Iceland’s president has done what its parliament and government didn’t dare to. He said no to British prime minister Gordon Brown and Dutch finance minister Wouter Bos regarding repayment of his country’s debts. In the Netherlands, the morality brigade has lashed out with full force. How dare Iceland sneak away from its obligations, condemning itself to pariah status? Minister Bos threatened an EU boycott and International Monetary Fund (IMF) blockade on television. And Age Bakker, a Dutch director of the IMF, announced that all aid already committed to Iceland would be delayed.

The background is well known: tens of thousands of Dutch citizens had been lured by higher interest rates to lodge their savings with IceSave bank. The money was wiped out in the crash of Iceland’s banking system. The country’s deposit-insurance fund wasn’t prepared for a collapse of the entire banking system, so its guarantee of up to 22,000 euros in deposits proved useless. Unexpectedly, Minister Bos decided to pay out on Iceland’s guarantees, for a total of 1,3 billion euros. The Dutch central bank also covered deposits above 22,000 to a limit of first 40,000 and later 100,000 euros.

Is the IceSave debt also Iceland's?

So Brown and Bos saddled Iceland with additional foreign debt amounting to an extra 40 percent of its gross domestic product, failing to check whether, legally, the country was really obliged to reimburse Dutch savers.

The latter remains unclear. Bos alleges Iceland infringed EU regulations, but those he cites actually say nothing on the subject. The then- applicable guidelines state only that a deposit-guarantee system must be in place with “sufficient resources” to cover deposits. It doesn’t say what must take place if a calamity wipes out the fund. And it also says nothing about who must pay for the central bank’s top-up, only that states must agree on that via a bilateral treaty. The Netherlands has no such agreement with Iceland. Thus the parliamentarian who called for legal steps to be taken to enforce repayment just displays his own ignorance, since there is no legal basis for that claim. Bos glibly said on television that it would take too much time; he knows, of course, that he doesn’t have a leg to stand on.

Strangely enough, the chattering parliamentarians haven’t asked if Bos was allowed to take the action he did. He doesn’t have responsibility for individual savers or banks. He has to guard the stability of the system. And that was not endangered by the IceSave debacle. There was thus no need for Bos’ actions, no budget mandate, and no prior consultation in parliament. A total of 1.3 billion euros was just rashly thrown away.

The facts: debt will never be repaid

But how must we now proceed? Iceland currently has an external debt that amounts to between 300 and 900 percent of its gross domestic product! The third world debt crisis of the 1980s taught us how to deal with overindebted countries. The Brady Plan that was applied involved discounting debts of countries like Mexico, whose commitments then amounted to 60 percent of GDP, and was therefore regarded as unable to pay. Nicaragua had ten times its GDP in debt. It has never repaid that. A debt of three or four times GDP cannot be repaid, and therefore will not be repaid, whether the president commits to repayment or not.

The Mexico experience demonstrates how wrong all these predictions of Iceland becoming a pariah are. After Mexico had negotiated a 40% cut in its debt, capital flowed into the country. That happened in all countries in the Brady Plan, amounting to about 600 billion in the first ten years. It’s logical. Payment of gigantic debts requires extremely high taxation, which chases away investors and leads to zero growth for decades. Iceland would be cast into a vicious circle: high debt, high taxation, low growth, low payment capacity and thus even more debt. This is called debt overhang.

Demanding full repayment in such circumstances leads to such turmoil that creditors end up with less than if they had been more modest in their demands. Moreover, creditors should not act in isolation. The international community should not permit Bos and Brown to insist on getting paid before other creditors. Someone, perhaps the Scandinavians, should coordinate the various creditors.

Bos: quit the tought talk

The remark by Dutch IMF director Bakker that the debts to these countries would endanger the IMF aid programme was extraordinary. That’s not his decision to make, but the IMF board’s. The institution has to remain above the interests of individual parties. It is unheard of for one director, with an obvious conflict of interest, to pre-empt that process; this will have negative consequences for the Dutch position within the IMF and for the IMF itself.

Iceland has to sell the banks that were nationalised so as to clarify its overall indebtness. It has to be established how much debt should be discounted to allow new growth so the country can repay the rest of its obligations. Stringent fiscal measures will have to be undertaken to convince creditors problems will not re-emerge. With such a restructuring and adjustment process, Bos will get more back for his money than he will with his current macho behavior.