After having gone through a dramatic financial meltdown and two years of recession in 2009 and 2010, Iceland started to recover in 2011 and IMF estimates now indicate that economic growth should average between 2.5% and 3% over the short-medium term.

Yet the country is in a post-crisis transition and a number of systemic and structural issues still need to be addressed by the authorities in order to secure economic stability for the future. One of these issues is whether or not the krona should be replaced with a foreign currency.

A recent Capacent Gallup poll indicates that 70% of Icelanders effectively would like to ditch the Krona, which is seen as a source of instability. But which currency should be adopted? And, even more importantly, is the use of a foreign currency going to benefit the Icelandic economy?

Going Canadian?

A perhaps surprising answer to the first question emerges from the Capacent Gallup poll: Icelanders would prefer the Canadian dollar (also known as the Loonie) over the euro, the Norwegian crown, and the US dollar.

The idea to adopt the Canadian dollar seemed to have gained momentum earlier in March when the Canadian Ambassador to Iceland declared that the Canadian government would be prepared to discuss it.

Since then, however, the idea has lost some steam, with the Canadian government stopping the Ambassador from making further comments on the issue and the Iceland’s minister of economic affairs stating on March 21st that the adoption of the Canadian dollar is not on the table.

In the economic jargon, abandoning the domestic currency for a more stable and solid foreign currency is known as “dollarisation”. By dollarising, the domestic country adopts the monetary policy of the foreign country. This, in turn, has both costs and benefits.

On the benefits side, the stability of the foreign currency should help control domestic inflation and eliminate the risk of sharp devaluations of the domestic exchange rate. In turn, this should boost international investors’ confidence, allow the country to borrow on international markets at a lower rate, and also facilitate trade with the rest of the world. Ultimately, these effects can be expected to result in more investment and faster growth.

On the costs side, the loss of control over monetary policy means that the domestic authorities could no longer devaluate in response to extreme circumstances. Moreover, as money would be solely printed by the foreign central bank, the domestic authorities would lose the revenues from seigniorage (profits accruing to the monetary authority from its right to issue currency). The provision of facilities for lending of the last resort and backing of the domestic banking system would also be significantly reduced in the dollarised economy.

Whether or not benefits are larger than costs is in the end an empirical matter. However, benefits tend to increase, and costs decrease, (i) the higher the volume of bilateral trade between the two countries and (ii) the greater the use of the foreign currency in domestic markets.

Now, these two conditions hardly apply to the Iceland-Canada pair. In particular, Iceland is much more integrated with the European Union than with Canada. IMF data indicate that in 2010, 66% of Iceland’s total international trade was done with the EU and only 1% of the total was done with Canada. Even acknowledging that Canada does enjoy some significant degree of monetary stability and economic success, these simple observations suggest that Iceland should not go Canadian.

Going European

The obvious alternative would be to adopt the Euro, given that Iceland and EU are very integrated. However, this route is also not immune from complications.

First of all, Iceland is not yet a member of the EU and polls indicate that the majority of citizens are actually against joining the union. In these circumstances, Iceland would have to adopt the Euro unilaterally; something that the European Central Bank would forcefully oppose and try to discourage as much as possible.

But beyond that, Iceland’s large natural resource endowment makes it economically quite different from the core of the EU. Iceland’s business cycles are not likely to be synchronised with those of most other EU partners, and this could significantly increase the costs of having the euro as the national currency

In fact, in terms of economic structure, Iceland is more similar to Canada – and this could be the only solid argument to support the adoption of the Canadian dollar.

Staying Icelandic

Obviously, Iceland does have the option to keep the krona. The problem? Since its launch as an independent currency in 1920, the krona has not provided Iceland with much of an anchor against instability or a buffer against shocks.

Historical data indicates that the exchange rate has been highly volatile for nearly a century and that this volatility is a primary driver of the volatility of private consumption. Furthermore, while in standard textbook analysis devaluations can help boost exports, in Iceland this is not likely to be the case. With a small domestic market, firms in export sectors produce almost exclusively for exportation.

So, when a devaluation occurs, increased foreign demand for Icelandic products cannot be met by reallocating shares of output from domestic to foreign markets. Exports can be increased only by stepping up production. But in most of Iceland’s export sectors (marine products, aluminium) production is very inelastic. Devaluations therefore do not bring about a positive export boom. Instead, given that the private sector is highly leveraged in foreign currency, the depreciation of the krona produces strong negative balance-sheet effects.

Against this background, it is not surprising that Icelanders are tired with the instability and depreciation of the Krona. Yet, one should recognise the factors that have historically undermined the currency: fiscal dominance, inadequate monetary policy framework, and lack of discipline in policy-making more generally.

