A vicious circle

Jon Danielsson of the London School of Economics on mistakes by the government and Central Bank on the radio show Sprengisandur. 

“Basically the reason for Iceland’s mistake lie in a series of wrong decisions in the government’s policy in the last ten years. The main reason for the crisis is the importance given to the Central Bank’s  inflation targets. Almost ever since the inflation targets were introduced inflation was above the target. Because of this the Central Bank kept its interest rates high, above 15% when they’ve been highest. In a small economy like Iceland, high interest rates encourage businesses and individuals to borrow in foreign currency. Similarly it entices traders and speculators to bet on the “imbalance of interest rates”. The consequences became a huge inflow of foreign capital, which in turn led to a higher currency, which in turn lead to a false notion of wealth while speculators made money. The inflow of foreign capital also lead to growth and inflation, which in turn made the Central Bank hike its rates even further.”


2 Responses to “A vicious circle”

  1. 1 Vilhjalm A. March 19, 2009 at 11:21 am

    Yes, he’s quite right. The high interest rates attracted a lot of “hot money”. I imagine it was a good game, until the ISK started to collapse. Then the smart money piled on short. It would be interesting to know how much the hedge funds like Bear Stearns made from shorting the ISK and the banks. Probably billions.

    It was really suicidal to put an interest rate like that on a small tradeable currency. I wonder if anyone told Doddson what happened to Indonesia and Thailand in the ’90s when the same “hot money” currency bubble and collapse happened.

  1. 1 Interest Rates » A vicious circle « Economic Disaster Area Trackback on March 19, 2009 at 2:48 am

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