ANALYSIS: Iceland's Economic Woes, Which Have Lingered For Five Years, Could Threaten A Euro Zone That Is Emerging From Recession

This week marked a transition many Europeans have been waiting for: The euro zone has come out of recession for the first time since November 2011, posting growth of 0.3 percent in the second quarter, slightly above analyst expectations.

The figure reflects both growth of 0.7 percent and 0.5 percent from Germany and France, respectively, as well as contraction in Italy of 0.2 percent, which was an improvement over the 0.6 percent contraction in the first quarter of this year. Worse off is Greece, which showed a loss of 4.6 percent in the second quarter of 2013 compared with the same quarter of last year, an improvement on the negative 5.6 percent during the first quarter compared with the same period in 2012.

But hanging over this generally upbeat development is a dark cloud, namely, Iceland. Back in 2008, the island nation was the marker for what turned out to be the beginning of one of the worst financial periods in Europe’s history. And now the past of the country of 300,000 people is starting to catch up with it.

In 2001 the Icelandic government decided to deregulate its banks, enabling them to run up large foreign debts amounting to about $50 billion, which ultimately led to the collapse of three privately owned commercial banks, Landsbankinn, Glitnir and Kaupthing in 2008. The banks had financed their expansion with loans on the interbank lending market, and when interbank credit facilities refused to lend to them, by deposits of overseas savers.

“If Iceland were a company, the financial crisis would have swallowed it whole alongside other former financial powerhouses (Lehman, Bear Stearns, and Washington Mutual, to name a few),” said Adam Sarhan of Sarhan Capital. “Since Iceland is a country, and not a company, it is by definition, larger than too big to fail. Which means the international community had no choice but to step up and rescue this tiny debt-laden nation.”

Unfortunately for the three banks, Iceland's central bank was unable to guarantee the debts because its assets were so much smaller than the three banks combined. Without a guarantor, the three banks eventually collapsed with combined debts of $85 billion. With the country’s finances in tatters, a bailout was organized with help from the IMF and neighboring Nordic nations extending the island nation a loan of $4.6 billion.

Since then, unfortunately, Iceland has done little to resolve the underlying causes of its financial collapse. It imposed capital controls that block citizens from investing money abroad and passed laws that held off the inevitable pains of paying back its debt, and rather inexplicably forced its citizens and massive pension fund to invest mainly in Iceland.

The nation’s banks haven’t been able to loan due to the current toxic loans left on their books. Household and corporate debt remains high at 109 percent and 170 percent, respectively, which is prompting the population to service its own debts. That's a positive move, but it has come at the expense of economic growth. Domestic consumption and investment in Iceland are both down 20 percent from their pre-crisis levels and continue to fall, and today output in Iceland remains 10 percent below the pre-crisis peak. And while GDP did grow at around 2.9 percent in 2011, it slowed to around 1.6 percent last year and is expected to fall even further this year.

“Europe's economic recovery remains very fragile and any unforeseen bumps in the road (a default from Iceland or any other nation) could easily jeopardize their anemic recovery,” said Sarhan. “The key from my point of view- is to determine how severe will that tremor will be: Either a light and quick one off or something with more severe that could adversely affect the broader recovery.”

“Unfortunately, the country, and its bankers, did not learn their lesson and sometimes people have to learn the lesson the hard way,” said Sarahan. “It appears that is what is happening here. Iceland might need to come close to failing or actually defaulting on their debt before a massive restructure occurs and they learn to respect risk.”