Comparing the Crisis in the Icelandic Krona to the Crisis in the US Dollar

We recently compared the crisis with the Argentinian peso in 2001/2002 with the current situation surrounding the US dollar, and postulated that the US would follow down the Argentinian path.

The current situation in Iceland also fits the bill of a currency crisis (also referred to as an inflationary depression). To illustrate this point, let's compare the factors leading up to the crisis in the Icelandic krona with the conditions of the US macroeconomy:

1. Like the US, Iceland de-regulated much of its banking sector in the '90s.
2. Like the US, Iceland then proceeded to target low interest rates. This resulted in a large amount of borrowing and spending, which resulted in a credit-based boom.
3. In both countries, de-regulation allowed for greater securitization -- meaning the loans that enabled this credit-based boom were re-packaged and sold to debt buyers all over the world. This resulted in a scenario where much of Iceland's wealth was owned by foreigners.
3. Like the US, Iceland also experienced the contraction forecasted by the Austrian business cycle theory, which we recently discussed.
4. In both countries, this resulted in a deflationary spiral: significant declines in equities markets, bank failures, and contracting GDP.

To learn more about the factors leading up to the Icelandic currency crisis, I recommend this article from CNN.

Now in Iceland, like in Argentina, the true breaking point came when its central bank became insolvent. The result was a complete lack of confidence in Iceland's ability to repay; essentially, Iceland had defaulted. The result has been a run on the Icelandic krona, which has lost half its value in just a few months time.

Government Response

Or should I say, there has been a partial run on the Icelandic krona -- for the government has put currency controls in place, after raising interest rates. Citizens of Iceland will find it difficult to legally exchange their krona for a foreign currency unless they are travelling.

Proposed solutions include integrating Iceland into the Eurozone, which would help stabilize Iceland, continue international trade, and help ensure that lenders are repaid, argue its proponents.

Social Response

Icelanders have united in protest against the government, in much the same way Argentinians did after their currency crisis. Thus far in the United States, criticism and dissatisfaction with the government handling of this crisis have risen significantly, though street protests remain at relatively low levels.

Market Response

The collapse of the Icelandic krona is the biggest event, as it devalues all assets denominated in the krona, as was the case in Argentina. A key difference between the US dollar and all other currencies, though, is that the US dollar is the world reserve currency. It will be interesting to see if Iceland enters the Eurozone as a solution to this crisis; if so, it paves the way for the creation of a world currency to be proposed as the solution to a crisis in the US dollar.

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Next Stop for the US Dollar: Argentina

Something I've touched on before but have not elaborated too much on is the similarities between Argentina in 2001 and 2002 and the US now. Here is a fantastic analysis of this subject. Below is a breakdown of the key events:

1. In 1997, Argentina experienced a recession. The government response was to ease credit -- i.e. lower interest rates -- and increase government spending, which for Argentina, would mean increasing deficit spending (i.e. borrowing and spending rather than taxing and spending). The US followed the same path in the semi-bursting of the 2002 and 2003 NASDAQ bubble.

2. The excessive easing of credit leads to inflation. For Argentina this occurred in 1998 and 1999; in the US, this peaked in the summer of 2008. During these episodes of inflation, both countries receive warnings from the IMF that their monetary policies are unstable.

3. Both countries than revert back into a recession. This time, however, they are both saddled with greater debt.

4. The recession, coupled with the increased debt burden, leads to a credit crunch, defaults on borrowed funds, and bank failures. For both countries, this results in a decrease in the money supply.

This is where the similiarities end, as we don't know how the US will get out of this situation. Will it continue to follow Argentina? Let's see:

1. During its debt ridden recession of 2000, Argentina responded by continuing deficit spending. Likewise, Barack Obama has already stated that deficit spending is not a concern, and that deficits to stimulate the economy is needed.

2. Eventually, Argentina was having trouble finding borrowers to lend it money. To make its debt more attractive, it increased its yield -- what it was willing to pay to borrow money. In the United States, we are seeing bond prices rally, and many are pointing out similiarities to other bubbles. If this is a bubble, and if it starts deflating, interest rates will need to rise to make the bonds appealing (see our previous article on this subject). Interestingly, Paul Volcker, the Federal Reserve Chairman who raised rates in the '70s to help curb inflation and tighten the money supply, has been brought on to head a new economic advisory board. Are they looking to Volcker for assistance in raising rates?

3. For Argentina, the rate hikes were not sufficient. Eventually, the diminishing tax base, bank failures, and higher interest rates made Argentina unable to make debt repayments. The result was a run on the currency. If the US cannot find buyers for its debt, the same scenario would play out here, which would result in currency devaluation.

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The US Dollar's Five Vital Signs

As many economists and analysts have noted, the stability of the US dollar is a key issue in our current times of economic turbulence. To keep an eye on the stability of the dollar, its value, and how this will affect other markets, there are a few key factors to watch:

1. CDS Prices. Credit default swaps (CDS) can be thought of as default insurance; the buyer makes regular payments, and the seller makes a payoff if the credit instrument in question goes into default. When CDS prices rise, that is an indication that the market is pricing in an increase in the likelihood of default risk. The CDS price for 10 year US Treasury bonds has increased by 2500% over the past year. If the market believes the US government will not be able to pay off its debt, or will have difficulty doing so, it introduces concerns about the stability of the dollar, as it increases the likelihood of the Federal Reserve creating more money to pay off US government obligations.

2. US Government Debt and Deficit Spending. The more deficit spending -- meaning spending that is greater than the revenue the government takes in via taxation -- the more treasury bonds the US government will need to issue to raise capital to finance deficit spending. More deficit spending leads to a greater need for debt, which leads to more Treasury bonds being issued; this could lead to an expansion of the money supply and higher CDS prices, particularly if the Fed continues to seek a low interest rate. Currently US government debt is rising rapidly.

3. Fed Funds Rates. To counter the effect of rising CDS prices, the Federal Reserve may seek a higher Fed Funds target rate to make US debt more appealing, and to counter concerns about a weakening dollar. At this point, however, we still see the Federal Reserve moving in the opposite direction -- towards zero percent interest rates.

4. Money Supply Indicators. Monitoring money supply can also give an indication as to how inflationary forces -- attempts at expanding the money supply, which can potentially weaken the US dollar -- vs deflationary forces (money supply contractions resulting from credit destruction) can give us an idea of stability issues related to the US dollar. At this time, one money supply indicator that recently turned downward is MZM. Declines in the money supply often correlate to a strengthening of the currency, though demand for money is also a key issue.

5. TED Spread. The TED Spread measures the difference between the rate on three month US Treasury bonds and the the rate at which banks will lend to each other. A higher TED Spread indicates banks are trying to pull credit out of the market. High TED spreads also result in the market countering the inflationary actions of the Federal Reserve. TED spreads have been volatile this year; they are currently declining, which suggests banks are starting to lend again, which is a factor that can lead to money supply expansion and corresponding potential currency instability.

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