The latest piece of big news in the sovereign debt crisis comes, remarkably, from Iceland. The country collapsed into depression after its experiment as an open economy with a large banking sector went pear shaped.

After a debt-fuelled boom and a huge influx of hot money due to high interest rates, its currency and banks collapsed under a fleeing of foreign money and huge losses. The government nationalized the banks’ debt, only to find the banks were too big to bail. The Icelanders rioted on the streets, a sovereign crisis ensued, and the government was toppled.

Iceland was rescued and it seemed all was well. They was even talk of fast-tracking Iceland into the EU. Then, suddenly, the population balked at the prospect of bailing out the banks. Now, the sovereign debt crisis is on again. At issue is Icesave, an Icelandic bank that operated in the UK and the Netherlands whose bust caused great hardship amongst British and Dutch savers who were attracted by high interest rates.

See the video below on why Fitch is now downgrading the country’s debt status to junk despite the lack of immediate liquidity concerns.

Icelandic President Grimsson blocked the legislation proposed by the new government under prime inister Jóhanna Sigurðardóttir after the last government was thrown out of office. This is significant since his is a largely ceremonial role and it was only the second time the President has ever done so in Iceland. Last year, I was in a small forum led by the Icelandic President Grimsson. You could see his violently visceral reaction to the bank issue as he spoke about it. His anger reflects that of the larger populace. Defending his decision, he said:

It is the cornerstone of the constitutional structure of the Republic of Iceland that the people are the supreme judge of the validity of the law.

I think this is big news and have a number of sources on this story below. Watch the Dutch and British stories for signs of European tensions as this is where the affected Icesave savers reside. The FT headline says it all. The Financieele Dagblad headline says “Iceland threatened to become next Cuba.” Ambrose Evans-Pritchard’s commentary is the most comprehensive and balanced in my view. The Norwegian headline, on the other hand, is “Iceland not on the verge of collapse” in huge typeface. The fault lines are definitely opening in Europe. I will discuss this later on the latest story on Greece and the likelihood of EU help. It’s because of the implications in other European countries that the Icelandic situation is significant.

Michael Hudson had this right when he said Iceland simply can’t pay. I have bolded the most significant part of his piece because it applies not just to Iceland:

Under normal conditions Iceland, a prospective EU member that had signed up to European deposit insurance rules, would have availed itself of the right to settle with depositors in an orderly manner… The EU law did not anticipate a systemic failure and made no provision for the government to be liable beyond its insurance agency. But guidelines agreed by the Ecofin meeting of European Union finance ministers on November 14 2008 were clear: “These negotiating discussions shall be conducted in a compatible and co-ordinated manner and account will be taken of the difficult and unprecedented circumstances in which Iceland finds itself and the urgent necessity of deciding on measures which will enable Iceland to restore its financial and economic system.” So the broader issue concerns Iceland’s ability to pay 250 per cent of its current gross domestic product – nearly $20,000 for each Icelandic citizen – to settle its Landsbanki mismanagement. The International Monetary Fund did not think this was a realistic option when its team calculated in November 2008 that: “A further depreciation of the exchange rate of 30 per cent would cause a further precipitous rise in the debt ratio (to 240 per cent of GDP in 2009) and would clearly be unsustainable.”… A pragmatic economic principle is at work in such conditions. Debts that cannot be paid, will not be (unless one pays back Peter by borrowing from Paul). At stake, therefore, is how much can be paid without wrecking Iceland’s economy. How many Icelanders must lose their homes as carrying charges soar on mortgages indexed to the exchange rate? Emigration is accelerating, and many foreign workers already have left. How many more must depart? And if the post-Soviet experience of a steep and sudden drop in living standards is relevant, by how many years must Icelandic lifespans shorten?

Sources

Reykjavik warned of political isolation – FT

Iceland can refuse debt servitude – FT

Iceland faces crisis after Icesave rejection – Reuters

Iceland leader vetoes bank repayments bill – BBC News

Iceland’s president blocks £2.3bn Icesave deal to compensate the UK – Telegraph

Angry Iceland defies the world – Ambrose Evans-Pritchard, Telegraph

Icelanders to vote on whether to repay UK over bank bailout – Guardian

Poll: Should Iceland be forced to pay? – Guardian

President IJsland verwerpt Icesave-akkoord – NRC Handelsblad

IJsland isoleert zich met veto Icesave-akkoord – NRC Handelsblad

IJsland dreigt ‘soort Cuba’ te worden – Finacieele Dagblad

IJsland houdt referendum over omstreden Icesave-akkoord – Financieele Dagblad

Island ikke på randen av kollaps – E24

Islands hårde krise – Berlingske Tidene

Islands parlament hasteindkaldes – Berlingske Tidene

Les Islandais consultés sur le remboursement de la dette – Figaro