Iceland melts

Iceland may become a big victim of the credit crisis.

Iceland is knows a one of the wealthiest countries in the world in recent years... and also as one of those with the biggest debts. You know, it seems to me that in a sane world, those two things would be mutually exclusive. In a sane world, your assets minus your debt should determine how wealthy you are, not your lifestyle!

An observer says of the Icelandian banks:
"I believe it is absolutely wrong to say these banks were reckless," said. "Quite the contrary. They were hugely unlucky."

But the article also says:
The country's top four banks now hold foreign liabilities in excess of $100 billion, debts that dwarf Iceland's gross domestic product of $14 billion.

Acquiring a debt SEVEN times the gross national product is not reckless?! WTF? How did they expect to ever pay it off?
What is it about their business that these banks couldn't possibly have known? Did a meteor drop? Aren't they supposed to know how things work?

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Jaycee has left a new comment on the post Blood on the market floor:

You imply you don't understand the 'business cycle' of booms and busts. It's simple enough to understand. Think of booms and busts as waves, up and down, around a central trend.

Now, if you're an engineer and you see continual waves of this kind, you look for a driving force that's driving the oscillation. Here's a sample of how it works.

Imagine that we have a starting point where interest rates are low. This could happen because people have been risk averse and steady savers and so there's a lot of capital available, but it doesn't really matter how we got there.

Now, some entrepreneurs say to themselves 'the cost of money is low, so I can borrow some and use it to fund a high-return but risky venture'. Others are willing to invest a portion of their money to get the higher returns. Invested by sane entrepreneurs, the returns are risk-rated acceptable.

Now, others see the returns being made, and they borrow money too. Over time this demand for money bids up the interest rates. Note that this makes newer investments more costly.

The driving force now becomes greed and me-too-ism, which is a constant in human affairs. People see the good returns being made and jump on the ship. This drives the cycle past the central point and into over-developed. This is one side of what drives the oscillation.

Eventually the enterprises being founded do not justify the risk being taken and the cost of money. Some start to collapse at the margins. People start to lose their money. Fear of loss, another part of the human condition, drives selling, which drives the market down; this is the other side of the oscillator.

Eventually people are so scared that they're willing to accept low cash rates rather than share investments, and interest rates bottom out as share market prices drop.

So the driving forces that continue the oscillation are greed or desire for high returns on the upside, and fear of loss on the downside. This is why the business cycle will always be with us, because the drivers are part of human nature, and even to some extent rational.

The current cycle is particularly volatile, and this has been cause by a number of things, including government keeping interest rates too low for too long, which forced the 'upside' push to be far too strong, and also various de-regulations of lenders which limited the size of previous up-cycles, and mis-pricing of risk in il-liquid debt instruments.

Because we swung too far on the upside, the downside swing will be too violent too, as many actually unprofitable ventures now crash to earth.

This is all simplified, but I've tried to put it into a physical driving-force context to show why we have ups and downs and why there will never be a simple flat trend line.

HTH.

Thank you very much. That makes sense, I guess.
Except for why it's human nature to be sheep instead of wolves. It would even out if not for the big rush to greed and the big rush to panic.