Jonina Benediktsdottir first realised that Iceland’s economic miracle was built on sand in 2003, about five years before the rest of the world figured it out.

Admittedly, Jonina – in Iceland’s patronymic system, first names are used almost universally – had the significant advantage of being girlfriend to Johannes Jonsson, who co-founded the investment group Baugur with his son Jon Asgeir. Jon Asgeir has since become one of the most notorious figures to be associated with the reckless financial model that led Iceland off a cliff. He is now a former billionaire, a shaming symbol of a nation’s irresponsibility, and a convicted fraudster. His father is dead. But back then, the two of them were toasted in Reykjavik and abroad as the kingpins of a new financial powerhouse. They owned a yacht, called Thee Viking, and a private jet, painted in pin stripes, and about 10 per cent of the British high street.

Jonina, 45 at the time, was an awkward addition to this opulent life. Perhaps a little too forthright and suntanned and blonde for the conservative tastes of Iceland’s tight-knit elite, her relationship with Johannes was notable for its scandalous origins as an affair that prompted her to leave her surgeon husband. Still, mulling it over now in her suburban Reykjavik home, she doesn’t much like the idea that the relationship was opportunistic on her part. She insists that as a successful businesswoman in her own right, she was only motivated by love. “I was much richer than he was,” she snorts, still forthright and suntanned and blonde. “I paid for everything. It was only ever economic loss for me to be with that guy. I could say that he was after my money.”

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Before long, she started to see things that drove all hopes of domestic bliss from her head. There were the emails from bank officials, seemingly intended to deceive the authorities as to the true nature of their accounts. There were the dubious payments on the Baugur Visa card, adding up to $19,000, that turned out to be for escorts provided for a group of executives staying on Jon Asgeir’s yacht in Miami. And then there were the meetings between bank officials and CEOs. It wasn’t that the discussions were innately suspicious, Jonina explains. But why were they holding them in the middle of the night?

When the relationship waned, Jonina’s bubbling indignation at her former paramour, and in particular at his son, was bound to boil over. The result was an almighty row. At one point, Jonina remembers, she stormed into the office of a senior executive at the bank, Kaupthing, and scared him so badly with what she threatened to reveal that he began to cry. The battle kept Reykjavik’s gossip magazines enthralled for months, saw its protagonists’ private emails splashed on the front of the newspapers, and made absolutely no difference to the course of Icelandic history. “Maybe I was too angry,” Jonina says now. “Maybe I wasn’t using the right words. People didn’t like hearing about it. It made them uncomfortable. No one likes to read these things about their friends.”

On 7 October 2008, the day the government put Iceland’s second biggest bank in receivership, Jonina was at Keflavik airport, about to leave on a business trip. People approached her in the departure lounge and apologised for doubting her. “It was such a relief,” she says, “to see that they knew I wasn’t just a stupid, bitter woman complaining after a relationship.” They have been apologising ever since.

Jonina is about the only person for whom that moment came as a relief; to the rest of Iceland, it seemed to signal the beginning of the end times. “Fellow countrymen,” said prime minister Geir Haarde, in a speech to the nation on 8 October, “if there was ever a time when the Icelandic nation needed to stand together and show fortitude in the face of adversity, then this is the moment… we need to explain to our children that the world is not on the edge of a precipice.” At the end of his speech, after a pregnant pause, he added: “God bless Iceland”. It was not an optimistic prayer.

And yet today, fully five years later, the dreaded crisis does not seem to have been quite as dreadful as all that. Times have not been easy in Iceland, to be sure, but Reykjavik does not feel like a city in a slump, unless the wholesale departure of McDonald’s (citing the “unique operational complexity” of the island) makes it seem that way to you; across the country, unemployment is at 3.1 per cent, and GDP has been growing since 2011. If there was a catastrophe, it has apparently been contained. As Nobel Prize-winning New York Times columnist Paul Krugman noted in 2010, “a strange thing has happened”: “although Iceland is generally considered to have experienced the worst financial crisis in history, its punishment has actually been substantially less than that of other nations”. That, the argument goes, is because Iceland did something unconventional: it let the banks fail.

