FORTUNE -- The inevitable unmasking of Iceland's dubious economic recovery could have severe consequences for the rest of Europe. Since 2008, the small island nation has been able to avoid an all-out economic meltdown thanks largely to government-imposed capital controls that have kept its currency from imploding. At the same time, the nation's zombie banks have managed to avoid total collapse thanks to delay tactics that have allowed them to avoid settling with their creditors.
But the walls the government and its banks erected to shield its population from the outside elements have finally started to crumble. Unfortunately, there is not much Iceland can do to save itself at this point; it will need to face the music eventually. The bigger concern is what impact another Icelandic currency crisis could have on Europe in the months ahead. After all, Iceland's spectacular collapse in 2008 helped set the European debt crisis in motion as it exposed weaknesses in the region's banking system. Another Icelandic meltdown could easily reignite investor fears, leading to yet another panic on the continent.
During the boom years Iceland was run more like a hedge fund than a sovereign nation. Its three main banks accumulated assets from around the globe that at its height equaled around 10 times the nation's total annual economic output, or GDP. They were able to attract this enormous amount of capital by promising depositors, mostly in the U.K. and the Netherlands, returns on their cash that were multiples of what they could receive back home. For a time, the banks were able to deliver on their promises as they borrowed cheaply in one currency and lent in others that carried higher interest rates. This allowed them to lend billions of Icelandic Krona to their own population, fueling a property bubble of unmitigated proportion.
Eventually, of course, it all came crashing down. The carry trade that fueled bank profits disappeared, and a great deal of those property loans turned sour. Iceland's economy started to crash, falling into a destructive devaluation-inflation led spiral that threatened to obliterate the value of the Icelandic Krona relative to other currencies and wipe out the savings of its citizens overnight.
The Icelandic government responded quickly, and with the help of the International Monetary Fund, introduced capital controls to restrict the flow of money in and out of the country. This preserved the value of its currency. At the same time, the IMF lent Iceland nearly $5 billion to stabilize itself. That may not seem like a lot of money, but it is actually equal to more than a third of Iceland's GDP.
Iceland's economy appears as if it has rebounded, growing faster than most of its European cousins. Unemployment has fallen sharply from a peak of 8% in 2009 to around half that today. At the same time, consumer confidence in the country is growing, as is tourism, which is one of the two major industries in Iceland, the other being fishing. All in all it seems that Iceland has recovered, at least that is what most economists and even the IMF say.
But hang on: Iceland has made little, if any, real progress in tackling its economic issues. The government and its banks have simply employed measures designed to delay the pain, not cure the disease. Capital controls imposed by the government in 2008 are still in effect, forcing its citizens, and, more importantly, the nation's massive pension fund, to invest mainly in Iceland. At the same time, Icelandic consumers still find it hard to buy foreign goods, forcing them to buy less-desirable local equivalents, giving an artificial boost to the domestic economy. Meanwhile, high interest rates have made borrowing expensive. A moot point, considering Iceland's now-zombie banks aren't really lending; they are too busy dealing with fallout from the billions of krona worth of bad loans on their books.
All in all, real output in Iceland remains 10% below the pre-crisis peak. And while GDP did grow at around 2.9% in 2011, it slowed to around 1.6% last year and is expected to fall even further this year. This is the ugly side of capital controls. In short, by restricting what people can buy and invest in, i.e. only Icelandic goods and opportunities, individuals eventually stop spending.
Indeed, domestic consumption and investment in Iceland are both down 20% from their pre-crisis levels and continue to fall. Icelanders are instead choosing to pay down their debts, which, while positive, comes at the expense of economic growth. And despite the debt paydown, household and corporate debt remain high, coming in at 109% and 170% of GDP, respectively.
Icelanders, frustrated with the slowdown in economic growth, voted in a new government coalition in May, the same that was in power during the boom years. The new government promised during the campaign to lift the capital controls and to force banks to cut people's mortgage principals. This has understandably shaken the rating agencies. S&P lowered its outlook on Iceland to negative in June on concern that the new government will go through with its plans. The IMF has expressed similar reservations.
Iceland has few good options. If it keeps the capital controls in place its economy will continue to shrink; lift them and asset values will fall as Icelanders ship their cash out of the country. The new government says that foreign direct investment will make up for the capital outflows, but they are either extremely optimistic or completely misguided. The lifting of capital controls will cause housing prices and other Icelandic assets to fall dramatically leading to yet another bank panic. In the wake of this chaos the Icelandic government believes foreign investors will come strolling in?
Iceland is small; it's easy to see why some might not think the country an important cog in the European machine. But Iceland is facing many of the same issues afflicting much larger economies. For example, capital controls have been instituted in several European nations amid the fallout from the sovereign debt crisis. How and when those nations choose to lift such controls will have a profound impact on the value of the euro and thus the economic integrity of the entire continent.
Furthermore, Iceland's banks are not unlike those in Spain as they both financed housing booms gone bust. How Iceland’s banks deal with the problem of its bad loans after capital controls are lifted could have a major impact on the way investors choose to look at Spain and its bank issues. Iceland's banks are expected to force losses of around to 75% to 100% on their investors and large depositors, many of which are hedge funds that also buy and sell sovereign debt and the insurance linked to it. How these hedge funds will retaliate could be replicated in Italy or in France where sovereign debt continues to mount relative to the size of their economies.
Iceland shouldn't be ignored. After all, it was the first country to implode during the financial crisis and was one of the first ones to see its GDP rebound. Its small size and simple economy means that it is less able to bury its problems under a pile of confusing monetary actions. This forces Iceland to face the music much sooner than larger nations in similar predicaments. As such, investors will be watching what Iceland's new government does intently. If it begins to falter, the rest of Europe could be next.