The crisis of 2009-2010 has resulted in new efforts to fix those weaknesses. This could then provide some firmer foundations to the Krona and strengthen its credibility. Exchange rate volatility could then be reduced with the adoption of a managed floating regime. This would be in line with the recently announced intention of the central bank of Iceland to become more active in the foreign exchange market. Still, the small size of the Icelandic economy will make it hard to manage a floating currency.

So, what’s the way ahead? From an economic perspective, Iceland is tightly linked to the EU. Certainly, its economic structure, largely based on the resource sector, makes it a bit of an outlier relative to the rest of the EU members. Still, given how important a trading partner the EU is for Iceland, the euro is probably the best possible anchor for the krona.

Pegging the krona to the euro would bolster the process of convergence prior to the “multilateral” adoption of the Euro and possibly smoothen some of the asynchronism between the EU and the Icelandic business cycle.

In this respect, the hard peg would pave the way towards full entry of Iceland in the EU and the monetary union. Economically, it is feasible and most likely convenient to both parties. But whether this idea will be able to gather political and popular consensus in Iceland is a different question.

Greece is rescued, for now…maybe. Perhaps it’s time to move on to the next basket case. So, which of the PIIGS is the next Greece?

For the moment, Portugal looks to be the front-runner. The country’s public-debt-to-GDP ratio is above 100%, and with a forecasted growth rate of -3.3%, its economy is shrinking at a faster rate than every other European country except Greece. Exacerbating the problem is the fact that financial markets are still jittery about the repayment of Portuguese sovereign debt. We continue to see stubbornly high spreads on Portuguese government bonds over German bond rates, which – contrary to those of Spain and Italy – failed to go down after the ECB changed its policy stance in late 2011.

Whatever one might think about the most recent Greek rescue package, Greece is not a role model for the other troubled Eurozone countries in general, and for Portugal in particular. It never was.

Greece may fit the German-favoured interpretation of the crisis: profligate southerners unwilling or unable to undertake reforms, thus requiring strict fiscal austerity measures to be imposed, eventually coupled with strict EU (read German) supervision. The same can’t be said for the other troubled Eurozone countries, where more often than not, fiscal deficits have been the consequence rather than the cause of the crisis.

It’s safe to say that Portugal is probably the most vulnerable Eurozone economy at the moment. But how did it get there? Portugal has suffered neither Spanish-type real estate bubbles or Irish-style bank rescues in recent years. Nor has it endured a Greek-style fiscal tragedy that can be blamed for the sad situation the country is in. Rather, it is the combination of a number of small sins conducted within an ill-designed Eurozone governance structure that has ultimately led to its punishment.

In particular, wages and prices in Portugal increased at a much faster rate than in the European core, leaving the country with a loss in competitiveness and an increasing current account deficit. In 1996, Portugal’s previously balanced current account deficit started to increase and reached almost 9% of GDP when Portugal entered the Eurozone in 1999. With limits in fiscal deficits at this time, the public sector current account deficit mirrored private sector excesses of spending over saving.

European banks helped to finance these deficits. To illustrate the point: according to BIS statistics, by the end of the third quarter of 2010, Eurozone banks had an exposure to Portugal of about $233 billion, of which only $42 billion was to the public sector. These exposures were concentrated on Spanish ($108.6 billion), German ($48.5 billion) and French ($45.6 billion) banks. When the crisis came, Portugal found itself trapped with both a fiscal and a current account deficit, and external investors became increasingly unwilling to finance both its public and private sector deficits.

Since 20 May 2011, Portugal has been operating under a €78 billion EU finance package to which the IMF contributes approximately €26 billion. The success of this program depends crucially on four factors.

Firstly, as it is now widely known and accepted, the market for sovereign debt is prone to self-fulfilling prophecies. Doubts about full repayments can reduce the demand for such bonds even when the prices of these bonds fall. Without a lender of last resort or or a big enough European rescue fund, bond prices can fall steeply at any time when investors get sufficiently pessimistic, thus raising public funding costs to unbearable levels. Both IMF and US officials have suggested that the current €500 billion rescue fund should be doubled or even tripled.

In other words, the first condition is that Europe and the ECB demonstrate convincingly their willingness to make strong moves to protect the Euro project with a large enough firewall.

Secondly, to overcome the crisis Portugal will need strong export markets. This will be difficult to achieve, since the Eurozone as a whole is projected to shrink by 0.3% in 2012 and additional risks remain in the global economy. Europe and the Eurozone will therefore need to overcome the austerity bias of their policy responses.

