On October 6, Iceland's prime minister, Geir Haarde, claimed his country was on the verge of "national bankruptcy." Over the following days, the government was forced to nationalize the three big Icelandic banks. The stock market crashed, and the krona became so devalued that trading was halted. Members of the Icelandic government were placed under police protection for the first time in the nation's history. Various English-language press reports suggested that food shortages were days away. The Icelandic government undertook formal negotiations for a bailout with Russia, speculation being that the Russians would want the abandoned U.S. airbase at Keflavik in return. Iceland, it seemed, was on its way to becoming a frozen banana republic.

The reality is somewhat less hysterical. Icelanders continue to work and drive and, to a lesser degree, shop. The grocery stores are fully stocked. Offering greenbacks to merchants doesn't trigger any under-the-table discounts. The Icelandic government, having previously said it had secured a loan from Russia (it hadn't), last Monday leaked word that it had coordinated a $6 billion loan with the IMF, Norway, Sweden, and Japan. That loan never materialized and on Friday, Haarde announced that the government would begin negotiations with the IMF for $2 billion in immediate aid--leaving Russia's generosity blessedly untouched.

The fact that Iceland has not gone literally bankrupt, however, is the end of the good news. The financial crisis that began with mortgage defaults in California and Florida has wreaked havoc in the North Atlantic. And the worst is yet to come.

Before October, Iceland was an economic Cinderella story with sustained annual growth of 4 percent and the fifth highest per capita GDP in the world. The OMX Iceland 15, their version of the Dow, stood slightly off its historic highs of 2007. The engine of this success was the country's banks, whose privatization was completed in 2000. The three banks--Glitnir, Landsbanki, and Kaupthing--embarked on a course of aggressive foreign expansion, gathering overseas investors attracted by Iceland's high interest rates. The combination of the krona's strength (in 2007, the Economist estimated that the krona was the most overvalued currency in the world--by 131 percent) and the Icelandic central bank's high interest rates (which peaked at 15.5 percent) made saving in Internet accounts, such as Landsbanki's "Icesave" program, particularly attractive to Europeans. Three-hundred thousand Britons socked away £4.6 billion ($7.8 billion) in Icesave alone. For a sense of scale, Iceland has a population of 304,000 and a total annual GDP of $20 billion.

Iceland's banks were not particularly risky constructions. They were not weighted down by the subprime-debt packages--excuse me, structured investment vehicles--which caused so much trouble in America. But their reliance on foreign investment left them dangerously exposed to disruptions in the credit markets. When the markets seized up in late September, Iceland's banks were unable to secure loans to meet their short-term debts. It was a difficult and perilous moment. Iceland's leaders made the situation worse.

When Glitnir faltered first, in late September, it approached the Sedlabanki, Iceland's central bank, for a short-term loan. The head of the central bank, David Oddsson, is a politician with no background in economics. He was mayor of Reykjavik and then prime minister from 1991-2004. Oddsson reacted to the situation like a politician: He declined to bail out Glitnir and pushed for aggressive nationalization.

As Richard Porkes explained in the Financial Times, "This triggered a sovereign debt downgrade and a sharp further fall in the already depreciated krona. Short-run funding for Glitnir and Landsbanki evaporated, margin calls came from the European Central Bank, loan covenants kicked in."

Because of all this, Landsbanki failed a week later. The government nationalized it, too. But Oddsson wasn't finished. In another political maneuver, he intimated that the Icelandic banks might not be able to pay their U.K. investors. This prompted Gordon Brown to lockdown Icelandic assets in the U.K.--using a provision originally crafted as part of a post-9/11 anti-terror statute. Brown wasn't about to abandon constituents who were losing their savings. The seizure killed Kaupthing, the one bank which still had life in it. The government took it over the next day. Suddenly, the Icelandic government was holding $61 billion of bank debt--roughly 8 times the national budget.

In the span of ten days, Oddsson had turned a crisis into a disaster, but the rest of the government didn't exactly cover itself in glory. The administration engaged in stunt casting, putting women in charge of two of the re-formed banks and playing gender politics: "Now the women are taking over," said one government official. "It's typical, the men make the mess and the women come in to clean it up."

