Wall Street Journal - Iceland's Useful Rebuke

On Saturday the people of Iceland voted down a second agreement to pay for the 2008 bailouts of British and Dutch depositors in a now-failed Icelandic bank. The outcome was not a foregone one: As recently as February polls were showing wide support for the deal. But we take heart in Icelanders' refusal to shell out for the £4 billion bill for London's and The Hague's decisions to shore up their countrymen. It sets a useful example for the rest of Europe's still-unraveling financial systems.

The British and Dutch savers who had accounts with Icesave were operating at their own risk. It wasn't a secret that Iceland's banking system had swelled to 10 times the island's GDP in just a decade. The potential damage from a meltdown, both for Iceland and for outside creditors, would start to seem catastrophic if investors had bothered to have a close look, though few did.

That's why, when banks began to teeter in 2008, Icelandic authorities could hardly be blamed for demanding that certain creditors take losses. In rescuing only what was needed to keep the economy afloat, the government naturally gave priority to domestic deposits. Foreign savers like the ones who received a hand from the U.K. or the Netherlands got cut out by necessity.

For Iceland and its trading partners, that ruthlessness is now being vindicated. Not three years out from the largest (relative to its GDP) financial crisis suffered by any country in economic history, the small island nation could be faring much worse. Output is recovering steadily, and inflation is already close to the central bank's target.

Still, public debt remains a problem. Even without counting a potential repayment deal with London and The Hague, Iceland's gross debt is projected to hit 97% of GDP by the end of 2011, up from a quarter of that in 2007. Iceland's ongoing difficulties in global borrowing markets may be causing more of its voters to rethink their stance on making foreign savers whole: Only 58% of Icelanders voted no on the repayment deal this time, compared to 93% in the first referendum last March.

Depending on how a European court rules on the dispute, as now looks to be the next step, Iceland may yet have an opportunity to restore its credibility among global lenders by successfully making the case for the radical idea that not every creditor to a failed bank deserves a bailout. But it may also suffer further if existing debts become burdensome to repay in the meantime.

Icelandic voters' rebuke is an encouraging show of principle amid Europe's ongoing attempt to clarify the rights and responsibilities of banks and their creditors. A country is liable for its blown-up banks only to a point. Back in 2008, the British and Dutch governments took the view that they could not afford the risk to their own banking systems if savers at home got burned by banks in Iceland. They were entitled to take that view, rightly or wrongly. But leaving Icelanders with the bill was always a step too far. Such, at least, is the view now twice expressed by Iceland's voters.

Inspired by Iceland