Iceland is the credit squeeze writ large, or rather, writ small: after a debt-fuelled boom, the Nordic island is faced with a debt-driven bust, and the risk that market fear will turn a slowdown into a headlong rout. Iceland is likely to suffer a recession in the process of getting inflation back under control, but that need not involve a financial crisis.

The Central Bank of Iceland on Tuesday raised its benchmark rate by 125 basis points to 15 per cent be­cause of persistent inflation. The consumer price index has averaged more than 4 per cent in recent years – far above a 2.5 per cent target – and the central bank has failed to curb inflationary expectations. Iceland is also suffering speculation about its banks and a rapid decline in its currency. The risk is that foreign investors will rush to withdraw, the Icelandic krona will collapse and the economy will contract sharply.