In 1997 the late Robin Cook, then foreign secretary, talked of a foreign policy with “an ethical dimension.” Many were unclear what he meant, but we can be sure he did not mean bullying a small European neighbour into accepting years of economic austerity or international isolation.

The British government does not present its policy towards Iceland in this light. We are, it says, negotiating reasonable terms for the repayment of monies due. Iceland’s banks failed in 2008, and the Icelandic depositor protection scheme was insufficiently funded to repay British investors. Our government stepped in to cover the losses. Now the Icelandic people should reimburse the British for any losses. Right?

Wrong. The government’s stance stems from the public’s willingness to applaud bashing foreigners, and has little economic or moral basis. No one in Britain was forced to invest in Icelandic banks. Those who put money into Icesave did so for high returns, either discounting the risks, or failing to consider them. It’s not even clear why the British government covered their losses in full; it was not obliged to. Maybe it felt guilty: neither the Financial Services Authority nor the treasury warned investors against using banks outside the EU, and where national deposit protection schemes were inadequate.

Even if there are grounds for thinking Iceland should cover some of the losses, the obligation must be proportionate. The sums involved are small for Britain, but enormous for Iceland, with repayment risking dire social and economic consequences. British government ministers, despite their renewed enthusiasm for the writings of John Maynard Keynes, have not learned from his book The Economic Consequences of the Peace (1919), which pointed out the risks associated with unjust international agreements that impoverish nations—in that case the Treaty of Versailles and its treatment of Germany after the first world war.

So what should the British government do? Simple. In December it introduced a windfall tax on bankers’ bonuses intended, it was claimed, to dissuade banks from paying them: the government suggested it would be delighted if it raised no tax at all, because the banks had decided to “do the right thing.” Yet, as is now becoming clear, the banks have not been dissuaded and are paying both the large bonuses and the tax too. Bank shareholders are the losers, and the treasury is the big winner. It was initially estimated that the tax would raise £550m. Now it looks as if this could be as much as £5bn. Since the treasury did not plan for this windfall, why don’t we give the proceeds to Iceland instead? It would pay off Icesave’s debt, and for all their grumbling about the bonus tax, bankers will be consoled by the fact that their taxes are not being swallowed up in Britain’s fiscal black hole. The Icelanders will be delighted; Britain will establish itself as the true leader of the cause of European unity; President Sarkozy will be dismayed. Irrespective of the small print of European law, justice will have been served. And finally, 12 years late, the citizens of Britain will get an ethical foreign policy of which we can be proud.