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Tuesday, October 28, 2008

Iceland: What Happens After Imploding?

Recently Iceland imploded. See the post Iceland Melts, 77% Single Day Drop for some charts that point straight to hell. So what happens afterwards?

The simple answer: Nothing pleasant…

Iceland Central Bank Raises Key Interest Rate to 18% (Update2): “Iceland's central bank unexpectedly raised the benchmark interest rate to 18 percent, the highest in at least seven years, after the island reached an aid agreement with the International Monetary Fund.

Policy makers raised the key rate by 6 percentage points, the Reykjavik-based bank said in a statement on its Web site today, taking the rate to the highest since the bank began targeting inflation in 2001. It will publish the reasons for today's move at 11 a.m. local time.

The central bank is raising rates as Iceland, the first western nation to seek aid from the IMF since the U.K. in 1976, faces a prolonged contraction, coupled with possible hyperinflation and rising joblessness. The economy will shrink as much as 10 percent next year, the IMF forecasts. Iceland will receive about $2.1 billion in aid from the Washington-based fund, according to a deal struck on Oct. 24.”

A sudden 6% overnight increase by the central bank has got to mess with local mortgage rates. Inflation in Iceland is expected to hit 75% because the economy is heavily import dependant and the currency has collapsed. This has instnatly tripled the costs of everything entering the country.

History shows that attempts to save currencies from plunges by raising interest rates are prone to failure. The U.K. on Sept. 16, 1992, boosted its benchmark rate by 5 percentage points in two moves to 15 percent in a doomed effort to keep the pound in a European exchange-rate system. Britain gave up the attempt the same day and canceled the second rate rise; the pound lost 22 percent against the dollar in the final two months of the year.

During the 1997-98 Asian financial crisis, the International Monetary Fund advocated high rates to help restore confidence in sliding currencies. Central banks from Indonesia and Thailand to South Korea and Singapore lifted borrowing costs. South Korea took its main rate to 30 percent in December 1997.

The strategy failed to prevent exchange-rate collapses across the region. South Korea's won lost 47 percent against the dollar in 1997, the Thai baht fell 45 percent and Indonesia's rupiah plummeted 56 percent.”

Clearly, nobody ever learns anything. Looks like more of the same all around.


Anonymous said...

"A sudden 6% overnight increase by the central bank has got to mess with local mortgage rates. Inflation in Iceland is expected to hit 75% because the economy is heavily import dependant and the currency has collapsed. This has instantly tripled the costs of everything entering the country."

Ok, now I understand that we may have some deflation in the near term, but this quote is what many people are worried about -- that this overnight tripling is headed to the US. What's to stop it?

Anonymous said...

IMF is always about first screwing over the population of the countries they "help" before the default.

Sensible nations skip the IMF and default straight away!

Anonymous said...

As for the 'evil' IMF, let us not be confused. Just b/c they are present in the collapsing economies makes them no more responsible than a doctor at a hospital is the cause of the sickness and injuries.
fajensen: Point taken: collapse may be preferable to the IMF.

Tord Steiro said...

The idea that raising interest rates will help stabilize the currency is based on certain preconditions, preconditions taught in any basic macro course, and conditions that are mostly correct in normal times. But nobody calls on the IMF in "normal times", but only in times of absolute crisis, and it is crisis-handling the IMF is supposed to be good at.

So why the IMF appears to be incapable of coming up with anything better than ECON 1000 is a mystery to me. And the fund is clearly not equipped with the intellectual capacity to deal with crises, which is indeed what it is meant to do.

So having the IMF, using their usual ECON 1000 prescriptions to cure countries' economic illnesses, is nothing short of a doctor using 14th century medicine in a hospital. It is potentially damaging to the patient, hence it is illegal and usually subject to severe punishment.

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