The Icelandic Response to Crisis

If you're looking for a sensible and coherent response to a major crisis, you could do a lot worse today than look to Iceland. The country's current currency crisis happened because it's so small. But the solution, too, is something which would be almost impossible to implement in a much larger economy: it involves everyone -- buy side, sell side, government, banks -- all working together, in concert, with nobody trying to game the system.

In a nutshell, the government first guarantees all the banks' deposits. Then the buy side -- the Icelandic pension funds, which have billions of dollars in foreign securities -- sell everything they own abroad, and bring it back home. At an exchange rate of 126 kronur to the dollar, that will buy them a lot of kronur. (The currency has lost fully half its value over the past year.) The banks, too, will liquidate their foreign holdings, and bring them all back home.

The resulting inflows into the krona should put some kind of a floor under the currency, helping to prevent runaway inflation in a country which is uncommonly reliant on imports. And there's an all-for-one-and-one-for-all aspect to the scheme, too: the banks are helping out the government in return for the government helping out the banks. It's entirely possible they'll all go down together: one look at the country's credit default swaps will tell you that. But they're certainly stronger together than they were apart.

What's more, now that the government is guaranteeing deposits, there might even be a tiny trickle of interest in getting back in to the carry trade: after all, interest rates are in the 15% to 20% range, and given the recent crash in the krona there has to be some scope for serious currency appreciation on top. Of course, it was the carry trade which was largely responsible for getting Iceland into this mess to begin with, but that doesn't mean that a few foreign speculators might not actually be quite welcome right now.

In fact, I quite like the idea of going long the Icelandic krona right now, and hedging by buying default protection on the sovereign. If all the inflows come according to plan, then the currency should at least stay flat, if not appreciate, and in the meantime you're getting something over 15% on your money. And if everything goes spectacularly wrong and the country isn't bailed out by its fellow Nordic governments, the CDS should pay off handsomely.

Of course, there's downside risk in this trade -- basically that Iceland devalues even further -- but that's something the entire country seems to be trying very hard to avoid. So if you have faith in the Icelanders, this could be an attractive way to support the country and make money at the same time.