Can Iceland Be Saved?

At one end of Laugavegur, Reykjavik’s main shopping (and partying) street, Icelanders jostle in the aisles of a Bonus discount grocery to fill their baskets with ham, dried codfish, and other staples. A mile or so up the road, on the ground floor of a shiny new office tower that also houses the stock market, sits an Apple store that is perhaps the only one of its kind: Save a salesman, it is completely empty.

This neatly illustrates the state of play in Iceland eight months after it essentially went bust. No country embraced the excesses of the credit bubble as zealously as this north Atlantic island nation of about 310,000 people. As a result, it’s hard to find a place that’s suffering the deprivations of the crunch to the same degree. It’s not just that iPods are off the shopping list in favor of processed pork. The nation is massively indebted, consumer spending is in free fall, its big banks have been taken over by the state, and capital controls restrict the flow of money outside the country.

But as hard as Icelanders will need to toil to fulfill the demands of their financial rescuers—including $5 billion from the International Monetary Fund, a phalanx of Nordic neighbors, and even the Faroe Islands—don’t cry for them. Iceland, unlike many of the other nations that went mad for credit, has lots of things going for it: an average age of 37, a highly educated work force, a nearly positive birthrate, overfunded pension schemes, and abundant natural resources. With a little extra creativity, the place should emerge stronger from its recent fall from grace.

“Yes, Icelanders have to work hard, but they have a natural inclination to do so,” says Svein Harald Øygard, a Norwegian McKinsey consultant who was parachuted in earlier this year as interim governor of the Central Bank of Iceland. “Given how small a country Iceland is, it has a surprisingly high degree of self-reliance; remarkably strong sectors like the fisheries and renewable energy-based industries; and a productive, highly confident, and well-educated work force.”

Statistics paint the remarkable fiscal challenge Iceland’s people face. The central bank estimates that about 40,000 of the country’s 100,000 households took out loans to buy automobiles denominated in foreign currencies, chiefly the Japanese yen and Swiss franc. Similarly, about 80,000 Icelandic households have mortgages—all of them with payments either directly linked to inflation or, like those car loans, denominated in foreign currencies. When the krona was soaring, taking out forex loans for new Land Cruisers and condos overlooking the harbor might have seemed rational. From about 2002, the soaring currency—buoyed by artificially high official interest rates—allowed hot money to flow over Iceland like the Gulf Stream that keeps the country temperate. Everyone from American hedge fund managers to Austrian dentists found it easy to borrow cheaply at home, or in low-rate currencies like the yen, and buy higher-yielding Icelandic securities.

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Ingenious bankers even came up with securities to capture this trade, selling 500 billion krona ($4 billion) of “glacier bonds” to retail investors. When this vast carry trade ended, though, the currency crashed and, all of a sudden, the cost of servicing all those liabilities priced in foreign currencies spiked. So did the prices of imported goods, which led to inflation that jacked up the three-quarters of Icelandic home mortgages that are linked to inflation. The central bank estimates one in six households now face mortgage payments equal to a crushing 60 percent or more of their take-home pay.

Iceland’s three major banks also got sucked into this game, rolling in easy money they then lent to enterprising Icelandic entrepreneurs. These “business Vikings”—as they are known locally—were also encouraged by soaring stock prices on the Reykjavik exchange to expand their businesses abroad. At its peak, the Reykjavik market’s capitalization rose to more than 250 percent of GDP—making it the most highly valued in the world. Today it’s at 16 percent. “We became victims of our own success,” says the president of the exchange, Thordur Fridjonsson.

Few Icelandic businessmen burned out as spectacularly as Jón Ásgeir Jóhannesson, the man behind the Bonus supermarket chain whose pink pig mascot is ubiquitous across Iceland. Through his Baugur investment company, he created an international retailing empire, accumulating stakes in Saks Fifth Avenue , Britain’s Hamleys toy stores, and even, no joke, a chain of frozen-food stores in Britain called Iceland. But like the banks that helped finance him—Landsbanki and its two primary rivals, Glitnir (now Islandsbanki) and Kaupthing—Baugur went bust earlier this year. Now it’s up to the government, and the majority of its citizens, to avoid a similar fate.

