Iceland Economy: How they got in this Mess

was possible. So the businesses selling goods overseas cannot bring their profits back into Iceland, and those importing cannot obtain foreign currencies to buy goods.

But how did it all happen? Many believe that Iceland’s central bank pursued the wrong monetary policy. It adopted an inflation targeting strategy which involves dropping rates if inflation is below a certain target, and raising them if it is above. And it did a lot of raising.

The inflation rate rose and rose, which meant the central bank kept increasing the interest rate. It even reached 15% or more. What this was designed to do was prevent more loans and thus restrict the amount of borrowing, effectively making money more valuable.

However, with such a high interest rate, it only encouraged firms and individuals to borrow from overseas, where the interest rates were much lower. Some even engaged in the carry trade, which is borrowing cheap money (like from Japan) and selling it where interest rates are high (like back home in Iceland). It’s often been said that the carry trade is like picking up pennies in front of a steamroller, but if you’re a wealthy housewife buying yen at zero percent and selling it for 14% back home, it makes sense.

The result was tremendous amounts of foreign funds being introduced to the nation which created large exchange rate differences, making the Icelanders feel even richer than they already were. As this prevailed and was profitable for many, it therefore continued, until a bubble was created, and the Icelandic króna was overvalued. A collapse was imminent.

In early 2008, the króna was worth 90 euro. By October 2008 it dropped to 340, and in now it has started correcting to around 145.

A senior government official in Icelandic recently said, “The króna is dead. We need a new currency. The only serious option is the euro.”

Vladamir Gonzalez, EconomyWatch.com