To kick off 2009 we deployed our Americas editor to the streets, boardrooms and bars of Reykjavik to report on the human cost of the country’s economic collapse. Across a variety of sectors she found two camps: those who were already on their way to greener pastures and those who were going to stick around and help right the nation. As our correspondent found, the tiny nation has plenty of raw assets to work with and bank implosions aside, is still relatively debt free. More worrying is that there are other Icelands out there and, as we reveal below, there are more than a few governments that are still operating in a rather opaque world.

“You’re safe with these banks.” Five words of reassurance that no finance minister or central bank governor would want to utter. But it is exactly what David Oddsson, Iceland’s central bank chief was telling me one year ago. In the intervening months, all of Iceland’s banks have collapsed and the nation is staring bankruptcy in the face, the International Monetary Fund (IMF) has had to step in to bail out the country and the modernist bunker where I interviewed Oddsson has become the focus of angry protests.

Reykjavik has seen riots. The crisis even evolved into a diplomatic incident with Britain. And all this for a country that is ranked by the UN as having the highest living standards in the world. Last February, two of Iceland’s big three banks sucked up billions of pounds of internet savings from ordinary European households. The sell was disturbingly simple. Icelandic banks had shaken up the staid, stingy savings markets of Britain and the Netherlands by ­offering eye-wateringly high rates of interest. Icesave public relations sent an “Ice Bar” around Fleet Street’s finance journalists and some were flown to Iceland. The high rates were hailed by the media in unquestioning headlines.

Landsbanki’s Icesave, and then Kaupthing’s Edge account, hurtled to the top of so-called “Best Buy” tables as money pundits recommended Iceland for the role of northern Europe’s new piggy bank. In less than 18 months, €6.5bn of savers’ money poured in. So it seemed reasonable to go to Reykjavik last February to hear Iceland’s central bank governor praising its banks and the main international deposit-taker. “The banking system has grown very fast and they have had sound, handsome profits. Last year the three major banks made £1bn and the latter part of the year was not the easiest,” said Oddsson, Iceland’s former prime minister. Seven months later they had collapsed.

“Deposits, mainly in Landsbanki, have been put in a safe place – Landsbanki has been around 120 years. It’s quite respected and doing well here and elsewhere. I wouldn’t say anything else than it was a good decision to utilise possibilities of saving with Landsbanki,” he insisted. It was to be expected that Oddsson would be diplomatic. A man in his position could not afford to say anything else to a journalist from a country that had bought so heavily into Iceland as a high-interest haven.

This was less than half the story, though. Icelandic banks had been in severe trouble in 2005, having expanded aggressively on the back of now-fickle flows of international capital. Sophisticated money market investors would not fund Iceland’s banks. Part of the solution was to do, three years early, what banks all around the world are doing now: raising money from consumer deposits. But there was one huge problem: Iceland’s deposit base was simply not big enough. Solution: adopt a foreign deposit base ­instead. Hence Icesave, Kaupthing Edge, and deposits of cash from public bodies such as the police, and even the British government’s own auditors. Oddsson thought the strategy to get funding from unsophisticated depositors, rather than the markets, was a win-win. “I think the Icelandic banks realised two years ago that they should go more in that direction [rather than] having to refund themselves in the market on such a large scale. It was healthier to do that by deposits – and they’ve been doing it successfully. I think we should applaud them for that – not punish them.”

The markets were not convinced at all. On open public markets the perceived risk of Icelandic banks shot up far more than any other banks in Europe. Yet the deposits continued to roll in. Sophisticated investors were concerned that they had invested too much in retail, leisure and property in Scandinavia and the UK at the peak of a consumer boom. “I hope they have done good shopping,” was Oddsson’s ­riposte. But there were also fears about whether Iceland’s government could really pay out many billions of euros of deposit guarantees, which would amount to over half its entire national income.

“The economy of this country is quite extraordinarily good – the state is net debt free – with good resources and a good situation,” he said. In his defence, the Icelandic Banks outlasted Lehman Brothers, two British banks and a German one. But only in Iceland has the crisis also brought down an economy. The lesson is that markets need to know the state can stand by the banking sector. The fact that the Icelandic government was debt free became irrelevant in the face of the risks taken by banks. Several countries are watching what happened in Iceland nervously.

All around the world mountainous risks are being transferred from banks to nations. Not all will be able to sustain this trick. The bond markets, where risk of bankruptcy is constantly assessed, are ­becoming dark lenses on the world. Argentina, the Ukraine and Belarus are the focus of financial concern. Ecuador defaulted last month. Latvia, Hungary, Turkey and Pakistan are queuing at the IMF’s door. Richer nations, such as Greece, have huge financing requirements this year in difficult markets. Ireland, which has guaranteed most of its banks’ deposits, has taken on a theoretical liability. And as the US, the UK, Germany and France have collectively spent thousands of billions of dollars bailing out their own banks, they may not be able to bail out smaller nations seeking help.

Britain, which many in Iceland blame for its woes, is not immune to similar problems. A former Bank of England interest rate-setter, Willem Buiter, refers to London as “Reykjavik-on-Thames”, and points out that Iceland’s bloated banking sector had a balance sheet that was 900 per cent of national income. Britain’s banks are 450 per cent of national income, and the pound has been tumbling sharply. He even ­believes that mighty Switzerland, with a total bank balance sheet of 650 per cent of national income, might be vulnerable.

“There are 15 to 20 nations including many in eastern and southern Europe with precarious financial profiles in every respect who may have to default or seek a bailout over the next year or so,” says Theo Phanos, who runs Trafalgar Asset Managers in London. Icelanders are used to being the subject of experiments. Their chromosomal homogenity makes this the world’s best testing ground for new ­genetic research. Its financial failure last year will not be unique. As David Oddsson said a year ago: “You have to ­remember that if this credit difficulty goes on for another 12 months, it will not be an Icelandic problem, it will be an overall banking, economic, world problem at that time.” Twelve months on, that is ­exactly where the world finds itself.

Oddsson remains in his job, despite hundreds of protesters ­demanding his exit. The bankers too are blaming him, suggesting he was at fault for scaring Britain into using anti-terror laws to seize Icelandic bank assets following a TV interview. He emerged in November with a feisty speech, saying that he had consistently argued in private with executives that the banks had to shrink. He said the Icelandic press was a “blatantly abused propaganda machine”, suggesting that their financial links to Iceland’s banks were influencing their journalistic rigour. Most startlingly, he said he knew “what actually prompted” the UK to use anti-terror legislation to seize the banks’ assets, but would not elaborate. In an interview he said that if he was forced out, he would simply return to politics.

Faisal Islam is economics correspondent for Channel 4 News in the UK.