Quiz About Interest Rates & Economic Imbalances
In his book about the financial crisis, A Perfect Storm (I reviewed it in Swedish here), Swedish libertarian writer Johan Norberg on the one hand argues that the Fed’s low interest rate policy was a contributing factor behind the U.S. housing bubble. Later in the book, he attributes Iceland’s imbalances on excessively high interest rates, as it caused the Icelandic krona to be overvalued, which in turn made imports too cheap and exports too expensive.
At first glance, that would appear to be a contradiction. After all, economic laws should be the same in all countries, and if there was something about low interest rates that created imbalances then surely high interest rates should have the opposite effect and prevented imbalances. And if high interest rates through the effect on exchange rates in Iceland created imbalances there, shouldn’t the depressing effect on exchange rates from low interest rates in America have prevented imbalances in America?
The apparent contradiction gets even worse if you adhere to a Keynesian analysis, according to which currency appreciation will reduce cyclical excesses, which would make the Icelandic bubble even more incomprehensible.
There are however good reasons to think that no contradiction exists here, and that it at the same time can be true that low interest rates created imbalances in America and that high interest rates could have created the imbalances in Iceland. This also further illustrates the fallacy of Keynesianism.
So the quiz challenge for you is to try to figure out why this is not a contradiction, despite the fact that it might appear so at first glance. A hint is provided through the mechanisms described, but there is a lot more to it than that. Some further hints can be found in certain previous posts from me related to the subject, but I won't tell you which. I know the answer, but before I present it I will give you the chance of trying to figure it out for yourself. And for those of you who have Norberg’s book, the answer can’t be found in there, as the apparent contradiction isn’t noted there. The reason why it's not there is probably that he hasn't thought about the issue, but if he reads this he is of course very welcome to tell us what he thinks the solution is.
Note also that there might be alternative solutions to this riddle unrelated to the one I had in mind and have hinted here which you might suggest. Just remember that it must explain why what applied to America didn't apply to Iceland, and vice versa.
You can think about this until Saturday (27/6) evening (Swedish time), after that I’ll present the answer. No comments on this post will be posted until then however, so as to prevent you from copying each other.