it’s probably not all right to buy four bottles of Veuve Clicquot at Reykjavik airport when the country has just gone t**s up, but there it is. I am here for the annual Airwaves music festival, and the shelves in duty free are still well stocked, so who will if I don't? These are sombre times for Iceland. The financial system has crashed — and their crash makes ours look like a broken wing mirror. There are a lot of crazy figures flying around — that there could be 50% unemployment by Christmas; that the national debt is 12 times the GDP. And nobody, including the government, knows what is next.

It’s all very strange. Iceland is home to Björk, Sigur Ros and some of the hippest kids on the planet. It has more books per capita than anywhere else in the world. You can buy Another Magazine here, and Bonpoint blouses for little girls. Now it’s nearly bankrupt, what does nearly bankrupt even look like?

Tonight, it’s wool capes with brooches and heels, pin-neat hair and skin dipped in sunlight. When everyone is so stylish, it’s hard to believe that something very bad is happening. The festival is in venues around downtown Reykjavik, and 101 hotel, where all the acts are staying, is bang in the middle. Björk used to have a share in it, and it’s across the street from Kaffibarinn, the bar Damon Albarn once famously part-owned. Everyone has a stake in everything here.

I go to watch Hjaltalin, Iceland’s answer to Arcade Fire. For their last number, they are joined on stage by the country’s most famous gay pop star, Paul Oscar. Hjaltalin’s cover of one of his songs has been the anthem of the summer, and everyone — the kids, the promoters, the band, everyone — is smiling and singing along. What do the words mean, I ask Arni, one of the organisers. “They mean, ‘I’m ready to take on anything. Bring it on’,” he replies.

And what about you? How do you feel about it, I ask Hjaltalin’s 23-year-old lead singer backstage. “It’s okay,” he says. “It won’t be that dramatic. We’ll overcome the difficulties.”

The next day, I do a spot of shopping on the main drag. “Life’s been better,” says Styrmir, a blond shop assistant at Kisan, the sort of gift shop that has popped up in every rich little Western town over the past 10 years. There are Sonia Rykiel bags, Annick Goutal scents, a nice range of Isabel Marant. “At the moment, we’re selling more than ever. The krona is so weak, stuff we bought two months ago is selling for less than it does in Paris. It will get harder, but people will always take gifts to dinner parties.”

Will they? At a protest in the town square, people are wearing Ray-Bans, but every second person I speak to seems to have lost, or is about to lose, their job, their savings, their home, their car, or all four. The lead singer of GusGus gets on stage and calls for the return of money they suspect has been swiped by the country’s flash Harrys. Iceland’s most famous rapper, Blaz Roca, is wearing a T-shirt that says: “Gordon Brown, your brains are haggis.”

“People have enough until Christmas,” says a mother of two. “After that, there will be no money to buy or import anything.” You’ll be smoking the local brand of fags, I joke, eyeing her pack of Marlboro Lights. “There is no local brand,” she says.

But let’s not forget the festival. At Reykjavik’s best club, Nasa, Dee from Robots in Disguise, the girlfriend of Noel Fielding, is performing. Amazingly, the crowd knows all the words, including Maria, a self-possessed 20-year-old who goes out with Arni and owns a vintage shop. “We buy the music on iTunes and learn it before Airwaves,” she says.

Over in the Art Museum, CSS are just finishing their set, and Vampire Weekend are on next. The band has a 5am flight, so we all stick around for the Icelandic act, FM Belfast. And what a jolly sight they make. The lead singer, who I met earlier (Bank job? “Gone.” Savings? “Gone.” Car? “No idea how I’m going to pay for it now”), is wearing a tiny bow tie and, over a little belly, a black cardigan. Behind him is a man in a giant white Babygro and trainers. “We’re not gonna talk about the financial system or the prime minister,” he says, to crowd approval. “But . . . what the f*** is going on?”

Then others clamber up onstage. By the last song, there are 40 of them, including nearly every significant face on the whole Icelandic music scene. The lead singer of Mum is there, so is GusGus. Jonsi from Sigur Ros is playing a Bacardi Breezer bottle with a 50-krona piece. Then it’s on to a bar for more drinking.

By the time we come out, it’s 6am. The sun is coming up, and the streets are packed with drunk kids. It feels anarchic, like the Glastonbury stone circle at sunrise, or Romford town centre after a big match.

Eight hours later, the sky is slate grey, and someone has tidied up so well that you could eat your brekkie off the pavement. A short cab-ride away, in a conference room at the business university, Iceland’s most famous celebrity export, Björk, is working a green-velvet Little Lord Fauntleroy outfit, a crown of plaits and a determination to turn things around. She is addressing a group of leaders in business — energy, health, high-tech. Anybody but actual government. “We need new, original ideas,” she says in Icelandic. “Seeds, patience — we see that all the companies that survived the crisis started as seeds.”

Right now, Iceland needs someone like Björk. In every bar, club and restaurant I go into, people are asking how they believed they could live on 215% beyond their income, and how simple living became so frowned upon.

“You’d see people with three cars, living in big houses, and now you realise that they didn’t own any of it,” says a photographer called Charlie Strand, who I bump into at B5, a Philippe Starck- designed bar. “Competing for sophisticated stuff seems naive now.”

There is talk of “new times”: of fresh ideas growing where old ones have fallen; banking being replaced with thermal energy, music, tourism, community. “Families are gathering together more now,” says Andri Snaer Magnason, author of last year’s prophetic bestseller Dreamland: A Self-Help Manual for a Frightened Nation. “Nobody can afford to pop to London for a meal out any more. Maybe it’s back to normal.”

Is this the end of one party and the beginning of another? “The artists and musicians never had money anyway,” says Arni. “These last few years have been a sham. Now we’ll do it differently.” What are your parents telling you to do, I ask Maria. “They’re telling me to save,” she says, and giggles. This is because she is Icelandic, and she knows that her landscape was created by catastrophic geological shifts, not gentle ones. And this is simply another one.

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