Alternative economics in Iceland

How did Iceland recover from economic meltdown? Adam Bushby finds out

It wasn't so much a crash as a capitulation. When the value of Iceland's stock market plummeted by 90 per cent in the wake of the global financial crisis in 2008, figurative white flags were waved across the Arctic island of 313,000 people. Unemployment skyrocketed to 10 per cent and inflation ballooned to 20 per cent, while the value of the krona halved against the major currencies.

The troubles in Iceland made the news on this side of the Atlantic due to the collapse of Iceland's three largest banks: Glitnir, Landsbanki and Kaupthing. The banks had expanded rapidly before the crisis and enjoyed a strong British customer base - especially Landsbanki, which operated as Icesave in the UK. When the banks fell like cards, the British government stepped in to protect the deposits of UK customers to the sum of £2.3 billion, while Iceland's president lafur Grímsson has twice refused to sign legislation to reimburse the money.

Iceland was on its knees, and the road to recovery was expected to be a long and painful one. But something curious happened. Flying in the face of received wisdom in Europe and the US, Iceland took a different approach to deleveraging - paying back its debts - and rebuilding its economy. Little more than four years since the crisis hit, Iceland's economy is forecast to grow 2.7 per cent in 2013, while the euro area GDP is expected to shrink by 0.2 per cent at best.

Breaking the rules

Like troubled economies in the eurozone, Iceland borrowed money from the International Monetary Fund (IMF) in the wake of the crisis to shore up the government as it dealt with the fallout when investment bank Lehman Brothers collapsed. But that's where the similarities end. "Iceland broke all the rules and things are not too bad," said US economist Paul Krugman.

In the short-term, Iceland put pain before gain and experienced ten straight quarters of shrinking GDP between 2008 and 2011. The country closed its stock market, imposed capital controls to prevent the flight of money from the country and suspended foreign currency transactions.

Instead of bailing out the banks with taxpayers' money, as the British government did for RBS and Lloyds, the Icelandic government allowed its privately-owned banks to fail. Its Financial Supervisory Authority stepped in to ringfence the Icelandic operations of the banks, so families and small businesses still had access to cash and services, but investors - and foreign depositors - lost everything.

Iceland also maintained its social welfare model. Rather than cutting benefits to the most vulnerable parts of society, the government actually increased its welfare budget. As a result, the unemployed and those on low incomes could continue to participate in the economy as consumers. Iceland's government also forgave private debt and shielded education, health and policing from the spending cuts to come.

Criminal investigations were also launched into the banking elite and former prime minister Geir Haarde was found guilty of not doing enough to protect Iceland from the financial crisis. Ultimately Haarde faced no punishment, but investigations are ongoing and a handful of bankers have been prosecuted.

Pain before gain

This isn't to say that life for ordinary Icelanders has been easy, though. It hasn't. Thousands of people who'd taken out mortgages in foreign currencies have been stung by soaring repayments after the fall in value of the krona. Meanwhile income and house prices fell while inflation continued to climb.

Although the public wasn't asked to pay for bankers' mistakes, wealthier citizens were called upon to pay more in taxes to help the country pay back its debts. The government has introduced over 100 new taxes, levies and fees over the past four years, and it has carefully cut spending - though not to the extent of austerity measures in the eurozone.

However, support has remained strong for the medicine needed to remedy the ailing economy, a situation that has sprung from a culture of collective spirit and fairness. Iceland's prime minister Johanna Sigurdardottir summed up this rationale by asserting: "Becoming more disciplined and lowering state expenses, while at the same time keeping the welfare system strong, is what needs to be done to have wide support from the public for such measures." There, in a nutshell, is the glue that has underpinned the recovery.

Economic revival

Iceland completed a three-year IMF-supported rescue programme in 2011 and the country has since experienced seven straight quarters of growth, averaging 2.5 per cent per quarter. This is in contrast to the eurozone, where the economy remains stagnant and recovery a distant dream. Unemployment in Iceland has fallen to 5 per cent - higher than pre-crisis levels, but less than half of the eurozone average, which stood at 11.7 per cent in December 2012.

So can Iceland provide a model for Europe? There's no reason why not, according to Sigurdardottir, who says she has "met with several leaders over the past years, some from Greece, and many prime ministers have been surprised by our economic turnaround and asked how we did it".

Most importantly, Iceland deleveraged and then diversified its economy. Before the crisis, the Icelandic banking system was dangerously over-extended, with the combined debt of Iceland's big three banks more than six times Iceland's total GDP of €14 billion. By allowing the banks to fail and its financial services industry to contract, Iceland has instead focused its resources on producing cheap, clean energy and returning to the traditional, but still profitable, industries of farming and fishing.

But where Iceland has led, Europe may find it hard to follow. Iceland's krona, which has slumped to the extent that government imposed capital controls to stabilise it, has proved to be something of a saviour. The country's international competitiveness has received a boost as the krona is now a fifth lower against the euro compared with its pre-crisis level. But the single currency means that replication of the fiscal tactic in other European countries is a no-no.

There's still work to be done in Iceland: inflation stands at 4.2 per cent and households remain heavily indebted. But there's certainly stomach for the fight in Iceland, and the tiny country has proven that with a little thinking outside the box, big things can be achieved.