We should learn a lesson from Iceland and let the banks go bust

A year ago, there was a joke in the City that went like this. "What's the difference between Ireland and Iceland? One letter and about six months."

But today, you could turn that around, and make the punch line: "One letter, and a realistic economic policy." The Irish crisis goes from bad to worse. Despite making the deepest public spending cuts imaginable, there is little sign of a durable recovery. Last week, the government raised the cost of the banking bail-out to €50bn. Its deficit will amount to an eye-popping 32% of GDP this year.

Here's what the country should do instead. Go bust. Apologise to the rest of the world, but point out that you can't possibly pay all the debts your bankers ran up. That's what Iceland did. And despite the warnings of disaster, it is now looking in remarkably good shape. It is possible that the Irish, and indeed the rest of the world, have got it all wrong. You don't have to bail out the bankers after all.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Two years ago, when the credit crunch hit, governments around the world decided that they had to rescue their banking systems, no matter what the ultimate cost to the taxpayer. Lehman Brothers in the US was allowed to go under, but after that no significant bank was allowed to fail. In Britain, we rescued Royal Bank of Scotland and Lloyds-HBOS. In France, BNP was helped out. Ireland was the most dramatic example, with Anglo-Irish Bank being the country's most costly bail-out. In a worst-case scenario and worst cases have a depressing way of coming true the total bill for Ireland's bank rescues will come to €50bn. Elsewhere, the relative cost hasn't been quite so horrendous, but taxpayers are still saddled with bills running into billions that will take a generation or more to pay off.

Only one country took an alternative route: Iceland. It is so small, and its bankers had run up such huge liabilities, that it simply wasn't feasible to keep all the Icelandic banks afloat. The country was bust. The banks have successfully sold the argument that a country has to rescue its financial institutions when they run into trouble, or the nation will be ruined. The economy will collapse. The global markets will slam the door in your face. If the banks go down, so the argument goes, pretty soon we'll all be living in caves again, scraping flints together to start a fire. In fact, it turns out that a banking collapse isn't so bad after all. In fact, Iceland looks in remarkably good shape.

With some help from the International Monetary Fund, the country is starting to recover. The economy will shrink by 1.9% this year but is forecast to grow by 3% in 2011. Interest rates are falling again the Icelandic central bank in September took rates down to 6.25%. Inflation is falling, and the Icelandic krona is rising it is up 17% against the euro this year. Capital controls, introduced during the emergency, should start being lifted soon.

That isn't to say Iceland hasn't suffered. Real incomes have fallen by about 20% since the collapse. Jobs have been lost on a huge scale, and savings wiped out. Ordinary people are angry enough about what happened to put Prime Minister Geir Haarde, who presided over the reckless expansion of the financial system, on trial for negligence.

But Iceland still functions. People still eat. The country has survived. By next year, it should start growing again. Modestly, no doubt, but with a sharply devalued currency, and with credit starting to flow again, it should be able to pick itself up. It may be a surprisingly short time before it is allowed back into the global capital markets after all, Russia defaulted on its debts in 1998, but less than a decade later you could hardly move in Moscow for investment bankers looking for business. The financial markets don't hold grudges. If you have money, they will do business with you.

So what lessons should we learn from the country's experience? Almost every government in the world has accepted the idea that they have to bail out troubled banks. But Iceland suggests it isn't true. Governments could just protect domestic deposits. After that, they could just say sorry, there wasn't enough money left to pay back all the debts bankers ran up.

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

Ireland is the most exposed country right now. The debts run up by its banks may well turn out to be quite literally unaffordable. But other countries should keep the Icelandic experience in mind next time a big bank gets into trouble.

So long as you protect domestic depositors, and keep the payment system working, a banking collapse needn't be the end of the world. Indeed, it may well be a quicker route to recovery than struggling for years to meet all the obligations run up by a handful of bankers.