The Island That Ran Out Of Money

During the financial crisis, only one Western country experienced a true collapse of its banking system: Iceland.

Things got so bad that the country actually ran out of foreign currency. Even today, years later, foreign money is still scarce, and the government controls how much anyone can get.

The strange story of how Iceland ran out of money begins in 2003. The country had just privatized its banks. These sleepy state run institutions suddenly grew, and started running ads in foreign countries. For example:

Foreigners responded, pouring money into Icelandic banks. The banks' balance sheets became 10 times larger than the entire country's economy.

But as the world slid into a financial crisis, investors turned on Iceland.

One night in January 2008, Ásgeir Jónsson, chief economist at Iceland's largest bank, got a call telling him to go to a certain hotel bar, to meet with foreign investors.

The investors were hedge fund guys who had come to the conclusion that Jónsson's bank was doomed. They told him they'd placed big financial bets that everything would crash.

The problem the hedge fund guys had spotted was in fact, the joke that John Cleese commercial: Iceland is a very small country. It's the smallest in the world to have its own currency. And it had borrowed huge amounts of foreign currency.

Normally that wasn't a problem. Icelandic banks could always change their domestic currency, the krona, for dollars or euros on the world market. But now the world was worried. And no one wanted krona.

In a bigger country, banks might get some foreign currency from their own central bank. But Iceland's central bank also ran out of dollars and euros.

"The central bank used all it had in a desperate attempt to save one of the banks," the economist Gylfi Magnússon says. "But that only kept the bank afloat for another couple of days."

Even if you had gone around Iceland and collected every euro on the island, there wouldn't have been anywhere near enough money to pay off the debt.

So Iceland, unlike other countries, couldn't bail out its banks. Jónsson remembers the day his bank collapsed in October of 2008:

And the funny thing is, during the panic it was so crazy. All the phones were ringing at the same time. But after the bank went down, all was silent. ... We were basically completely cut off from the outside world.

Eventually, the International Monetary Fund had to step in and lend Iceland a ton of foreign currency. In 2012 Iceland will have to start paying that foreign currency back.

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