Last week, the economic blogosphere lit up with a report from The Globe and Mail that Canada’s ambassador to Iceland would address the possibility of Iceland replacing its beleaguered currency, the króna, with the Canadian dollar.  When the story broke, the speech was cancelled, but economic commentators have been discussing the possibility ever since: should Iceland replace the króna with the loonie?

In a week when Iceland also opens an unprecedented trial against former prime minister Geir Haarde over the 2008 financial crisis, it perhaps goes without saying that finance and politics go hand in hand in the tiny nation.  When the crisis hit in 2008, Iceland realized how things could horribly, massively wrong in a global economy with a currency used by just 300,000 people in a country where every single bank has been wiped out virtually overnight.

Of course, a turn to Canada’s currency would provide a currency backed by a well-respected central bank in a country with a relatively conservative approach to banking, both in its regulatory posture and in its broader culture.  It helps that Canada, unlike the European Union, is not currently embroiled in a sovereign debt crisis.  And the loonie would instantly replace a basketcase currency mistrusted by global financial institutions and riddled with currency controls, both internally and externally.  Certainly for every Icelandic person who took out a loan in a foreign currency before 2008 (and everyone in the UK and Europe who kept their savings in an Icelandic bank to reap the high interest rate on their savings), the memory of watching a national currency disintegrate in the course of days will not be soon forgotten.

But giving up sovereignty over monetary policy can be also a dangerous proposition, with consequences that reach deep into the cultural and political currents of a nation.  The world is littered with examples of economies with mismatched monetary policy — Argentina in 1999, Europe and the Gold Standard in the 1920s and 1930s.

But you don’t have to step into a time machine to see the damage that it can cause — just book a flight to Athens.

Both of the elected governments in Greece and Italy fell in November 2011 due to the turbulence of each country’s sovereign debt woes.  Spain, Portugal and Ireland are reeling from the harsh austerity measures implemented to stave off their own debt problems at a time when deficit spending could otherwise spur GDP growth.  Each of the other eurozone countries (minus Germany) remain susceptible to their own sovereign debt crises, which also limits the ability of any country to tackle recession conditions across the EU, including creeping unemployment and very, very low GDP growth.

So Iceland has a crisp example of how hitching its economy to another currency could also go horribly, massively wrong.

In the immediate aftermath of the Icelandic financial crisis, you heard a lot of talk from Iceland’s political elite about joining the European Union and acceding to the euro as soon as possible as the best lifeboat for a country that had gone bankrupt overnight.  Within six months, though, you heard a lot less of that from within Iceland — harmonization of fishing rights along the coast of Iceland would have been a difficult negotiation with the EU, but the greater point is that all talk of Iceland (or any of the other Eastern European countries) joining the euro abruptly ended with the onset of the Greek/EU sovereign debt crisis in 2010.

So why Canada?

El Salvador, Ecuador and Panama use the U.S. dollar. Kosovo, Montenegro and Andorra use the euro. Liechtenstein even uses the Swiss franc.  But as Swedish economist Stefan Karlsson notes, all of those countries have more extensive trade with the United States, the European Union and Switzerland, respectively.   Canada received less than 0.5% of Iceland’s exports in 2010 and supplied less than 2%, so the trade gains would be minimal.  Trade aside, it’s not exceptionally clear why Canada and Iceland would form an optimal currency zone, despite the fact that the 9,000 Icelanders in Winnipeg make it the second-largest Icelandic settlement outside of Reukjavik.

So maybe the euro would, in fact, be a better fit.  Or perhaps the Norwegian krone, although Icelanders might be a bit prickly about turning to Scandinavia after having gained its independence from Denmark only in 1944.  Economist Justin Wolfers thinks the Australian dollar is a better fit (imagine Kevin Rudd and Julie Gillard fighting about that one!)

Furthermore, as FT Alphaville’s Joseph Cotterill points out, just ask the sovereign nation of Newfoundland how well it recovered from its debt crisis:

Canada fully absorbed Britain’s oldest colony as its tenth province in 1949, 15 years after a debt crisis had forced Newfoundland back under London’s direct control.  Just a bit involved more than a currency switch — but shows that Canada’s been seen as a long-term solution to a North Atlantic debt bust once before.

That’s not to say that Iceland would become the newest province of Canada, but it’s another data point to give Icelandic policymakers pause.

For Canada, which would not even necessarily need to consent to Iceland’s decision, the benefits would be the same as those the United States (or any other currency exporter) reaps from circulating so many dollars into the world economy — the seigniorage benefits, in the simplest terms, basically mimic a loan from Iceland to Canada in the amount of all Canadian currency circulating in Iceland minus the costs of printing the currency.

The Canadian ambassador was slated to give his speech to Iceland’s Progressive Party, a liberal/centrist party that currently holds nine seats in Iceland’s Alþingi (formed in 930, it’s the oldest parliament in the world) and serves in opposition to the current coalition of the Social Democratic Alliance and the Left-Green Movement headed by prime minister Jóhanna Sigurðardóttir (also the world’s first openly LGBT head of government).

So while it’s not clear that Iceland will take the loonie plunge anytime soon, the story is really quite a touchstone for the tension between monetary policy control and democratic legitimacy that is at the heart of the politics of so many European countries today.