But not everyone agrees. It’s not that anyone disputes that Iceland has had a relatively soft landing. Rather, it’s the lingering suspicion that the country’s troubles have not so much been averted as postponed. A recent analysis in Fortune magazine, headlined ‘Why Iceland is Europe’s ticking time bomb – again’, caused a stir in Reykjavik, and while the piece is somewhat melodramatic, it raises some fair points.

The controls on currency exchange that stopped money fleeing the country willf at some point, have to be lifted. Perhaps even sooner, the new government will have to deal with the consequences of its promise to voters of relief on their mortgage repayments – a policy which most experts say would bring the country to its knees, and which has already prompted credit ratings agencies to warn that Icelandic bonds could be given junk status. “It’s dangerous to make predictions,” says Fridrik Mar Baldursson, professor of economics at Reykjavik University. “One thing that I learnt from that episode was to be much more sceptical about information.” But, he adds, “people probably have thought that things would have normalised by 2015, but there are warning signs. We’re not out of the woods yet.”

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The problem of whether the worst is yet to come is partly dependent on another, more fundamental question: do Icelanders see the financial crisis as the moment a fantasy was dispelled? Or do they believe that the past five years have simply been an unfortunate blip? In a country where dire warnings of economic catastrophe can be summarily ignored because everyone is simply having too nice a time, how sensibly do people think about the future? When asked this question, Asgeir Jonsson, assistant professor of economics at the University of Iceland, laughs. “In Iceland,” he says darkly, “we’re very close to the forces of nature. There are a lot of things we cannot control. And this has created some carelessness. We never prepare things in advance – we just take things as they happen. Our thinking is, take the opportunity when we see it, and don’t worry too much about tomorrow. Because it might just be that we will all die.”

An overcast sky sits low over Reykjavik in mid-August, as it usually does: almost always light, and almost never sunny. The weather has the curious effect of making Iceland’s capital feel as if it is inside a crystal ball, hidden from the observations of those who would try to squint through the clouds to discern its future. Even though more than a third of Icelanders live there, it is still a city of just 120,000. The size of the place is one of the things that makes the crash so unique. And yet despite its idiosyncrasies, Iceland has drawn intense international attention for the past five years, as a kind of petri dish for financial crises.

Everyone who visits from the US or UK finds something quaint about the scale of the place, where toy-town cottages sit alongside fashion boutiques that aren’t quite as overpriced as they used to be. Once, Iceland’s exuberant capitalists fancied that their home was a financial hub that bore comparison to New York, London, and Tokyo; more recently, a range of rather less flattering likenesses have been drawn, depending on the point the observer is trying to make. Reykjavik is about the size of Hull, if you are talking about its historic reliance on fishing. It has fewer citizens than greater Peoria, Illinois, if you are preoccupied with its hubris. Or, if you would like to hint at how things might be done better, it is only a little smaller than Luxembourg.

Certainly the idea of Iceland as a stronghold of aggressive capitalism is hard to square with most of its history. For centuries it had a good claim on the title of the poorest country in Europe; it was a Danish colony until 1944. (Before the crisis, its most impactful moment on the international scene was arguably the eruption of a volcano in 1787.) The last stage of the transformation from pedestrian economy to financial high-wire act began in 2002, when prime minister David Oddsson privatised the state banks. In an environment of limited regulatory oversight and extraordinarily aggressive leadership, the three biggest banks expanded rapidly overseas; over the next three and a half years, as they backed investors like Jon Asgeir Johannesson (who also owned a stake in one of the trio, Glitnir), their assets grew from a few billion dollars to $140 billion.

Meanwhile, cheap loans domestically helped fuel a property bubble, and high interest rates that were supposed to help control inflation instead just heralded the arrival of the ‘carry trade’ – the process of borrowing money in a low-interest rate economy and then lending it out somewhere you can earn a healthy return. As a package, it was bold indeed. One 2002 text that offered some pointers on the government’s philosophy was written by Oddsson’s adviser, Hannes Holmsteinn Gissurarson, and entitled: ‘How Can Iceland Become the Richest Country in the World?’.

