Should Iceland join the euro?

by on January 4, 2017 at 12:49 am in Current Affairs, Economics, Law | Permalink

That may not be in the cards anytime soon, but at least it has surfaced as a potential option, along with EU membership, to be considered by Icelandic referendum.  Matt Yglesias questions whether this might be a mistake.

I see the creation of the euro as a big mistake, and in general I favor flexible exchange rates, but on this question there is a plausible case for Iceland joining up with the euro.

First, Iceland cannot defend itself and does not want to rely only on the United States.  European Union membership helps out on that front, and the EU has at least been claiming that new members also will be euro-using members.  Fishing rights are a big deal for Iceland, and maybe the country will decide it does better within EU structures.

Second, and more to the macroeconomic point, very small countries do not always do well with floating rates.  For instance, no one suggests that every household should have its own currency.  Iceland, with a population of about 330,000, may be small enough to make this comparison at least a bit apt.  Keep in mind the biggest exports are tourism, fish, and aluminum products, not much else.  Using the euro may help tourism a bit, while I suspect the fisheries and aluminum smelters can get by with a mix of a) not employing that much labor anyway, and b) making wages more flexible if need be, rather than needing a floating rate to stay competitive.

Another way to put the point is this: floating rates are most useful as a protection against nominal shocks, not real shocks.  But when an economy is sufficiently small, real shocks tend to be the more significant problem because usually there is not so much diversification.

On the macro front, so what if Iceland becomes the north Atlantic version of how Panama, Ecuador, and El Salvador stand pegged with respect to the U.S. dollar?  Those economies have various troubles, but fixed exchange rates are fairly low on those lists.

Not long ago, the Icelandic economy was hit by a massive shock from capital flight, which in turn stemmed from a banking and real estate collapse.  Capital controls were imposed, in part because the flow of funds whiplash was so large relative to the size of the Icelandic economy.  Relying on continental, euro-denominated banking from Dutch, German, and other suppliers may well be a better option.  A true EU banking union, if one ever comes, would be better for Iceland yet.  In other words, in the eurozone Iceland might be better protected against at least some real shocks.

I don’t have a firm view here, so it is fine to think of my conclusion for Iceland as agnostic.  I ‘m just saying you can be a euro skeptic, and favor Icelandic euro membership, without fear of contradiction.  The European countries that should not be in the eurozone, such as Italy and Greece, are much bigger than Iceland and are also more economically diversified.

iceland

1 Brandon January 4, 2017 at 1:00 am

Interesting, but on point 1 does Iceland *really* need protection?

From who? The WaPo’s Russia?

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2 Doug January 4, 2017 at 1:43 am

+1

Tyler says: “Iceland… does not want to rely only on the United States”

Why? I can’t even imagine a possible imagine a scenario where Iceland is invaded and the US military doesn’t immediately and vigorously intervene. There’s no reason to keep redundant smoke detectors in a room, if one unit already has 99.999% reliability.

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3 Tyler Cowen January 4, 2017 at 3:42 am

Would America go to war to protect Icelandic fishing rights from external depredation? I don’t think so. Many of the world’s smaller countries have learned the hard way not to be too dependent on any single external large power.

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4 john January 4, 2017 at 7:34 am

Interesting question. But do you think that EU would go to war to protect Icelandic fishing rights?

I don’t mean a little bit of argy-bargy, handbags at dawn. I mean full-blown missiles blowing destroyers out of the water kind of war.

Personally I remain completely unconvinced in the European defence model. There are some European countries that will fight and die to aid a neighbour who is under external threat. There are some that won’t lift a finger. It’s not a moral judgement. There are too many cultural and political differences. To pretend otherwise is dangerous.

For instance most Western European countries would happily fight an external enemy who invaded Poland, Czechoslovakia, Sweden, Spain or Italy. But it’s exceptionally unlikely they would willingly send their young men and women to die in order to protect Turkey from Russian aggression.

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5 A Black Man January 4, 2017 at 9:25 am

The US has maintained a military presence in Iceland for a long time. Keflavik was a US base through the Cold War. It was decommissioned a decade ago, but it is now slated to be re-opened. The Navy will base P-8 Poseidon aircraft there along with F-16’s. Iceland is also a member of NATO.

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6 DiplomatBob January 4, 2017 at 10:34 am

As a member of NATO Iceland is already connected via defense ties to the European countries that matter militarily. Which I would argue do not really matter all that much, but personal opinion. I do not see how joining the EU would help defensively, esp. since the EU has shown a real inability to defend itself absent American leadership.