Prime Minister Haarde waged an unhelpful war of words with Brown and publicly belittled the IMF, saying that he would not seek its help, but might consider a plan if they wanted to offer one. "The question," he sniffed, "is what kind of program [the IMF] would envisage for an advanced economy like ours. .  .  . I wouldn't expect them to put conditions like they do in third world countries or underdeveloped economies in this situation."

While Haarde postured, the Icelandic stock market collapsed. At its height in 2007, the OMX Iceland 15 was trading at 9,000 points. In the midst of the crisis, trading was halted for three days. When the market reopened on October 14, it plunged 77 percent in a single day, settling at 678.40.

In the midst of the turmoil, there was a run on the krona as Icelanders and investors tried desperately to trade the falling currency for harder cash. Sale of the krona was halted on currency markets. Oddsson stepped in again, attempting to peg it at a rate of 131 krona per euro. Since the central bank had only 4.5 billion euros in foreign currency reserves, the gaudy peg was doomed from the start. Forty-eight hours later, it went down. The krona, which had been trading at 122 in September before the crisis began, was at 340 when the collapse of Kaupthing brought currency trading to a permanent halt.

In a final act of economic malpractice, Oddsson cut the central bank's interest rate from 15.5 percent to 12 percent, a move which had no practical effect except to announce that Iceland was resigned to high inflation. Already, the inflation rate was ripping along at 14 percent. Icelandic economists predict that 25 percent is the best-case scenario in the near term, while their models suggest it could hit 75 percent in the worst-case.

Iceland's financial crisis had become an economic crisis. Three weeks in, the effects are visible. While the krona is off the currency markets, all banking is run through the central bank, putting a premium on foreign coin. Foreigners cannot trade in their kronas. Icelanders can only exchange krona for other currencies if they can prove they are about to travel abroad.

Every day the Icelandic government auctions off 25 million euros, which are prioritized for the import of "necessary" goods--food, medicine, and gas. This has prevented shortages of essentials, but rationing is occurring subtly. For instance, Geir Matthiasson, a professor of economics at the University of Iceland, notes that hospitals are prescribing smaller amounts of drugs and requiring more frequent refills in order to maximize the reserves of medicines on hand.

Importers of nonessential goods are out of luck. Where foreign suppliers used to do business with Iceland on 30-, 60-, or even 90-day lines of credit, they now demand non-krona cash in advance. Businesses that rely on nonessential imports--which is almost all of them--have only the stocks they had at the end of September. Laura Petursdottir, who runs an upscale bath and body store, says she hasn't received new shipments in six weeks and is worried that she won't have stock for the Christmas season. Not that Icelanders would likely be able to afford her wares, anyway. The combination of inflation and contraction has already reached into every sector of the economy.

Carola Falk manages a shop that sells Icelandic hand-knit sweaters--which is like winning the lottery: The only two materials she needs are sheep and old Icelandic ladies, both of which remain in strong supply on the island. But Falk points out that the supply of goods is immaterial, since no one can afford to buy them. Inflation is already running so high that she sees the prices of everyday goods change weekly, and in some cases daily. "The sandwich I buy for lunch across the street was 220 krona last week," she says. "Now it's 280 krona."

At Kringlan, the main shopping mall, you can walk past four or five stores in a row without seeing a shopper. Sigurjon Orn Thorsson, the mall's general manager, says that the number of visits remains roughly constant, but that spending is off sharply from a year ago. Thorsson also sees a shift in where shoppers are spending their money: high-end is out. For instance, the mall has two grocery stores. When I visited on a weekday afternoon, the big, fancy Hagkaupf--think Whole Foods--was almost empty. The no-frills Bonus--a Nordic Dollar General--had every checkout lane open and packed ten-deep with customers. The same is true of clothing. Kringlan's many designer boutiques were deserted. A store called Next, which sells discounted, off-label clothes, was humming. One item doing brisk business elsewhere in the mall was an anti-Oddsson T-shirt.

In the big-ticket capital sector, the outlook is positively macabre. Construction has ground to a halt as builders find themselves strapped. Most of the construction workers in Iceland are Polish immigrants. They are leaving by the boatload, either laid off or finding Icelandic wages now lower than what they can make at home. The result is that construction sites around the city are closed or being operated by skeleton crews.

