Reykjavik can leave the eurozone without fear

On 29 August, Iceland will hold a referendum on whether to resume negotiations on joining the European Union. Should Icelanders vote ‘yes’?

As a member of the European Economic Area, the Schengen Area and the European Free Trade Association, Iceland already benefits from the free movement of goods, services, people and capital guaranteed by the EU. It applies the same regulatory standards to its financial sector as those of EU Member States, and Icelanders, as well as visitors, can travel throughout most of Europe without passport checks.

However, Iceland does not participate in the EU’s decision-making processes; it is exempt from the Common Agricultural Policy (CAP) and the Common Fisheries Policy (CFP); and it retains its own currency. If Iceland, with its population of around 400,000, were to join the EU, it would have a seat on the European Council, where its vote would carry the same weight as that of the Union’s most populous countries.

This is no trivial matter. As a country with a small population, Iceland would have little power to block routine EU decisions. However, on many issues that Member States regard as sensitive, the European Council requires unanimity.

Naturally, the obligation to join the CAP would be a disadvantage, and Icelanders regard the CFP as a major sticking point. The country would be subject to fishing quotas and rules on fisheries management set by the EU and would have to accept shared access to certain waters. Its fishing industry and the communities that depend on fishing for their livelihood could suffer significant losses. However, as Iceland’s geographical position makes it strategically important to the EU, the country has a certain amount of negotiating power, and some have already suggested that accession negotiations could lead to an exemption from the CFP.

There are also many advantages to adopting the euro, the main one being greater financial stability. This is a crucial aspect for any central bank, because crises – or even simply the uncertainty arising from financial instability – make it impossible to achieve monetary policy objectives. Without an effective lender of last resort and market operator of last resort, even fundamentally sound banking systems can fail as a result of bank runs or liquidity problems.

Thanks to its ability to create national currency, the central bank is in a unique position to fulfil these roles as a lender of last resort, but only if the loans it has to grant and the assets it has to purchase are denominated in its own currency. If the majority of the banking system’s assets and liabilities are denominated in foreign currency, the central bank is powerless. The classic example of what can go wrong is precisely the 2008 Icelandic banking crisis.

The problem has not gone away. The Icelandic banking system has been scaled back: its assets now amount to around 127 per cent of Iceland’s GDP, compared with around 900 per cent at the start of 2008, and it is subject to stricter regulation. However, there are no capital controls, and the banks have significant long-term liabilities denominated in foreign currency. If Iceland were to join the euro area, the Eurosystem could act as a lender and market operator of last resort, preventing another crisis. For a country with an internationally active banking system, this could in itself be sufficient reason to join the EU.

Joining the euro area would also give Iceland access to the European Stability Mechanism, which provides low-cost loans to countries experiencing serious economic difficulties as part of a macroeconomic adjustment programme. The mechanism offers financial assistance for the recapitalisation of banks in difficulty and a precautionary credit line to euro area Member States with sound fundamentals. It can also act as a market operator of last resort by purchasing Member States’ government bonds when liquidity dries up.

The adoption of the euro also presents potential disadvantages. Iceland would lose the ability to conduct an independent monetary policy and to use the exchange rate as a buffer against shocks. Currently, if Iceland experiences a negative shock requiring a reduction in real wages, exchange rate depreciation allows this to be achieved instantly. Without an independent exchange rate, adjustments to nominal wages may be slow and lead to distortions in relative prices. The euro area’s monetary policy, which is the same for all members, may not be suitable for Iceland if the external shocks affecting the country are not positively correlated with those affecting the rest of the euro area and if its economic cycle is not synchronised with that of the euro area as a whole.

When assessing these trade-offs, it is important to recognise that shocks are not independent of the exchange rate regime. For this reason, membership of the euro area should reduce the shocks associated with financial instability, making the cost of membership lower than past data would suggest.

Consider a recent report on Iceland’s options, prepared by the Ministry of Finance. The report praises the stabilising role of an independent exchange rate, highlighting its positive effects following the bank failures in the wake of the 2008 crisis. But that shock might never have occurred had Iceland been in the eurozone. If Iceland were to adopt the euro, its economy could gradually become more flexible and more similar to that of the eurozone, whilst future shocks could be mitigated. As long as the ratio of public debt to GDP remains contained, Iceland will have the scope to use fiscal policy to respond to shocks and fluctuations.

At the same time, a floating exchange rate might be less of an adjustment mechanism and more of a source and amplifier of shocks. Speculative bubbles, herd behaviour, irrational exuberance and a long list of other phenomena can cause large and persistent exchange rate misalignments, and very small economies can do little to counter them. Of the two Nordic EU member states that have retained their own currencies – Denmark and Sweden – even the smaller of the two, Denmark, has a population almost 15 times that of Iceland and a GDP almost 12 times larger.

Quite apart from any other benefits that EU membership might bring, Icelanders should accept that, for a tiny country like theirs, it makes no economic sense to have its own currency.

Willem H. Buiter and Anne C. Sibert

Copyright Project Syndicate