Iceland’s decision to let its banking system fail has not saved it from a difficult economic situation

By David Murphy, Business Editor

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This time three years ago, Ireland put €24bn into its banks to keep them afloat. It was hoped it would be the last occasion when the taxpayer would be tapped to fix the country’s lenders.

But another island in the North Atlantic allowed its banks fail in 2008 instead of rescuing them.

Now that both countries are recovering, it is worth examining how Iceland fared after its own decision to burn the bondholders and start new banks from the ashes.

Last month I travelled to Reykjavik to report for RTÉ’s Prime Time on the Icelandic boom, bust and recovery.

On the surface Iceland doesn’t seem in bad shape.

The statistics look reasonable, unemployment and inflation are low and the economy is growing again.

But a deeper examination reveals serious problems for ordinary people which restrict basic freedoms taken for granted elsewhere in the Europe.

The difficulties are so severe, it becomes clear that the notion that Iceland let its banks collapse and escaped unscathed is a fallacy.

When the crash happened the Icelandic krona plummeted by 77%, which made imports much more expensive. There has been a marginal recovery in the country’s currency but the effect of the collapse continues to make it much more difficult for ordinary people to be able to fill their shopping trolleys.

Neil McMahon and David

David Murphy and Irishman Neil McMahon, who has been living in Iceland for almost 40 years

Neil McMahon, who is originally from Limerick city, has been living Iceland for 38 years.

When financial crisis was looming in 2008 he converted his savings from krona to euro in an effort to avoid the collapse of the Icelandic currency.

It seemed like a sensible decision at the time. Now Mr McMahon finds he cannot take his euro out of the Icelandic banks because of government restrictions called currency controls.

Like other inhabitants he cannot withdraw foreign currency unless he shows the bank a plane ticket – which allows him withdraw a maximum of €2,000.

I also spoke to Hilmar Veigar Pétursson, who is CEO of computer games company CCP.

Like many other firms in Iceland, CCP employs a large number of foreign nationals. Many of them prefer to be paid in euro, but they cannot take their savings out of the country.

Currency controls have also frightened foreign investors and as result money coming from abroad is negligible.

Magnus Kelly in Iceland

RTÉ’s camera crew Magnus Kelly filming in Iceland for Prime Time

Another problem for Iceland is its mortgage crisis.

The country has a unique system of home loans which were linked to the rate of inflation. In simple terms, if somebody owed the bank the equivalent of €100,000 at the beginning of a year, by the end of a 12 month period with inflation of 5% the amount owed would be €105,000.

In this paper academic Jacky Mallett from Cornell University explains that “the outstanding principal is increased by the rate of consumer price inflation”.

The idea behind the home loans was to stop inflation but there is very little evidence that it worked.

When inflation rocketed during the height of the financial crisis, the mortgages exploded in value pushing thousands of home owners into arrears.

Last year a new government, led by former television journalist Sigmundur David Gunnlaugsson, swept into office on wave of popular support following commitments to introduce debt relief.

However, after ten months in power his promises have yet to materialise into concrete measures and proposals have been criticised by the opposition as too ineffective.

There are a number of important differences between the banking collapses in Iceland and Ireland. It is not fair to make a like-for-like comparison.

Iceland’s banking system was nine times larger than the size of its economy. Ireland banking system was three times bigger. So Reykjavik could never afforded to bail out its banks – they were too big.

Also, Iceland was not in the euro and did not have to follow the orders of the European Central Bank.

Another key difference is that Ireland continues to struggle with unemployment, while only 4% of Iceland’s labour force is out of work.

However, one of the key lessons from Iceland’s decisions is that letting its banks collapse did not save the economy from numerous painful measures which continue to cause lasting problems.

The most important lesson from both countries is: don’t let your banks get in a mess in the first place.

No matter what course of action a country takes it will negatively affect its citizens.

David Murphy’s report on Iceland is broadcast on Prime Time on Monday April 7 at 10.25pm on RTE One.