Tuesday, April 4, 2017

Floating rates?

I was interested to read in the Financial Times, "Iceland weighs plan to peg krona to another currency":
Iceland’s finance minister has admitted it is untenable for the country to maintain its own freely floating currency....Benedikt Johannesson told the Financial Times that the Nordic island of just 330,000 people would look at options to link Iceland’s krona to another currency, most likely the euro or pound.
“Is the status quo untenable? Yes. Everybody agrees on that. We’d like to have a policy that would stabilise the currency. It’s really not good when a currency fluctuates by 10 per cent in the two months since we took over,” said Mr Johannesson, who became finance minister in January. 
The main thing is if you want to peg against a currency, do it against a currency where you do business. Once you decide on a currency, that will also change the future. You will do more business with that area,” he added, pointing to Denmark’s experience of doing more business with Germany after pegging its currency first to the Deutschmark and then the euro.
This is interesting in the context of Conventional Wisdom, which says the euro is a bad idea, and every tiny country needs its own currency, to devalue any time there is a "shock." In this view, Iceland is a great success because it did devalue after its banking crisis. I am a skeptic, largely favoring a common standard of value. Greece did not become a growth tiger from its previous umpteen devaluations. I'm interested that even the supposed success story for devaluation does not see it that way.

Update (via marginal revolution) here at Bloomberg. The idea is controversial.

Everyone wants a float after the fact, to devalue their way out of trouble. But everyone should also want a peg before the fact; the firm commitment that you will not devalue your way out of trouble makes international investment and trade flow much better. 

3 comments:

  1. The Icelandic crisis would probably have been prevented if Iceland had been part of the Eurozone. Icelandic banks had accumulated massive foreign debt (mostly in euros) and the Icelandic central bank was unable to act as a lender of last resort when the run occurred. Had Iceland been part of the Eurozone, the ECB might have prevented the crisis.
    Of course, this news is only about pegging the currency, but this might be seen as a first step in adopting the euro.

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  2. I’m with John in seeing the utility of a “common standard of value”. Iceland will be a happier place if the people who buy and sell codfish see prices that reflect the actual demand and supply of codfish. But do they come closer to this ideal by pegging to the euro? Maybe, since, as the guy pointed out, the presumption should generally be to use a currency that measures value the same way your important business partners measure value. But can Iceland really trust the value of the euro? Sure, good monetary policy in Iceland can stabilize the euro value of the krona but that doesn’t do what you really want to do—establish a common standard of value. Bad monetary policy in Europe can destabilize the value for the euro.

    The ECB (or the Germans or somebody) talk a good game but it doesn’t appear that they’ve really altered their financial system in a way that would make it possible for them to resist bailing out zombie banks. Until they figure out a way to create pan-European banks with lots of capital, I’m not sure the euro can be trusted to provide a common standard of value.

    (But maybe that’s just me looking at things from the perspective of an American who finds it incredibly frustrating to see simple solutions to stabilize banks and reduce systemic risk being ignored.)

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  3. Bob Mundell has long argued the 2008 crisis itself was driven primarily by the huge (25%) appreciation of the dollar vs the euro from Aug 1-Oct 28. Since then, multiple large swings in the dollar in sync with Fed easing cycles. Mundell calls for a stabilization agreement like the Plaza and Louvre Accord to reduce big swings between these two titanic currencies.

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