After a few years of indebted instability, Iceland’s economy is set to undergo a short sharp shock. We are in for a much more protracted downturn.

Exactly two years ago this weekend, this column focused on the strange and rapidly growing economy of Iceland. It seemed likely that, because the Icelandic economy was becoming rapidly indebted, it was becoming more unstable. Equally, as it did not have the protection of the European Economic and Monetary Union (EMU), its unsustainable debts were likely to lead to a financial crisis.

The mainstream financial markets rejected this view, spouting the usual mantra about Iceland’s fundamentals and so on. However, question marks remained. For the past two years, the Icelandic authorities have been doing their best to stave off the day of reckoning – but it appears that the predicted catastrophe is now upon them.

Every single financial measure in Iceland is now screaming ‘meltdown’. For example, interest rates on credit default swaps for Iceland’s main banks are now trading at 1,500 basis points. A credit default swap is an instrument that ensures against the risk of default. This means that if you are lending to an Icelandic bank and you want to ensure against the likelihood of a default, it will cost you €1.5 million to insure every €10 million loan you give it.

This is ten times the rate of the average European bank, implying that the market believes that a serious default is now only a matter of time. Banks simply can’t do business on these terms.

Meanwhile, the krona – Iceland’s currency – has fallen over 25 per cent this year, and is still in free-fall, despite recent hikes in interest rates.

It is clear that the Icelandic model is over. It was based on a bank-led boom, taking full advantage of financial liberalisation to borrow huge amounts of money and lend it to all takers. Icelandic banks expanded aggressively abroad – including in Ireland where Landisbanki bought stockbroker Merrion Capital and thought about bidding for Irish Nationwide.

Bjork may be Iceland’s most famous export, but the vast bulk of the wealth created in recent years has spun off from the banking sector, leveraging up and expanding. This was a country behaving like an out-of-control hedge fund, and it is suffering accordingly.

Iceland will recover, but it will experience large currency devaluation, one or two of the banks will possibly be nationalised to stave off bankruptcy and, like Norway and Finland in the early 1990s, it will probably have to issue a state-backed bank bond to pay off debts. As is happening in the US in the case of Bear Stearns, Iceland’s ordinary taxpayers will pay for the swashbuckling idiocy of its banking high-fliers.

However traumatic the experience, it will be swift and the turnaround is likely to be quick. Some people may be punished as dodgy practices are exposed and the country will start again. It is a world leader in hydrogen technology, at the cutting edge of genome research, and it will take more than a financial whirlwind to topple these Norsemen.

Most importantly, house prices will fall rapidly, to such an extent that within a year of two there will be great value in Iceland. Lessons will have been learned and the cycle will start all over again.

At the moment, Ireland can look north and thank our lucky stars that we are in the eurozone. Our banks have behaved in the same way as those in Iceland. If we still had the punt as an independent currency, we would look exactly like Iceland. For example, by late last year, only 50 per cent of Irish banks’ loans were covered by domestic deposits. So the banks here, like their Icelandic partners, were borrowing enormous amounts of money abroad to finance lending at home — which was almost exclusively going into property.

As a result of economic and monetary union and the creation of the euro, we won’t run out of money as a country. However, if the share prices of Irish banks are any indicator of future banking demand, we are in for a torrid time. Bank insiders have known this for awhile.

As far back as last summer, for example, some senior figures in private banking were advising their rich clients to get out of property, while telling the ordinary Joe Soap that there was never a better time to buy. So it’s not that the banks weren’t aware of the difficulties. It’s just that they chose to tell different stories to different people – one message for the rich and another for the not-so rich.

Now let’s try to read the tea leaves for a moment. We know that, in Iceland, the short sharp shock is already under way because it has its own currency. We, on the other hand, are going to suffer a much longer domestic slowdown. Ireland will experience what a US region experiences after a property/banking boom and bust, which is more akin to a slow puncture than a high-speed blow-out.

House prices will continue to fall, not rapidly, but progressively. Instead of prices collapsing, as happened in the early 1990s in Britain, Finland, Sweden and Norway, and now Iceland, we will go through what Massachusetts did in the late 1980s.The adjustment will take place on what is called the ‘‘real’’ side of the economy.

When I worked as a student in Boston in the late 1980s, there were loads of jobs and nowhere to live. By the early 1990s, there were loads of places to live and no jobs. People who had flooded into the New England area in the 1980swent back to the mid-west, Chicago and the South.

Immigration stopped. The region’s budgets went into deficit and the place felt a lot less crowded, congested and pricey. This process took time.

There was no crisis, no single event or catastrophe. On the contrary, there was a slow realisation that the game had changed. There were still dollars in the banks, but people simply slowed down, re-examined their credit card bills and tried to hold onto their jobs. House price fell for six years.

However, on the upside, the technology hubs around Cambridge, MIT and Harvard thrived. They could attract the best people because Boston was no longer prohibitively expensive. Cash that had been diverted into the fool’s gold of property now was available for real investment, and the high-tech hub boomed.

Ireland is likely to experience the first part of this Massachusetts story. It is already happening and will get much worse. The big challenge for all of us is to make sure that the second part of the Boston story is repeated here over the coming years.

Oddly, even though the EMU gives us an element of protection, it also anaesthetises us to the severity of our difficulties. Like Iceland, our problems started in the banking system, and it would not be surprising if over the course of the next few months we get more bad news from this sector. However, unlike Iceland, which will go through the mill, we are likely to experience something much more protracted.

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