The krona lost 58% of its value by the end of November 2008, inflation spiked to 19% in January 2009 and GDP contracted by 7% that year. The Prime Minister Geir H. Haarde resigned after nationwide protests.
As a Bloomberg report argues, if early signs are any indicator (with economy projected to grow 3% in 2011), then Iceland’s decision to let the banks fail is looking smart and may provide important lessons for others. The GDP grew for the first time in two years in the third quarter, by 1.2%, inflation is down to 1.8%, the cost of insuring government debt has tumbled 80%, and banks have bounced back into the profitability.
The three biggest Icelandic banks - Kaupthing Bank hf, Landsbanki Islands hf and Glitnir - who had indulged in the spectacular lending spree at home and overseas were seized by regulators on October 6, 2008. The Bloomberg report writes,
"The government negotiated with the creditors, almost all of them outside the country, including mutual funds and hedge funds in the US and the UK and European banks and pension funds. Kaupthing’s creditors agreed to take an 87% stake in Arion, and Glitnir’s creditors now own 95% of Islandsbanki. Glitnir’s biggest creditor as of June was Dublin- based Burlington Loan Management Ltd., followed by Royal Bank of Scotland and DekaBank Deutsche Girozentrale, the fund manager for Germany’s state-owned savings banks.
Glitnir’s 8,500 creditors and Kaupthing’s 28,000 expect to get about 30 cents on the dollar for their claims, based on secondary-market prices of the banks’ debt and asset valuations by the resolution committees. About half of Kaupthing’s creditors are German depositors who had Internet accounts, have gotten their principal back and are seeking interest payments.
Landsbanki’s creditors opted for a promissory note from successor NBI hf instead of a stake in the new bank. Landsbanki had collected about $5 billion of overseas deposits through branches in the U.K. and the Netherlands. Iceland didn’t guarantee those deposits at the time it seized the bank, as it did for domestic customers, leading to a dispute with the British and Dutch governments. In December, Iceland agreed to compensate the U.K. and the Netherlands in full for their payments to Icesave depositors, as the Landsbanki accounts were known. Payment, including interest of about 3 percent, will be made over 35 years."
In contrast, Ireland guaranteed all the liabilities of its banks when they ran into trouble and has so far injected 46 billion euros ($64 billion) as capital so far to prop up these banks. The result is an unsustainable debt burden that could swell to twice its GDP, up from 94% now and the near certainty of a sovereign debt default. It is a widely held feeling in Icleand that if it had guaranteed all the banks’ liabilities, they would have been in the same situation as Ireland.
See this Vanity Fair article by Micheal Lewis on Ireland. Micheal Mandel has an excellent series of graphics that puts the role of external sector, exports/imports and financial profit repatriations, on Ireland's economic fortunes in perspective.