Thursday, April 21, 2011

The Lesson of Iceland

. Thursday, April 21, 2011

I've been thinking a lot lately about exchange rates, capital flows, and related issues. While looking for something else, I came across many news articles since the crisis Iceland's bid to join the EU, including the EMU. Many of the articles focused on how Iceland's refusal to pay Icesave's creditors might jeopardize their accession, but the screening process appears to be at a fairly advanced stage already, so negotiations leading to accession in 2013 or so are realistic. Emmanuel's discussed some of this.

All that reminds me of Krugman's constant arguing that Iceland was doing so much better than Ireland and the Baltics, because having their own currency allowed them to depreciate quickly. As I noted here, that's all fair and good, but a large depreciation massively increases the burden of external debt, and also leads to a large increase in costs of living for a small open economy. Particular one as small and open as Iceland. Iceland's 50% currency depreciation made them much poorer, and their debt-to-GDP not only quadrupled after the crisis but became much more expensive to service. Note that before the crisis, Iceland had no desire to join the EMU, and no intention of doing so, although it did "Euroize" the krona somewhat.

In other words, I was right. Iceland is applying for EMU membership so as not to be as exposed to currency risk and balance of payments problems as they are now, and they're willing to give up plenty of policymaking flexibility to achieve that. Including the right to depreciate.

We'll see whether the EU lets them in. I imagine that will have a lot to do with what happens to Greece, Ireland, and Portugal in the meantime.


The Lesson of Iceland




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