Is Iceland an Optimal Currency Area?

Willem Buiter

Economics from Department of Economics, Central bank of Iceland

Abstract: The paper considers the pros and cons for Iceland adopting the euro as legal tender. The current Icelandic monetary arrangements are contrasted both with a unilateral adoption of the euro and with a full membership in the EMU. Microeconomic transactions costs savings argue in favour of either form of monetary union. Loss of seignoirage revenues does not seem to be an economic obstacle to either form of euroisation for Iceland. Loss of the lender of last resort is, however, a powerful argument against unilateral monetary union. The optimal currency area arguments (which concern the macroeconomic stabilization aspects of a permanently fixed exchange rate) are unfavourable to a unilateral monetary union, but the case against a full membership in the EMU is more balanced. The extraneous instability and excess volatility inherent in a marketdetermined exchange rate dominate the shock absorber properties of a flexible exchange rate when financial markets are highly integrated. On balance, the economic arguments favour a membership in the EMU, but not the unilateral adoption of the euro. Because Iceland is not a member of the EU, the political arguments against any form of monetary union are overwhelming. Without a EU membership, the transfer of national sovereignty to the ECB would lack political legitimacy. The lack of institutions for ensuring the political accountability of the ECB in Iceland means that euroisation of Iceland is unlikely to happen, except as part of Icelandic membership in the EU. Euroisation without a membership in the EU is simply unlikely to survive.

Date: 2000-08
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