Iceland went bankrupt today. The small island nation in the North Atlantic was best known for the singer Björk, glaciers, and waterfalls suddenly found itself bankrupt when its three largest banks collapsed today.

The three banks, Glitnir Bank, Landsbanki, and Kaupthing, were heavily involved in overseas lending. They had more money lent out on their books than the entire GDP of Iceland. In other words, the $61 billion the banks had given out more money than everything produced, sold, or made in Iceland for the year was worth. By a factor of 12, which means that the banks had loans out which came to total more than 12 times the size of Iceland’s GDP.

When the loans went bad, so did the banks. And they lost more money than 10 years worth of Iceland’s economic production. No-one seems to know why Iceland’s financial regulators allowed the financial system to leverage itself so deeply. In the words of one bank executive I spoke with, “I don’t run Iceland, and I don’t know what they were smoking.” But to fix the situation, Iceland will need a capital infusion from either the EU, the US, or the IMF to get going again.

Now what does it mean when a country goes bankrupt? How does the country itself go bankrupt if its banks go under? Suppose the GDP of Iceland is $50 billion USD a year, and the banks lost $100 billion. Where will the extra $50 billion come from to cover their losses? It will usually have to come from the financial regulatory authority, but if those losses are greater than its budget, the country goes bankrupt.

The idea of a bankrupt country is kind of weird, but countries do go bankrupt from time-to-time by default on their debt. Recall when Argentina went through something similar a few years ago: the Argentine government forced people who were holding dollars in Argentine banks to “loan” the money to the bank in exchange for Argentine dollars at $1 USD for ¢40 Argentine cents, which meant bond holders lost 60% of their money immediately. Argentina was a mess for two to three years after they went into default.

That is an extreme case. When a country goes bankrupt, not much happens inside the country. But externally, other countries stop lending to it, and its trading partners stop selling to it.  The US, for example, issues bonds to fund projects and such. The US issues bills (less than one year), notes (from one to 10 years) and bonds (30 years). Other governments buy these from the US with their excess dollars.

In Iceland, they might have to “borrow” to fund, say, a new hospital, or new roads, or a fish processing plant, etc. And they would issue bonds to the international market place to do so. Usually, they carry a very low rate of interests, because the investment is very safe. After all, when was the last time a European country defaulted on its debt? Not since the 1930’s. But now, the entire resources of the Icelandic economy will be required to salvage those banks.

For the moment, all trading in Iceland’s equity markets has been suspended until 13 October 2008. Things are about to get very, very ugly for Iceland according to Lars Christensen, chef analyst at Danske Bank in Copenhagen:

“The economy may well contract more than 10 percent between now and the end of the crisis,” he said. “Inflation will jump to at least 50 percent to 75 percent in the coming months.”