What The World Can Learn From Iceland's Default Model

Iceland

Photo: AP

In 2008, Iceland was struck hard by a financial crisis.Instead of bailing out its banks using taxpayer funds like the United States did, Iceland let its bank default.

Some economists, such as Joseph Stiglitz and Paul Krugman, now think that letting the banks default was the right thing to do for Iceland’s economy, and some see it as a model for other debt-stricken European nations.

Others aren’t so sure.

Here’s your guide to the Icelandic crisis, and what its lessons for the rest of Europe.

In 2008, Iceland's banks became insolvent

Icelandic banks owed more than six times of the country's GDP in debt, and when the world's credit markets dried up, they could not pay their loans back.

The banks ended up defaulting on more than $85 billion.

Source: BBC

Negligent practices by the banks were blamed for the failures

20/20 did a special called 'The Icelandic Financial Crisis in 6 minutes' in which they argued that Icelandic banks borrowed more than they could afford and gave out bad loans without giving out stringent enough credit checks.

Watch:

Instead of financing the banks with taxpayer money, Iceland let its banks default

Iceland transferred domestic loans and savings into new banks, but did not transfer foreign assets and debts into the new banks, leaving them behind.

Source: The New York Times

Icelandic voters refused to let Iceland repay its foreign debts

In two separate referendums, Icelandic citizens voted that Iceland should not have to repay foreign creditors the money they lost when Icelandic banks defaulted.

Source: BBC News

And in the process, angered the UK and the Netherlands

The UK and the Netherlands pushed for Iceland to pay back the $6 billion its citizens lost when Icelandic banks failed.

Some British and Dutch citizens had money in Icelandic banks because of the high interest rate the banks offered, but when the banks collapsed, Iceland could not insure their assets.

The UK and the Netherlands are currently suing Iceland for failure to repay these debts in the European Court of Free Trade.

Source: The New York Times

Despite this, Iceland is undergoing a strong recovery

Iceland's economy is expected to grow 3% this year and the government expects a budget surplus by 2013.

Source: OECD

And defaulting did not cause a catastrophe

In the words of the IMF, 'the most adverse effects (of the country's sweeping capital controls) have not materialised.'

Source: BBC

Iceland's basic economic indicators are now stronger than countries that received bail-outs

Iceland's economy will have shrunk 0.75% a year in the 4 year period of 2008-2012. For comparison, Ireland's economy has declined at a rate just under 2% while Greece will have decline 1.6% a year.

Source: OECD and the BBC

Unemployment is less of a problem in Iceland as well

Unemployment:

Iceland: 5.8%

Ireland: 14%

Greece: 15%

Portugal: 12.4%

Source: OECD and the BBC

This has led some economists to argue that Ireland and Greece should let their banks default

Krugman wrote in praise of Iceland as well

Paul Krugman wrote an op-ed in the New York Times that praised Iceland for defaulting, saying that its better off than countries that followed the IMF/EU bailout model to solvency like Ireland did.

In the short term at least, the average Icelander hasn't necessarily benefited.

The collapse in the Icelandic krona means that prices for items that have to be imported soared. Icelanders who took out loans in foreign currency have had their mortgages double or triple because of the fluctuation in their currency.

Icelanders saw an 18% slump in their disposable income in 2009.

Source: BBC

And Europe should be careful if looking to Iceland for a model

Iceland is unique for a couple of reasons.

First, Iceland was not too big to fail. Its population is 329,000, about the size of St Louis.

Also, unlike Ireland, Greece or Portugal, Iceland has its own currency--the kronur. Iceland can devalue its currency in a way that Eurozone members cannot.

Icelandic Finance Minister Steingrimur J. Sigfusson said that:

'People should be careful when it comes to drawing comparisons between Iceland on the one hand, and Greece, Portugal, Spain and Ireland on the other. Iceland didn't have the ability to save the banks. Trying to rewrite the events that led to that eventuality as some sort of an export product is irresponsible.'

A future in the Eurozone?

There are those who wish to see Iceland join the eurozone. The OECD recently argued that currency shocks would be easier for Iceland to withstand if it were part of the eurozone.

And as recently as May, the governor of Iceland's Central Bank said they were still interested in joining the eurozone, despite the region's current woes.

NOW WATCH: Briefing videos

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.