By the mid-1990s reforms to the financial market had significantly liberalized capital movements to and from other countries, transforming Iceland’s banks and markets into favoured destinations for international investors. This boom in foreign investment in the late 1990s and the 2000s, however, left Iceland’s economy especially vulnerable to the vicissitudes of the global credit markets. The country’s currency, the króna, showed signs of weakness beginning in 2005. Inflation skyrocketed, domestic interest rates more than doubled, and foreign investors flocked to króna-denominated bonds. The tide of capital reversed abruptly in 2008, when the so-called global “credit crunch” led foreign investors to flee Iceland’s bond market, leaving the country’s dangerously leveraged banks depleted and resulting in the collapse of a host of international investment banks. The effect on Iceland’s economy was swift and dramatic. The value of the króna plunged more than 70 percent before all currency trading was suspended, the domestic stock market shed 90 percent of its value, and interest rates fluctuated wildly. The central government took control of the three largest private banks, which held a combined liability equal to roughly 10 times the country’s pre-crisis GDP, and the economy was declared to be in a state of “national bankruptcy.” Relief was sought through appeals to Scandinavian neighbours, and a series of austerity measures was implemented to secure a $2 billion loan from the International Monetary Fund.

The failure of one of the three large banks, Landsbanki, sent shock waves abroad as the British and Dutch governments stepped in to compensate their citizens whose deposits in the bank had been lost. Initially, the Althing voted to compensate Britain and the Netherlands, but in 2011 Pres. Ólafur Ragnar Grímsson refused to sign the resulting legislation and instead put the repayment matter to the public in a plebiscite, which was soundly rejected by the electorate. Following the vote, the Icelandic government announced that no further attempts would be made to settle the issue, which would be left to the international courts to resolve. The British and Dutch governments responded by suing Iceland for the recovery of their outlays, but in 2013 the European Free Trade Association (EFTA) Court rejected their claims.

In the wake of the financial crisis, Iceland’s economy went into a swoon, with GDP dropping by 6.5 percent in 2009 and by 4 percent in 2010, while unemployment hovered between 9 and 10 percent. Tax increases and austerity measures were undertaken in an effort to get the economy back on solid footing. By 2011 the country’s economic prospects had begun to brighten, as GDP grew by some 3 percent in both 2011 and 2012, while unemployment fell to about 5 percent.

Political developments

The tendency toward overexpansion was caused in part by weak political leadership. No party has ever held an absolute majority in the Althing, and, generally, the country has been ruled by coalition government. Two coalitions had remained in power for extensive periods without interruption: one formed by the Independence Party and the more leftist Social Democratic Party that ruled from 1959 to 1971 and the other a partnership between the Independence Party and the agrarian-liberal Progressive Party that governed from 1995 until 2007.

The blurring of the political left and right was probably caused by another dividing line in Icelandic postwar politics: that between the more integrationist Independence and Social Democratic parties and the more isolationist Progressive Party and the parties that came together to form the Social Democratic Alliance in 2000. As the financial crisis of 2008 deepened, public outrage was increasingly directed at the right-of-centre and Independence Party-led coalition government, which resigned in early 2009, making way for a caretaker government comprising its former partner, the Social Democratic Alliance, and the Left-Green Party. In April 2009 the Social Democrats and Left-Greens won a slim majority in the parliamentary elections.

The widespread disenchantment with the system that had produced the financial crisis was embodied in the protests that occurred outside the Althing building as the crisis mounted. Demonstrators harangued officials and banged kitchenware, igniting the “Pots and Pans Revolution.” In April 2010 a special investigative commission examining the financial sector collapse issued a report that revealed an array of dubious business practices and concluded that both banks and prominent individuals had speculated in the stock market with borrowed funds. Following the release of the report, many prominent businessmen and bankers fled the country. Moreover, in 2012 a special tribunal ruled that former prime minister Geir H. Haarde had been negligent in having failed to inform his cabinet of the pending bank crisis in the months before the collapse.

