Iceland: Victimized by its Tiny Currency

Jim Surowiecki has a good piece on Iceland this week. "When we look at Iceland's predicament," he says, "we should say that there but for the grace of China go we."

It's a good point. If Iceland risks becoming the Bear Stearns of the North Atlantic, then America is the Citigroup: too big to fail.

I do differ with Surowiecki on one thing, though. He says that the troubles currently besetting Iceland are a direct consequence of the subprime crisis and the ongoing credit crunch. In a narrow sense, that's true, but looking at the bigger picture Iceland has always had a very fragile economy. And the main reason is its insistence on having an independent, free-floating currency.

Iceland is the smallest economy in the world to have a floating currency. And floating currencies are dangerous to have: they're by definition at the mercy of international currency speculators, with their trillions of dollars in daily flows. Iceland, in particular, has seen the value of its currency set not by any real fundamentals so much as by the mechanics of the notorious carry trade, where hedge funds borrow money in Swiss francs or yen, and invest it in high-yielding currencies like the Icelandic króna or the Brazilian real.

In strong years, this is good for Iceland: it means that Icelandic companies, including its banks, can snap up northern European retailers and financial institutions at attractive prices. But when the carry trade is unwound - and it always unwinds with a snap, never gradually - then Iceland is forced to implement extremely unpleasant pro-cyclical monetary policies to avert financial disaster.

Did Iceland borrow too much from abroad, as Surowiecki asserts? Yes. But if it had adopted the euro before doing so, it wouldn't have its current problems. Of course, Iceland isn't even in the EU, let alone close to becoming a formal member of the eurozone. But as Willem Buiter reminds us, you don't need to be in the EU to adopt the euro. Maybe this present crisis might force Iceland's population to start thinking the unthinkable.