ICELAND pursued better policies than Ireland or Latvia when the three countries' economies collapsed in 2007 because the Reykjavik government allowed banks to fail, according to a new report by the influential Bruegel think tank.
The report by economist Zsolt Darvas looked at the response of the three small and open economies. The three countries all initially allowed the credit boom to fuel property speculation and investment imbalances. As the crisis began, property prices fell, banks went bust and all three countries had to turn to the International Monetary Fund (IMF) for help.
The governments then introduced fiscal austerity programmes, structural reforms and reforms of the banking system. These similarities allow economists to compare the different responses in an attempt to determine what worked best.
"The experience with the collapse of the gigantic Icelandic banking system suggests that letting banks fail when they had a faulty business model can be the right choice," the report notes.
"The banking sector suffered meltdown in Iceland and foreign lenders to banks suffered massive losses. Yet, the crisis impact was much more benign in Iceland than Latvia."
Mr Darvas notes that it was the last Fianna Fail-led government's decision to issue a bank guarantee to Irish-based banks [that led to the crisis deepening] but adds that Ireland then came under pressure from the European Central Bank to keep the guarantee in place.
"While socialising bank losses in Ireland was initially an Irish decision, later, when the Irish government wanted to change course, European institutions barred it primarily in the name of financial stability in the euro area and beyond," he writes.
The report is sceptical that a collapse in the Irish banking sector would have harmed the rest of the eurozone.
"Little is known about what would have happened to financial stability outside Ireland in the event of letting Irish banks default, but one thing is clear: other countries have benefited from the Irish socialisation of a large share of bank losses, which has significantly contributed to the explosion of Irish public debt," it adds.
The only way to avoid potential cross-country spillovers of national bank collapses would be to centralise the regulation and supervision of European banking along with the system for bailing out insolvent lenders, the report concludes.
"There is a strong case for a banking federation," states the report.
Iceland has suffered least among the three countries. Latvia has suffered most since the economic crisis began -- seeing a bigger collapse in output than any other country in the world, the report notes.
Ireland has endured the fifth worst economic contraction, while Iceland's was the seventh worst. Latvia has also suffered the worst declines in employment. Iceland came out from the crisis with the smallest drop in employment (-5pc).
The good news for all three countries is that recovery has begun in each economy. Latvia is seeing the fastest improvements, although this has not yet generated many jobs. Both Latvia and Iceland have returned to the bond markets.