Iceland: The future is in the EU

Iceland is undergoing a traumatic financial crisis. This column argues that the main anchor for its recovery strategy should be EU membership and entry into the euro area.

Iceland is undergoing a traumatic financial crisis. In just a few weeks, it has seen the collapse of its currency and its banking system, plus a spectacular decline in its international reputation and its diplomatic relations with long-standing international partners. Much of the current debate revolves around the attribution of blame for its predicament, and there is certainly much to be learned from a rigorous forensic enquiry into the origins and mechanics of the crisis. Although Iceland ultimately proved unable to ensure the survival of a banking system with a balance sheet that was ten times the size of its GDP, the debate about whether its demise was inevitable is sure to remain intensely contested.1,2However, this debate should not overshadow the important process of setting a strategy for the recovery of the Icelandic economy and ensuring that the risks of a future crisis are minimised.To this end, it seems clear from the outside (and also to many in Iceland) that the main anchor for its future strategy should be membership of the EU and, once the Maastricht criteria are fulfilled, entry into the euro area. This is not to claim that membership of the EU and the euro area is a panacea.Indeed, the current members of the euro area are not immune to the international financial crisis and important weaknesses in the financial stability framework for the euro area have been vividly highlighted by recent events.In particular, the combination of international banking with national-level supervisory and stability systems has been shown to represent substantial risks to European taxpayers. Indeed, Iceland and the existing members of the monetary union would have much to gain from the promotion of cross-national consolidation in the banking sector, delivering a smaller number of large banks that would hold more diversified loan books, reducing exposure to country-specific and sector-specific shocks. For this to happen, national governments will have to agree ex ante on burden sharing rules in order to ensure that such banks would be backed by a sufficiently large fiscal base. In related fashion, the supervision and regulation of such banks would have to be designed in order to ensure that such banks are operated on a truly pan-European basis rather than being organised as a hierarchy of a parent national bank that takes precedence over its international branches and affiliates in the event of a crisis.Membership of the euro area also involves macroeconomic policy challenges for member countries. The absence of a flexible exchange rate has the potential to make the adjustment to country-specific asymmetric shocks more difficult. For countries such as Iceland that are highly reliant on a small number of export sectors, this can be a non-trivial problem. However, the flexibility of the Icelandic labour market is a key compensating factor, with a coordinated approach to wage setting allowing real wages to fall during downturns and rising international labour mobility providing an additional adjustment mechanism.Moreover, the potential gains from a flexible exchange rate are surely dominated by the capacity for financial shocks to drive currencies away from the values that would be justified by current macroeconomic fundamentals. While the role of risk premium shocks is most dramatic during crisis episodes, it is also an ever-present factor during more tranquil periods, especially for small currencies that are thinly traded in less-liquid markets. The consequences of such shocks have been scaled up by the rapid growth in cross-border investment positions over the last decade: the balance sheet impact of currency fluctuations in many cases dominates their impact on trade volumes.

The current crisis has also illustrated that banking supervision and crisis management are very demanding tasks that pose a challenge even to the largest countries that have deep talent pools. It is plausible that very small countries do not attain the “minimum efficient scale” to run these systems in an effective manner.

For these reasons, the logic of very small countries participating in monetary unions is compelling. The rationale of membership is even stronger for a country – such as Iceland – that has suffered damage to its credibility as the sponsor of a national currency.

It is important to emphasise that there is no close substitute for membership of the euro area. In particular, unilateral euroisation or the adoption of a currency board would represent much weaker forms of monetary discipline, since such regimes are more easily reversed in the event of a crisis. These routes are much more expensive from a fiscal viewpoint relative to joining a multilateral monetary union as a fully-integrated member.

Moreover, the importance of EU membership should not be discounted, even in the narrow context of a discussion about the monetary regime. In particular, the multi-dimensional commitments that are involved in EU membership have the effect of embedding each member country in a deep institutional and inter-governmental network set of relations with other EU member countries. The current crisis has highlighted that Iceland’s relations with other European countries proved to be relatively weak under the stress of a crisis situation and many problems could have been avoided if it had enjoyed a better level of comprehension and empathy among its European neighbours.

Although membership of the EU and the euro area cannot be achieved in the very short run, announcing an intention to enter the process of applying for membership would have an immediate stabilising benefit for the Icelandic economy. In addition, the anchor of medium-term entry into the EMU would enable the Icelandic central bank to pursue a managed float system during the transition period in an environment in which it need not prove its capacity to independently deliver a long-term nominal anchor for the Icelandic economy. The current crisis also raises questions about the appropriateness of the “exchange rate stability” criterion in determining whether a country is ready to join the euro area. Under the existing rules, a country must spend two years inside the ERM II mechanism before it can enter the EMU. Recent weeks have shown that even countries with excellent macroeconomic fundamentals are vulnerable to major currency shocks. In this new environment, it seems expensive to impose a two-year currency stability test on countries that wish to join the euro.

Finally, Iceland’s entry into the EU and the euro area should be welcomed by the existing member countries. In particular, the Icelandic financial collapse has imposed heavy losses on many investors across Europe and contributed to the instability of international credit markets.All member countries stand to gain from a better-integrated financial system.

References

Willem Buiter and Ann Sibert (2008), “Iceland’s banking collapse: Predictable end and lessons for other vulnerable nations,” VoxEU.org. 30 October 2008. Richard Portes, “The shocking errors behind Iceland’s meltdown”, Financial Times, 13 October 2008.


1 Buiter and Sibert (2008) provide an excellent account of the vulnerability of the Icelandic banking system in view of the limited capacity of the Icelandic authorities to act as a lender of last resort in respect of the Icelandic banks’ considerable foreign-currency positions. Portes (2008) argues that better crisis management by the Icelandic authorities may have avoided the collapse.

2 This article is based on a presentation to the Reinventing Bretton Woods Committee conference held in Reykjavik on October 28th 2008 “Testing Times for the International Financial System: Inflation, Global Turmoil, New Challenges for Small Open Economies”


Originally published at Vox and reproduced here with the author’s permission.

3 Responses to "Iceland: The future is in the EU"

  1. Michael J. McGarry   November 8, 2008 at 3:01 pm

    The article begs the question as to why the Icelandic authorities were unable to appreciative the advangages of EU and euro membership without the trauma of a financial collapse? It may well be that one lesson for them is that they should broaden and deepen their contacts with European states that are less eurosceptic than Norway and the UK, two countries on which they seem, at least to an outsider, to be overly focussed.

  2. Guest   November 8, 2008 at 8:43 pm

    Iceland relies heavily on the sovereignty of it’s fishing territories. EU membership not only relaxes trade barries, but opens up these fishing areas to all EU members. As serious as the collapse is, Iceland has little else to trade without the fishing industry. I wouldn’t be surprised if they don’t at least try to circumnavigate this requirement if the kroner gets much worse.

  3. Guest   November 10, 2008 at 4:08 am

    But… who wants that bride now?