Economic History in the Making, Iceland’s “el error de diciembre”

As an economics student one of  the most fascinating topics I ever studied was the Mexican Peso Crisis (nicknamed “el error de diciembre”, in Mexico). When studying the Mexican crisis and the ripple effect it had through the developing world (the ripple was a run on several developing Asian countries because of a fear that even well maintained small economics were exposed to similar risk) I never thought it possible in a modern developed economy[1]. Now, after watching Iceland approach the brink of disaster I have an entirely new perspective. Here is a brief background on how a currency crisis occurs and overview of what is going on in Iceland.

 

 

 

Monetary Economics 101 - A brief background.

Currencies are traded on an open market. Businesses make transactions in a specific currency, and then deposit those transactions in a bank. The bank acts as a clearinghouse by trading large quantities of their deposits on the foreign exchange market so they can provide domestic currency to customers at local branches. The foreign exchange market determines the currency’s value using a supply and demand model.

 

The demand side of the market, can be described through a simplistic example. An Icelandic businessman makes a transaction in dollars, deposits the dollars in his Icelandic account, the Icelandic bank trades dollars for Krona in the foreign exchange market, then the Icelandic businessman is able to withdraw Krona and use it to buy things. This basic process happens in bulk countless times throughout the day, more demand to change dollars into Krona will push the value of Krona (relative to dollars) up.

 

The supply side of the market is controlled by a Country’s central bank. A central bank uses open market operations to reduce or increase the amount of currency in circulation, thereby inflating or deflating the currency. An open market operation can be demonstrated through another very simplified example. The Icelandic Central Bank holds several different currencies including U.S. Dollars. Through a direct open market transaction it can “buy” Krona using its dollars, then hoard the purchased Krona, thereby reducing the supply of Krona in circulation. Central banks can also indirectly effect the money supply through the interest rate (in the U.S. the federal funds rate). By increasing this rate a central bank makes it relatively more expensive for commercial banks to make loans, less loans means slowing general economic activity, which translates into lower amounts of circulating domestic currency.

 

During a currency crisis there is a sudden drop in demand for the at-risk currency. There is a fear that a country is having some catastrophic problem, and will not be able to control the value of the currency through an open market operation. As demand for the currency drops, the value of the currency (in relation to other currencies) follows. A central bank can raise interest rates and/or buy domestic currency directly in the foreign exchange market using foreign denominated assets (from the example above a central bank can take all the US dollars it holds and buy as many Krona as possible to hoard from the market, which decreases supply). These actions will attempt to curb the fleeting value of the domestic currency measured as the inflation rate. The problem is if the fear factor that set off the crisis cannot be stemmed. As world demand for a currency spirals downward a central bank will have an increasingly difficult time keeping up on the supply side. Just as a bank run this is a self fulfilling prophecy, a country’s currency is perceived to be highly risky, so demand for the currency drops, and that makes the currency even more risky. A central bank will continue to fight the run on the currency by continuing to contract the money supply, but once this snowball starts it is often difficult to stop.

 

This crisis also has far reaching effects on the domestic economy. With the central banks raising the interest rate there is an automatic cooling effect on the economy, unemployment will start to creep up and business credit will slow. For small and developing countries there is often a huge problem with foreign debts. If a business has any debts denominated in foreign currency a rapid inflation can be devastating. For example if I owe someone $100 when 1 dollar = 1 Krona, and now 1 dollar – 10 Krona my debt just increased to $1,000. Multiply by the billions of dollars in trade and even the slightest drop in value could bankrupt a country.

 

 

What happened to Iceland

On October 7^th Iceland made drastic moves to protect its financial system by nationalizing two of its three major banks. Within days the last and largest of the three banks was also swept under the control of the Icelandic central bank, triggering a fear driven collapse of the foreign exchange market for the Icelandic Krona. It is a mark of how serious the liquidity crisis has become.[2] The fear was that Iceland was overexposed to U.S. sub-prime real estate market, and the Icelandic banks would not be able to meet their debt obligations given the collapse of the real estate market. Once controlled by the Icelandic Government, the concern passed onto the central bank. Further a lot of these debt obligations are denominated in U.S. dollars, and as noted above this can compound debt many times larger than its original principle. This tiny country with far less citizens than many U.S. cities was forced to defend its currency against a run.

 

Iceland at the start of this financial crisis had all cards stacked against them. The country’s leading export in recent years is financial services. Iceland’s major banks were heavily leveraged in foreign mortgage markets which were all denominated in foreign currency. It led to a boom in Iceland’s GDP during the golden years but left the country open to a disaster when the U.S. housing bubble popped. As soon as the instability was apparent Iceland’s central bank immediately requested support from allied nations to shore up the balance sheets of its financial institutions with foreign investment. Unfortunately with all major countries looking at a global recession Iceland suddenly found itself without any friends. The member of NATO found its only hope for survival with Russia, and the IMF.

 

The central bank followed protocol, and raised its key interest rate 6 points overnight on October 28th, putting the rate at 18%. The estimated $6 billion IMF loan will be denominated in dollars giving some added protection to shore up the currency but the country is facing some serious economic hardship ahead, adding fuel to the problem.

 

To add insult to injury Iceland probably never expected to be stabbed in the back by the Brits! An important modern twist to this story was reported in last Sunday’s New York Times. For reasons described above Iceland moved to liquidate many of their non-Krona based assets in an effort to buy up as much Krona as possible. Britain, fearful that Iceland may default on their government debt held in British banks, used a broadly defined anti-terrorism law to freeze all Icelandic assets held within the country. In one quick move Britain classified this NATO ally as a terrorist state, and tied their hands from protecting their currency. The public relations disaster did not help in curbing the fear that the country could not meat its debt obligations, further fueling the problem.

 

Iceland’s situation is a tragic piece of economic history. The country has not survived this crisis yet, there are dismal growth projections and still the possibility of hyper inflation but I am confident it will overcome eventually and sit next to Mexico, and the Asian countries as another to weather the storm. In a final note when Mexico entered their crisis in 1994 the U.S. stepped up through a series of emergency loans to try to stabilize the country. It is sad to see (obviously we were in a much better situation in ‘94) we could not have done the same for Iceland, and even sadder to see the acts of Britain in their time of need.

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[1] Britain had a devastating run on the Pound in 1931 when it abandoned the gold standard, which is why I specify modern developed economies.

[2] This is not the only currency crisis occurring right now. There is the well known currency crisis that has gone on for a long time in Zimbabwe that is absolutely out of control. In August the inflation rate in Zimbabwe hit 11.2 million percent. I would argue this is not due to the global credit crisis as much as it is a result of a mismanaged government.