Reintroducing Sovereign Bankruptcy

Think countries can’t go bankrupt? Think again. Philip II of Spain had to declare four state bankruptcies in 1557, 1560, 1575 and 1596. Japan went bankrupt twice in the early 20th century. And Iceland, despite having the world’s highest Human Development Index (HDI) and last year winning the U.N.’s “best country to live in” poll with the most contented population in the world, may be on the brink of sovereign bankruptcy:

This volcanic island near the Arctic Circle is on the brink of becoming the first “national bankruptcy” of the global financial meltdown. Home to just 320,000 people on a territory the size of Kentucky, Iceland has formidable international reach because of an outsized banking sector that set out with Viking confidence to conquer swaths of the British economy — from fashion retailers to top soccer teams.

The strategy gave Icelanders one of the world’s highest per capita incomes. But now they are watching helplessly as their economy implodes — their currency losing almost half its value, and their heavily exposed banks collapsing under the weight of debts incurred by lending in the boom times.

“Everything is closed. We couldn’t sell our stock or take money from the bank,” said Johann Sigurdsson as he left a branch of Landsbanki in downtown Reykjavik.

The government has taken drastic measures. The government has nationalized the country’s third largest bank, granted itself authorities to seize companies and limit board of director control, and was even negotiating a $5.4 billion loan from Russia to shore up its national finances.

Who is to blame?

As regular Icelanders begin to blame the government and market regulators, Haarde said the banks had been “victims of external circumstances.” Richard Portes of the London Business School agreed, noting the banks were well-capitalized and had not bought any of the toxic debt that has brought down banks elsewhere. “I believe it is absolutely wrong to say these banks were reckless,” said. “Quite the contrary. They were hugely unlucky.”