Ian Birrell: It is counter-productive to humiliate another nation

Sitting amid the trawlers in Reykjavik harbour is a solitary gunboat, a reminder of what happened when Britain and Iceland last went to war. The little grey vessel saw off the British Navy 37 years ago in the Cod Wars, and it serves now to underline the bravery and bloody-mindedness of an isolated island nation.

Once again, the two countries are at loggerheads as they clear up the mess of the credit crisis. Both recklessly rode the boom and are now suffering the hangover, with huge debts threatening prosperity for a generation. And since Iceland owes us £3.6bn after Alistair Darling bailed out British customers of one of its banks, it seems a simple equation that Icelanders should pay us back.

A deal was struck that involved reimbursement at a hefty 5.5 per cent interest rate over 14 years. But now, following the first grassroots revolt against a bailout since the credit crunch swept the globe 16 months ago, the Icelandic president has bowed to people power and refused to sign the repayment schedule into law. Instead, it will be put to referendum.

Iceland is not saying it won't pay, just querying the terms. Predictably, British ministers fired off fusillades across the Atlantic, telling Iceland to forget about joining the EU. Equally predictably, their opposite numbers in Reykjavik are returning fire. Now Britain should back down, stop the bullying and seek a compromise.

Consider the facts. A group of greedy oligarchs in Iceland, egged on by inept politicians, borrowed huge amounts in a bid to turn a tiny fishing nation into a global financial powerhouse. It didn't take a genius to see they were building empires on foundations of sand as they gobbled up third-rate retailers and offered savers market-beating rates of interest.

When Landsbanki collapsed, British ministers panicked, using anti-terror legislation to freeze assets belonging to a Nato ally. Understandably, this was viewed as betrayal in Iceland, causing bitterness that still fuels the anger behind protests.

The Icelandic bankers were incompetent, taking huge risks to build market share. But so were their domestic regulators, the British regulators, their political masters and, dare I say, those depositers who failed to question why a bank was offering such good deals. Britain and Holland did not have to bail out investors with Icesave, who were putting cash into a foreign-based institution. The suspicion remains that they acted hastily to cover up their own regulatory failings, a draconian move blamed for precipitating the downfall of Kaupthing, Iceland's biggest bank.

Despite the ill-feeling, Alistair Darling has played hardball. But the terms are extreme. The Icelandic people know their nation has behaved foolishly, and they know they must pay the consequences. The economy shrank more than seven per cent last year, unemployment has soared and national bankruptcy remains a possibility. The country's debt was downgraded this week to junk levels.

Now the mood is turning ugly. "I fear for our future. I have never seen such heated debate and felt such an unpleasant mood," said one prominent local yesterday. "We are not being allowed time to rebuild."

At the heart of things remains the divisive figure of David Oddsson, who viewed himself as Iceland's answer to Margaret Thatcher when his government privatised the banks, unleashing the disastrous boom. After a spell as governor of the central bank, he became editor of the main newspaper, from where he has fermented resistence against the Icesave deal, embarrassing his social democrat and green successors.

History shows it is counter-productive to humiliate nations with savage reparation demands. The sum we are seeking is small to us, but crippling for a nation with a population the size of Coventry. It amounts to £11,700 per person, taking national debt to 200 per cent of GDP. Imagine how would we feel if we had to pay £718bn – the equivalent sum based on our population – to another country to cover the misdemeanours of Sir Fred Goodwin?

Instead of firing off new threats, ministers should reflect on their own role in the affair. Then they should sit down with their Icelandic and Dutch counterparts and work out a longer-term and less punitive deal.