A FEW days before the terrorist attacks of September 11, 2001, the then-prime minister of Iceland was in lyrical mood as he addressed a meeting of his country’s diplomatic corps.

David Oddsson was renowned for his literary interests. He wrote two plays in the 1970s, translated an Estonian history textbook and now he was quoting WH Auden, the British poet, who had written of Iceland half a century earlier: “Fortunate island/ Where all men are equal/ But not vulgar — not yet.”

Oddsson said his government’s aim was to “manage things so well” that future poets would return to Iceland to pay similarly handsome compliments. Instead, the 60-year-old former prime minister finds himself at the eye of the financial storm that last week swept away his country’s banks and provoked a decidedly vulgar outbreak of international rancour.

Oddsson stepped down as premier in 2004 and was rewarded a year later with a new job as chairman of the country’s central bank.

The appointment went largely unremarked at the time, but last week’s collapse of the Icelandic banking system — and the eruption of a nasty diplomatic spat with Britain — has caused many Icelanders to question the wisdom of handing effective control of a supposedly independent financial institution to a powerful, right-wing politician who enthusiastically espoused the free-market policies of Margaret Thatcher and Ronald Reagan.

Oddsson’s distaste for the euro and his rigid support of a high interest-rate policy aimed at taming inflation thrilled British savers and lured billions in inward investments.

Yet several analysts last week concluded that serious misjudgments by the Icelandic central bank had opened the door to meltdown and destroyed the national currency, the krona.

“Oddsson has very strong political views,” said Professor Snjolfur Olafsson of the University of Iceland. “A lot of people think he has been the main problem.”

As both politician and banker, Oddsson played a crucial role in Iceland’s emergence as a Nordic powerhouse with a punch that far exceeded its size. His career in many ways symbolises both the energy and vision that propelled a country with the population of Coventry (around 320,000) to world-beating fiscal eminence.

Yet it also reflects the pressures of a sheltered Icelandic elite that would have seriously disappointed Auden. The Nordic restraint the poet so admired gave way to vulgar ambition.

ABOVE the door to the Bar 11 nightclub in downtown Reykjavik hangs a sign that reads: “Lead us into temptation”. For much of the past five years, Iceland’s ruling class obliged, with dramatic effects on the ancient alleys of this once-dormant cod-fishing capital.

Down the street from Bar 11, the windows of another nightclub are covered with portraits of scantily clad Viking maidens. Around the corner there’s an “Erotik Cafe”.

Souped-up Range Rovers and Maseratis are a common sight on Laugavegur, a street packed with boutiques, bars and gourmet restaurants serving delicacies such as puffin terrine and guillemot smoked in tea leaves.

Yet as each day brought a fresh announcement of disaster last week, the only happy faces belonged to British tourists who were suddenly flush with devalued kronur.

The roots of Iceland’s volcanic transitions — from grim insular subsistence to electric Euro-cool to instant global shame — are surprisingly easily traced. It all started in the 1990s with a newly liberated horde of thirsty Russians and an angry young Icelander named Thor. The son of a Reykjavik shipping owner, Bjorgolfur Thor Bjorgolfsson set off for St Petersburg in 1993 to explore business opportunities in the wake of the collapse of communism.

With his father, Bjorgolfur Gudmundsson, Thor helped form a bottling plant that was later sold to Pepsi. The proceeds were reinvested in a local brewery that quickly flourished.

Named Bravo International, Thor’s operation had 17% of the St Petersburg market by 2002, and healthy sales in Moscow. When Heineken expressed an interest, Thor sold the business to the Dutch giant for a reported $400m (£235m), and promptly spent much of the proceeds on a 45% share in Landsbanki, newly privatised by Oddsson. Thor named his father as chairman, both men were on their way to becoming billionaires and a new age of Viking raiders was born.

With a trio of private banks behind them, the Bjorgolfurs and a group of like-minded entrepreneurs leveraged their strong currency and buckets of then-easy credit into an acquisition spree. Thor’s father snapped up West Ham United. Icelandic investments mushroomed in British high streets, from Somerfield supermarkets to Slug and Lettuce pubs.

“Few Icelanders were rich and it was suddenly very easy to borrow cheap money,” said Olafsson. “Several people at the time expressed doubts about the country getting in so much debt. But basically we were proud that Icelanders could get rich, too.”

