An article by Philip Lane, Professor of International Macroeconomics and Director of the Institute for International Integration Studies (IIIS) at Trinity College Dublin:
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.
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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”
We liked being Isolated…
inevitable, really, when we live in a world of bullies coercing us, carrot and stick, into foddering their safe havens…
Just got done talking this over with Gutti, Guttormur Björn Þórarinsson, over ooVoo a free video phone service. He thought that was a good idea.
Well I am not sure I am happy with Obama and his “spreading the wealth”. We feel our taxes are too high. So the “proof will be in the pudding” and we will just have to wait and see.
By the way, we have a Leif Erickson park here in Sioux City, so the ground work has already been started.
DONALD WHEAT
that sound alot better than joining the EU
USA looks alot better after you elected Obama
im sure the EU is out of the question anyway,
people were talking about it a few days ago
but you dont hear anyone talking about EU now
if we were ever going to join EU we would have done that already.
Nope, Iceland should become the 51st State in the US Union. This would remove any Trade Barriers between the US and Iceland and raise the standard of living by cutting out the terrible import taxes. Plus Iceland has a great Airline which could teach the US Airline industry a few operational techniques. And finally, the US sure could use the Iceland Aluminum Industry.
Anyway if you don’t float your money because of fears it would plunge then you will only have as option to have very high interest which is very costly.
Having a low value money is interesting if you can export heavily, the contrary is true if you import a lot and are intrinsiquely rich but you are not.
As your land have no real resources that you can monetize easily (except tourism) you only have the option to export: Aluminium (already done), other ore products, even oil who knows?
Do you have some of the incredibly rare but highly needed metals needed in battery or semiconductor industry?
Another option could be to have a great agriculture for example organic agriculture on large scale (because you obviously have the land) and organic agriculture products are sold at high prices.
If Iceland has any chance to join EU, Iceland would have to first allow the ISK to float and ‘find its true value’. Icelanders will not do that because the ISK might for to 500/600 to the Euro.
No doubt the impact on Iceland would have been buffered with membership of the EU but essentially we would be talking about a slower death to the macro economic model in Iceland. And now that Fishing has grown in importance by default what impact would the Common Fisheries Policy actually have on Iceland?
The professor is either the master of the understatement or just living in an academic cloud cuckoo land when he refers to “substantial risks to European taxpayers”. I suspect it’s a bit of both.
One of the “important weakness” was its total failure of the impotent EU macro economic risk models, that the EU academics were so fond of constructing, to predict the risks caused by a deregulated and liberalised macroeconomy
In other words while Banks/Investment groups have gone on a frenzy of loaning out or investing from 10 to 30 or 40 times a savers deposits, the good professor is more reassured when there is a large base of taxpayers with which to buy up the bad debts of the banking failures of macroeconomic policy.
Then there is the derivative elephant in the corner. The EU Commissioner financial services chief Charlie McCreevy (a two bit chartered accountant) stated recently that $60 Trillion credit swaps had to be cleared up urgently. The EU’s own regulators have not got a clue about the extent of exposure to the derivatives market. The total market at risk globally in this investment gambling house is estimated at $600 Trillion, could be twice that, no one knows and there is no macro economic model that exists to calculate the upcoming inevitable serious damage to the EU economy. The big unknown.
All signs are pointing to that the european recession will be reflected in high inflation. A natural consequence of printing money/Government borrowing to buy up bad debts and “clear up” the derivatives.
In the Euro Zone last year there was only an estimated €700 billion of real Euro bank notes floating around but there is about €8.5 Trillion created by EU banks and the markets.
Hi,
If you where asked to consider how a middle European town (300,000 inhabitants)in a hostile climate could survive by living mostly autarkic? The answer appears to be different if you live in Iceland and in other parts of the world.
The Icelandic politicians will not help much because of the free fall on the self esteem! One moment you are in the government and the next you are only a member of the city hall of a city roughly the size of Manheim or Coventry.
One thing important is which alliance you want to be in and which alliance will consider it seriously.
Another thing is the dynamism of your economy, it should benefit from this integration so access to the credit should be easy. As long Iceland is independant and not a subsidiary of Denmark or of the rich Norway, this is quite difficult. So no integration will not save EU economy.
My advice is more to join EU because of the long term peace project of EU and let economy recover alone by hard work and the right combination of education and common sense.
You are in need of intelligent initiatives understanding your strength but also your weaknesses, you are not in need of more and more politics just after suffering from financial hubris and lost of common sense.
I think joining the EU would be far worse for Iceland than what has occured here recently.
Not really. It appears to have been the opinion of foreign academics/consultants for some time (although I wonder about their impartiality):
http://www.resourceinvestor.com/pebble.asp?relid=47709
Had this been proposed for reasons other than Icelend wishing to dig itself out of a hole, with the EU footing the bill – then it would have deserved credit.
However, Icelands continued hubris deserves a dose of realpolitik.