And that’s where the hard work comes in. Fiscally, Iceland needs to revert to its mean: Under the agreement it reached with the IMF, the country must gradually lift capital controls over the next year, tighten up its monetary policy, and return to a current account surplus by 2013. This won’t be an easy task. Iceland is expected to have debt equal to 120 percent of its 14 billion euro GDP and a budget deficit of about 13 percent of output this year. That’s Italian- or Belgian-style economics.

And the political pressures on the central bank to set monetary policy that aims to achieve the goals set by the IMF and other creditors without causing too much pain at home are intense. To wit: When the central bank earlier this month lowered the overnight repurchase lending rate to 12 percent, Bloomberg called it an act that defied the IMF’s prescriptions. But the Icelandic press—echoing calls from labor unions and employers for lower rates—reported that the bank buckled under IMF pressure.

To get the country out of its hole, Iceland’s leaders are broadly focusing on four economic pillars to propel an export-led recovery and bring in hard currency: fisheries, energy-intensive businesses, tourism, and technology. Not everyone, however, is in perfect agreement about the weight of these objectives—and with good reason.

While fishing has been a mainstay since Norse settlers first landed in the ninth century, fleeing the harsh rule of Norwegian King Harald the Fairhaired, it’s not a growth business. There are natural limits to the tons of fish Icelandic trawlers can land. And it will be a long time before Icelandic delicacies like meaty minke whale and hakarl, or fermented shark, make the aisles of Stop & Shop. Fishing is also the industry most opposed to scrapping the krona and joining the European Union, as it would probably be forced to scrap its successful system—whereby fisherman are assigned scientifically determined quotas and then allowed to trade them among themselves. While some argue that Iceland could teach the EU a thing or two about managing fishing, Eggert Benediktsson, who runs HB Grandi, the largest fishing fleet in the country, is convincingly skeptical: “How do we as an entire country on its knees stand a chance to negotiate anything?”

Technology is a better long-term growth option for Iceland. Not only does it offer a more palatable existence to all those former-fishermen-turned-bankers than heading back on a trawler, the country’s telecom infrastructure is top-notch, its people are highly educated, and, because Icelandic is a rather niche language, nearly everybody speaks good English (albeit with a sort of Elven accent).

CCP Games embodies this vision of the future. In a renovated fish processing plant, just down the wharf from Grandi’s headquarters—which are redolent of its marine catch—CCP oversees an alternative universe called Eve Online, a space-age, massively multiplayer online game that counts as many customers globally as there are men, women, and children in Iceland. They pay $15 a month to navigate characters that pilot intergalactic spaceships, engage in commerce, and shoot one another.

More controversial is what to do with all the plentiful and cheap geothermal energy bubbling below the volcanic island’s surface. As global energy prices rise and the cost of labor falls, it becomes highly economical for aluminum producers like Alcoa and others to rev up their nasty smelters in the Icelandic countryside, to the chagrin not just of Björk and Sigur Rós, Iceland’s two most popular musical exports, but of most residents with functioning olfactory senses.

Of course, all that steam from the bottom of the earth has other uses. It warms the springs that dot the country and lure in tourists. It also heats up the greenhouses that allow Iceland to grow produce, flowers, and even bananas.

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More From The Big Money:

• China's Growing Fear That the U.S. is a Deadbeat
• Why FOREX Trading is Hazardous
• What Would a Global Reserve Currency Look Like?

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Familiarity with one of the ideas for fixing California's own giant budget troubles suggests a quirkier use for the hothouses: growing legal crops of marijuana. If Iceland were to decriminalize pot it would enhance its allure as a tourist destination, saving North Americans, especially, half the distance to Amsterdam. That may sound like a step too far for Iceland’s conservative leaders. But perhaps anything to hasten the island's departure from its debtors’ prison should be on the table.