For a while, the answer seemed to be, ‘easily’. In 2006, the average Icelandic family was three times as wealthy as it had been in 2003. But in the last months before the crash, another answer to that question suggested itself: it can’t. As the global downturn gathered pace, it began to seem rather more troubling than before that the banks’ liabilities were so vast. When the end finally came, the country’s debts amounted to 850 per cent of GDPf Relative to the country, it was the world’s biggest ever banking collapse. (Another indicator of Iceland’s relative size, and incestuous establishment: one economist has estimated that there were just 33 people who could reasonably be blamed for the crisis.)

At the time, Asgeir Jonsson, now an academic and author of a book about the crisis, Why Iceland?, was chief economist at Kaupthing bank. “I never wanted to be a banker,” he says, and in his university office surrounded by his textbooks, it is easy to believe him. “My father is a left-wing farmer. I didn’t even go for the money – I went for the experience. I was the only man there with a beard.” But Asgeir was frequently rolled out to make media statements, and became identified with the bank. He still remembers the day the phones stopped ringing, when creditors realised that there was no money left.

It was, he says, a traumatic experience. “This is a very close-knit society. I was quite popular and well-respected, and that turned around. You know, in the past, when Iceland had no state and no prisons, if you committed a crime the worst sentence you could get was to become an outlaw. You would have to leave the country or go and live in the highlands. Well, for many people who worked in the banks, this is what it felt like. Being an outlaw.”

Today, Asgeir is respected as an academic. His past, he says, came with “a lot of costs” but “also a lot of benefits”. But the scars of the financial crisis are not only found on the people who experienced it. Consider, for example, the new suburb of Ulfarsardalur, where the impact of the recession is written into the earth. When work started on the site, it was intended to house 18,000 people; today, just 453 people live there.

There’s one particular enclave, on the fringes of the neighbourhood, which looks more like a blueprint than a place to live. It sits on the edge of the city, with a view of Reykjavik one way, and nothing but majestic mountain and forest the other. The roads are in place; so are the power supplies and council services. A solitary fire hydrant pokes out of the earth. The only thing lacking are the houses. Instead, there are just foundations, dug into the ground and left waiting for someone to fill them.

In among the empty sites, there are a few completed homes. “We started building in 2009,” says a woman making bread in the kitchen of one of them, a beautiful, austere house in exactly the Nordic style that a spate of TV dramas have taught us to expect. The woman, a civil servant, and her husband, were the first to start building in the area. “It was like living in the countryside at first. It didn’t bother us – it’s peaceful. We expected it to be like this.” She thinks that the neighbourhood will take 10 years to fill out.

In neighbouring Grafarholt, which was also left half-empty by the recession, there are more encouraging signs. “I don’t think people feel the neighbourhood is disadvantaged any more,” says Sigridur Gudmarsdottir, who is the local Lutheran pastor. “It doesn’t feel like a ghost town any more. Now it is more like a little village in the city.”

In retrospect, it now seems that Iceland’s great stroke of good luck was that its banks were not “too big to fail”. As a result, the government was able to execute what one Icelandic journalist told me was informally called operation ‘Fuck the Foreigners’, whereby domestic assets and liabilities – including Icelanders’ deposits – were hived off and put into new banks, while foreign bondholders and depositors were left in the old ones. That split protected Icelanders from the very worst impacts of the crash. It is still not clear what the foreigners will get back.

The other bold move that the Icelandic government made was to install capital controls, thereby saving the krona from collapse. But while everyone acknowledges that was a necessary step, it also carries significant risks. The problem is, if Icelandic firms are ever going to access international markets again, they will need the controls to be lifted; but if they are lifted, those ‘carry traders’ and other foreign entities – as well, one presumes, as many Icelanders – will move their money out of the country instantly, bringing the krona to a new low.

Most experts agree that the process has to be staggered. But so far the government has not specified a time frame. This may be because it is preoccupied with a more pressing concern: how on earth it can keep an electoral promise it made to use money taken from the vulture funds that own assets in the old banks to write down household debt. No one I spoke to, of any political persuasion, thought this was a good idea. Attractive though it might sound when high inflation has made such debt so crippling, there are many more pressing needs for the money – and, besides, the risk of a credit rating downgrade is too awful to contemplate. It was, says the writer Andri Snaer Magnason, a nakedly populist move on the part of the same right-wing parties that steered Iceland into trouble in the first place, and which swept their left-wing successors out of office earlier this year. “In the vulture funds they’ve created a perfect enemy,” he says. “Who can love a vulture? And who can be against this? How bad are you if you don’t want families to have more money?”