Or consider auto sales. Knutur Hauksson is president of Hekla, Iceland's biggest car dealership. "This is just the beginning," he says. "The worst is yet to come."

Hauksson buys his vehicles in euros. Since January the krona has declined 64 percent against the euro, so he's raised vehicle prices by 25 to 30 percent. In 2007, Hekla sold 9,000 vehicles, used and new. As of August, sales were off 68 percent year-on-year. But even that doesn't give an accurate picture of present reality. Asked how many vehicles he's sold recently, Hauksson laughs. "We sold six new cars last week--which was 30 percent of sales in all of Iceland. This week will probably be zero." Hauksson is trying to ship as much of his stock as possible back to Europe.

In an odd twist, there has emerged a small market for used cars. Polish immigrants leaving Iceland are buying them. Since they can't convert their savings out of kronas and kronas are worthless outside of Iceland, they're converting their money into cars--four-wheeled investment vehicles, if you will--and shipping them home.

Nearly every industry is being crunched. In the midst of the crisis, the country's two biggest newspapers merged as ad sales evaporated overnight. The bankrupt banks laid off 500 white-collar workers. This might not sound like much, but Iceland has traditionally had very low unemployment: In 2007, the country had 1,476 unemployed people, or 0.9 percent of the workforce. Even before the crisis, that number had jumped 50 percent. No one knows how high it will be by the end of the year.

More unemployed means more government expenditures in benefits. (Not to mention the money the government will need to put aside to pay back the IMF loan.) And government revenues will be down. The banks alone contributed $330 million to the government's coffers last year; this year that number will be closer to $110 million. The government's total budget in 2007 was $8.6 billion. In toto, Geir Matthiasson predicts "a decline as bad as 10 percent of GDP next year."

Another Icelandic economist, Gylfi Magnusson, is more optimistic: "There's certainly going to be a real contraction with unemployment. GDP will almost surely fall a bit, but it shouldn't collapse. The job market will obviously be quite bleak." Year-on-year real wages were down 2.5 percent before the crisis hit and will drop much further. There will be higher taxes on fewer jobs paying less money.

Which brings us back to the individual consumer. Hauksson explains, "We've seen the banks fail. In the next few weeks, some of the companies will go down. And then the personal bankruptcies will begin." In an attempt to escape Iceland's high interest rates, many Icelanders took out foreign currency loans for cars and mortgages. With the krona collapse, those loans have increased by 50 to 80 percent. When it comes to home mortgages, even Icelanders who took out krona-based loans are in trouble. As Eyglo Svala Arnarsdottir, an editor at Iceland Review, told me, traditional krona-based mortgages are indexed to inflation--meaning that principal is now increasing faster than it can be paid off.

Foreclosures will follow, unless the government prohibits them. There is already a surplus of 2,000 to 3,000 flats, which, combined with out-migration, foreclosures, and, of course, inflation, means you have a housing market headed for trouble, too.

Icelanders vary in their outlook. Everyone here assumes the krona will soon be stabilized and traded at a "reasonable" rate, meaning that businesses will be able to import goods again. Prime Minister Haarde told Icelanders that they're in for a rough few weeks, but that the situation will improve. Finnur Oddsson, managing director of the Icelandic Chamber of Commerce (and not related to the central banker), says, "It's going to be manageable. If you look at the scale of this economy, it's very small. When you look at historical records, when we've had shocks to the economy, which has occurred a number of times, it's bounced back very quickly."

Others are more pessimistic. Andres Magnusson, head of the Icelandic Federation of Trade & Services, says, "A lot of the companies will not survive--how many and which of them I cannot say. What I can say is the longer this situation maintains, the more likely it is that good and sound companies will become casualties. .  .  . Definitely two to three years of serious recession. Next year will be very difficult--there's no way to avoid that."

Hauksson hopes it's only two years. "The maximum it could go would be 30 months," he says. "If it's more than 30 months, we're dead."

Jonathan V. Last is a staff writer at THE WEEKLY STANDARD.

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