The Iceland follies: loony currency schemes

from Dean Baker

Those who thought we have seen as much financial craziness as possible from this small island-country are in for a big surprise. The nuttiness is just beginning. Iceland is apparently considering adopting the Canadian dollar as its official currency.

It is hard to know where to begin the ridicule. If they had any sense, the people of Iceland would be thanking the god of small currencies every day for the fact that the country had its own currency, as opposed to say, being part of the eurozone at the time that its financial system imploded.

As a result of having its own currency, the country was able to make much of the necessary adjustment to the crisis by allowing the value of its currency to decline relative to the currencies of its trading partners. This made imports more expensive, sharply reducing the volume of imports. The lower-valued Icelandic kroner also made its exports cheaper, leading to a surge in exports.

The effect of this change in relative prices was that Iceland’s massive trade deficit, which soared to more than 28 percent of GDP in 2008, is projected to be turned into a surplus of more than 3.0 percent of GDP this year. This incredible turnaround restored the economy to growth in 2011 and has started to bring Iceland’s unemployment rate down.

The 6.7 percent unemployment rate Iceland reported for the fourth quarter of 2011 is high by Icelandic standards but looks great compared with the euro-bound crisis countries. The most recent unemployment rate reported for Portugal was 13.6 percent, for Ireland 14.5 percent, Greece 19.2 percent, and Spain 22.9 percent.

These countries were cursed by being on the euro for three reasons. First, they were stuck with the European Central Bank’s (ECB) obsession with inflation. While much of the debt burden of ordinary Icelanders has been alleviated by two years of 12 percent inflation (2008 and 2009), debtors in the eurozone crisis countries have had to suffer through the ECB’s celebration of continuing low inflation.

Second, by being unable to devalue their currency, the eurozone countries could not rely on a jump in net exports to provide the same boost to growth as in Iceland. Finally, being a part of the euro meant that the ECB, along with its partners the IMF and the European Commission, were able to demand budget cuts and tax increases even in the middle of a steep recession, slowing economies in the crisis countries even further.

The imbalances created by Iceland’s financial excesses of the last decade dwarfed anything seen in the troubled eurozone countries. Its current account deficit exploded to an incredible 26 percent of GDP in 2006. This was enough to even get the attention of the IMF, an organization not ordinarily troubled by irrational exuberance in private markets. If Iceland did not have the freedom to use the devaluation of its currency as a key part of its adjustment process, it might be looking at a decade or more of stagnation and high unemployment.

Rather than celebrating this good luck, Iceland’s leadership seems intent on putting the country into the same sort of straightjacket as its less-fortunate eurozone neighbors. If Iceland were to join any major currency block, it would immediately lose the flexibility that protected it during its recovery from the crisis. For this reason, the country should be extremely cautious about the terms under which it relinquishes control of its currency.

However the choice of Canada is especially bizarre. As a major exporter of oil, Canada’s currency is likely to follow the price of oil. This means that when the price of oil is high, the Canadian and also the Icelandic currency will rise in value. This will have the effect of raising the price of Icelandic goods and services relative to prices in other countries.

That will make Iceland less competitive in the world economy. It will be buying cheap imports from abroad instead of domestically produced goods and its exports, for example tourism, will shrivel as people decide that Iceland is too expensive.

Canada has this problem as well. In recent months there have been several instances where major manufacturers announced decisions to relocate to the United States to take advantage of the relatively lower costs here. The difference between Canada and Iceland in this story is that Canada will have the income from its oil to tap to help ameliorate the displacement that results from a rise in the value of its currency. Iceland is not likely to be able to share in Canada’s oil wealth in the same way.

The last time Iceland’s leaders were infected with nutty ideas about the economy they hired Frederick Mishkin, a prominent U.S. economist to say that everything was just fine even as the financial system was just about to implode. Let’s hope the public forces them to take a more serious route this time.

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