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01/13/2010

Lehman Brothers "happened" on Sept. 15, 2008, and less than four weeks after the American investment bank collapsed, Iceland's three largest banks had all been nationalized. Iceland itself teetered on the verge of bankruptcy. All of a sudden, Iceland was Europe's crash-test lab, for it seemed that what it was experiencing would sooner or later befall the rest of the world: a huge national debt, economic crisis, unemployment and inflation.

Some 550,000 e-mails flooded into Kramer's small online bank. Investors wanted their money back. They had bet on Iceland, and had lost their bet.

Kramer walks over to the conference room. On the table there are boxes containing all that is left of the Icelandic model. "Transfer cancellations" someone had written on the boxes in permanent marker. "Interest demands," "100 percent account liquidations," "lawyers." Each letter a loss of faith.

All that remains are complaints and threatened lawsuits, the entire legal caboodle.

Iceland's Economic Bubble

The question is what will replace it. What will become of a country that narrowly escaped death? Can it be brought back to life? And if so, what sort of a life will it be?

The headquarters of Kaupthing Bank still exists, although the institution itself is now called Arion Bank. Its new boss is Finnur Sveinbjörnsson, a small, polite man in his early fifties. From the desk in his corner office Sveinbjörnsson has a marvelous view over the bay of Reykjavik and the snow-capped mountains beyond. The green waves are crowned with froth.

Sveinbjörnsson was named as Kaupthing's new chairman just over a year ago. The appointment brought him his very first corner office. Sveinbjörnsson first worked at a savings bank then spent many years at the Icelandic central bank before heading the small stock exchange in Reykjavik. His career has been solid and pretty unglamorous for a banker.

By 2007 he was no longer in any doubt that Iceland's boom was a huge bubble, Sveinbjörnsson says. At the start of the new millennium, more and more banks in Iceland were being privatized. The bubble continued to grow for years. Because short-term interest rates were lower than long-term ones, people took short-term loans to invest money long-term. The banks were funding projects that were risky, but they were earning money from the interest.

The value of Iceland's banks rose. In 2007 Kaupthing became the first Icelandic firm in the top 800 on the Forbes list of the world's biggest companies. At one point, the balance sheet total of the three major banks was ten times the size of Iceland's gross domestic product.

With that sort of a ratio, it's unlikely anyone could have bailed the banks out when crisis struck. At first, Sveinbjörnsson recalls, he was hoping for a soft landing. But in the end all that mattered was to minimize the force of the impact.

Pruning Back to Allow New Growth

Since then, all Kaupthing's riskier assets have been transferred into a kind of "bad bank" that is being put through insolvency. Sveinbjörnsson's job is to turn Kaupthing Bank from a risk-loving behemoth into a small, low-risk savings bank. Iceland's strategy is the strategy of landscape gardeners: prune back to allow new growth.

Unfortunately nearly all the Kaupthing workforce has had to be laid off, Sveinbjörnsson says, looking out over the bay. Some of his former bankers have gone back to university, others have turned to writing poetry.

Sveinbjörnsson himself has a one-year contract. At the end of this time his post will be re-advertised. He says the aim is to dispel all suspicions of cronyism by sending out a clear signal that the old boys' network no longer holds the reins of power in Iceland.

About 10 to 15 percent of Kaupthing's customers are classified as "problem cases," that is, customers who temporarily can't meet their long-term obligations. Sveinbjörnsson says he has to "develop solutions" for them. In other words, reschedule payments, extend deadlines and write off bad debt. Bankers have become rescuers -- saviors of the nation's souls. Icelandic banking is now about security rather than returns.

An Icelandic writer found a pithy image for the country's current situation, one that comes from the world of mining: In the past, mineworkers often took a canary down into the mineshaft with them. Canaries are extremely sensitive to changes in oxygen levels, and miners knew that it was safe to work as long as their canary carried on singing. The writer suggested that Iceland is the canary of international financial capitalism. When it fell off its perch, the other countries recognized that danger was close at hand. Today the bird is coughing, it looks rather disheveled, but it has survived its fall, and that's all that matters.

'The Boulevard of Broken Dreams'

Sveinbjörnsson says one major question still hasn't been answered yet: Were the bankers merely unlucky in the autumn of 2008 or were they simply too stupid to see the dangers that lay ahead?

The final report on an investigation into the matter is due to be published in early February. The answer this report gives to the question will decide if the people of Iceland ever regain confidence in their banks, their government and indeed the entire system.

Kaupthing's headquarters, a light cube of glass and granite, stands directly opposite a tower block built by Björgolfur Thor Björgolfsson, Iceland's richest man. The skyscraper is now a white elephant, and no-one knows what will become of it.

