Maintaining a “strong” Icelandic Krona

Teresa, March 26, 2008 @ 2:50AM ET | Link | RSS | Read via Email | Start a Discussion

Pundits have spent the last months beating on U.S. Treasury Secretary Paulson over his apparent oxymoronic comments about “a strong Dollar”, but can you imagine what would have happened if they pursued the course Iceland has chosen?

Bloomberg reports:

Iceland’s central bank raised its key interest rate by a record 1.25 percentage points at an emergency meeting to halt a slump in the krona and a surge in inflation. The currency made its biggest ever jump against the euro.

Sedlabanki raised the repo rate to 15 percent, the Reykjavik-based bank said on its Web site today. It hadn’t planned to hold a rate meeting until April 10. It was “crucial” to reverse the krona’s decline “as quickly as possible,” the bank said.

The krona tumbled 17 percent against the euro in the past three weeks on concern that the global financial turmoil would make it harder for Iceland to finance one of the world’s largest current account deficits. The country risks “spiraling” wages and inflation if that decline isn’t pared, the central bank said. Inflation reached a one-year high of 6.8 percent last month.

I immediately recalled the 1992 Finland crisis, but upon cursory research, it appears that Iceland’s problems stem from too much of a good thing.

Still, how do you think the citizens would react if the FOMC sent rates up to 10% to halt the slide of the Dollar? Could it be that the “cure” would be worse than the disease? In present circumstances, might a weak Dollar be a competitive edge?

Do high interest rates defend currencies during speculative attacks?
Aart Kraay, January 2000
Do high interest rates defend currencies during speculative attacks? Or do they have the perverse effect of increasing the probability of a devaluation of the currency under attack? Drawing on evidence from a large sample of speculative attacks in developed and developing economies, this paper argues that the answer to both questions is ‘no’. In particular, this paper documents a striking lack of any systematic association whatsoever between interest rates and the outcome of speculative attacks. The lack of clear empirical evidence on the effects of high interest rates during speculative attacks mirrors the theoretical ambiguities on this issue.
Finnish Monetary and Foreign Exchange Policy and the Changeover to the Euro
This paper presents the salient aspects of Finland’s monetary and exchange rate policies during the run-up to monetary union in the 1990s. In the course of slightly more than a decade, Finland’s monetary and exchange rate policies were thoroughly revamped. The remnants of heavy regulation were removed and a market-based financial system was put in place. There were serious problems associated with the liberalisation process in the early part of the decade, the most noteworthy being an economic and banking crisis. Finland’s financial system nonetheless developed rapidly and became a more integrated part of the global system. As regards exchange rate policy, almost all varieties of exchange rate regime were tried. A fixed rate regime based on a currency index fell apart in the early part of the decade and was replaced by a floating rate system. Later, in 1993, this was combined with an inflation-targeting monetary policy strategy. At the start of 1995 Finland joined the European Union, and in October 1996 the markka was joined to the EU’s Exchange Rate Mechanism. The improvement in financial and price stability that followed the economic crisis facilitated the adjustment to the euro area’s single currency and single monetary policy at the start of 1999, which was accomplished without serious problems.
Monetary policy in Finland: experiences since 1992
Pentti Pikkarainen, Antti Suvanto, Juhana Hukkinen and Ilmo Pyyhtiä
This paper discusses monetary policy experiences in Finland since 1992. The paper starts with a discussion on general macroeconomic developments (Section 1) then focusing on inflation developments (Section 2). Changes in the monetary policy framework are discussed in Section 3. Finally, Section 4 draws some conclusions.
CURRENCY MARKET; Finland’s Move Jars Markets
But Prime Minister Esko Aho, faced with a deep recession caused in part by a decline in trade with the former Soviet Union, chose today to allow the currency’s value to float rather than raising interest rates further or intervening heavily in foreign currency markets to protect the markka. In currency trading today, the markka fell about 13 percent. Finland had devalued the currency once before, in November of last year, by a similar amount. Finland’s decision quickly created problems for Sweden and Norway as well, as investors fled their currencies, worried that they, too, might be devalued. Norway, seeking to avoid a sharp decline in its krone, intervened by buying the currency in the markets. Sweden acted quickly to maintain the value of its krona by pushing interest rates up to an all-time high of 24 percent, from 16 percent.

Further Reading: Financial Crises and Contagion, The World Bank Macroeconomics and Growth Research Program

Greenspan: No Perfect Model of Risk

Teresa, March 17, 2008 @ 2:54AM ET | Link | RSS | Read via Email | 3 Comments

Former FOMC Chairman Greenspan wrote a lengthy article in today’s Financial Times:

Credit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems - and the models at their core - were supposed to guard against outsized losses. How did we go so wrong?

The essential problem is that our models - both risk models and econometric models - as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all riskasset classes ensued.

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.

Also by Greenspan: The Roots of the Mortgage Crisis

Maintaining a “strong” Icelandic Krona

Greenspan: No Perfect Model of Risk

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