RENEE MONTAGNE, host:

During the financial crisis, only one Western country experienced a true collapse of its banking system. That country, Iceland, still has emergency laws in place to keep its economy together. David Kestenbaum with our Planet Money team was in Iceland recently and has this report.

DAVID KESTENBAUM: Things got so bad in Iceland that the country ran out of foreign currency. Even today, foreign currency can be scarce. The government controls how much anyone can get.

Mr. BALDUR HEDINSON: Just went into one of the local banks here in Iceland, my bank.

KESTENBAUM: This is Baldur Hedinson. Baldur was an intern at Planet Money, and happens to be from Iceland. He was driving around Reykjavik trying to change some of his Icelandic krona into dollars so he could pay rent back in New York. The teller said, sorry, no U.S. dollars.

Mr. HEDINSON: So she called around. She called different branches of the bank. And the word on the street is that there are some dollars in the suburbs. So we are headed toward Arbai, which is - it's a nice suburb.

KESTENBAUM: The strange story of how Iceland ran out of money - foreign money -begins in 2003. Iceland had just privatized its banks and those sleepy state-run institutions, they suddenly grew. They even advertised internationally, with international celebrities.

(Soundbite of Kaupthing Bank commercial)

Mr. JOHN CLEESE (Actor): Kaupthing is the biggest company in Iceland.

KESTENBAUM: This is John Cleese doing an ad for Iceland's largest bank.

(Soundbite of TV advertisement)

Mr. CLEESE: It's a company where you get all the benefits of a huge global, multi-million - I mean how millions live in Iceland?

Unidentified Man: Three hundred thousand.

Mr. CLEESE: Three hundred thousand million?

Unidentified Man: No, just 300,000.

Mr. CLEESE: Ah, so Kaupthing is the biggest company in this tiny little country...

KESTENBAUM: And foreigners put their foreign money in the Icelandic banks. The bank's balance sheets became 10 times larger than the country's entire economy. It's always hard to put a finger on the exact moment things turned. But this one is as good as any.

Dr. ASGEIR JONSSON (Former Chief Economist, Kaupthing Bank): This is Hotel 101.

KESTENBAUM: We're at a bar called Hotel 101 with Asgeir Jonsson. Asgeir was the chief economist at Iceland's largest bank. And one night in January 2008, he got a call saying come to this bar. Foreign investors are in town and they want to meet you.

Dr. JONSSON: They were actually pretty loaded. They were, you know, had a lot of alcohol.

KESTENBAUM: They were drunk when you came in?

Dr. JONSSON: Yes. Yes.

KESTENBAUM: It turns out these were hedge fund guys who had come to the conclusion that his bank, his country was doomed. They'd placed big financial bets that everything would crash. The problem the hedge fund guys had spotted was in fact, the very thing used as a selling point in that John Cleese commercial.

(Soundbite of Kaupthing Bank commercial)

Mr. CLEESE: How millions live in Iceland?

Unidentified Man: Three hundred thousand.

Mr. CLEESE: Three hundred thousand million?

Unidentified Man: No, just 300,000.

KESTENBAUM: This was a big bank in a very small country. Iceland is the smallest country in the world to have an independent currency. And normally that wasn't a problem. Icelandic banks could always change their domestic currency, the krona, for dollars or euros on the world market. But now the world was worried. And it got hard for the banks to exchange krona - no one wanted krona.

In a bigger country, banks might get some foreign currency from their own central bank; in this case, Iceland's equivalent of the Federal Reserve. But the central bank also ran out of dollars and euros.

Here's economist Gylfi Magnusson.

Professor GYLFI MAGNUSSON (Economics, University of Iceland): The central bank used all it had in a desperate attempt to save one of the banks. But that only kept that bank afloat for another couple of days.

KESTENBAUM: Suppose you'd gone around the country with like a big plastic bag and said we need all the euros we have on this island. Put them in this bag. Would there have been enough euros to pay off the debt?

Professor MAGNUSSON: No, not even close.

KESTENBAUM: It's so funny, because you have money. You have krona but you don't have the money that you need.

Professor MAGNUSSON: Yeah, that's basically it. That was the fundamental - one of the main flaws of the banking system.

KESTENBAUM: So Iceland, unlike other countries, could not bail out its banks. Asgeir Jonsson, chief economist at the largest bank, remembers the day his collapsed - October 9, 2008.

Dr. JONSSON: And the funny thing is during the panic it was so crazy. All phones where ringing at the same time. But after the bank went down, all was silent. That there was this eerie silence, we were basically completely cut off from the outside world basically.

KESTENBAUM: Eventually the International Monetary Fund had to step in and lend Iceland a ton of foreign currency. In 2012, Iceland will have to start paying that back in the one thing it ran out of, foreign currency.

David Kestenbaum, NPR News.

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