A note on the Icelandic crash from an amateur Austrian perspective.

[Disclaimer: I am not an authority on these matters, and there may be mechanics to which I am oblivious at play. You should by all means try to come to your own conclusions, rather than blindly trusting something on the internet.]

[Edit: This was posted on reddit, and after having received some feedback, there are some parts of this note which are wrong. I'll make a later post that will serve as errata for this post later.]

By ABCT, Austrian Business Cycle Theory, busts are mainly caused by low interest rates. We see the phenomenon here in Iceland, when Icelanders could borrow money in the form of foreign currency. Due to the large size of the Icelandic banks (among other things), the belief in Icelandic Krona was high, causing it to be seemingly overvalued.

This increased demand for the krona, and responding to this, the Central Bank of Iceland, through the Floating exchange rate policy raised the exchange rate. They might have tried to offer the krona undervalued, and then foreign currency would have flowed into the Central Banks stash, as always happens between good money and bad money, for all would have wanted to get their hands on the krona instead of the foreign currency, seeing as it was seen as being better.

This enabled Icelanders to get pretty cheap loans for various items, and was used to buy cars etc. The price of housing was also artificially high, causing many entrepreneurs to go into housing construction, trapping capital in projects in which there was not as much demand as it seemed.

Then, when the Icelandic banks fell, due to being in a "liquidity trap", this of course raised the cost of capital to even higher levels than it should have been. When capital was now more expensive, the nations companies could not delve into projects they had planned, and many had to stop existing projects, like the famous Harpa,  and the building of the University of Reykjavik. The belief in the Icelandic Krona fell, and thus the exchange rate set by the Central Bank was too high, causing an outflow of foreign currency, as it was now determined as being overvalued, and now no one wanted the Icelandic Krona. They then lowered the exchange rate, and thus the foreign currency loans which so many thought were so cheap turned out to be not so cheap at all, merely a fluke.

But why did this happen? How could the banks grow so large? Well, for one thing, they can count on getting bailouts if they over extend themselves, causing them to take bigger risks. When the Icelandic banks were originally privatized, the Icelandic State guaranteed some portion of the deposits, thus leaving even less worries for those in charge to having to meet their obligations, if things should ever go wrong.

So what is the lesson here? How can we prevent this from happening again?

Well, we could start by going onto a gold standard, or some other standard in which the value of the currency is based on some commodity (though not many commodities, as this would fix the exchange rate between them). Gold is seen as a pretty good commodity to base this on, for there seems always to be demand for gold, it is a hassle to dig up more gold (certainly more than just to print more money/issue government bonds), and as it does not corrode, it does not decrease in value. It is also almost universally acknowledged that gold is valuable  so people would accept gold as an exchange for other commodities.

This would stifle inflation, as it is caused mainly by more money entering the system, and through the gold standard this becomes hard. It also helps people pick up the notion that we have an economy because of scarce resources, and to actually raise prices of every thing (that is demand more resources for everything), there must be more resources to demand. Demand is caused by, as I've gone into before, people having supply and wanting to exchange it for something else. More demand for everything would mean that people had more supply of everything to demand for, and thus the problem would resolve itself.

Another step would be to not bailout banks, and letting the market actually control itself. Removing the safety net of guaranteeing the deposits would also force people to evaluate whether they trust the bank to store their money, and as they'd be on a gold standard, they wouldn't actually be losing money to inflation by keeping it at home. If they want to get interests, they will have to give their money to the banks, and face the fact that if you want your money to make money for you, you'll have to risk losing some of the money.

Not allowing the banks to borrow out their depositors money except when explicitly allowed to do so would also be a step, for if they have a deal with every depositor that they'll give them their money back at any time, they are actually committing fraud the moment when they can't pay all back at once. Don't worry though, they would still be able to loan out money, though this would have to be on money that people put into locked accounts, say for three months, and the bank could then loan out the money for those three months and pay them back after that time, without having committed fraud.

All this would create a much stabler banking system, which wouldn't have to rely on bailouts time and time again to be functional, nor having it committing fraud just to meet their expected obligations. With a stable banking system, the market could function as it should and inflation would be less.

Though I'm by no means a fan, I'd like to end this note by quoting Keynes via Wikipedia, on how the government can use inflation to confiscate wealth from the citizen, for he seems to have gotten this one right:

"John Maynard Keynes, who had argued against such a gold standard, proposed to put the power to print money in the hands of the [then] privately owned Bank of England. Keynes, in warning about the menaces of inflation, said, "By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some"." - Wikipedia: Gold standard

This turned out a bit longer than I anticipated (I actually removed "short" from the title), but I hope it leaves you a bit more understanding of the crash and how we could break the cycle. If you are interested in more, I recommend What Has Government Done to Our Money? by Murray N. Rothbard, available for purchase or free at the link provided.

tl;dr: Busts are caused by over expansion of credit. By limiting the possibility of this over-expansion  we might be able to break the boom and bust cycle. 

P.s.:
If you spot any error, feel free to notify me so I can rectify it.