The Icelandic and Irish Banking Crises: Alternative Paths to a Credit-Induced Collapse

Iceland’s and Ireland’s banking crises since 2008 provide good examples of credit-induced collapses. While traditional Austrian Business Cycle Theory emphasizes central bank induced low interest rates as the origin of crisis, this paper focuses on two different instigators using the Icelandic and Irish collapses as narratives. First, the artificial reduction in risk through Iceland’s comprehensive deposit insurance plan fueled the króna carry trade throughout the early 2000s, helping to spur a debt-based expansion. Second, the reduction in risk upon accession to the Eurozone increased foreigners’ willingness to invest in Ireland. Higher Irish inflation rates until normalization with core European countries also created higher risk-adjusted returns for foreigners to invest in Ireland. These two factors compounded the lax monetary policies of the central banks of Iceland and Europe and elevated the propensities to take on risk and debt in both countries, thus instigating Austrian-type business cycles.