The Iceland-Dow Connection

Josh has been watching the Icelandic krona:

This morning, the ISK reached a nadir of 350 ISK to the EUR, and I was placing phone calls to travel agencies trying to book the cheapest holiday of my life.
Then, suddenly - a 4 billion EUR loan from Russia (which might or might not exist?) and the imposition of a currency peg, and ISK traded as high as 140 to the EUR. Think about that for a sec: the value of the Icelandic economy doubled in less than an hour.
...and then the ISK promptly slumped back to 220-ish, because you can't impose a peg if you don't have anything to defend it with.

Iceland is in truly dire straits: the headline in the Times this morning is "Terror as Iceland faces economic collapse", over a story which includes this sentence:

The country's state surgeon even warned politicians and the media to ensure that they did not alarm old people.

There's a British angle, of course: Icelandic banks have been taking Brits' deposits. This is not exactly reassuring:

Times readers reported yesterday morning that they could not withdraw their money from Icesave accounts over the internet. But a spokesman for the bank said that Icesave was now operating normally and depositors could withdraw money. He added that the Icelandic Government had ample foreign reserves to cover the £4bn of British deposits in the event of any collapse.

Er, no, it doesn't. The Icelandic government has 374 billion kronur of foreign exchange reserves; if you convert that at 188 kronur to the pound (as plausible an exchange rate as anything else, and the one I get from Yahoo), that works out at less than £2 billion. Even with an extra €4 billion from Russia (Russia!), Iceland's foreign-exchange reserves aren't enough to last a day, if the locals sensibly decide they'd really rather be in any currency but kronur.

Willem Buiter says the government should simply bite the bullet and let its banks fail, lest it fail itself:

A government should only nationalise a bank (let alone most of its banking sector) if it has the fiscal strength to support the bank (or its banking sector). If it does not have the fiscal resources, now and in the future, to restore the banks to solvency, a private sector insolvency problem is transformed into a government insolvency problem. On the whole, the consequences of state default are more serious for the residents of a country than the consequences of a private bank default.

According to the CDS market, Iceland's going to take Buiter's advice:

Insurance against default on Iceland's sovereign debt now trades at $1.5 million upfront, with a $500,000 annual payment, to protect $10 million in bonds against default, according to Markit. Landsbanki and Kaupthing are trading at $4.5 million and $5 million upfront, respectively.

Could the imminent collapse of tiny Iceland help explain the whopping 60-point fall in the S&P 500 today, to below 1,000? Maybe -- we've had many big failures in this credit crisis so far, but we haven't had the implosion of an entire European economy -- one which is home to systemically-important international banks, too. That kind of thing could cause stock-market jitters at the best of times; right now, I can easily see how it's good for 500 Dow points.