of expertise among the council members, they were only given four months to come up with a draft that would have to be ratified by two successive parliaments.

The draft produced by the council has been criticised widely by the scholarly community for its unclear terminology, poorly-considered ideas on separation of powers, complicated electoral system and misguided efforts to reduce the role of political parties. For all such concerns, however, it soon became clear that the parliamentary majority was reluctant to change the draft in any significant way. One reason may have been that the government’s reduced parliamentary majority made it dependent upon the support of the small Citizens Movement, which strongly supported the draft.

To gauge popular support for the draft, the government decided to hold a consultative referendum in October 2012. Voters were asked to vote on several questions, the most important one being whether they favoured the draft becoming the basis of a new constitution. The turnout was 50%, and two-thirds voted “yes”.

Although it may have pleased the government to be finally on the winning side in a referendum, the outcome did not resolve the controversy about whether the draft could, or should, be changed. It is obvious that a draft that includes more than 100 articles is too complex to be subjected to a simple “yes” or “no” vote. Some voters only regarded the text as a rough draft, while others claimed it was perfect. Citizens Movement belonged to the latter group, but some of the MPs of the coalition parties started to have second thoughts about the draft when criticisms from scholars gained more traction in the media. Moreover, the Venice Commission – the Council of Europe’s advisory body on constitutional matters – echoed the concerns raised by Icelandic scholars in a recent review of the draft.

At the time of this writing, the fate of the draft is unclear. With only a few weeks left in the term, the greatly weakened coalition is eager to claim to be the champion of the people. That is especially because it also seems unlikely that it will be able to significantly change the individual-transferable-quotas system of the fisheries, another issue high on its agenda.

Legacy of the crisis

This paper has sketched the political aftermath of the financial crisis in Iceland and the changes it produced in the Icelandic political system. The most important changes are a move towards direct democracy and a reduction in the power of the parliamentary majority. This was made possible by a reinterpretation of the existing constitution, which also shifted power towards the president.

The government that took office in February 2009 made the mistake of ignoring the importance of national unity in the face of a crisis. It also proved unable to live up to promises to restore public confidence in government and protect the interests of the large middle class, which still is struggling with huge debts and reduced incomes. Instead, the coalition spent too much energy on Icesave and measures that easily could be portrayed as anti-business. It therefore found itself locked in a fight with the public, major interest groups and the opposition – which has benefitted from the unpopularity of the coalition. The result was the loss of popular support and defections from the government majority, leaving the government ineffective. That said, it remains to be seen whether the next government will prove to be more effective than the one it will replace.

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