flavianopolis

According to the man on the picture above, Mr. Geir Haarde, the prime minister of Iceland, the Icelandic currency is "significantly undervalued". However, he is completely wrong and I fear that his misperception of economics might result in catastrophic consequences if the Icelandic currency authorities are as stupid as Mr. Haarde, and Iceland therefore fixes the exchange rate of the Icelandic Crown not on the basis of sound economic analysis, but on the basis of what is considered appropriate from the perspective of national pride.

Without any question the Icelandic Crown is still significantly overvalued from nearly every perspective, although it a few years ago was overvalued from absolutely every perspective. According to the theory of purchasing power parity, on the basis of the price of a Big Mac, the Icelandic Crown is undervalued against perhaps a handful of currencies, but overvalued against a good hundred currencies.

Although the Icelandic Crown has fallen sharply Icelandic farmers still sell their products at the minimum prices guaranteed by the Icelandic government. One fairly certain indicator of a truly undervalued currency is that the farmers of the country in question prefer to sell their products at the rates prevailing on international markets instead of selling them at the prices guaranteed by their national government. One truly undervalued currency was the Argentine Peso just after the Argentine government decided to float the Peso in 2002.

Another way of looking at the problem which happens to give exactly the same result is the following. A few years ago Icelanders borrowed excessive amounts of euros, but now they have difficulties in servicing those debts. They need more euros in order to meet their obligations. How can the Icelanders make greater sums of euros flow to Iceland? Well, one opportunity is to increase exports, but since most exports are already priced in terms of euros a lower exchange rate of the Icelandic Crown will not necessarily fuel exports. I think that the only way to make more euros and other foreign currencies flow to Iceland is to make more foreigners visit Iceland and spend more money there. What is needed in order to attract tourists? Well, you need a beautiful landscape and the opportunity to experience something you will not experience at home. Iceland has all those things.

What Iceland does not have, however, is a reasonable price level for the kind of services tourists demand. Tourists like to have meals at restaurants and sleep in hotels. In these aspects Iceland is, yes, cheaper than the most expensive European countries but still more expensive than nearly all countries on this planet. The only way to correct that is to allow the Icelandic Crown to depreciate without any corresponding price increase for domestic services. If the Icelandic Crown would depreciate more and prices for domestic services and foodstuffs would not increase correspondingly, Iceland would enjoy greater revenues, not only in terms of depreciating Icelandic Crowns, but also in terms of foreign money. That's what they need in order to service their foreign debt. The fear that higher exchange rates for foreign currencies in terms of Icelandic Crowns will make it more difficult to service the foreign debt is thus mistaken. The opposite is true.

If Iceland were governed by clever people, which it is not, the problems would be easy to solve. Iceland should actively devalue its currency and do it sharply, and Iceland should also establish a fixed exchange rate or, even better, replace its currency with something else. However, before the Crown can be replaced with something else, the government of Iceland will have to establish a fixed exchange rate against that currency or precious metal which is supposed to replace the Crown.

How could that be done?

Well, to make Iceland approximately as cheap as Argentina was just after the peso was left to float in 2002 would require a US dollar at about 600 Icelandic Crowns. Since one Big Mac on Iceland costs 610 Icelandic Crowns and it ought to cost about $1 in order to make Iceland approximately as cheap as Argentina was after its devaluation, I have built my calculation on the figure 610. If the price is of a Big Mac will be raised or lowered, I will of course alter that figure correspondingly.

I admit that that would be a shockingly sharp devalutation, but I am also absolutely certain that such a sharp devaluation would make the Icelandic economy recover immediately and I also think that the inflationary consequences of such a bold step could be limited. If the Icelandic Crown were devalued as sharply as I propose, Iceland could immediately abolish all tariffs and quotas regarding imports. Imported foods would be unaffordable anyway and Icelanders would have to rely on domestic foods.

Secondly, the deposit insurance should be abolished. If people want perfect financial security they should keep vaulted cash, if they want interest they must be ready to accept a risk.

Thirdly, I think Iceland should fix its currency not in terms of dollars, euros or yens, but in terms of gold. Actually, that is easily done. You start with a multiplication where the price of one Big Mac in terms of Icelandic Crowns on Iceland is multiplied by the US dollar price of one ounce of fine gold, which today is about $796. 610 times 796 makes 485.560 and that will also be the Crowns per fine ounce parity. That would leave the Icelandic Big Mac at about $1.

The Central Bank of Iceland therefore should declare that it pays 485.560 Icelandic Crowns per fine ounce of gold brought to the Central Bank. Theoretically, the price could soar above that level, but that is not realistic since the Icelandic Crown at that rate certainly would be so extremely undervalued that this risk is purely hypothetical.

On top of that the Icelandic central bank could and should raise its official interest rates to some absolutely astronomical level in order to make those rates obsolete. That would not have any significant deflationary effect anyway, since the high purchasing power of gold on Iceland would have an inflationary effect many times greater than the deflationary effect of the astronomical interest rates. I am thinking of official interest rates at perhaps millions of per cent.

At this point the central bank of Iceland should also withdraw from circulation all notes and coins, except a few with ridiculously small denominations, and replace the bigger denominations with small denominations. If it is inconvenient to use notes and coins issued by the central bank, people will rely on debit cards, and the result of that will be that the balance sheet of the Central Bank will shrink dramatically.

Finally, the Central Bank purchases the remaining circulation of change and replaces it with gold coins.

# posted by Flavian @ 12:18