Unless you have been living in a hole for the last year then you have probably heard that the European financial system is in a bit of a mess. Put simply, the countries of the Euro-zone have borrowed quite a lot of money. Some of the people that governments have borrowed this money off of have become less than convinced that the euro-zone countries pay it back. As a result debt holders have been selling a lot more than buying, which has forced the price/value of these loans down and interest rates up. All-in-all, not too pretty.

The question most people are asking, is how likely is it that the cost of debt gets so high for a country (say Italy), that it will have no choice but to default on its debt. This is a very hard question to answer.

So turning to the other side of the story, what happens if a country defaults? I thought it would be interesting to take a look back at one of the more colourful periods in financial history, the Spanish Bankruptcies.

A little History

In 1492, Rodrigo de Triana became the first European to set sight on the Americas in almost 500 years. Few at the time would have thought that the sighting of land sailor on la Pinta, one of three ships in the expedition led by Christopher Columbus, would transform the shape of Europe. The ships had been sent to discover a trade route around the east of the globe to the orient. The goal was to ship spices, which were extremely valuable is Europe at the time from the east, thus making a fortune. The Portuguese would get the spice route as it later became known but the Spanish got a lot more.

It became apparent, over the next few decades that the Americas were extremely rich. Areas that now include Mexico, Peru and Bolivia had huge reserves of gold and silver. At Potosi, there was a mountain which contained the largest reserve of silver ever found. So large in fact that it is still being mined to this day. The value of gold and silver was particularly important in the 16^th century as it was literally used as currency. The influx of gold and silver made the Spanish exceedingly rich, unfortunately this didn’t last.

What would you buy with all the gold in the world?

By the time the Spanish had begun to realise the extent of their new-found wealth a new family had come to power, the Habsburgs. The Habsburgs were extremely ambitious and used their money to finance a large number of wars in order to consolidate and expand their power. They fought for control of Italy, they fought against France and later they fought against protestants in the form of the Dutch, the English and later still many Germans. They didn’t just fight. They donated huge amounts to the catholic church, building the Vatican in its current form. They even built a brand new city from the ground up, which would become their capital, Madrid.

One of the problems they faced was that while the government had a lot of money to spend, by spending it they increase the supply of money in their own lands and inevitably throughout Europe. The rate at which the money supply grew was like nothing Europe had ever seen. Not only that but it grew far faster than the Spanish economy, causing a huge amount of inflation. This impoverished the lower and middle classes and the domestic economy stagnated.

The well dries up

By 1557 Spain’s finances were extremely overstretched and the Spanish were forced to declare a state bankruptcy. This caused chaos in the European financial system of the day. It bankrupted a large part of the Fugger family which had been the Habsburgs main financiers. At the same time the Spanish crown began to borrow large amounts of money, largely from the Genoese (ironically Columbus was born in Genoa).

Continued borrowing and debt led to more bankruptcies in 1576 and in 1596. They lost the great bulk of their European possessions outside of Spain itself and the financial mismanagement in the 16^th century set the stage for the perennial decline of the Spanish Empire over the next two hundred years.

I am not saying that the west is going to go bankrupt. The two situations are not very comparable. It was fiscal mismanagement, a high growth in the money supply and overspending on foreign wars that caused the Spanish Empire to decline. It’s worth not forgetting just how bad, bad economic policies can be.

Iceland has been the world’s whipping boy for the last few years.  The collapse of its banking system uncovered huge international systemic failures leading to the economic crisis.  The snowy nation has had a rough time of it.  But as we begin 2011, I ask the question, are they really still in that much trouble?  Figures released by the International Monetary Fund in December 2010 showed that Iceland’s GDP grew by 1.2% in the third quarter, ending the recession caused by the actions of those in its banking sector.  What about those European countries still in economic strife?

In direct contrast to the actions taken by almost all other western countries and most significantly Ireland, Iceland let its banks fail.  It was able to do so because the international risk of contagion is comparably lower than many of the European countries currently receiving bail-outs.  This forced foreign creditors and the banks themselves to foot the bill of failure, rather than the taxpayer.  Essentially, Iceland stuck to free market principles.  Those institutions that operated in an economically viable manner were able to survive; those that chose to take on too many liabilities in foreign currency must face the consequences.  In a system such as banking where when times are good, the mechanisms of capitalism and free market economics define the actions of agents in market, why should those mechanisms not also define what happens when it goes wrong?  In addition to the economic reasoning, there is also the moral issue of the taxpayer having to pay for the mistakes of a small elite.  The actions of many other governments in bailing out the banks served as an attempt to prop up an already unsustainable bubble.  These actions have exacerbated existing public finance problems further, the implications of which are to be felt by those who have not caused the problem.

