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Iceland Without the Ideology

NEW YORK ( TheStreet) -- You're going to be hearing a lot about Iceland over the next several months.

That's because, in the eternal struggle between creditor and debtor that marks every financial crisis, Iceland chose the side of the debtor.

While the U.S. and Europe bailed out their creditors in 2008, Iceland let them fail. It let the currency fail, too. It instituted capital controls to keep money from leaving. And it kept government spending stable, even though that meant that people weren't getting much purchasing power in the short run.

As outlets like MSNBC are starting to notice, the results four years on are in, and they look good for Iceland. Growth is 2.6%, unemployment is down, it has its credit rating back.

Sure, the people are poorer, there's inflation and supposedly no one likes the government, although they just re-elected their president to a fifth four-year term in office. But their crisis is over, while ours rolls on and on.

Bankers insist the Iceland solution is a one-off. Iceland had its own currency, the krona, which could be devalued, as Bloomberg notes.

The counter-argument to all this, offered by Fisher Investments at iStockAnalysts, is that Iceland's path is not the only way forward and that Ireland's cooperation with austerity, as described here at TheStreet, can also work.

The Iceland model implies the following path for Europe:
  • Weak economies may choose to leave the euro, but have a path to get back in.
  • German banks write-off loans to any country that chooses an exit.
  • Lots of banks go under. Investors in those banks lose their money. Lots of bankers lose their jobs.
  • People in affected areas lose their savings to devaluation, and capital controls prevent them from taking money out.
  • Europe goes through a period of heightened nationalism. Northern Europe loses export markets in the short term, and southern Europe has to start over.

In theory, any country with a sovereign currency can do this. Argentina did this early in the last decade, and it prospered for a while. It is a bit like the trick of the magician blowing himself up -- you can only do it once -- but once it's done you re-boot from that lower base.

Jeff Nielsen of BullionBullsCanada did a piece on this at TheStreet a week ago. At BullionBullsCanada he writes about dark days for the U.S. -- hyper-inflation, economic collapse. He thinks that collapse has already begun.

It's true that, with a lot of sovereign debt held by U.S. banks and institutions, and with the U.S. position as a creditor nation, we are going to take a big part of the hit if other countries follow Iceland's lead. An IMF official told BusinessWeek that Iceland has yet to lift its capital controls and there will be further economic pain from that. Despite modest growth, Iceland will have to raise interest rates to enable this.
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