If No Bailout, Then?

You wind up like Iceland, as Jonathan Last describes in the current Weekly Standard:

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. . .

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.