New Currency Peg Is No Panacea for Iceland

Iceland has provided a fascinating case study for economists. Now that it has impressively battled to restore economic and financial well-being, Finance Minister Benedikt Johannesson appears to be toying with a new experiment for the krona, the country’s currency. His thinking is being driven by the recent volatility of the exchange rate. But it also is informed by a much-larger inconvenient truth facing several other countries: Managing a “small and open economy” is becoming a lot harder in a world facing considerable trade and economic fluidity and, to use Federal Reserve Chairman Ben Bernanke’s insightful phrase, “unusual uncertainty.”

Having fallen into the trap of expanding its financial sector well beyond what its economy could sustain, even without a global financial crisis, Iceland has spent several painful years regaining its composure. In the process, it has impressively re-energized its growth rate, cleaned up its banking system, negotiated with irate foreign depositors, attracted considerable tourist and external capital flows, and, most recently, lifted capital controls.