Maybe it was the toxic paradigm that home prices would never go down and persist upward eternally. Easy credit caused increased speculation and people began buying several houses or houses they could not afford. Mortgage companies had relaxed lending standards and were therefore unconcerned with the credit worthiness of the buyers because most sold their mortgages in the secondary market.

Maybe it was the rating companies Moody's, Standard and Poor's and Fitch. Their job was to properly rate securities relative to risk. They stamped the highest and most secure AAA rating on toxic mortgage backed securities assets on which mortgage insurance had been purchased from AAA rated Insurance Companies.  

It is clear multiple culprits were responsible. By the fall of 2008 it became evident there were formidable troubles as housing prices continued to fall and more and more people who now owed more against their homes than those homes were worth.  Defaults and foreclosures were rising well beyond what the models had predicted, and it was way beyond the worst case scenario. This economic freefall sent shockwaves across the globe. No country was immune to the destruction.  Banks started to have severe capital and liquidity problems as home prices fell and their mortgage backed securities dramatically sank in value. The banks were in jeopardy of running out of money.

Countries across the globe took different measures to address the credit crunch. Most resorted to bail outs and to this day many countries are still dealing with the repercussions. Between TARP (Troubled Asset Relief Program), bank bailouts, auto bailouts and 3 stimulus packages the total price tag for the United States reached $1.4 trillion (that we know about). Much of this money will never be recouped. Not to mention the $1.4 trillion investment yielded an agonizingly sluggish recovery with unemployment still years later of 14.9% (U6), trillions of dollars in debt, a credit rating downgrade of US Treasury Debt (first time in history) and a projected GDP for 2012 of an anemic 2%.

What should the United States government have done differently? We were told the bailouts were the only option to prevent a worldwide 1929 style depression. Iceland took a different approach. Just like the United States in the early to mid 2000s, Iceland benefited from nearly a decade of robust economic growth. The country's three largest banks Glitnir, Kaupthing and Landsbanki went broke within weeks of each other after the collapse of Lehman Brothers and Bear Stearns.

What set the Icelandic government apart from most governments in the world is they declared that the government would only rescue domestic bank account holders. They were not going to save the banks or any other industry. The free market would correct itself. And, instead of attempting to prop up its currency, Iceland let the value of the Krona devalue. It also enforced capital controls to thwart money from leaving the country.

Make no mistake this was an audacious effort for the Icelandic government. Iceland still took a beating. From the peak in the third quarter of 2007 to the low in the second quarter of 2010, the economy contracted by 14.3%. The decrease in the value of the Krona slingshoted inflation up to 19%. Slicing real wages through inflation meant that unemployment rate climaxed at 7.6% in 2010 lower than any of the peripheral European countries, and even the United States. The collapse of the banks demolished domestic stock markets. On August 17 2007 the stock market peaked at 8,238. By March 13 2009 just over 18 months later it grasped a low of 379.93 a plunge of more than 95%. Prime Minister Geir Haarde asked for God's support. Protesters packed the streets in retribution for not bailing out the banks. Years later Geir Haarde is currently facing charges and may possibly be jailed if found guilty of "gross negligence in failing to prepare for the impending disaster." He is rejecting the allegations. His fate will be determined later this year.

This economic freefall sounds excruciating and I am sure if you ask any local residents they would agree. But once Iceland hit bottom the markets began to change and rather quickly. GDP expand on average rate of 6.9% since the second quarter of 2010. Three years later, the unemployment rate has fallen considerably. Tourism has improved by leaps and bounds. The government lucratively raised money from investors in the summer of 2011 for the first time since the disaster.

Arguably just as important, the result of not bailing out the banks has destined the debt to GDP levels peaked at a high but acceptable level of 100% of GDP, and are projected to recede. By contrast, the United States and many other European counties are facing higher than 100% GDP ratios because of the colossal money spent on bailouts.  The Greek bailout deal is hoping to achieve a debt to GDP ratio of 120% by 2020 and that's the best case scenario. Right now the debt/GDP ratio of Greece is 166%.  

The lessons learned from Iceland are incredibly powerful and simple. In the heat of the moment I believe decision makers want to believe that fiscal measures will cure the problem because there is nothing else they can do. The consequences of such actions are evident. Bailouts do not work. They only prolong the original problems and never solve the core issue. Iceland's economic course was risky, yet I am sure in hindsight they were glad to let the banks fail. In future economic downturns governments should focus on saving depositors only not other bank creditors, insurance companies and whole industries. Iceland's experience suggests that devaluation and capital controls may be the least painful solution to an economic contraction. Compare Iceland's troubles to what happened to other countries and you will realize that things could have been much worse for Iceland particularly given the absolute scale of its banking bubble. Iceland represents a tiny fraction of the size and impact of the American Economy and the US Dollar in the world's reserve currency. But there are some parallels that are worth noting when the intellectual arguments of bail outs and the moral hazard associated with government sponsored bailouts are considered.