To Gigja Svavarsdottir, who runs a language school called The Tin Can Factory, such worries must seem relatively insignificant. On the same day in 2008 that Jonina Benediktsdottir was flying out of the country, she was arriving back from several years in Italy – and wondering what on earth she had got herself into. “It was such a shock,” she says. She had first noticed something wrong on a visit home the summer before, when none of her friends were around because they were all on holiday. “We turned on the radio and the first bank had collapsed. It was immediately clear how bad things were. It was a national sorrow.”

Today, though, Gigja’s language school is thriving – it’s grown from a living room at the flat she and her husband borrowed from her father-in-law, to a set of ground-floor offices in downtown Reykjavik.

Her success may partly be thanks to a broader upturn that’s unfolding in the tourism industry. One ironic consequence of the financial crash – and of the eruption of Eyjafjallajokull in 2010 that paralysed European air traffic – is that this previously obscure island became suddenly well-known; all the free publicity alerted people to the fact that it was very reasonably priced. The result was a tourist boom that took annual visitors from 100,000 to more than 700,000.

Inevitably, people are starting to capitalise. The last time I reported from Iceland, in 2010, I found a luxurious apartment hotel for the same price you might ordinarily expect at a Holiday Inn; this time, the only way I could find somewhere for a reasonable sum was to use AirBnB. Accordingly, hotels are going up all over Reykjavik, even at the expense of longstanding cultural venues; 14,000 locals who signed a petition are worried that the expansion might kill the goose that laid the golden egg. “It’s a sensitive topic,” says Anna Andersen, editor of the Reykjavik Grapevine, an English-language newspaper aimed at foreign residents that recently ran a lengthy report on the subject. “Do you want to come to a city that is just one hotel after the next? Are we going to get rid of everything that makes the city special?”f

Luckily, tourism isn’t the only industry that Iceland is leaning on to replace the lost financial sector. Fish exports keep on growing, and there are grand hopes that the country’s excess power might one day be piped to mainland Europe.

It’s striking, when you talk to people in Iceland about these prospects, just how much store they seem to set by them. Each one is discussed as a magical route to prosperity, a little like the banks were, in their day. Partly, of course, this is the result of a natural yearning for anything that feels optimistic. But you might also wonder whether it has something to do with a certain Icelandic sense of grandeur. Several times during my visit, I thought of president Olafur Ragnar Grimsson’s 2005 speech extolling the virtues of Icelandic entrepreneurship, which listed 13 key factors in the country’s success – and the contrast with another speech he made earlier this year. In the latter, he explained, to widespread acclaim on the left, how he and his country were “wise enough” to avoid the “traditional prevailing orthodoxies of the Western world of the past 30 years”, with the result that “Iceland is enjoying progress and recovery”.

I ask Andri Snaer Magnason, whose book Dreamland offers an idiosyncratic and insightful take on his country’s character, about it. He sighs. “It’s a bit complicated,” he says. “It’s both the good and bad in our psyche. It’s part of this hubris that comes with wanting to be like London instead of Aarhus in Denmark. We want to be one of those big places. We want to have an Indian restaurant, a Chinese restaurant, an Italian restaurant. We want to have techno jazz, acid jazz, alternative jazz, speed metal, death metal, trash metal, black metal. And we want to be the best at all of them.”

The next night I have dinner at an Italian restaurant. The food isn’t great, to be honest.

A disused power plant doesn’t seem like an obvious place to look for a different sort of recovery, but that’s Iceland for you. Toppstodin, a coal-fired power station that had been out of commission for 25 years, was about to be knocked down when Sæmundur Asgeirsson persuaded the authorities to let him take it on for free, instead. Now it provides office space to all kinds of creative workers, from engineers and machinists to tailors and product designers, in an extraordinary shared space, often in demand for fashion shoots and music videos, where they’re able to bump into each other and – with a bit of luck – come up with things they mightn’t have otherwise thought of. “People come here, have an idea, and then after a year or two maybe they leave and start their own firm,” says Sæmundur. “They start on their own, then they start hiring people. That’s the idea, anyway. This is a starting point.”

