Thursday, July 06, 2006

Icelandic Economy Melting

Those who believe the Friedmanite floating exchange rate is the path to economic stability would be well advised to study the experience of Iceland, the smallest of the Nordic countries with just 300,000 inhabitants. Meaning Iceland is exactly 1000 times smaller than the United States.

Iceland have good microeconomic policies with tax rates well belove the levels of other Nordic countries with a top personal income tax of 35% and a top corporate income tax of 15%. Unemployment benefits and other government hand outs to people who don't work are also much leaner than in the other Nordic countries. Combined with the strong traditional Lutheran work ethic of Nordic countries, this have given Iceland an extraordinarily low unemployment rate of just 1.5% and the by far highest employment to population ratio in the world.

Yet Iceland's macroeconomic foundations are anything but sound, except for the government finances, who like the other Nordic countries show a surplus. Iceland is one of the smallest currency zones in the world and pursues a Friedmanite floating exchange rate policy.

In recent years there have been massive foreign borrowing by Icelandic banks. Together with a investment by the American company Alcoa in an Aluminum plant called Fjarðaál, this caused the Icelandic krona to massively appreciate, paving the way for a massive current account deficit of more than 15% of GDP.

Investor nervousness about the massive external deficit have caused the Icelandic Krona to plunge. Because Iceland is such a pathetically small currency zone, this have sent consumer price inflation sky-rocketing, reaching 8%. Moreover, the dramatic decline in the krona is also ominous because given the large external debts denominated in foreign currencies, a weaker krona will sharply increase the debt to income ratio, just like it did during the East Asian crisis 1997-98.

To defend the currency, the Icelandic central bank have raised interest rates to 13%, and is expected to raise it even more soon. This have helped stabilize the currency in the short-term, and is under the circumstances a wise move as the alternative of a plunging currency is far worse. But interest rates at these levels will likely send the Icelandic economy into a recession soon, possibly a sharp recession.

What the Icelandic currency crisis illustrates is that contrary to the assertions of the Friedmanites, floating exchange rate policies are not a guarantee too avoid the kind of currency crisis that have been associated with some countries who have pursued fixed exchange rates.


Blogger Flavian said...

Magnificent you are 100% right!

8:31 AM  

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