The Melting Icelandic Economy
Iceland has long had a problem with a much too spendthrift economy, as is evident in its massive current account deficit and its high inflation rate. In recent years, the people of Iceland (or more specifically its banks) have borrowed far too much from abroad, something which they have done mostly in foreign currencies which have had a much lower interest rate than in Iceland. Because of the willingness of Icelandic banks to borrow in foreign currencies, it has been difficult for the Icelandic central bank to contain credit expansion by raising interest rates in terms of Icelandic kronor.
Now the Icelandic krona has fallen some 45% in the latest year against the euro and the U.S. dollar . A year ago a U.S. dollar stood at ISK 61 and a euro stood at ISK 86. Now (October 7, 2008) a dollar costs ISK 107 and a euro costs ISK 147. There are two consequences of this. First, there will be a massive increase in price inflation as Iceland, being a tiny nation, is very dependent on foreign trade and thus also foreign exchange rates. And secondly it will cause a massive collapse in domestic demand and only to a somewhat lesser extent. The reason for the latter is that the value of all those foreign debts accumulated by have now risen some 80% in terms of ISK, bringing many banks and other companies and households to the brink of bankruptcy. The Icelandic government though, is as reluctant as others to allow banks to collapse so it has nationalized the two biggest banks, Landsbanki and Glitnir.
This scenario where a massive currency collapse will cause both a sharp increase in inflation and a sharp economic downturn caused by a massive increase in the foreign debt burden is not to dissimilar to what happened in many East Asian countries in 1997-98.
To avoid a further collapse in the currency, the Icelandic government now says it will peg the ISK to a basket of currencies. Ironically, during the East Asian crisis it was often said that the pegs formerly kept by the crisis hit countries and if they had only kept a floating exchange rate this wouldn't have happened. Now Iceland seems to think that the floating exchange rate policy it kept until today is the root cause of its crisis and that a peg is the solution.
In reality both systems are vulnerable and the only real way to do away with the exchange rate risks is a monetary union (assuming that it is permanent). It remains to be seen just how sustainable this peg will be. What will Iceland do if there are speculative attacks against the peg? Impose draconian capital controls? Raise interest rates to 500% like Sweden did in its futile attempt to defend its peg in 1992? The risk is high that this measure could end up causing even more problems.
In any case though, Iceland will be forced to stop living beyond their means and run as large current account deficits as it has in recent years.