There is, for example, the clothes designer I’m told about by Sæþor Asgeirsson, who takes care of the place (and makes his own windmills there, to boot). “She had to shut down her shop when her loans became unaffordable,” he explains, “and reduce production of her designs. But now she has an office, and she’s designing, and getting into a position where she can sell clothes again.”

This is not a particularly grand plan, it’s true. Then again, you might think that Iceland would have less of an appetite for grand plans these days. And it does have the merit of not having a lot of obvious potential for ending in catastrophe.

Jonina Benediktsdottir’s life has certainly calmed down somewhat since her days of taking on the most powerful people in her country. Nowadays, she says, she confines herself to offering behind-the-scenes advice to the government, although she wasn’t selected to run for the right-wing Progressive Party in the last election. It’s a change in approach she has settled on since she wrote her book, which she says prompted a slew of false allegations of sexual harassment against her husband. He is, she says, taking his accusers to court.

Jonina says she’s not angry any more. And it seems to be true: the rigours of the challenges she has set herself, and that she has been presented with by others, must wear you down. When she thinks about her dead ex-boyfriend, who dragged her into the whole business in the first place, her tone is one of sorrow. “He was a strange man,” she says. “ I knew he had been sick… after it became clear that it was me who had helped the police, he still said that he had loved me. He said I had treated his family badly, but never that I had treated him badly.”

To Jonina, like most Icelanders, the past is simply too exhausting to dwell on any more. So, I ask, what does she think her country’s future holds? Her eyes light up, and she sits forward in her chair. “Yes, we still have some problems,” she says. “But I think we are in a fine position. A very fine position. And if we can get rid of those problems, we will be the richest nation in the world.”

Timeline: anatomy of an economy

1881-1976 Iceland’s economy is reliant on fishing. Fish products account for 90 per cent of exports. In the mid-70s – after several poor catches – the government privatises fish stock, leading to a system where fish quotas are traded and borrowed against like stocks.

1996-2001 Iceland witnesses a period of economic growth encouraged by a boom in power-intensive industries like aluminium smelting and a recovery in fish stocks.

2002 The prime minister David Oddsson experiments in free-market economics by privatising national banks Landsbanki and Bunadarbanki (later part of Kaupthing).

2003 The three major Icelandic banks, Kaupthing, Landsbanki and Glitnir, hold assets of a few billion dollars – 100 per cent of its GDP. By 2008, it would be 800 per cent.

2005 After leaving office, David Oddsson is appointed one of three central bank governors. Time later name him ‘one of 25 people to blame for the financial crisis’.

2006 A study suggests that Icelanders are the fourth happiest people on Earth. The country was later put at number one on the Global Peace Index Rating.

2007 While the US stock market doubles in value over three and a half years, the Icelandic equivalent increases by nine times its pre-2003 amount. Property prices triple.

2007 Average income in Iceland almost $70,000 per annum. The fifth highest in the world. Icelanders owned 50 times the foreign assets they did in 2002, including Hamleys.

2009 A series of protests against the government’s handling of the crisis swell into riots outside of its parliament. The protests lead to public involvement in a new constitution.2008 Iceland is ranked No 1 in the UN’s Human Development Index. Meanwhile, the Icelandic krona begins to decline in value and inflation and interest rates begin to soar.

September 2008 The ailing Glitnir bank is expected to be nationalised, but before the deal can go through, the bank is put into receivership. The krona plummets in value.

October 2008 Kaupthing, Glitnir and Landsbanki collapse. The Icelandic banking system goes into meltdown. Iceland’s 300,000 people are on the hook for $100bn of losses.

October 2008 British Chancellor Alistair Darling invokes anti-terror legislation in order to freeze the assets of Icelandic banks operating in the UK. Icelanders are furious.

November 2008 Iceland’s central bank agrees a new set of currency regulations, banning movements of capital in and out of the island without a licence.

November 2008 The International Monetary Fund approves a £2.1 billion loan over a two-year period. The loan is the first by the IMF to a Western nation since the UK in 1976.

March 2012 Iceland makes an early repayment of around a fifth of its IMF loan. The island is described as ‘booming’ by the Daily Telegraph when it makes another in June.

2013 Iceland’s economy is on its way back, with seven straight quarters of GDP growth, and unemployment below 5 per cent.

Michael Knowles