The lesson from Iceland’s recovery: let banks go bust

The sovereign debt crises around the world rumble on. If it isn't the UK and other European countries being downgraded or threatened with downgrades by credit rating agencies, then it's the latest twists in the Greek saga.

You'd be forgiven for thinking that it's all doom and gloom in the bond markets.

However, some countries are having their credit ratings raised. Fitch has just upgraded Icelandic debt to BBB-. This means that all three major agencies, (the other two being Standard & Poor's and Moody's) consider Icelandic debt to be investment grade once again. It costs nearly the same amount to insure Belgian debt against default as it does that of Iceland's government.

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And it's not just markets and rating agencies who are happy - Iceland's unemployment is only 7.2%, and GDP growth is expected to come in at 2.4% this year. That's a lot stronger than anything forecast for the UK or the rest of Europe.

So what went right for Iceland? And what can we learn from its experience?

How Iceland's problems started

From 2003 to 2008, Iceland went on a debt-fuelled buying spree. Iceland's major banks began borrowing from international lenders on a huge scale to finance asset purchases. The population followed suit, borrowing from low interest-rate countries like Japan to bet on domestic assets (the carry trade).

While prices remained high, the banks made big profits, and a booming property market allowed ordinary people to borrow even more. At the peak of the debt bubble, the top three banks owed lenders debts equivalent to six times Iceland's GDP.

Even rising interest rates could not halt the cycle, as foreign lenders piled in to take advantage of a strong currency and high-yielding Icelandic debt.

The warning signs were apparent for a good while even before the credit crunch kicked in. However, the party finally came to an end in October 2008 when the international financial crisis hit asset prices. The country's over-levered banks were forced into bankruptcy.

What Iceland did

Governments around the world bailed out their financial sectors. The US government bought stakes in key banks and lent them money. Britain nationalised RBS, assuming all its debts. Ireland guaranteed all the debts of its six largest banks.

However, Iceland took a different tack. The government declared that it would only save domestic bank account holders - everyone else would have to fight over the remaining assets.

It also refused to pay foreign governments for the cost of compensating retail depositors in foreign subsidiaries of Iceland's banks. Although a deal that would have paid the debts, over a longer schedule, was nearly agreed twice, it finally collapse due to public opposition.

Meanwhile, instead of trying to prop up its currency, Iceland let the value of the krona more than halve. It also imposed capital controls to prevent money leaving the country.

What happened

Make no mistake:Iceland still took a big hit. From the peak in the third quarter of 2007 to the trough in the second quarter of 2010, the economy shrank by 14.3%. The fall in the value of the krona pushed inflation up to nearly 19%.

The collapse of the banks decimated domestic stock markets. On 17 August 2007 the stock market peaked at 8,238. By 13 March 2009 - just over 18 months later - it reached a low of 379.93; a fall of more than 95%.

The decision not to compensate British and Dutch regulators for bailing out investors turned Iceland into an international pariah. The UK used anti-terror laws to freeze the assets of the Icelandic central bank. And Iceland may end up having to pay up anyway, if it loses an European Economic Area case against it.

That all sounds appalling. And most Icelanders would probably tell you that it was. But it's only when you compare Iceland's plight to what happened to other countries that you realise that things could have been much worse - particularly given the sheer scale of its banking bubble.

Cutting real wages through inflation meant that unemployment peaked at an annual rate of 7.6% in 2010 - lower than any of the peripheral European countries, for example. And after the initial plunge, the Icelandic economy has started to grow strongly again: GDP has grown by 6.9% since the second quarter of 2010.

On top of that, the decision not to bail out the banks has meant that debt/GDP levels peaked at an acceptable 100% of GDP, and are set to fall. By contrast, the Greek bail-out deal is hoping to achieve a debt-to-GDP ratio of 120% by 2020 and that's the best-case scenario.

The lessons for Europe

Iceland's problems were closer to those of Ireland than those of Greece: the explosion of an outsized financial sector rather than a chronic inability to balance revenue and spending in the context of a fixed currency.

However, there are two key lessons that the rest of us, and those two countries in particular, can learn from Iceland. To avoid having banks drag them into bankruptcy, governments should focus on saving depositors only not other bank creditors. That's the lesson for Ireland.

As for Greece, Iceland's experience suggests that devaluation and capital controls may be the least painful solution to an economic contraction.

None of this is easy or painless, as the Icelanders could tell you. And it doesn't alter the fact that the best way to avoid a bust is to avoid having an unsustainable boom in the first place. Unfortunately, that's a lesson that none of us seems able to learn.