"Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts."

Here's the Danielsson piece on Vox:

"Iceland’s banking system is ruined. GDP is down 65% in euro terms. Many companies face bankruptcy; others think of moving abroad. A third of the population is considering emigration. The British and Dutch governments demand compensation, amounting to over 100% of Icelandic GDP, for their citizens who held high-interest deposits in local branches of Icelandic banks. Europe’s leaders urgently need to take step to prevent similar things from happening to small nations with big banking sectors.

Iceland experienced the deepest and most rapid financial crisis recorded in peacetime when its three major banks all collapsed in the same week in October 2008. It is the first developed country to request assistance from the IMF in 30 years.

Following the use of anti-terror laws by the UK authorities against the Icelandic bank Landsbanki and the Icelandic authorities on 7 October, the Icelandic payment system effectively came to a standstill, with extreme difficulties in transferring money between Iceland and abroad. For an economy as dependent on imports and exports as Iceland this has been catastrophic.

While it is now possible to transfer money with some difficulty, the Icelandic currency market is now operating under capital controls while the government seeks funding to re-float the Icelandic krona under the supervision of the IMF. There are still multiple simultaneous exchange rates for the krona.

Negotiations with the IMF have finished, but at the time of writing the IMF has delayed a formal decision. Icelandic authorities claim this is due to pressure from the UK and Netherlands to compensate the citizens who deposited money in British and Dutch branches of the Icelandic bank Icesave. The net losses on those accounts may exceed the Icelandic GDP, and the two governments are demanding that the Icelandic government pay a substantial portion of that. The likely outcome would be sovereign default."

At least he mentioned the U.K.'s use of those terrorism laws. Mighty classy.

"The original reasons for Iceland’s failure are series of policy mistakes dating back to the beginning of the decade.

The first main cause of the crisis was the use of inflation targeting. Throughout the period of inflation targeting, inflation was generally above its target rate. In response, the central bank keep rates high, exceeding 15% at times.

In a small economy like Iceland, high interest rates encourage domestic firms and households to borrow in foreign currency; it also attracts carry traders speculating against ‘uncovered interest parity’. The result was a large foreign-currency inflow. This lead to a sharp exchange rate appreciation that gave Icelanders an illusion of wealth and doubly rewarding the carry traders. The currency inflows also encouraged economic growth and inflation; outcomes that induced the Central Bank to raise interest rates further.

The end result was a bubble caused by the interaction of high domestic interest rates, currency appreciation, and capital inflows. While the stylized facts about currency inflows suggest that they should lead to lower domestic prices, in Iceland the impact was opposite."

So, high interest rates in Iceland led to:

1) Borrowing in other countries

2) Other countries buying higher interest investments in Iceland

"The reasons for the failure of inflation targeting are not completely clear, a key reason seems to be that foreign currency effectively became a part of the local money supply and the rapidly appreciating exchange-rate lead directly to the creation of new sectors of the economy."

I thought the reason was very clear: they kept the rates high. As to new businesses sprouting up, welcome to capitalism.

"The exchange rate became increasingly out of touch with economic fundamentals, with a rapid depreciation of the currency inevitable. This should have been clear to the Central Bank, which wasted several good opportunities to prevent exchange rate appreciations and build up reserves. "
This is simply poor investing. It was clear that they rates would change someday. In fact, this is the same exchange rate problem on the other side in Japan. Isn't this that Great Moderation or whatever it's called? Also, lack of capital again? Come on. That's banking 101.

"Consequently, the governance of the Central Bank of Iceland has always been perceived to be closely tied to the central government, raising doubts about its independence. Currently, the chairman of the board of governors is a former long-standing Prime Minister. Central bank governors should of course be absolutely impartial, and having a politician as a governor creates a perception of politicization of central bank decisions.'

That's smart.

"Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP, with debts to match. In normal economic circumstances this is not a cause for worry, so long as the banks are prudently run. Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts."

Now wait a second. What does build up reserves mean? Just the national bank I suppose, so that they can be a lender of last resort. In other words, the private banks swamp or dwarf the national bank. However, saying that Iceland's banks were better than many other banks in the world is slight praise now. It wasn't enough.

"In this crisis, the strength of a bank’s balance sheet is of little consequence. What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. Therefore, the size of the state relative to the size of the banks becomes the crucial factor. If the banks become too big to save, their failure becomes a self-fulfilling prophecy.

The relative size of the Icelandic banking system means that the government was in no position to guarantee the banks, unlike in other European countries. This effect was further escalated and the collapse brought forward by the failure of the Central Bank to extend its foreign currency reserves."

I said earlier this seems obvious, but I guess it isn't. How can you guarantee what's far bigger than you are. I guess you could believe it's fine in normal times when you're dealing with one or two banks at a time.

"If a reasonable settlement cannot be reached and with the legal questions still uncertain it would be better for all three parties to have this dispute settled by the courts rather than by force as now. "

Seems reasonable.

You might want to hire Buiter a little sooner next time, and make the report known sooner.

Yves Smith with some helpful comments on this:

"The article focuses on the role of high local interest rates in attracting hot money inflows, and the author is a bit perplexed as to why inflation targeting failed. Not that I am a fan of economic theory (not that theorizing is bad, theorizing is good, provided you use it to generate testable hypotheses. But most economists seem to just like the theorizing bit) but inflation targeting, while popular, is (from what I can tell) a made up approach. For instance, some economists have criticized it for failing to allow for the role of imports in raising or lowering the official inflation rate. Domestic interest rate policy will have no impact on import prices (save through changes in foreign exchange rates). Increasing interest rates in Iceland, for example, will not slow down inflation on good imported from the EU."

I think we can ponder how useful inflation targeting is from this case.