but there is a reason that Krugman did not recommend this course for the US:
For the most part, Icelandís lesson is relevant to countries that experienced big capital inflows followed by a sudden stop ó that is, the European periphery, not the US or the UK.
What Iceland did allowed their own economy to avoid the worst of the recession, but with several caveats:
1) Unlike Greece and the other PIIGS, they had an independent currency which could be devalued. This was just as critical a part of their plan as repudiating the debt.
2) Unlike larger countries, the losses went predominantly overseas, meaning that to some extent they exported their problems. Otherwise, allowing banks to fail would have taken down business payroll accounts as well, and employees of those would have stopped receiving paychecks. That would have cause a crash worse than anything seen in the Europe or US.
3) This policy that can only be counted on once. Iceland can no longer rely on external financing.
4) They jury is still out -- almost literally -- on whether Iceland has permanently escaped the burden of its banks' foreign obligations. The EFTA has outstanding cases such as the one against Icebank that appear to reimpose some burdens on the Icelandic financial industry.
Krugman is not proposing that the entire financial industry of a country be allowed to collapse. Rather:
What it demonstrated was the usefulness of devaluation (and therefore of having your own currency), and the case for temporary capital controls in an emergency. Also the case for letting creditors of private banks gone wild eat the losses.