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7 Barkley Rosser January 4, 2017 at 4:55 pm

The big issue for Iceland has long been fishing, which has not been a simple employment one. It is the main activity for the nation outside the capital city, and it has been fear of having to let EU nations into their fishing waters that has been the main reason Iceland has not joined the EU so far, with the Brits and Spanish the bad boys on this. This has been an issue for Norway as well. As it is, I think talk of joining the euro is completely premature without them being in the EU, which is not all that likely, although maybe they will change their mind. But “getting EU protection for their fishing rights” is not an argument that anybody in Iceland would be impressed by.

BTW, a lot of people in UK, especially in Cornwall, have been resentful of EU fishing regs, even though they have arguably gained from them. Cornwall, which gets huge amounts of aid from EU does not seem to understand that it does and voted hard for Brexit. In this regard they look like people who are on ACA medical insurance who voted for Trump.

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8 Art Deco January 4, 2017 at 11:00 pm

It is the main activity for the nation outside the capital city,

About 2.2% of the labor force has its principal employment in fishing, or around 4% of those outside the capital.

9 TMC January 5, 2017 at 8:52 am

I’d expect the EU to be the major source of threat of depredation of fishing rights.

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10 TallDave January 5, 2017 at 1:18 pm

We’re still in Iraq because 25 years ago they invaded Kuwait, a country few Americans were even aware existed (and not a particularly admirable one at that). We’re still in S Korea because Japan took it over nearly a century ago and then foolishly bombed Hawaii over 70 years ago.

Should we? Probably not. Would we? Probably.

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11 dan1111 January 4, 2017 at 3:42 am

I would put the chance of the U.S. failing to intervene in Iceland at somewhere above .001%.

Still, through NATO Iceland is already allied nearly all of the EU, in addition to the U.S. and several other countries. I don’t really see how joining the Euro strengthens their position.

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12 Jacob Aaron Geller January 4, 2017 at 1:09 am

The photo is of Vestmannaeyjar, or “Western Islands,” if anyone’s wondering.

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13 Jacob Aaron Geller January 4, 2017 at 1:09 am

* Westman Islands

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14 Shane M January 4, 2017 at 2:00 am

Thank you

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15 Mark Thorson January 4, 2017 at 2:23 am

Good example of a place that looks pretty, but I would not want to live there. I’ve had a lifelong fear of cliffs.

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16 Jeff R January 4, 2017 at 4:38 am

I would build a driving range there.

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17 Cliff January 4, 2017 at 9:56 am

With good reason

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18 ricardo January 4, 2017 at 11:02 am

LOL.

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19 The Other Jim January 5, 2017 at 12:29 pm

The sledding in winter would be incredible.

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20 Mark Thorson January 5, 2017 at 8:24 pm

Until you get to the end.

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21 Altern January 4, 2017 at 1:59 am

“First, Iceland cannot defend itself and does not want to rely only on the United States.”

Defend itself against who? Fish? This is just lazy thinking.

“European Union membership helps out on that front.”

Did you hear about the new European Union tank? Neither did I.

On the currency issue I think you have a valid point, however, there is a risk if there’s another big crisis and Iceland wants to devalue, it’d have to leave the Eurozone, a huge challenge. With a currency peg, it could just be suspended, no need to change the ATMs or cause a bunch of political drama.

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22 dan1111 January 4, 2017 at 3:09 am

“Defend itself against who? Fish?”

A statement like that is the real lazy thinking. What possible basis could there be for assuming that no country would ever want to invade or dominate Iceland. Because it is cold? Or far away?

In fact, countries are competing for access to Arctic resources. A foothold in Iceland would greatly help China, for example, who has Arctic ambitions but no nearby territory.

Of course there is no near-term prospect of Iceland being invaded, but to suggest they need no defense strategy is naive.

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23 So Much For Subtlety January 4, 2017 at 4:05 am

Without nearby territory, how do you think China would grab a foothold? How would they support their Army with no bases?

They would be better off looking to New Zealand anyway. They already have a large contingent living there ….

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24 dan1111 January 4, 2017 at 4:39 am

Surely China could easily invade and occupy Iceland if there were no powerful allies defending it.

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25 Keith January 4, 2017 at 11:46 am

This whole discussion is ridiculous. Tourists are the only people that will invade Iceland.

26 AnthonyB January 4, 2017 at 10:45 am

The British invaded Iceland in 1940.

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27 carlospln January 4, 2017 at 2:14 am

Haven’t you learned anything in the last 8 years from Greece, Spain, now Italy?

They can’t devalue and they can’t leave the cursed ‘union’ [as you point out, it doesn’t extend to banking]

Iceland would be mad to even consider joining.

btw, what’s your daily rate?

Asking for a friend, who can’t believe this post.

