5  The young and already internationally renowned economist Jeffrey Sachs called on the then Secretary General of the OECD, Jean-Claude Paye, immediately after the collapse of the former Soviet Union. Sachs claimed that all that was needed to get the economy moving was to liberate Russia’s animal spirits. Paye demurred, saying that he thought that institutions would matter too. Sachs countered, saying “But you are French, and so you think that institutions are more important than they really are.” To which Paye replied “And you are young, and take your institutions too much for granted.” And then he added, almost as an afterthought, “If you do not have good, strong institutions, all you will get will be the mafia.” E-mail correspondence from John Llewellyn, former colleague of Paye’s, dated 3 November 2013. 6  Acemoglu, D. and J. Robinson (2012): Why Nations Fail: The Origins of Power, Prosperity and Poverty, Crown Publishers, New York. 7  Acemoglu and Robinson are not alone in attempting to capture institutional differences using concept pairs. In a historically based social analysis, North, Weingast and Wallis use the distinction between natural state and open access societies as reference for stage of development. The former was a strongly hierarchical society with tightly woven personal bonds with a clear social order. Collaborating elites had a monopoly on violence and dictated the allocation of resources. In an open- access society, on the other hand, the state holds power but there are institutional constraints.
But risk and high yield often go hand in hand and it must be assumed that equity prices can fall just as easily as rise. The Central Bank has assessed the banks’ credit portfolio quality on the basis of geographical and sectoral distribution. It is no longer enough to focus solely on activities in Iceland, because threequarters of the banks’ total lending on a consolidated basis was to non-residents, especially in the other Nordic countries and the UK. The assessment indicates that the banks’ loss provisioning is more than adequate to meet expected losses. However, this view must be tempered by hefty credit growth in recent years and the large increase in leveraged buyouts and forward contracts connected with them. House prices are at a historical peak in real terms and may unwind. Equity prices reflect expectations of ongoing rapid output growth, but such sentiment can quickly reverse, as recent experience has shown. Arrears and impairment are minimal, but both may be expected to increase in the coming years. One major vulnerability of the Icelandic economy at present is the risk of a rapid and unforeseen rise in international interest rates and premia. Short-term rates have already risen widely and may go up further. Long-term rates have not changed much but could begin to climb. Premia are prone to change at short notice due to shifts in investors’ risk assessments or risk-seeking. The Icelandic economy has never been so sensitive to changes in global markets, which could significantly affect it.