Just a few yards further on there is the historic guesthouse in which Ronald Reagan and Mikhail Gorbachev met in 1986 to discuss ending the Cold War. Icelanders say that whereas communism's fate was sealed in the guesthouse, Björgolfsson's building, diagonally opposite, sealed capitalism's fate. They call the street between the two houses the "Boulevard of Broken Dreams."

Also nearby are the offices of a man who must now pick up the pieces and sweep up all the debris left behind by Professor Gissurarson's friends. Gylfi Magnusson is the new government's economics minister. Because he used to criticize the old system, he believes he now has a duty to help develop another.

It's hard to see the crisis from his office window high up on the fourth floor. There are still a surprisingly large number of SUVs on Reykjavik's roads -- Range Rovers, Audis and BMWs. These powerful vehicles were much sought-after before the crisis. But nobody wants them anymore, not even used.

Magnusson wears a black suit and a red tie. He speaks quietly, a little like a mortician who is afraid to disturb the mourners. Magnusson says it's fair to describe Iceland's case as an invisible disaster.

When he moved into his new office, he put a few books on his shelf: "Why Iceland?", written by Kaupthing Bank's chief economist, "Fixing Global Finance," and "Surviving Large Losses." Guidebooks. Books that provide few answers but ask many questions.

Just how close did Iceland come to bankruptcy in the autumn of 2008?

Magnusson gives a thin smile.

"If the government hadn't saved the banking system, Iceland would have been all but insolvent. It was touch and go."

'The Costs Are Huge but Nowhere Near Crippling'

Why can't you see the effects of the disaster? Why does life go on as if nothing had ever happened?

Many companies are as good as bankrupt, Magnusson says. They took out loans that they couldn't service, and they invested their money in bonds and shares that lost nearly all their value in the financial crisis.

What's more, imports have fallen dramatically since the crisis hit. There are hardly any buyers for furniture and luxury goods in Iceland. Car imports, for instance, have plummeted by almost 90 percent.

Complete collapse was only prevented because the International Monetary Fund promised Iceland $2.1 billion. The welfare system remained largely intact, the new banking system is practically the same as the old one, though without the imagination, the overconfidence and the virtual madness.

Magnusson says that by 2014 Iceland will be back where it was before the crisis. Unless there are some nasty surprises. "We'll lose five, maybe six years. Iceland has lost its innocence. The costs are huge, but they are nowhere near crippling."

Magnusson is an economics professor by trade. The job of minister gives him a unique opportunity to put his models to the test in a real-life situation.

He says his belief in the capacity of market self-regulation has dramatically eroded. Market prices aren't fair and "mistakes that are made will be made."

A Hiccup of History

On the other hand, there were positive aspects about the crisis. Magnusson, himself a father of five, recently read a survey which found that Icelanders are rediscovering traditions and values that were forgotten during the boom years. They have started wearing traditional Icelandic clothes again, vacationing in Iceland and cooking local dishes. Parents have more time for their children, time for family walks and to read to them.

The new Iceland is like pre-boom Iceland because the one that existed in-between wasn't real. It was a mistake, an error, perhaps; a hiccup of history.

The new era is allowing new people rise to prominence and making room for new ideas. One of the players in this new era is Gudjon Mar Gudjonsson.

Gudjonsson's headquarters are located in a former furniture store on the Reykjavik harbor. The furniture business folded right at the beginning of the crisis. Now his former store is home to the House of Ideas.

Gudjonsson always carries a book around with him. Although the cover is marked "The Idea Book," most of the pages are blank. Now and again he flips it open and hastily scribbles down an idea. Gudjonsson wears a gray shirt and jeans. His eyes are set deep in their sockets. He is a nerd who had the good fortune to make a lot of money early on with a software company. That gives him the freedom to have visions, and credibility among those he wants to sell his blueprint for a new Iceland.

'We Are About the Future'

In mid-November Gudjonsson invited about 1,500 Icelanders to a kind of national assembly in Reykjavik. He wanted them to debate the country's future, to discuss values and what makes Iceland special. The idea, Gudjonsson says, was to capitalize on the "wisdom of the crowd," as he calls it.

"The recovery (of the government) is about the past," he says. "We are about the future."

Gudjonsson thinks countries ought be run more like companies. He says Wikipedia -- not the Encyclopedia Britannica, Linux and not Windows -- is the business model for the 21st century. He wants a society that communicates via Facebook and Twitter, has ideas and can put good ideas into practice. He models himself not on Margaret Thatcher, but on Barack Obama.