More inflation (through looser monetary and fiscal policies) in the hypercompetitive core countries like Germany could help countries such as Portugal to regain competitiveness, with less pain. Such policies could also help to avoid a recession in the core. However, the concept of reflation has not been looked upon favourably by Germany and other core countries.

Thirdly, and as a consequence, if Portugal has only an internal devaluation left as an alternative to regain competitiveness, it is clear that improvements will take a long time. Portugal will need to significantly lower its unit labour costs relative to the Euro core countries in order to increase its competitiveness. The IMF is projecting a drop in unit labour costs by only 1.1% in 2012, with no decrease projected thereafter. This is not good news for the country, as its social consensus is already extremely fragile.

If the pain that has to be shouldered by the Portuguese people is too high in relation to uncertain gains in a far-off distant future, there will be political resistance against the adjustment program and a reconsideration of the Euro exit option. Thus, Portugal needs more financial support to initiate programs to revive economic growth.

Finally, to survive as an attractive future option, Europe needs to provide a convincing solution on how to fix the current flaws of the common currency area. Adjustments will need to be made so that it is both crisis-free and welfare-enhancing to its members. If members stay in only because the exit option would be too devastating, then the Eurozone will be dead before too long.

So the deal is this: the EU and the IMF have demanded that Greece put in place austerity measures in return for a 130 billion euro bailout. That’s £110 billion and $170 billion by the way.

As the austerity measures in Greece have tightened, so the rate of suicides in the country have escalated, and so has, unsurprisingly, the violence from on-street protesters. Last night (Sunday 15th) tens of thousands violently protested in Athens and there were many more violent protests in other cities across the country. According to Nick Malkoutzis, a poster on Twitter, 45 buildings were set on fire with at least 67 people detained by police.

Max Keiser’s take on the situation sounds somewhat hysterical, but I trust Keiser even though I know almost nothing about economics. To put it bluntly, he sounds very convincing and he is widely respected throughout the world for his economic analysis. I also trust him because he is not afraid to say things that most other economists wouldn’t dare to mention. This is what Keiser had to say on Russia Today recently:

“Germany is prowling around Europe looting assets from countries like Greece. This is a financial holocaust perpetrated by Germany. They’ve been force feeding toxic debt for ten years going back to the creation of the Euro.

We now know that Goldmann Sachs on Wall Street force fed accounting fraud so that Greece could be included in the Euro. This is all planned ahead of time because Germany knows that eventually it will all fall apart. Germany is there to pick up the pieces. Germany is storming into Greece, they’ll be storming into Portugal, they’ll be storming into Spain. This is the Fourth Reich. This has all been baked into the cake. As I’ve been saying on this show for some time, Germany holds all the cards and they’re playing them brilliantly.

The debt in Greece did not originate in Greece, it originated in these other countries, they’ve used Greece as a toxic debt dump, to dump their debt, now they want the Greeks to pay their debt.

The government in Greece was put there by the bankers, the previous government was put there by the bankers, the Greeks have not had representational government in quite some time. They need to take a page out of the Arab Spring. They need to regain their sovereignty again by staging some kind of coup. There’s no rule of law in banking anymore, its open season, its just looting. Germany knows it, they love it, they’re going to take all of Greece’s assets, Portugal, Spain…”

So is Keiser right on this? Could Greek citizens stage some kind of revolution? Anyone watching the growing violence on tv and on Youtube could certainly believe that such an event is possible if the frustration and anger of Greek citizens continues to grow, and we all know what that level of anger led to into Tunisia and Egypt last year.

Calmer voices also cast blame on Germany. Ambrose Evans-Pritchard writing in The Telegraph today argued that by demanding a “budget viceroy for Greece and now an escrow account to seize Greek revenues at source” the German government has essentially ‘brutalised’ EU politics.

Gavin Hewett writing on the BBC News website in June last year asked whether indeed a revolution is in the offing. He certainly didn’t reject the idea in the concluding paragraphs of his article. “Greeks have lost faith in the plan” he commented “All they see is debt piling on debt. This is where the danger lies. A creeping despair. Injured national pride. Ten years of austerity. Even so the bet must be that the Greeks reluctantly, sullenly, will go along with new austerity but I have sensed a despair that last year just wasn’t there and no-one knows where that will lead.”

Greece is not the only country in Europe that is in a dire financial situation. Portugal and Spain have seen protests on the streets in response to austerity measures and there has even been talk of France’s economy starting to go down the pan.

Which leads to the question – if Greece goes, who is next?