The president of Iceland's decision does not mean a rejection of his country's obligations. On the contrary, Icelanders have already agreed to compensate the UK and Netherlands. The decision by Olafur Ragnar Grímsson stems instead from the fact that over 70 per cent of Icelanders find the terms of the current deal unreasonable.
The core of the problem is the conditions attached by the national parliament last August, limiting repayments to 6 per cent of GDP and reserving the right to challenge the obligation in a court of law. These conditions were accepted by a significant majority of the Icelandic parliament, but rejected by the UK and Dutch governments.
As a result, a much watered-down bill was hotly disputed and only narrowly passed last week. This has now been rejected by the President.
Other factors have also influenced the negative attitude in Iceland. It is widely felt that the UK and the Netherlands have used their influence to hold up approval of IMF loans while Iceland's recent application to join the EU appears also to be conditional on settlement. However, since the majority of Icelandic voters have consistently opposed EU membership, and IMF loans may not really be needed, Icelanders have not responded well to this pressure.
The overall amount involved might not seem excessive – around £3.5bn – but only 300,000 people live in Iceland, so that equates to about £40,000 per family. The annual interest alone, if adjusted for population size, would be the equivalent of the UK paying over £40bn a year, almost half the cost of the NHS.
Iceland is already just about the most indebted country in the world as a consequence of the crisis. The economy is in dire straits, but stabilising. If the Icesave repayments become too burdensome it may trigger a sovereign default. This means that the UK taxpayer would be unlikely to get reimbursed.
Therefore, it is in the best interests of all three governments to come to a reasonable agreement, enabling Iceland to make good on its obligations, without tipping the economy into the abyss. Limiting repayments to 6 per cent of GDP would be a big step in that direction.
The writer is a reader in finance at the London School of Economics