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28 mulp January 4, 2017 at 4:04 am

Yep, if they were like Venezuela, they could fix all their problems by printing money, imposing price controls to hide the exponential inflation, …

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29 dan1111 January 4, 2017 at 6:30 am

Congratulations, you have a winning argument against the claim “floating currencies fix all problems”.

Now all you have to do is find someone making that claim…

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30 MMK January 4, 2017 at 6:56 am

Wasn’t Iceland pretty successful with its currency devaluation during its banking crisis? I genuinely don’t know, but that’s what it seemed like.

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31 JC January 4, 2017 at 2:18 am

“very small countries do not always do well with floating rates” My former Macro professor was used to say “small economies should not have own currencies”… my question is, how small Greek economy is? Anyway, Greek problem is beyond monetary policy, isn’t it?

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32 mulp January 4, 2017 at 4:11 am

Venezuala is 32-35th in gdp rank.
Greece is 49-50th at about two-thirds the size.

Anyone want to argue Venezuela has solved any problems by printing money that would provide hope for Greece exiting the euro?

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33 JC January 5, 2017 at 4:59 am

I agree with you mulp. I can’t see how great Grexit can be either.

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34 prior_test2 January 4, 2017 at 3:00 am

‘I see the creation of the euro as a big mistake’

A fifteen year old one, at this point. Don’t worry, at some point, the euro, like all other currencies, will no longer exist, and you will be right. Possibly, you could have a memorial park bench inscribed with that, in case it does not occur in the next four or five decades.

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35 mulp January 4, 2017 at 4:13 am

I assume you make your point by pointing to the floating currencies of Venezuela, Texas, and California?

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36 Heorogar January 4, 2017 at 8:00 am

Dr. Milton Friedman thought the euro was a big mistake. Who am I to disagree?

As a member of NATO, Iceland doesn’t need to depend on German technocrats in Brussels or Angela Merkel who is supinely destroying Germany and Europe.

More interesting to economic study would be how, alone on the Planet, Iceland (I think) correctly approached its banks’ foreign liabilities in the 2008+ worldwide great recession.

FYI – Before the EU was a gleam in the eye of some technocrat, i.e., during the Cold War,. the USAF/NATO maintained an air base in Iceland. Plus, Tom Clancy wrote, in one of his novels, about Soviet paratroops dropping into Iceland in WWIII.

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37 dan1111 January 4, 2017 at 8:08 am

The Euro’s mere survival doesn’t disprove that it was a mistake. It’s true that, a couple of years ago, Tyler seemed to expect the imminent collapse of the currency, and he was wrong about that. But that doesn’t settle the larger question of whether it was a good idea in the first place.

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38 JWatts January 4, 2017 at 11:30 am

From prior_approval’s POV, the Euro has helped Germany; and that’s the deciding factor.

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39 carlospln January 4, 2017 at 3:22 pm
40 So Much For Subtlety January 4, 2017 at 3:34 am

Fishing rights are a big deal for Iceland, and maybe the country will decide it does better within EU structures.

Exactly how would letting European kleptocrats control Iceland’s fish actually help Iceland? I don’t see it. Stocks have collapsed all over the world largely because some countries do not obey the rules. In the old days that was the Soviet Union and the Greeks. Now it is pretty much all of southern Europe although if the Russians still sail I assume they still cheat. So how badly would Iceland’s management have to be that asking the Italians, the Spanish, and the Portuguese in to scoop up everything they can would be an improvement?

Look at Britain’s fish stocks. British people do obey the law. How is that working out for them?

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41 WillS January 6, 2017 at 7:58 am

In my local fish and chip shop (yes, I’m British) there’s a notice on the wall which reads:

“All of our cod comes from sustainable and protected Norwegian and Icelandic fishing grounds”

Given the importance of fishing to Iceland, and the revered position the fishing industry seems to have within Iceland, I find it difficult to understand how anyone would think that Iceland would join the EU and ruin this industry by handing control over to the geniuses behind the common agricultural and fisheries policy.

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42 dearieme January 4, 2017 at 3:38 am

“European Union membership helps out on that front”: an elementary confusion of the EU with NATO, surely? Unless you take the view that Iceland is in grave danger of being dragged into the next war between Germany and France, which the existence of the EU might avert.

“Fishing rights are a big deal for Iceland, and maybe the country will decide it does better within EU structures.” Yep, if they want their waters hoovered by the Spanish fishing fleet, joining the EU is probably a good way to arrange that.

Sometimes in the attempt to play the gadfly, one can in fact end up playing the role of dolt.

