Iceland's Pain Provides the Path

 | Dec 12, 2011 | 11:30 AM EST
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Another Monday, another rocky day in the equity markets as Europhobia again dominates the global financial psyche. And why not? Friday's summit produced a little progress, but not nearly enough to declare the crisis over.

Meanwhile, Bloomberg reports a sort of bank run as European companies move cash to Germany "just in case," and the U.K. Telegraph reports banks are running out of good collateral against which to borrow. Oh, and the Bundesbank is fighting the latest idea to have the IMF bail out the PIIGS.

To assess the likely outcomes, I look for similar situations in which successful policies were implemented, and right now my gaze is to the north. Iceland was the first European country to be bankrupted in this crisis that actually started in 2008, and how that country handled its bankruptcy is a powerful lesson that the Greeks, Irish and Portuguese would be foolish to ignore.

In Iceland's case, the government had to consider bailing out its three largest banks, which had massive global deposits and massive real estate exposure around the world. As real estate collapsed, depositors put a run on the banks. Iceland's government, to its credit, simply repudiated any liability and let the banks fail.

In the very near term, the results were harsh. The krona collapsed, and the vast swath of middle-class Icelanders employed in the financial sector had to find new work. Yet three years on, the country is far better off having swallowed that tough pill early on. The economy is growing again, around 2%, and inflation is low at 2.7%. Unemployment is only 6%, and the budget deficit is a manageable 2.7% of GDP. Every PIIG would be ecstatic to be sporting those economic statistics!

As a result of the bitter pill and subsequent convalescence, the country is again able to access the bond market, having done an issuance last summer. Spreads on Icelandic credit default swaps are reasonable too, and far better than other European credits.

Of course, because Iceland was not in the euro, it had the flexibility to move quickly due to the currency collapse, an option Greece and others do not have at the moment. (This handcuffing is one reason currency union is a bad idea.) Nonetheless, as southern European countries look north, they may embrace this example of rapid recovery and decide the best way to eliminate a debt burden is to tell your creditors, "I won't pay." It is hard to argue with success.

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