Should we adopt a foreign currency?

After the collapse in 2008, the hunt for a scapegoat began almost immediately in Iceland. The list was endless: the bankers, the politicians, the business moguls, the endless consumerism, the Central Bank, the corruption and so on. On that list was the Icelandic krona.

Now of course, most of the usual suspects were on the list of scapegoats for a reason. Yes, political corruption - in the form of "I know a guy who knows a guy who could do this for us" and "ahh, you're a member of that political party, well, then you'll get the job!" - is high and the level of debt-infused consumption was astronomical! And yes, the fact that Iceland tried to carry out an independent monetary policy with, at that time, the smallest free-floating currency in the world, is partially to blame for the crisis. We messed up big time (in my opinion, mostly by relying on bad economics).

Today, the "necessity" to adopt a foreign currency is very prominent in the general discussion in Iceland. And the foreign-currency vs. krona discussion is stark and heated. I think it's safe to say that not a week goes by without somebody, in a newspaper article or on a widely read news website, making the case that Iceland should or should not adopt another currency. Some economists, and of course politicians and others, thank the devaluation of the krona for the "rebound" in economic activity since the collapse. Paul Krugman has made this case. Others blame the krona for the high interest rates compared to our main trading partners and for the high inflation. In response to Krugman, Jon Danielsson, at the London School of Economics, said that Krugman deserved an F.

The politics in the discussion are almost too obvious as well. And since there is a tradition for hung parliaments in Iceland, the politics in the currency question can become a bit funny as well. As an example, today's government is a coalition between Social Democrats and Left-Greens. The Social Democrats want to join the EU. They blame the krona for every economic misfortune of Iceland and they want to adopt the euro (given an EU membership). The Left-Greens don't want to join the EU and the Minister of Finance, who is a Left-Green, has thanked the flexibility of the krona for the rebound in economic activity. Blatantly, this is absurd! I would love to be a fly on the wall during government meetings whenever EU and euro vs. krona are on the agenda.

The almost certain inevitability of mixing politics into the foreign currency vs. krona discussion makes the subject both flammable and, since it's natural for so many people never to give back an inch on their political convictions, open for tunnel vision of rather high degree. As an example of that, the president of Icelandic Confederation of Labour, Gylfi Arnbjornsson, recently said, during a conference he spoke at, that "we [Icelanders] shouldn't let the short term problems of dollar, yen and euro block our sight. The euro is like a rock in the sea compared to the Icelandic krona." The Icelandic Confederation of Labour want to adopt a foreign currency, preferably the euro. They blame the krona for high inflation in Iceland.

Now, no offence to Gylfi but I wouldn't call the lack of economical and political coordination in the Eurozone a "short term problem." In my opinion, this is an example of economic tunnel vision: OK, let's adopt the euro. But what next? Pay into the EFSF fund? It would possibly make some sense to adopt the dollar, we do trade somewhat in USD-denominated goods in international markts. But the yen? We hardly trade with Japan, why not the Australian dollar then?

I admit it freely that I don't know whether it would be beneficial for Iceland to adopt a foreign currency. Quite frankly, I think the fundamental problem of the economy of Iceland is not the currency or what currency we use. Yes, there is a moral hazard problem associated with using an independent monetary policy with free flow of capital and free-floating currency. The nation, especially the banks and the government, can go on a spending spree and let the currency take the hit later in order to rebalance the economy (this has been the normal course of events in Iceland). But at the same time, if a nation is using a foreign currency and there is a real exogenous shock (natural disaster, collapse of international markets with its main exports, etc.) it can be more easily met with an independent monetary policy through devaluation of the currency. And for a small "city state" like Iceland, population 320,000, nobody would care if we would run a "beggar-thy-neighbour" monetary policy for the rest of the universe's life.

So for a small state like Iceland, running an independent monetary policy is like getting a full coverage on your car. You'll get any cracks and scratches repaired. But will you have the discipline to drive carefully as well, given that you have full coverage? Historically, we certainly haven't, we've "gone Greek" for decades. And quite frankly I think we wouldn't resist the temptation to drive carelessly, even if we hadn't full coverage, i.e.if we used a foreign currency. Backed up by that pessimistic view, I sometimes think Jefferson was right: banking institutions are more dangerous than standing armies.

So one of the economic problems of Iceland is not the currency we use. It's the banking and financial system. If we had that under control, we could use whatever currency we wanted. It would be like putting a stone under the accelerator of our car: we couldn't drive carelessly.