It's now dark outside. Gudjonsson's wife has come to the House of Ideas with their two children, and they are waiting in the cold outside the door. Although she knocked, Gudjonsson didn't hear her. He's busy enthusing about "wikinomics" and the "renaissance plan" that is to be put into practice in April next year to "reboot" Iceland.

Eventually his wife rings him on his mobile phone, but he leaves her out in the cold a little longer because he simply must finish what he's saying.

How The Crisis Has Hit Everyday People

Society would have been forced to change anyway, he says. The crisis just made the change more urgent. Gudjonsson imagines the "wisdom of the crowds" as being like a colony of ants. Individual ants can't see danger coming, but each helps to move the nest to a safer place because they all sense danger is in the air.

The crisis is just about money, not war, Gudjonsson says, although he adds that it's not quite true that the crisis is equally invisible to all or that the losses are purely virtual. The losses are pretty real for 38-year-old Gunnar Hansson and thousands of others like him.

Hansson is an actor, and he's currently shooting the second season of a comedy series that's extremely successful in Iceland. He suggested we meet at the National Museum in Reykjavik. He arrives on a bright-yellow Vespa through the drizzle that has draped itself over Iceland like a gray flannel.

Hansson loves Vespas. During a 2007 vacation in Italy, he even visited the headquarters of the company that makes them in Pontedera. When he inquired about a scooter, the dealer thought Hansson wanted to import Vespas to Iceland. As a man who believes opportunities should never be passed up, Hansson left the store as an authorized Vespa retailer.

It was a business idea based on a fortunate misunderstanding. Nevertheless, the Icelandic banks he asked for advice were thrilled by it. But then, as early as December 2007, they suddenly became more hesitant. They promised him a loan, but demanded Hansson's apartment as collateral.

At first everything went smoothly. Hansson put his scooter between the sofas in the furniture store that is now the House of Ideas, and by September 2008 he had already sold 80 of them. Hansson conducted real business on the back of the virtual wealth of others. In fact he made good money from it.

But as the Icelandic krona gradually lost value, Hansson was forced to increase his prices with every delivery he received. When the furniture store ran into financial trouble in early October 2008, he moved to a car showroom.

'Everything Froze Up'

At the end of 2008, the car dealership also went bankrupt. Suddenly, Hansson recalls, "everything froze up." Last May he received his last shipment of Vespas. A little later he sold the business without making any profit, though more importantly not at any great loss.

Unfortunately he had less luck with the apartment he had bought in February 2007 and had offered he bank as the security on his loan. The loan on the apartment was initially in Icelandic krona. However because the loan was coupled to the rate of inflation, Hansson's debts grew even though he was keeping up with his repayments.

The bank therefore recommended he convert the loan into a foreign-currency loan. "All you read in the newspapers and saw on the television back then was 'foreign-currency loans!'" Hansson says. "Banks called their customers: Foreign-currency loans!"

Hansson decided on the Japanese yen and Swiss francs; the world's safest currencies -- at least according to his advisor at the bank. When the Icelandic krona went into freefall, Hansson's debts doubled. Today he owes some 46 million Icelandic krona.

How much is that in euros?

Hansson grabs his mobile phone and pulls up the calculator function. "No idea," he mumbles. "I haven't had the courage to work it out yet." He hits a few keys, stares at the display and then, clearly impressed, says, "Two hundred and fifty thousand euros!"

Discipline, Modesty and Optimism

In this respect, Hansson of all people is one of the Icelanders for whom the virtual crisis became very real in the end. He wasn't involved in the virtual boom, partly for lack of money, partly a lack of opportunity, but he -- and maybe also his children -- will have to carry the burden.

After a moment's reflection, Hansson says he still hopes the krona will eventually rise in value again, that the debts which ballooned during the financial crisis will shrink again one day.

Perhaps this is the new model Iceland; "Iceland rebooted," so to speak. A country characterized by discipline, modesty and optimism, a country with an eye for what is possible, an example of how to draw genuine consequences from a virtual crisis.

Hansson's loan has a 35-year lifespan. At the very latest, he'll be rid of his debts by the time he's 73. "In this way, we are reminded every day how bad the crash was," he says. "It touches so many things and has changed so many others, maybe forever."

Then he goes outside. "I used to be proud to be Icelandic when I was abroad. Today I'm embarrassed by it."

He climbs on his bright yellow Vespa, the only one he has left, tightens the strap of his helmet below his chin, and drives off. Soon he is gone, swallowed by the drizzle.

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• Part 1: What Comes Next for the Crisis-Stricken Country?
• Part 2: Europe's Crash Test Lab