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John Quiggin

Taking Iceland's hot tip

John Quiggin Australian Financial Review

22 June 2006

Iceland rarely makes it to the news headlines. The Fischer-Spassky chess championship match held in Reykjavik in 1972 made a splash, and the pop world has Björk. More significant for Australia, if less glamourous, was the Cod War of the 1970s, when Iceland successfully asserted its right to prevent overfishing in a 200-mile economic zone, facing down the British Royal Navy to do so. But that was a long time ago. With a population of only 300 000, Iceland is just not big enough to attract a lot of attention.

Just now, however, Iceland is worth paying some attention. With interest rates at 12 per cent, inflation at 16 per cent and a current account deficit running at 26 per cent of GDP, Iceland’s economic statistics for the first quarter of 2006 are at levels more commonly associated with banana republics. The Prime Minister has resigned, its currency, the krona, has depreciated sharply and rating agencies are downgrading Iceland’s foreign debt.

Until about a year ago, though, Iceland was a miracle economy, having enjoyed a decade or more of strong economic growth, widely attributed to sound fiscal policy, economic liberalisation, extensive privatisation. The last few years saw a full-scale boom based on rocketing house prices and strong energy exports. The parallels to Australia are obvious.

The economic crisis in Iceland reflects the impending end of what is called, in the picturesque jargon of financial markets, the yen carry trade. The Japanese central bank responded to a decade of economic stagnation by cutting interest rates to zero and holding them there. This made it highly profitable to borrow money in yen and use it to buy assets in countries with large current account deficits and relatively high interest rates, such as Australia, New Zealand and Iceland, as well as in the United States. Like the Swiss franc loans marketed here in the 1980s, such deals yielded an automatic profit, provided the exchange rate in the borrowing country did not depreciate.

Now, at long last, the Japanese economy is expanding again, and interest rates are about to rise. Participants in the yen carry trade are looking at their exposure and, in some cases, deciding to unwind it. The same seems to be true, in part at least for New Zealand, where interest rates approaching double digits have not been enough to prevent a significant depreciation.

Australia has not yet been greatly affected, but market sentiment in these matters can change rapidly. The Bank for International Settlements recently suggested that a sharp but short-lived, decline in the Australian dollar in February this year was due to a knock-on effect from the run on the krona.

A sharp depreciation would pose some interesting problems. During the Asian crisis, the Reserve Bank, unlike its New Zealand counterpart, accepted the depreciation of the Australian dollar, allowing a relatively smooth adjustment. But with inflation already at the top of the Reserve Bank’s preferred range, and rising around the world, the choice would be harder this time. An increase in interest rates, even at the risk of a domestic downturn, might be considered necessary.

A more fundamental question concerns the hypothesis that governments should not worry about the current account deficit, as long as their own fiscal position is in balance. On this ‘consenting adults’ view, the correct focus is on the capital account. If foreigners are willing to lend, and Australians to borrow, that is a matter for the parties concerned, and governments should not worry about the aggregate outcome.

Iceland seems like an ideal, if somewhat extreme, test case for this viewpoint. The government has maintained consistent budget surpluses, and pursued liberal economic policies, just as the consenting adults view suggests. On the other hand, even allowing for the volatility associated with a small economy, Iceland’s current account deficits are far beyond the level which should, on traditional views, lead inevitably to an economic crisis.

If Iceland can manage a soft landing, it seems clear that anybody can. And a soft landing may still be feasible. A recent IMF Mission, for example, expressed cautious optimism, but observed that ‘mounting macroeconomic imbalances are concerns that policymakers must promptly address.’

On the other hand, if Iceland experiences a hard landing, this does not imply that Australia is due for the same outcome. Our imbalances are smaller, and our fundamentals are, arguably stronger. Still, a hard landing for Iceland would demonstrate that there are still limits beyond which current account deficits cannot safely be allowed to grow.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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