TROMSOE, Norway (Reuters) - Europe's struggling economies should look to tiny Iceland as a model for managing their crises and returning quickly to growth, especially in winning public support for moderate austerity policies, Prime Minister Johanna Sigurdardottir said.
The North Atlantic island has had one major advantage as it recovers from a crash in 2008 which countries locked in the euro zone do not have - a currency of its own.
Nevertheless, Sigurdardottir told Reuters that Iceland's mix of measured austerity and unorthodox policies - such as private debt forgiveness and defending welfare payments as much as possible - could offer some lessons to euro zone members.
"We believe and so does the IMF that our case can be a role model for some of the countries in crisis now," she said in a rare interview. "I've met with several leaders over the past years, some from Greece, and many prime ministers have been surprised by our economic turnaround and asked how we did it."
In 2008 Iceland's banking sector collapsed, a shock which euro member Ireland also suffered and which Spain is now trying to avoid. The International Monetary Fund and other lenders had to bail out Iceland, which remains outside the EU, and the economy contracted more than 10 percent over 2009 and 2010.
But while Greeks are suffering in the fifth year of a recession deepened by punishing austerity policies, Iceland has bounced back to growth after just two years with a drive to narrow the gap between the rich and poor.
Sigurdardottir, a Social Democrat, became prime minister in 2009 when the government which presided over the crash fell following weeks of popular protests.
The cure that her government administered has hurt many of Iceland's 320,000 people and state spending has been cut sharply. However, there has been little backlash from voters who have largely accepted the need for limited austerity measures.
By contrast, in Greece a radical left-wing opposition party which rejects the austerity terms of the country's own EU/IMF bailout has surged in popularity, and elections on Sunday are unlikely to break a dangerous political deadlock in Athens.
"Becoming more disciplined and lowering state expenses, while at the same time keeping the welfare system strong, is what needs to be done to have wide support from the public for such measures," said Sigurdardottir, an airline flight attendant and union activist turned politician.
With the crisis past, the country is now drawing up plans to ease capital controls and sell down a stake in one of the banks it took over at the height of the crisis, Sigurdardottir said in the interview, conducted in Norway on Monday.
Comparisons can go only so far. Iceland's economy is infinitely better run than that of Greece, which is bedevilled by inefficiency and corruption.
Also the Icelandic crown - which dived by two thirds during the crisis, forcing the government to impose the capital controls to stabilize the currency - remains 20 percent lower against the euro than its pre-crash level.
This has given a useful boost to the country's international competitiveness, something no euro zone country can get short of taking the nuclear option of leaving the currency union.
While many of the euro zone's problems are due to too much government debt, Iceland's were caused by its banks. By 2008, the banks' balance sheets had grown to over 10 times its entire annual economic output, with many of the assets in foreign currencies and backed by short term borrowing.
When funding markets shut after the Lehman Brothers failure, Iceland's top banks collapsed in quick succession, hitting depositors and creditors and forcing the government to agree to the 3.4 billion euro ($4.25 billion) bailout.
The collapse provoked a row with Britain and the Netherlands, which claimed more than $5 billion from the estate of one of the banks, Landsbanki, having compensated depositors in their countries for losses on its Icesave online accounts.
Capital controls were one measure the IMF would once have frowned upon. Iceland also took unorthodox steps in other areas, forgiving around 200 billion crowns' ($1.54 billion) worth of household debt and providing big tax benefits to the lowest income households.
It severely cut back state spending in some areas, but preserved the social safety net.
"We cut the budget but we preserved as much as possible in education, health, social security and infrastructure like law enforcement," Sigurdardottir said. "In the years leading up to the crisis, the gap between the richest and the poorest in society widened and our measures in the crisis focused on diminishing this gap, with more equality."
The relief boosted consumption, lifting growth to 4.5 percent year-on-year in the first quarter this year, in sharp contrast to stagnation or recession in much of the euro zone.
In a sign of returning normality, the government is getting ready to sell part of its 81.3 percent stake in Landsbankinn, a lender created from the ashes of Landsbanki.
"The aim is to start selling shares this year and sell small stakes at a time this year and next until we are down to two thirds," Sigurdardottir said, adding that the government aimed to hold on to a two thirds stake indefinitely.
"We have only small stakes left in the other banks and we are open to selling them if we get a good price," she added.
Iceland has also repaid about a fifth of its rescue loans early while building its currency reserves, and Sigurdardottir said no further large scale debt forgiveness would come.
Not all the problems have been solved though. Capital controls, though eased, remain in place and may stay for some time, Sigurdardottir said. "Some hope it would be just a year, others say it may be three. It's difficult to say and it will take time," she said.
Investment also remains low, unemployment at around 7.5 percent is modest by euro zone standards but twice as high as before the crisis, household debt - despite the relief measures - remains astronomical, and public debt has not started to fall.
The country is still faces tough negotiations on joining the EU, with the debate on its fisheries industry a "make or break" issue, according to Sigurdardottir, before a referendum to be held sometime following elections next year.
"We have come a long way to get past the crisis," Sigurdardottir said. "Don't underestimate how difficult this process has been for the people."
($1 = 0.7993 euros)
(editing by David Stamp)