In 2008, Iceland briefly became a haven for investors by offering hefty interest rates. Unfortunately for investors. the Icelandic banks could not sustain this generous rate of interest and collapsed. Foreign investors. particularly British and Dutch. who had put their money into the Icesave banks in their own countries (oblivious to the fact that they were dealing with an Icelandic bank and not a bank regulated by their own country) were left in the lurch. The British and Dutch governments compensated their own nationals. They. however. expected Iceland's government to pay them back for the $4 billion that they were out-of-pocket.
Iceland's governments were prepared to do so. but they held referendums in which the payback terms were soundly rejected. After the "no" vote reached over 90% in the first referendum, an attempt was made to better the terms for Iceland, but the 2nd referendum failed this week, albeit by a smaller but still substantial margin. The sentiment of Iceland's citizens was that if the banks were stupid enough to fail and investors were stupid enough to place their confidence in them, then there was no reason for Iceland's citizens to bail them out.
This line of thinking runs counter to the approach that governments have a duty to insure bank deposits. This principle has been a staple since the government of Franklin Delano Roosevelt established the FDIC to convince investors that it was more profitable and safe to put money in the bank than under the floorboards of their home.
That counter policy is not going to encourage foreign investment in Iceland. It will also extinguish Iceland's hope for admission into the European Union, as both Britain and the Netherlands will exact retribution by vetoing Iceland's acceptance. Britain and the Netherlands have also threatened to sue Iceland. The Icelandic government has attempted to mollify them by pledging that they will have first call on the sale of assets from the defunct banks.
The stance taken by Iceland's citizens has aroused interest in Ireland. The previous Irish government went for a bailout deal with onerous repayment terms. One part of the problem is the need to refinance the Irish banks that were laid low by the collapse of the construction bubble. As in the Icelandic case, many depositors in the Irish banks were foreign nationals. The Irish could threaten the European Union by calling for an Irish referendum in the hope that it will force the European Union to improve Ireland's repayment terms. The alternative would be to let the Irish banks fail and have the European depositors accept the consequences.
This creates a nightmare for the European Union. If the more solvent members of the European Union are expected to put up money to bail out their more troubled partners, the least that they can expect is that they will be repaid eventually. If repayment becomes an uncertainty, then the current grumblings will become a tsunami shaking the foundations of European finance.