The Icelandic people have spoken and the message could not be clearer. Despite the threat of their country becoming a pariah in international credit markets, the weekend's referendum result shows that Iceland's population is simply not prepared to repay the £3.4bn owed to British and Dutch taxpayers on the terms agreed by their own government last year.
The history is well established. When Iceland's banks collapsed in the credit meltdown of 2008, the Icelandic authorities lacked sufficient funds to compensate the UK and Dutch citizens who had invested their savings in the online lender Icesave. British and Dutch taxpayers therefore stepped in with £3.4bn to compensate these savers. Icelanders unquestionably owe Britain and the Netherlands a debt for that intervention.
Yet the objection of most Icelanders is not to repayment, but the terms. What they resent is the agreement by their government last year to pay 5.5 per cent annual interest on that £3.4bn. Their resentment is justified. It is important to remember that £3.4bn represents 50 per cent of Iceland's GDP. Iceland, with its 320,000 population, is simply too small to bear such costs without severe economic pain for years to come.
There is no issue of moral hazard here. The Icelandic economy contracted by 6.5 per cent in 2009 and will shrink further this year. Unemployment has hit 9 per cent. The value of the krona has fallen by 50 per cent against the euro, sending the cost of imports soaring. Icelanders have learnt their lesson of what happens when banks are allowed to rampage.
Of course, sympathy should not be overdone. Icelanders did very well in the years of the banking boom, when living standards soared. And there was a gross political failure of regulation, too. The former Icelandic government gave free rein to its banks to snap up vast assets abroad financed by irresponsible levels of borrowing. It is galling to see Iceland's right-wing opposition – which was responsible for presiding over that boom and bust when in office – now leading a populist revolt against the terms of repayment.
But some empathy is in order. Iceland's bankers, not its population, were to blame for the financial meltdown. How would we react if some of Britain's large international banks collapsed, leaving ordinary savers in, for example, the Far East out of pocket, and taxpayers here forced to pay back the money at a punitive rate of interest?
The £3.4bn does need to be repaid. But we should be flexible and moderate in the terms and timing. One option that should be explored is writing off the debt in return for claims on the assets of the stricken Icelandic banks.
But despite the result of the weekend's referendum, the mood among Iceland's creditors still seems to be punitive. The Dutch government has suggested that Iceland's bid to enter the European Union could be jeopardised by its resistance. Our own government is playing hard ball too, blocking Iceland's International Monetary Fund loans until a deal is reached.
Such crass bullying should end. Policymakers need to arrive at a fair settlement that takes into consideration Iceland's already painful economic circumstances and its practical ability to repay. They also urgently need to turn their attention to the underlying causes of this debacle: an insufficiently regulated and inadequately insured cross-border banking system.