The first shock occurred in 2006, when analysts at Merrill Lynch, the US investment bank, and the Danske Bank of Copenhagen warned that Icelandic banks had taken on too much debt in relation to the country’s GDP and were vulnerable to a credit squeeze.

Oddsson responded with characteristic aggression. Talk of a banking crisis was “preposterous”, he said. “I don’t think this is a crisis, not even an indication of a crisis.” A Landsbanki economist dismissed the doubts as “fantasy”.

After a brief wobble, the krona and the stock market recovered, but a fateful lesson had been learnt. Icelandic banks needed to even up their balance sheets. The central bank’s commitment to raising interest rates to combat inflation offered a promising solution — high-interest deposit accounts.

Thus was born Icesave, Kaupthing Edge and Heritable, a trio of ventures that proved magnets for bargain-minded British savers. No other western bank could match Iceland’s interest rates.

The only surprise was that in the rush to profit from their savings so many British investors failed to heed the warnings that multiplied this year. In January, Moody’s, the credit-rating agency, described Iceland’s banks as “fragile”. A study by Morgan Stanley concluded that Iceland’s banks were 7.5 times more likely to default than their European counterparts.

In July the International Monetary Fund published a gloomy report on Iceland warning about impenetrable ownership structures and murky lending practices. Several analysts concurred that the Icelandic central bank was simply too small to support the debts incurred by the private sector.

Oddsson’s response was to accuse unnamed foreign hedge funds of conspiring to undermine the Icelandic economy. He blamed “speculative attacks . . . that give off an unpleasant odour of unscrupulous dealers”.

WHEN the end came last week, there was a ruthless irony about Iceland’s collapse. For all of their free-lending ways, Landsbanki, Glitnir and Kaupthing had largely steered clear of the sub-prime mortgage fiasco that started the crisis.

Until the final moments before Landsbanki and Glitnir were put into receivership and Kaupthing was in effect renationalised, Icelandic officials were complaining that none of the banks deserved to go under, that their core businesses were sound, and that they hadn’t behaved irresponsibly.

Prime minister Geir Haarde, a former political ally of Oddsson, declared with grim understatement: “What we have learnt from this whole exercise over the past few years is that it is not wise for a small country to take a lead in international banking.”

Others have reached an additional conclusion — that it is not wise for politicians to run central banks, especially in very small countries.

Iceland might have achieved a softer landing had the central bank reduced its interest rates and put a brake on lending. Instead the central bank clung to an outmoded inflation target of 2.5% — even when that rate climbed rapidly to a 20-year record high of 12.3% last May.

Inflation is around 14%; on Friday the central bank announced that one of Oddsson’s two fellow governors, Ingimundur Fridriksson, was taking a “short medical leave of absence” on the advice of his doctors. Earlier last week Iceland’s president, Olafur Ragnar Grimsson, was treated in hospital for heart problems.

At her office at the University of Iceland, the country’s best-known political personality was also in sorrowful mood. In 1980, Vigdis Finnbogadottir became the world’s first elected woman president.

She is now a sprightly 78, still works for Unesco and other international causes, and runs an institute named after her. Last week she recalled that after a volcanic eruption in 1973 Icelandic workers succeeded at what experts had declared impossible: they diverted a stream of boiling lava away from a fishing harbour by pumping seawater onto the flow.

Yet the volcanic effects of a global economic meltdown proved impossible to divert. “It has been a very strange crisis,” she mused. “We have talented men, but unfortunately they flew too high. We recognise that perhaps people invested too much. But that’s the weakness of mankind.”

As British and Icelandic officials prepared to sit down yesterday to hammer out questions of compensation, more critical voices were beginning to be heard. “What will happen when the dust settles ?” asked the Rev Karl Sigurbjornsson, the bishop of Iceland. “A lot of people will be very angry”.

At Hresso’s café a few steps from the government building, one of Iceland’s most popular authors reflected on what he described as “the crash of the Icelandic dream”.

Andri Snaer Magnason said that when he published Dreamland two years ago, some Icelanders laughed at its subtitle, “A self-help manual for a frightened nation”. He added: “People were laughing about fear last year. They don’t think it’s funny now”.

