flavianopolis

Today in the Swedish business daily Dagens Industri there was an article about disturbances in the Icelandic economy. Icelandic banks are in difficulties, which I believe is related to the extremely high real exchange rate of the Icelandic Crown. At the moment the Euro trades at about 100 Icelandic Crowns, but in order to establish an approximatly identical price level with Germany the Euro ought to trade at about 150 Icelandic Crowns.

In my opinion these problems would be very easy to solve. The first problem is, as I have already pointed out, that the Icelandic Crown is heavily overvalued according to the theory of purchasing power parity and the second problem is that the Icelandic Crown has a floating instead of a fixed exchange rate.

The floating and overvalued exchange rate ought to be replaced by a fixed and initially undervalued exchange rate after which a corrective inflation ought to be allowed to raise the real exchange rate to a more normal level.

I propose that the Central Bank of Iceland should do the following and in the following order.

1. The Central Bank of Iceland declares that it will from now on purchase gold at a rate fixed in terms of Icelandic Crowns. The rate should be extremely high in the sense that a very high gold price ought to be chosen. I propose that the Central Bank of Iceland ought to pay 20 million Icelandic Crowns per kilogram of 24 carat gold which is about 10 times more than the present market rate.
2. The Central Bank of Iceland raises it's policy rate to 999.999,5% and it's overnight lending rate to 1.000.000% and lowers it's current account rate to minus 2%. After that absolutely nobody would borrow nor lend as much as one Eyrir from or to the Central Bank of Iceland.
3. The Central Bank of Iceland ought to withdraw from circulation notes with large denominations and replace them with notes or coins with small denominations in order to encourage the use of debit cards.

After those reforms, Iceland would still have a paper currency, though a paper currency with an exchange rate ceiling defined in terms of gold. In order to avoid macroeconomic disturbances the government of Iceland ought to carry out the following reforms in the following order.

1. The deposit insurance ought to abolished in order to make people suspicious about banks with excessive lending policies. New Zeeland and Australia do not have any deposit insurances.
2. All tariffs and quotas regarding imports ought to be unilaterally abolished. This can be done without any disturbances for Icelandic farmers since the extremely low initial exchange rate would make foreign food products unaffordable for the Icelandic population. Estonia had no tariffs nor quotas at all between 1992 and 1999. The purpose of unilateral free trade is to establish a price level above which Icelandic farmers would not be able raise prices without losing market shares to foreign competitors.
3. All opportunities to deduct from taxation interest payments on loans ought to be abolished in order to discourage borrowing. This is the case in Hong Kong.
4. Earned interest ought to be exempt from taxation in order to encourage savings. This is the case in Hong Kong.
5. Gold clauses as well as the denomination of loans, assets and deposits in terms of gold ought to be legalized. If people are allowed to use foreign currencies as means of payment, they ought to be allowed to use precious metals as means of payment.

The outcome of those reforms would probably be similar to what happened in Estonia after the introduction of the Estonian Crown which had a fixed exchange rate against the German Mark. Prices rose sharply until the combination of a fixed exchange rate and a high domestic inflation rate had raised the real exchange rate to a more normal level. At this point inflation slowed down.

I am convinced that the great advantage of a fixed exchange rate in comparison with a floating exchange rate is that the combination of fixed exchange rates and inflation rate differentials adjust real exchange rates far more precisely than floating exchange rates, which are prone to misalignments. The great advantage of a floating exchange rate is it's ability to quickly correct severe misalignments created by monetary policies, but instead replace them with other, though less alarming, misalignments.

However, the Icelandic experience seems to indicate that sometimes those misalignments are sufficiently large to create severe macroeconomic disturbances. I think that a fixed exchange rate is the answer.