Arguably, the most significant outcome of the Pots and Pans Revolution was the Althing’s decision that a new constitution should be drafted, which resulted in a process that was widely praised for its transparency and inclusiveness, prompting some to label the resultant document the world’s first “crowdsourced” constitution. In 2010 a national assembly of 950 members drawn randomly from the population at large determined that the new constitution should be grounded in democracy, human rights, and equal access to education and health care, among other principles and values, including public ownership of the country’s natural resources and more stringent regulation of the financial sector. A committee of 25 individuals, selected from a pool of 522 Icelanders, then went about writing the new constitution, soliciting feedback through social media, e-mail, and mail as they compiled 12 successive versions of the document. In October 2012 a final draft of the constitution was submitted to a nonbinding referendum, in which it was endorsed by some two-thirds of those who voted. Once the new draft constitution reached the Althing, however, progress on its adoption ground to a halt, seemingly as a consequence of opposition to it by the Progressive and Independence parties.

In the meantime, in 2013, Icelanders, apparently tired of austerity, voted overwhelmingly against the incumbent coalition of the Social Democratic Alliance and the Left-Green Party, which lost 18 of 34 seats in the 63-member Althing. The Progressive and Independence parties—with 38 seats between them (a gain of 13 seats)—formed a new government on May 23 under Progressive Prime Minister Sigmundur Davíð Gunnlaugsson.

In April 2016 the prime minister was forced to resign after he found himself at the centre of international news, when a leak of more than 11 million documents from a Panamanian law firm revealed that he was among a number of current and former heads of government and state worldwide with links to offshore companies in tax havens. The so-called Panama Papers seemingly revealed that he had hidden millions of dollars in an offshore company that had considerable investment in Iceland’s three major banks that collapsed in 2008. As prime minister, Gunnlaugsson had been involved with negotiations related to the banks that could impact his company’s holdings.

At the end of October 2016, Gunnlaugsson’s replacement, Sigurður Ingi Jóhannsson, also of the Progressive Party, made good on a promise to hold parliamentary elections before the end of the year. In the event, the Progressives dropped 11 seats from their 2013 total, falling to 8 seats and forcing the resignation of Jóhannsson. Their partner in the ruling centre-right coalition, the Independence Party, added seats to its 2013 total to reach 21 seats and become the largest presence in the Althing.

Benefiting from broad activist support by young people, the antiestablishment Pirate Party had a huge impact on the election, capturing 10 seats, as opposed to 3 in 2013, and increasing its percentage of the popular vote from 5 percent to about 14 percent. Founded in 2012 by a mixture of veterans from the Pots and Pans Revolution, anarchists, Internet-freedom advocates, and hackers, the Pirates had pledged to enact a new, partly crowdsourced constitution that would institute direct democracy (including public veto power over new laws), bring greater transparency to government, and nationalize Iceland’s natural resources.

Although the Pirates and their left-of-centre partners won a total of 27 seats, they fell 5 seats short of attaining a majority, and the Independence Party looked to be in the best position to form a ruling coalition. For some three months, however, negotiations between the main parties on forming a coalition came up empty. Finally, in January 2017 the pro-EU Reform and Bright Future parties joined the Independence Party (which opposed EU membership) in forming a coalition government with Independence Party leader Bjarni Benediktsson as prime minister.

The contrast between the integrationist and isolationist approaches that had been characteristic of politics in Iceland continued to come to a head in controversies over three other recurrent issues: defense, European integration, and the extension of fishing limits. A fourth issue, the status of women, formed still another dimension of Icelandic politics.

Defense

From the time that Iceland joined the North Atlantic Treaty Organization (NATO) in 1949 and received American forces in 1951, the Independence Party has firmly supported a pro-NATO policy, while the People’s Alliance has been NATO’s most ardent opponent. The Social Democratic Party and the Progressives have supported NATO membership, and most of the time they have accepted the presence of American forces—the Progressives with considerably greater reluctance than the Social Democrats. Since the 1980s this issue has moved to the background, while Iceland’s attitude toward Europe has occupied the foreground.