Iceland Shows Other Europeans How to Survive Bankruptcy

Small Atlantic nation enjoys growth and employment gains after failing to rescue its banks. Mainland Europe remains stuck with stagnation, decline, and ruinous "rescue" packages.

Taxpayers in Europe (and the United States) who have been terrorized since 2008 by government officials warning about economic armageddon, catastrophe, and pestilence should look to tiny Iceland for a taste of how little there is to fear when the experts can't save the people. 

Christine Lagarde, managing director of the International Monetary Fund, recently branded Iceland's economic performance "impressive." In the last few years the small island in the north Atlantic has managed to shrink its deficit, reduce unemployment, and allow its economy to grow.

Meanwhile, on mainland Europe, there is hardly any economic growth to be seen, and countries that pledged to make necessary austerity reforms have almost certainly failed to do so.

Government growth, fiscal activism, and national resentment are the norm. Officials from the eurozone have been trying to help heavily-indebted nations like Greece, Portugal, and Italy avoid banking-system collapse and exit from the single currency. Were they to examine Iceland's example they might find that temporary financial collapse and monetary sovereignty provide a better roadmap to economic recovery than bailouts backed up by unpopular and unenforceable "austerity" conditions.

Iceland, like the rest of Europe, was faced with an almost unprecedented economic situation in 2008. Iceland's central bank tried to rescue some of the country's largest banks, bankrupting itself in the process. Iceland's largest banks held almost 10 times Iceland's GDP in assets (much of it foreign) in 2008. The central bank was forced to attempt the rescue after agreeing to guarantee future bailouts in 2001. With the central bank out of commission and a crippled financial sector, Iceland's GDP took a nosedive.

Because so many of the assets held by Icelandic banks were foreign, the diplomatic fallout was almost as severe as the economic one. The British prime minister at the time, Gordon Brown, invoked anti-terrorism legislation in a bid to freeze assets of one Icelandic bank in the United Kingdom.

Iceland's GDP per capita (in current U.S. dollars) was a little over $65,500 in 2007; in 2009 it was almost $38,000. It would be cruel to overlook the effect a sudden loss in wealth like this had on the average Icelander's economic well-being. Having investments you thought were safe vanish is unfortunate at best and tragic at worst. However, the economic future of young Icelanders will almost certainly be substantially better than that of their peers in Greece.

Icelanders will do better than Greeks precisely because financial institutions collapsed in Iceland, ironically in part because of mechanisms in place requiring bailouts from the Icelandic Central Bank. Economic collapse allowed for proper refinancing. Greece has suffered from too much attention, and because of all of that attention, the actual size of the Greek economy has been forgotten.

Greece's GDP is roughly the size of Maryland's, about $300 billion. The eurozone as a whole has a GDP of almost $12 trillion. Figures like these only highlight the strictly political motiviations behind the attempted rescue of Greece by the rest of the eurozone. Certainly, a Greek exit from the eurozone would be a major event. However, Iceland's example shows that letting financial institutions fail allows for strong and comparatively quick recoveries following a period of economic hardship.

Unsurprisingly, government attempts to fix the European financial crisis have made the situation worse and humiliated the most affected countries the most severely. Had Greece been left to default on its debt and leave the eurozone early, the effects, economic and political, would have been much less dire in comparison to the effect of a Greek exit now. What is forgotten about the example of Iceland is that although the initial international reaction to Iceland's collapse was anger, the country's reputation recovered. The animosity brewing between the Greeks and other Europeans (especially Germans) will not diminish within a matter of months. Too often the cultural changes that are happening in Europe are overshadowed by the economic fiasco.

The comparison between Greece and Iceland is not perfect. If Greek GDP, at $300 billion, puts it on par with the Old Line State, Iceland's, at just $15 billion, puts the island nation below even Vermont, the U.S. state with the lowest GDP. But so what? The economic stagnation caused by Too Big To Fail, of which the Euro "crisis" is only the most monstrous example, resulted from policymakers believing that the same math you know to be true at the local level does not apply at the macro level. The central bankers are wrong about that, and the example of Iceland provides Greece and the rest of mainland Europe with a valuable example.

Unfortunately, it looks like it will be a lesson learned in hindsight. How severe the effects of fiscal and monetary activism will be on the eurozone will depend in part on how quickly continental policymakers can abandon their political agenda and focus on the economics.