Following our previous article, Can price inflation occur in the midst of debt deflation?, one of our readers asked,

Yes, how can we explain Iceland? I still don?t understand your explanation, so it would be great if you could further elaborate on it.

Iceland is a country with huge current account deficit and foreign debt. It is also a tiny country that is hardly self-sufficient. Therefore, it is highly dependent on imports. The global financial crisis (GFC) triggered a massive debt deflation in the country. In addition to debt deflation and skyrocketing unemployment rate, the Icelandic currency collapsed.

The trashing of the Icelandic currency resulted in massive rise in prices of imported goods in terms of their local currency. At the same time, debt deflation and rising unemployment rate means that aggregate demand in their economy fell drastically as well. But a huge reduction in Icelandic demand does not necessarily mean that the price of imported goods will have to fall significantly as well. To understand why, consider these two hypothetical perspectives:

1. Let’s say you are an Icelandic car dealer who imports cars from Japan. Suppose the Icelandic currency collapses suddenly relative to the Japanese yen. Consequently, the prices of imported Japanese cars shoot up in terms of the local currency. In addition, with the economy going through debt deflation, the demand for your Japanese cars will evaporate. In this case, will you cut your prices massively (say, by 90%) and take massive losses in order to spur ‘demand’ for your imported cars? No, chances are, your business is in debt too and will not survive. The liquidator of your business, in order to fetch the highest price for the sale of the cars, will more likely re-export the cars than to sell to the comatose local market. In fact, we heard some stories that used cars in Iceland are heading for countries like Norway.
2. Let’s say you are an Australian farmer who exports wool to Iceland. Suddenly, the demand for your wool in Iceland evaporated as the Icelandic currency collapses. Will you cut the price of wool drastically in order to sell to your Icelandic customers? No, chances are, you may say, “Bugger the Icelanders. They’re a small market anyway. Who cares about them. If they want to buy my wool, they have to pay the price that is fair to me!”

Now, let’s say the Australian dollars fall like a stone. Some may argue that since Australia is self-sufficient in food, we will not experience any food price rises in Australia. We argue that this line of reasoning is wrong.

Assuming that our Rudd government will not impose any export controls (i.e. free trade), there will still be upward price pressures on Australian food too. To understand why, consider this: Let’s say you are a farmer who grows grain. Because of the huge fall in the Australian dollar, your grain becomes much cheaper to foreigners. Consequently, demand for your grain increases significantly. In this case, you will earn bigger profits by selling your grain to the foreign market than to the local market. Hence, if the locals want to buy your grain, they have to be prepared to cough up higher prices.

Our worry is that in the context of debt deflation in Australia, our dollar can be trashed further. If our Foreign Investment Review Board (FIRB) is too zealous in protecting our vast mineral wealth and valuable mining companies from foreign takeover, it will give foreigners a stronger reason to dump our dollar.