It was not the drama and mismanagement of the last three months that brought down Iceland's banks. Instead it was absolutely obvious, as soon as we began, during January 2008, to study Iceland's problems, that its banking model was not viable. The fundamental reason was that Iceland was the most extreme example in the world of a very small country, with its own currency, and with an internationally active and internationally exposed financial sector that is very large relative to its GDP and relative to its fiscal capacity.

Even if the banks are fundamentally solvent (in the sense that its assets, if held to maturity, would be sufficient to cover its obligations), such a small country – small currency configuration makes it highly unlikely that the central bank can act as an effective foreign currency lender of last resort/market maker of last resort. Without a credit foreign currency lender of last resort and market maker of last resort, there is always an equilibrium in which a run brings down a solvent system through a funding liquidity and market liquidity crisis. The only way for a small country like Iceland to have a large internationally active banking sector that is immune to the risk of insolvency triggered by illiquidity caused by either traditional or modern bank runs, is for Iceland to join the EU and become a full member of the euro area. If Iceland had a global reserve currency as its national currency, and with the full liquidity facilities of the Eurosystem at its disposal, no Icelandic bank could be brought down by illiquidity alone. If Iceland was unwilling to take that step, it should not have grown a massive on-shore internationally exposed banking sector.

This was clear in July 2008, as it was in April 2008 and in January 2008 when we first considered these issues. We are pretty sure this ought to have been clear in 2006, 2004 or 2000.