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Iceland's recovery offers case for reviving drachma

Iceland's krona isn't getting the respect it deserves.

Last week, The Globe and Mail's Barrie McKenna reported that some of Iceland's top business leaders have been quietly lobbying for Iceland to drop its 137-year-old currency and adopt the Canadian dollar instead. That would go in a different direction than the Icelandic government's official position – which is to join the European Union and drop the krona in favour of the euro, a currency that comes with plenty of baggage of its own.

Yet the krona may very well have been pivotal to Iceland's economic resurrection. In fact, the country's independent currency may be the critical difference between its recovery from financial ruin and euro-bound Greece's inability to pull out of its own nosedive.

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It was only three years ago that Iceland was, arguably, a bigger mess than Greece is now. Its three biggest banks went under. Its economy contracted by 15 per cent. Its former prime minister faces criminal charges over the financial collapse that happened on his watch.

Yet Iceland is now back in business. Six months ago, it emerged from the International Monetary Fund's assistance program. Last month, credit-rating agency Fitch upgraded the country's bonds to investment grade. Iceland's gross domestic product grew 2.7 per cent last year and is forecast to be close to that again this year – one of the best growth rates in the developed world.

Brockhouse Cooper global macro strategist Pierre Lapointe said the "first ingredient" in Iceland's speedy turnaround was its independent currency. Far from the rapid devaluation being a curse on the country's economy, he said, it allowed Iceland to become more competitive in the global market and make the adjustments necessary to bring its wildly tilted finances back into a semblance of balance.

"This has not been matched anywhere else, especially not in the euro zone, where both currency and labour costs are fairly rigid," Mr. Lapointe wrote in a recent research report. "Unsurprisingly, GDP has rebounded much more strongly in Iceland (with its flexible exchange rate regime) than in countries that are sticking to the single-currency area."

In its rating upgrade last month, Fitch agreed that Iceland's floating exchange rate was a key to the country's speedy revival.

"Flexible labour and product markets and a floating exchange rate have facilitated the correction of external imbalances and contained the rise in unemployment," the rating agency said.

The argument in favour of an independent, flexible exchange regime is one Canadians should recognize: The Bank of Canada has been saying it for years, going back to times not that long ago when a weak Canadian dollar and an underperforming economy had many Canadian business leaders talking about adopting the U.S. dollar.

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"The significance of having [an independent, floating exchange rate]is our ability to respond to external economic shocks that affect us differently from our southern neighbours, or to respond to differences in domestic economic policies," Bank of Canada governor Gordon Thiessen said back in a 2000 speech that defended an independent Canadian dollar. This "shock absorber" argument is one the central bank has repeated often – and quite convincingly – in the years since.

Maybe, then, instead of Iceland talking about adopting some bigger currency over which it would have little or no policy control, Greece should be talking more seriously about abandoning the euro and bringing back its drachma.

Without doubt, such a drastic move would result in some serious short-term pain; Mr. Lapointe predicts that the new currency would plunge and Greece's imports would collapse.

But a devalued made-in-Greece currency would instantly make the country's exports more competitive relative to its regional neighbours. And, with control of its own independent monetary policy, Greece would have the flexibility to impose the kind of capital controls that helped Iceland stop the bleeding.

As long as Greece is attached to the euro zone and the common currency, though, an Icelandic-style rebound looks all but impossible.

That doesn't mean Greece won't eventually find a path to recovery. But Iceland shows us that when push comes to shove, having your own currency flexibility might make the path a lot shorter.

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About the Author
Economics Reporter

David Parkinson has been covering business and financial markets since 1990, and has been with The Globe and Mail since 2000. A Calgary native, he received a Southam Fellowship from the University of Toronto in 1999-2000, studying international political economics. More

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