I've been in Iceland, promoting my new book on markets (The Best Book on the Market) – Icelanders are huge book-buyers – and giving talks to the RSE think-tank and the Iceland Chamber of Commerce. As Adam Smith said, there is a deal of ruin in a nation – even a tiny nation of just 300,000 people. But after years of boom based on sound policies, Iceland seems to be falling into a slump caused by unsound ones. Worse, it's contemplating even more.

The upturn began in 1991 with tax cuts and economic liberalization. Iceland now boasts a corporation tax of 15%, and just 10% on capital gains. It also liberalized government-run and government-regulated businesses – notably the banks, which promptly boomed, making Iceland a leading European financial centre (with more banks in Iceland than the rest of Scandinavia put together). And those banks financed the expansion of Icelandic business all over Europe.

Like Ireland, tax cuts and liberalization made Iceland an attractive home for enterprise and investment, and the place boomed. But the monetary authorities over-egged the liquidity that booming business required, unleashing inflation of a whopping 12%, No democratic country's economy can survive that. Rapid general price rises disguise real price movements, leading to malinvestment. Workers put in huge wage claims to make up not just what they have lost last year but what they expect to lose next – further stoking the inflationary pressure. Hayek was right: inflation must be stopped dead.

Iceland can do this. The trouble is that many people think it's somehow too small to run its own monetary policy. Quite a number – including, predictably, many businesses who see only the economic issues  – want to fall into the embrace of the Euro and sign up as full members of the EU. Like mediaeval sufferers of scrofula, they imagine that their illness can be cured merely by touching.

To make matters worse, Althing (the world's oldest parliament, founded 830), has decided that the power sector (Iceland has unlimited geothermal supplies) will never, ever be privatized. Plain daft. If you face economic problems, as both Iceland and many other countries do right now, the first thing you need is sound money and the second is to ensure that you use your capital more efficiently. That means privatization, liberalization, and competition.