The biggest victim of the global financial turmoil may just turn out to be the tiny nation of Iceland whose population is just slightly above 300,000. Much of its woes are self-inflicted.
Iceland has long had a problem with a much too spendthrift economy, as is evident in its massive current account deficit and its high inflation rate. In recent years, the people of Iceland (or more specifically its banks) have borrowed far too much from abroad, something which they have done mostly in foreign currencies which have had a much lower interest rate than in Iceland. Because of the willingness of Icelandic banks to borrow in foreign currencies, it has been difficult for the Icelandic central bank to contain credit expansion by raising interest rates in terms of Icelandic kronor.
Now the Icelandic krona has fallen some 45% in the latest year against the euro and the U.S. dollar . There are two consequences of this. First, there will be a massive increase in price inflation as Iceland, being a tiny nation, is very dependent on foreign trade and thus also foreign exchange rates. And secondly it will cause a massive collapse in domestic demand and only to a somewhat lesser extent. The reason for the latter is that the value of all those foreign debts accumulated have now risen some 80% in terms of ISK, bringing many banks and other companies and households to the brink of bankruptcy. The Icelandic government is as reluctant as others to allow banks to collapse so it has nationalized the biggest banks, Landsbanki and Glitnir.
This scenario where a massive currency collapse will cause both a sharp increase in inflation and a sharp economic downturn caused by a massive increase in the foreign debt burden is not to dissimilar to what happened in many East Asian countries in 1997-98.
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