flavianopolis

If one takes a look at the internetsite of the Icelandic Central Bank one easily gets the impression that the Icelandic Central Bank attempts to fix the exchange rate of the Icelandic Crown against the euro at the rate 150,- crowns per euro.

I am strongly in favour of fixed exchange rates and monetary unions. However if a country that used to have a floating exchange rate wishes to fix it's exchange rate there are many traps on the path to a stable and credibly fixed exchange rate. I doubt that the Icelandic authorities are aware of all the things they ought to be aware of if they wish to fix the exchange rate.

The probably most important factor is the real exchange rate. If country A tries to fix it's exchange rate against the currency of country B, country A must make sure that it's domestic price level is not higher than that of country B. The rate 150,- icelandic crowns per euro would leave the icelandic price level slightly below that of Germany, which is the most important country of the euro area so from this perspective the attempt might not be doomed beforehand.

On the other hand the chosen exchange rate is not low and the icelandic economy would probably need the help of an undervalued exchange rate to recover from the present chaos. Therefore I suspect that the present exchange rate will not give the icelandic economy the boost it needs. On the other hand it will not fuel inflation either.

I also doubt that the chosen exchange rate is low enough to make the icelandic banks recover on their own. Since the rate 150,- icelandic crowns per euro will leave Iceland fairly expensive for the vast majority of the world population, there is no reason to believe that the supposedly low exchange rate will make foreign money flood to Iceland. It therefore seems likely that the government of Iceland will have to remain the owner of an enormous quantity of sour loans for which there will be no buyers. This fact will of course fuel speculations against the exchange rate and make interest rates remain high. The situation will perhaps be a little bit less shaky, but yet not stable.

In my opinion there is a simple and good solution to all those problems and the solution is an enormous and extremely sharp devaluation which plan I have already described. However, there is one strong objection against such a plan and that is the fact that many Icelanders are in debt in terms of euros and that therefore a devaluation would not serve the interest of the debtors whose debt is denominated in terms of euros. However, I wish to question that because of the simple and obvious fact that shortly after my proposals would have been realized, Iceland would be an extremely cheap country. Foreign visitors would give the Icelandic economy the boost it needs and in case the exchange rate I have proposed is far too low the purchasing power of foreign currencies will drop until an approximate equilibrium has been established.

A constant gold price and unilaterally free trade would make sure that a possible inflation would be short-lived and that after it had come to an end Iceland would experience economic health. The text about how Iceland could rescue it's economy is available at this address.

http://flavianopolis.blogspot.com/2008/02/fixed-exchange-rate-is-answer.html