Heidar Gudjonsson: What is the way out for Iceland?

With its currency down over 70 percent in two years, with 90 percent of its financial sector collapsed, and with its stock index down 95 percent over the same period, what can Iceland do?

The political discussion has been confusing at best, and the chaos in the economy is not helping.  Iceland was hit with a triple crisis: first a currency crisis that started in 2006, then a financial/economic crisis that started in October 2008, and finally a political crisis as of this year.

The public is angry and confused, but there is a clear lack of leadership and constructive debate within the country. Some people argue that joining the European Union would be the only way out. After Iceland joins the EU, some of the government would be effectively outsourced and a new currency could be introduced by joining the European Monetary Union (EMU).  What this argument overlooks is the time factor. Negotiations with the EU would never take less than one year. Then all the existing 27 members of the Union would need to approve Iceland as a new member. There is currently a waiting list, and Iceland could not be fast-tracked to the front of that list. In fact, given the many problems that the EU is having as it is, the process may take three to four years, at best.

To join the EMU, Iceland would need to fulfill the Maastricht criteria of low and stable inflation. But here the track record of Iceland is anything but impressive, having consistently volatile and high inflation of at least twice the criteria, over the internationally low inflation period of past two decades. Iceland would also need to have a very low budget deficit, something the current leftist government is hardly going to meet (the target is below 3 percent but the current deficit is 10 percent). The last big obstacle is government debt.  With the current IceSave agreement, which the government is pushing the parliament to approve, the Maastricht target would be impossible to reach for the next decade or so.

It should be noted that the public is anything but interested in joining the EU. But the current government is very keen. It just got a resolution through parliament to grant the government the power to start negotiations with the EU on July 16.

Iceland today has very strict currency restrictions, first put in place in October 2008. The restrictions are so tight that they can only be compared to communist Eastern Europe in the sixties and seventies. The policy makers are unwilling to lift these restrictions since they are afraid that the currency will add to its 70 percent devaluation. For Iceland to operate with these restrictions is impossible. A developed country cannot function without a currency. The economy will only deteriorate further and much-needed capital to restore the country will not enter under such restrictions.

Some nationalists (I would not call them patriots) think that Iceland would be better off returning to its old ways of having the smallest independent currency in the world and not join any monetary union. It’s hard to see how one can support that argument without relying purely on emotions.  Under such conditions inflation could be very volatile. Moreover, interest rates would be correspondingly high, while the weak currency would dampen economic activity since transactions costs would be extremely high. Such a system would not support a decent banking system, much needed since Iceland is virtually the only developed economy without a banking system.

By “dollarizing” the economy Iceland would immediately solve most of its problems. Inflation would not be an issue, interest rates would quickly drop from the current 12 percent to international market rates, Iceland would automatically transport itself into an efficient economic and monetary area, where lending is more active and transactions costs a fraction of what they are in the Icelandic Krona.

The creditors of the collapsed banks, who as of July 20, are going to take over two of the three large collapsed banks, would welcome such a measure.  Then the main risk of the system, the currency risk, would disappear and the banking system would fit with any other international operation.

The Central Bank in Iceland would render itself obsolete by supporting such a change, but that would of course be in the interests of the economy which the bank is supposed to safeguard, rather than the interests of the current 150 member staff. The Central Bank reports net currency reserves of over 400 billion Icelandic krona, more than 15 times the amount needed to convert all the notes and coins in circulation. They have seven times the total money supply necessary for a unilateral currency adoption. 

Unilaterally adopting the euro or the dollar would be the most logical choice. The EU has an official stance as always being opposed to such measures, even though Montenegro, Kosovo and others have unilaterally adopted the euro. Unilateral currency adoption takes four weeks. In the very successful cases of Ecuador and El Salvador the adoption of the dollar has made the economies and financial markets stable even though the local politics have been quite volatile.

It is hard to see why the politicians of Iceland do not support such a quick fix. They seem to be disconnected from the public and want to force the nation into a decade long ordeal to try to get a proper currency their political way.  If the politicians have it their way, the costs to the living standards of the Icelandic people will be extreme.

Heidar Gudjonsson, an economist living in Zurich, served as a managing partner at Novator in London, a 7 billion Euro family office, 2005-2009, after operating a managed account at Islandsbanki London and a global macro hedge fund in New York. Earlier, he was a senior manager at Kaupthing New York and Islandsbanki.

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