Iceland is recovering from its financial shock – without the aid of a bank bailout

It’s been a good week for the admittedly small band of people who get excited about the decisions made by central banks. In America, the Federal Reserve embarked on a second great round of printing money. In this country, the Bank of England abandoned any idea of controlling inflation, leaving interest rates at a three-century low despite having missed its inflation target for seven months.

But by far the most interesting decision was made a long way to the north, in a country which people usually only pay attention to when its banks or volcanoes blow up, bringing either the financial or air traffic system grinding to a halt. Mar Gudmundsson, the governor of the Icelandic Central Bank, cut his country’s interest rate, bringing it down to a fairly normal 5.5 per cent. And he wasn’t trying to stave off a banking collapse or salvage an economy as it plunged into recession. It was just part of a slow process of getting business back to usual.

Iceland, I hear you say. Isn’t that the country that got wiped out by the credit crunch? The place where they are all shivering in the dark, eating cod tails, and wondering whether a single pack of candles will last them through the winter? Yes, that one. Two years on from the credit crunch, however, Iceland hasn’t stepped back into the Palaeolithic era. All those experts who told us in 2008 that the only alternative to rescuing the banks was economic Armageddon turn out to have been not quite right. Iceland’s three big banks, Glitnir, Kaupthing and Landsbanki, did end up being taken over by the state, but, while domestic depositors were protected, the government didn’t attempt to meet all international obligations. Kaupthing, for example, is being wound down, and has been renamed Arion Bank. This approach was very different to the British, American and Irish bank rescues, which tried to cover all bank losses by pumping untold billions of taxpayers’ money into financial institutions.

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The Icelandic method hasn’t worked out too badly. From an emergency rate of 18 per cent, interest rates have been brought under control. The economy has stabilised this year and is expected to start growing next year. Its currency — the krona — is doing fine again, up 19 per cent so far this year against the euro.

In truth, the Icelandic experience raises an alarming possibility for the rest of the developed world. Maybe we didn’t need to bail out our banks quite so expensively. Maybe we should have let them go bust?

Iceland was in many ways a microcosm of the financial bubble of the last decade. Its banks rode a wild wave of speculation, lending money on a scale that might have left even the Royal Bank of Scotland’s Sir Fred Goodwin gasping. When the collapse came, Iceland simply didn’t have the option of bailing out its banks. Between them, the three main Icelandic banks had $86 billion in outstanding debts. The total GDP of Iceland was only $13 billion in 2009. As many British depositors with Icelandic financial institutions know to their cost, there was nothing the government could do but grovel a bit, make some apologies and explain that it simply didn’t have the money to pay them back.

The consequences were horrific. The krona collapsed by almost 80 per cent at the depths of the crisis. Iceland’s economy, the fifth richest in the world on a per capita basis in 2007, shrunk by 6.8 per cent last year, and is still getting smaller this year. Almost 40 per cent of households are estimated to be technically insolvent, mainly because they took out foreign currency mortgages. The International Monetary Fund has had to bail out Iceland with emergency funds. Capital controls have been introduced. It has been a nasty and brutal shock. But — and this is the interesting point — it has also been relatively short. Iceland now looks to be on the road to recovery, while other countries are still grappling with banking systems that are going to be in intensive care for years to come.

The Icelandic economy is still expected to shrink by 1.9 per cent this year, but the central bank forecasts that it will grow by 3 per cent in 2011. Inflation is now down to 3.3 per cent, rather less than the retail price index in Britain (currently going up by 4.6 per cent a year). The total peak-to-trough fall in GDP has been about 7 per cent, only slightly more than the 6.4 per cent contraction seen in this country, and about average for Europe. The krona is on the mend, and capital controls are expected to be lifted next year. People still eat. They drive cars, and heat their homes. Financial Armageddon turns out not to be so bad after all.

In many ways, Iceland is in better shape than Ireland or Greece, both of which may well be stuck in recession for a decade. It may even be in better shape than Britain: we still don’t have much idea how much RBS or Lloyds-HBOS will end up costing us, or when we will be rid of them. There is an important lesson in that experience. Almost every government in the world has accepted the idea that they have to bail out their banks if they run into trouble. But Iceland suggests that isn’t necessarily true. In fact, governments could simply protect domestic deposits. After that, they could say they were very sorry, but there simply wasn’t enough money to pay back all the debts the bankers had run up.

It might be better financially. Bad debts would get written off immediately, rather than remaining a millstone around the neck of the country for years to come. More importantly, it would be better morally. Reckless, irresponsible behaviour would not be rewarded. Bankers would have to think a lot harder about what risks they were taking, and what their consequences might be. And depositors would have to be a lot more careful about where they put their money, rather than just lazily assuming the government would pick up the tab for any losses.

If Britain followed Iceland’s example, it’s possible the economy would survive and bounce back fairly quickly. Perhaps we could even put the prime minister who presided over the reckless expansion of the banks on trial for negligence, just as the Icelanders have. Come to think of it, that might not be a bad idea.

This article first appeared in the print edition of The Spectator magazine, dated