Vigdis was confident that Iceland would recover, though probably much chastened. She turned to a popular Icelandic metaphor to sum up her view of the future: “All hailstorms stop sooner or later.”

What they said

Geir Haarde, Iceland’s prime minister What we have learnt from this whole exercise over the last few years is that it is not wise for a small country to try to take a leading role in international banking.

Sigurdur Einarsson, chairman of Kaupthing bank We are not Barclays, HBOS or Lloyds TSB, but I believe we are the twelfth largest bank in the UK and we were not allowed to participate in the rescue plan. We asked and the answer we got was a firm ‘no’.

Gordon Brown, prime minister What happened in Iceland is completely unacceptable . . . They have failed not only the people of Iceland, they have failed people in Britain.

Island’s hot and cold fronts

THINGS weren’t always so gloomy at Iceland’s big banks — far from it. Only last June the second-biggest lender, Landsbanki, chartered

two 737s to fly all 600 of its London staff, from the postboy to directors, to Iceland for a weekend of entertainment.

By day they were driven around the sights, including the Strokkur geyser, and went whale-watching. By night it was dinner and dancing.

It was not the first time the bank had displayed such largesse. It staged a similar event two years earlier, over three weekends to fit in all its staff across Europe.

Landsbanki had indulged in an aggressive spending spree, snapping up City stockbrokers Teather & Greenwood and Bridgewell plus Dublin-based Merrion and Kepler in Europe.

Despite efforts to ingratiate itself with workers, including an office refurbishment, the bank apparently took a laissez-faire approach to knitting its newly acquired operations together. A staffer was told: “You’ll work it out for yourselves,” when he asked a Landsbanki executive what the integration plan was for his department.

The Icelandic invasion of the UK was not restricted to Landsbanki, and there are few corners of British life that remain untouched by the influence of this tiny island nation of only 300,000 people. A number of local councils have deposits at Icelandic banks, as does Transport for London; slices of our high streets are in the hands of its investors, notably Baugur, the retail conglomerate; high-profile entrepreneurs such as chef Gordon Ramsay and property investor Robert Tchenguiz were financed by Kaupthing, the country’s biggest lender.

Iceland is portrayed as a close-knit, insular society, and those who did business with its bankers and investors noted an air of inscrutability.

Tony Shearer ran Singer & Friedlander before its takeover by Kaupthing. At meetings with the Icelanders before the bid, discussions rarely focused on business, something he found curious. “They’re nice people but there was no engagement on a business level at all,” he said. Like Landsbanki, Kaupthing was a good host, taking executives salmon fishing after the takeover.

Simon Burke ran Hamleys, the toy retailer, when Baugur bid for it in 2003. He had no direct dealings with them in the takeover battle but noted their determination to win. “There was no charm offensive. Their offensive was all based on cash,” he said. It had even taken the unusual step of raising its offer on rumours of a higher counterbid from a rival.

Paul Manduca, chairman of Bridgewell when it had a bid from Landsbanki, said: “They weren’t in the business of asking for advice. They had the money and they knew what they wanted to buy.”

Over a few years the Icelanders snapped up a range of UK assets, but what will happen to many of those businesses is unclear.

Teathers, for example, which continues to trade, is looking for a new owner after Straumur, another Icelandic bank, pulled out of a deal to buy it. Baugur insists that its British retail operations will be safe from the turmoil affecting banks. Gunnar Sigurdsson, its chief executive, said: “Our portfolio companies have committed loan facilities with Icelandic and other international banks, commitments which may not be revoked or altered by those banks unless done so in accordance with the agreed terms of those loan facilities.

“The businesses are performing well and the portfolio is generating strong cash flows, which is key in markets like this.”

The Candy brothers have secured a deal to buy out Kaupthing’s interest in two property deals it is working on — one for the former Middlesex Hospital in London, and the other in Beverly Hills, California.

And Ernst & Young (E&Y) was appointed last week as administrator to Kaupthing Singer & Friedlander Ltd, the UK arm of the bank. Among its assets are the fashion retailer Phase Eight, ADP, a chain of dentistry surgeries, and a stake in Bay Restaurant Group, owner of chains such as La Tasca and Slug & Lettuce.

E&Y said it was too early to say what might happen to these investments.

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