During the recession Iceland’s economy shrank 11 – 15% depending on your source, but it did so with inflation peaking at 18%, which devalued its debt.  The soaring inflation was furthermore caused by the Icelandic central bank’s decision to halve the value of its currency, the Kroner.  The difference in terms of inflation between Iceland and those euro-zone countries thought to be in the worst economics position, the PIGS (Portugal, Ireland, Greece and Spain), is quite stark.  Iceland’s inflation soared whilst Ireland, for example, is still going through through a sustained period of deflation

Iceland’s inflation is now down to a respectable 3%, hence interest rates are now at 4.5% from an 18% peak.  These inflation rates are, however, higher than the PIGS.  Iceland’s debt situation is also looking up.  Forecasts for 2011 predict a deficit of 6.3% which will soon turn to surplus approaching the mid-point of the decade.  The IMF said Iceland has turned a corner and that its economic performance “compares favourably against other countries hard hit by the crisis”.

Iceland’s current account balance suffered greatly at the beginning of the crisis with the nation running a 26% of GDP trade deficit with the rest of the world, which is much greater than any of the PIGS.  However, due to the high inflation rates and devaluation of its currency, the trade deficit in 2010 fell to just 0.9% of GDP, with a surplus forecasted in 2011.  Comparably, the PIGS are still running significant deficits approaching and exceeding 10% of GDP.  The long-term effects of these deficits are yet to be seen.  One thing is clear, the PIGS do not have the monetary sovereignty of Iceland and hence cannot devalue their debt, they must in effect, toe the economic line of the European Monetary Union and European Central Bank.

Many have portrayed the path chosen by Iceland and subsequent recovery as a model for other beleaguered economies, such as the PIGS group in the EU.  However, such comparisons must be contextualised.  Iceland’s economy is comparably tiny and would have little chance of bringing the entire world economy down if it walked away from its liabilities compared to the aforementioned PIGS.  Defaulting in one of those economies would risk contagion throughout the euro zone and possibly beyond.

Iceland’s monetary independence from the European Monetary Union has been sighted by many as a possible reason for its recent good performance.  Having experienced the worst financial crisis in memory, the country has emerged ahead of many of its contemporaries having endured less punishment than many EU member states.  Greece and Ireland have already been forced to accept bail-outs, and it appears Portugal will soon follow with an €80bn rescue package mooted.

But how sustainable is this recovery?  Iceland’s public debt has reached in excess of 115% of GDP, over four times what it was in 2007.  Furthermore, Government bonds issued in foreign currency are becoming more and more expensive to repay due to the devaluation of the kroner.  Domestic austerity was aided by this devaluation and the subsequent increase in inflation; however, many commentators have indicated this had little to do with the recent return to positive growth.  The turnaround is attributed to the return to current account surplus from deficit.  Moreover, the aforementioned debt burden is not only applicable to government finance; house prices have plummeted in the crisis leaving many homeowners in negative equity.  By no means is Iceland out of the woods, its current account turnaround from deficit to surplus has been accredited to falling imports rather than a surge in exports.  More tough times are ahead.

The implications of bail-outs on the PIGS are also uncertain.  What is obvious is the political motivation behind their economic choices; the European Union needs the single currency.  It is those with vested interests in the Union that have the most to lose; there is an unnerving air of inevitability in what is happening.  Interest rates are remaining low, aimed at a sluggish Germany, whilst those euro-zone countries experiencing increasing inflation desperately need interest rates to rise.  Where the European project falls down is, in throwing hugely different nation economies under a single monetary policy, it lacked the complete supranational economic governance and social mobility required.

On balance, Iceland has taken a radical path of devaluation which saw violent shifts in economic measures, which all looked terrible whilst it was happening.  It may however appear preferable to the long-term damage that may be seen in those countries which have chosen austerity, debt deflation and bail-outs, but like driving a car using only the rear-view mirror, we will not know until it has happened.

About the author: Harry is a first year undergraduate studying Politics and Economics (BA) at the University of Leicester.