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43 vic January 4, 2017 at 6:45 am

“The European countries that should not be in the eurozone, such as Italy and Greece, are much bigger than Iceland and are also more economically diversified.”
I don’t get this point: is it not because Iceland is not well-diversified and because Iceland is sensitive to real shocks that might not be similar than those affecting the Eurozone that it should keep the flexiblility to adjust its real Exchange rate?

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44 Brian Donohue January 4, 2017 at 7:27 am

Iceland doesn’t need the permission of Europe to adopt the euro, anymore than Panama needs US permission to adopt the dollar as its medium of account and exchange.

Whether it’s better for small economies to impose this kind of discipline on their monetary regime or not is a separate question.

Recent history suggests this has not worked out so well for Greece, Italy, or Spain. Irish currency, on the other hand, used to be pegged to the pound and now they have the euro, and they seem to be doing ok, but Ireland is a much smaller country.

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45 MOFO January 4, 2017 at 9:23 am

Why does Iceland even need a currency at all? What would happen if the government just said that it would take as payment any reasonable currency their countrymen were using?

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46 Art Deco January 4, 2017 at 9:47 am

Is this argument for real?

The EU is not a military alliance and all but two EU members are militarily impotent. They’re protected by the United States, France, or Britain or they’re not protected.

Iceland had a bizarre spike in its metered output during the years running from 2001 to 2006, then it all came crashing down. It’s mean performance over the years running from 2001 to 2015 is slightly better than its performance over the period running from 1986 to 2001. Iceland began its recovery in 2009 and currently has unemployment rates around 3%. Greece hasn’t recovered yet and has unemployment rates over 20%.

About 70% of the value added in the economy is accounted for by services, about 23% by industry (of which 55% is manufacturing and 45% the sum of extractive industry, construction and utilities), and about 7% by agriculture (which includes fishing and forestry). The export sector the last few years has been evenly divided between merchandise exports and service exports. It’s a heavily trade-dependent economy, and exports account for 55% of gdp as we speak. About 20% of export revenue nowadays derives from ores and minerals, about 6.5% from manufactures, about 6.5% from information and communications services, about 15% from tourism, about 1% from fuels, about 2% from insurance and financial services. I’m not seeing that the country’s economy is abnormally dependent on any one sector.

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47 Slugger January 4, 2017 at 11:15 am

Perhaps a small country with a fairly large tourism sector makes a profit by having its own currency since the tourists might be willing to pay more than the natural exchange rate to get the local currency. I remember that some nations printed postage stamps to profit off international stamp collectors rather than just provide for postage. I have been to Iceland, had a good time, and still have some of their money. The fact that I overpaid for the local currency is not a big deal to me. Milking tourists is a big part of many economies.

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48 dan1111 January 4, 2017 at 11:43 am

Iceland is already very expensive for tourists, though. Making it even more expensive would drive business away.

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49 JWatts January 4, 2017 at 11:45 am

I think this was an interesting topic by Tyler, but after reading the comments it looks like his premise is wrong.

a) It’s doubtful if joining the EU would provide any additional national security to Iceland.

b) It’s doubtful if being forced to used the Euro instead of just pegging it’s currency to the Euro would be worth the costs.

c) In 2008/9, Iceland confiscated the value in foreign held banking accounts (mostly UK pensioners) . It’s doubtful that this would have been nearly as politically feasible if Iceland were a member of the EU.

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50 JWatts January 4, 2017 at 11:47 am

In saying all this, I’m not predicting that Iceland will never join the EU. I’m just doubtful that national security and being on the Euro will be the deciding factors.

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51 Art Deco January 4, 2017 at 11:03 pm

They didn’t confiscate the accounts. They wouldn’t compensate the depositors when the banks went bust.

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52 James January 4, 2017 at 11:57 am

Newbie question:

What difference does it make if Iceland adopts the Euro in comparison to just pegging their currency to the Euro? Isn’t that basically the same thing?

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53 Cooper January 4, 2017 at 5:44 pm

Pegs can be broken at will. Even the Swiss couldn’t maintain their Euro peg.

Formally adopting another currency is a more firm connection.

It’s the difference between living with your girlfriend and marrying her.

Sure, you could get divorced but it’s extra work.

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54 Cliff January 5, 2017 at 1:18 am

The Swiss chose not to maintain its Euro peg

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55 chuck martel January 4, 2017 at 12:07 pm

What would happen if Iceland adopted the gold standard?

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56 AnthonyB January 4, 2017 at 2:20 pm

What if the Chrysanthemum Throne were to adopt the ice standard?

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57 TallDave January 5, 2017 at 1:13 pm

Not sure it really makes any sense for their monetary policy to be directed by Germany, which seems to be the de facto result of joining the euro.

More localized institutions are generally more effective.

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