Friday, July 06, 2007

Icelandic Economy Starts To Melt

Exactly a year ago, I wrote on this blog on the imbalances of the Icelandic economy. I pointed out that Iceland pursues very sound microeconomic policies with low tax rates, low unemployment benefits and a deregulated labor market and also have a budget surplus. Iceland differs from other Nordic countries in being relatively low tax in most areas.

However, Iceland's macroeconomics isn't very sound. Iceland with its mere 300,000 inhabitants is simply far too small to be an independent currency area without causing significant economic distortions. And so when e American company Alcoa invested in an Aluminum plant called Fjarðaál, this caused the Icelandic krona to massively appreciate (when a currency zone is so small as Iceland, transactions that in bigger currency areas would have almost no effects can cause massive distortions of the exchange rate), making it absurdly overvalued, contributing in turn to a massive current account deficit and a generally overheating economy.

Now Iceland have formally fallen into a recession, with GDP being down 0.9% (3.6% at an annual rate) compared to the previous quarter and 0.1% compared to the same quarter in 2006.

Domestic demand was in fact down as much as 10%, with only a rapid decline in the trade deficit preventing a even larger decline in real GDP. Arguably, the cyclical boom in the rest of Europe have limited the extent of the cyclical decline.

Ultimately, this recession is sound for Iceland as it helps limit the unsustainable imbalances of excessive inflation and current account imbalances.

The question is how to prevent these problems from happening again. The obvious solution would be for Iceland to adopt the euro as currency. The trouble with that is however that in order to formally join the euro zone, Iceland would have to join the EU. And that would entail quite large costs in membership fees and loss of rights for its important fishing businesses.

A better solution would really be to unilaterally impose the euro as currency (Something which both Montenegro and Kosovo have done). While this would imply the loss of seignorage revenues to the ECB, it would nevertheless be cheaper than the alternatives of either joining the EU or suffering more of these kinds of crisis.


Blogger Flavian said...

You are right, but an even better solution would to liquidate the central bank and introduce a gold coin standard.

Small currencies are subject to nervous exchange rate movements.

10:51 PM  

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