Instead of mass foreclosures and bankruptcies, southern Europe would do well to follow Iceland's example

As recession deepens across southern Europe, stories abound of indebted firms and households being forced to hand over ownership of their assets to their creditors.

For example, a recent report in Der Spiegel tells of a Spanish bank that evicted from his home a now unemployed man, previously earning less than €1,000 a month. The bank had happily lent him €240,000.

Mass foreclosures of this kind ricochet through the economy, grinding down economic activity and compounding the "social recession".

Iceland shows how to do things differently, with creditors bearing more of the direct cost upfront. Southern European governments – and even the creditors to southern European firms and households – would be wise to study its example.

Iceland was hit by a perfect financial storm in October 2008. Its financial sector, with a balance sheet 10 times that of the country's GDP, collapsed. The national currency, the króna, lost 50% to 60% of its value overnight. Inflation shot above 20% within a few months. The equity market collapsed and real estate lost a more than a quarter of its value.

By early 2009 it was clear that some 80% or 90% of Icelandic companies should have declared bankruptcy, including some of the biggest firms in the economy. The central bank estimated that 25% to 30% of households were in a similar position.

In normal times, the occasional bankruptcy is evidence of a well-functioning economy. Mass bankruptcy in hard times is another matter entirely.

For one thing, the legal system is painfully slow in clearing up even one bankruptcy, let alone thousands at a time.

For another, it cannot be the case that 80% or 90% of all private activity becomes genuinely unproductive overnight. The question is how to keep firms with temporary balance-sheet problems going and at least partly covering their losses until demand improves.

And how are the banks going to make money from the property they have acquired? Not by selling the house to someone evicted from their house by another bank. The bank will probably have to leave the house empty, and pay real-estate taxes and fees without receiving rental income.

After the collapse of its oversized banks, the Icelandic banking sector was composed of three banks erected on the domestic operation of the fallen giants, a state run real-estate bank and few small savings and loan institutions. It was obvious that the financial sector would suffer a second collapse if all firms under water were forced into bankruptcy and if all families in a similar situation were evicted from their homes.

After much heated debate, the government, the financial sector, and the federation of businesses agreed on a comprehensive debt-relief programme.

The main components were as follows:

• For the household sector, debt in excess of 110% of the fair value of each property was written off. Specific relief measures (administrated by a bank or a new debtors ombudsman) applied for those that could not service a reduced loan.

• Low-income, asset-poor households with high-interest mortgage payment got a temporary subsidy from the government.

• Small to medium sized firms could apply for debt relief if they could credibly document positive cash flow from future activities.

The firm had to be willing to re-engineer its operation so as to make best use of its assets. Given those conditions, the firm could expect its debt to be written down to equal the discounted value of future earnings; or alternatively, written down to the amount that the bank or other financial firm could expect, in the best of circumstances, to gain from taking the assets over and realizing their monetary value. Hence the debt relief programmes did not create new equity on the balance sheets of firms or households.

The process provoked plenty of conflicts. For example, the supreme court ruled some forms of loans in foreign currencies illegal. The government intervened to extend the ruling to all foreign exchange loans granted to households. These legal challenges have not yet been brought to an end, but so far 12% of the household sector pre-2008 debt has been written off.

The bottom line is that the government, the financial sector and the business sector collectively created a situation that leaves the financial sector with as good a result in terms of total debt collection as possible without the pain of sending most of the firms and many families into bankruptcy, unemployment and dispossession.

Thanks in good part to this tempered approach to debt write-down Iceland's economy is now growing faster than most countries in Europe, and unemployment is less than 5% (having hit 9.3% in early 2010).

Of course, many Icelanders are still angry at the government and the banks, like their southern European counterparts. But at least they have a job, they pay property and income taxes, they service their reduced debt, and they can make plans for a vacation or a new car in two years' time.

• Thorolfur Matthiasson is professor of economics at the University of Iceland and member of a parliament-appointed committee overseeing equality of treatment in debt writedowns by the Icelandic financial sector.