Will Iceland beat the hedge funds?

It looks a fight to the death between the puffin-eaters and the fat-cats. The Icelandic Prime Minister Geir Harrde had declared war on the international financial speculators. He claims that “false rumours” are behind a recent run on the Krona which has lost a third of its value. The international investors say that Iceland simply lived too fast and furious in the boom years and is now coming face to face with the reality.

This tiny energy-rich country, with its ambitious banks and industrious population, has certainly been targeted by the hedge funds and short-sellers who nearly brought down Halifax Bank of Scotland three weeks ago. So far, the hedgies are winning. Interest rates have been hiked to 15% to hold down inflation which has been running at nearly 7%.

Does this mean a reality check too for Scotland? Iceland has figured prominently in SNP mythology as a part of the Nordic “arc of prosperity” which Alex Salmond Salmond wants Scotland to join. With one of the world’s highest GDPs per head based on one of the smallest populations, Iceland has shown that small countries can do well in the new globalised order. Its economy, like Scotland’s, is strong on fish, energy, tourism and financial acumen. But Iceland is beginning to look like a victim of too much independence as well as economic hubris.

Simply, the country is just too small, with a GDP of only £8.5bn. Most self-respecting hedge funds could eat it for breakfast, and that is pretty much what they have decided to so. It is not hard for a group of financial institutions, working as a pack, to start selling shares in Icelandic banks, in order to create a crisis from which they can benefit by selling their short positions. (Short positions are essentially bets that a company or a currency is going to collapse in value). In the past, the international financial ‘community’ might not have bothered about a country which is a pimple on a map of the Arctic Circle. But nowadays, with the credit crisis, every billion counts.

So, could Iceland’s fate await an independent Scotland? Well, on the face of it, there are good reasons for thinking that we may be equally vulnerable. We have a similar abundance of renewable energy, as well as a lot of residual hydrocarbons, which means a Scottish currency might behave like an unstable petro-currency. Scotland has a very ambitious banking sector, based on the Royal Bank, HBoS and numerous financial institutions in Edinburgh. They are very big players, but vulnerable to credit crunches.

If Scotland , already one of the top ten countries of the world in terms of GDP, were to become independent there is every reason to believe that our economy would be liable to a similar boom and bust cycle. However - and this is the nub - there would have to be a boom first. There would probably be an upsurge in economic growth after independence, based on full employment, high wages, immigration and foreign investment, as Scotland made up for three hundred years as a dependent economic backwater.

Now, you may say, well - that’s one problem we wouldn’t mind having, and in many ways this is the right way to look at it. Abundance is no bad thing; and economic growth, especially when based on renewable energy, is a good thing. Scotland’s problem, if Iceland is any guide, would be one of managing economic success - intense growth and accumulated wealth.

But the downside is that we would also be vulnerable, like Iceland, to international economic shocks. In particular, to the predations of financial speculators who like a plague of locusts, have a habit of descending on countries and reducing them to economic dust-bowls. They did it to the Asian ‘tiger’ a decade ago, to Iceland today and will probably hit the debt-ridden Baltic states tomorrow. The advantage of globalisation is that small countries can become big players fast; the disadvantage is that global capital movements are so massive, involving trillions of dollars a day, that small economies can be swept away.

Now, the one difference between Iceland and what the SNP envisage is that Scotland under the SNP would be a part of the european single currency, whereas Iceland like Norway, sought to remain aloof from the euro. That looked like a good idea in the good times, but is not looking so attractive now. The Icelandic banks cannot draw on liquidity injections from the European Central Bank. Iceland has had to defend its currency by raising interest rates to more than three times the EU rate. One suspects that, whatever its attitude in the past, Iceland will be applying soon for membership of Europe.

But Scotland might not join the euro either, at least not immediately. Indeed, at the moment SNP policy is to stick with sterling for the time being. This could lead to Scotland being stuck in a limbo with much of its economy determined by decisions made by the Bank of England and the UK Treasury. The reason for sticking with the pound is that the alternative - customs posts at the border and currency exchanges - would be politically unattractive to Scots.

So, where lies the balance of advantage? My best guess is that Scotland, as a mature economy, would not be as vulnerable as Iceland to financial storms. But there is no doubt that an independent Scotland would be exposed - especially if England were feeling ill-disposed to its former Union partner. On the other hand, remaining tied to England, with its over-dependence on the City of London, its fatal attraction to American wars and its inability to come to terms with Europe, might not be a bed of roses either.

Independence would almost certainly liberate economic dynamism, but that comes at a cost. Iceland has brought much of its problems on its own head by allowing a runaway economic boom, based on huge foreign debts, which has now burst. Iceland’s banks have been investing abroad on a massive scale, as is evident by the presence on Britain’s high streets of investment houses like Baugur which owns House of Fraser and is bidding for Moss Bross.They tried to play the international financiers at their own game, and came off worst.

As so often in economics, you pays your money. Perhaps the greatest lesson from Iceland is not to become too dependent on banks, and not to get carried away by credit booms that can turn to bust in the blink of Bjork’s eye. But the bottom line is that there's no way Iceland would go back to being part of Denmark.