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Can Iceland afford its own
currency?
Francis Breedon –
Tanaka Business School, Imperial College London
19 March 2008
Outline
1.
Why does Iceland have its own currency?
2.
The trade impact of adopting the Euro
3.
A scorecard for Euro adoption
4.
Is Krona Volatility Benign or Malign?
Why Does Iceland have it own currency?
Small countries tend to adopt or peg to another currency
Iceland is the smallest country in the world with a freely floating currency
What’s special about Iceland?
•
Strong institutional capability – unusual for a small country
•
Highly independent economy – unusual for a small country
…in fact economic independence is Iceland’s strongest argument for an
independent currency
Macro Volatility: Iceland vs. the Western European Outs
Terms of Trade Volatility (Standard Deviation of quarterly terms of trade 1980-2007)
Iceland
Std. Dev
Norway
1.51%
Sweden
3.81%
1.31%
UK
1.06%
Export volatility & Correlation (Standard Deviation of quarterly export growth 1980-2007,
correlation with Euro Zone export growth 1990-2007)
Std Dev.
EUR correl
Iceland
Norway
Sweden
UK
4.54%
-0.13%
3.85%
0.14%
3.14%
0.48%
2.59%
0.31%
Output Volatility (Standard Deviation of output gap 1980-2007, correlations 1990-2007)
Iceland
Std Dev.
EUR correl
USD Correl
4.20%
0.13%
0.27%
Norway
2.88%
0.24%
0.55%
Sweden
2.45%
0.38%
0.79%
UK
2.54%
0.21%
0.47%
Macro Volatility: Iceland vs. the Western European Outs
Output gaps
10.0
7.5
5.0
PERCENT
2.5
0.0
-2.5
-5.0
-7.5
-10.0
91
92
93
Euro Zone
94
95
Iceland
96
97
Norway
98
99
00
Sweden
01
02
03
United States
04
05
06
07
08
09
United Kingdom
Source: Reuters EcoWin
The Trade Impact of adopting the Euro
Iceland’s high and idiosyncratic macro volatility may explain why it has opted for
its own free floating currency. But at what cost?
Breedon and Pétursson (2006) estimate a gravity model of trade for all EU and
EFTA countries (1978-2002) including an EMU and EU effect (à la Rose)
. Gravity trade model (log of bilateral trade as function of)
Standard gravity model
Variable
EMU membership
EU membership
Exchange rate volatility
Log of output
Log of output per capita
Log of distance
Contiguity
Language
OLS estimates
0.25 (0.033)
0.46 (0.016)
-0.12 (0.009)
1.23 (0.010)
0.23 (0.031)
-1.24 (0.016)
0.19 (0.019)
0.25 (0.016)
IV estimates
0.21 (0.040)
0.45 (0.017)
-0.15 (0.009)
1.23 (0.008)
0.23 (0.028)
-1.24 (0.016)
0.18 (0.024)
0.26 (0.020)
Fixed effect model
OLS estimates
0.25
(0.016)
0.25
(0.009)
-0.008 (0.0035)
2.37
(0.264)
-1.16
(0.262)
–
–
–
–
–
–
IV estimates
0.26
(0.014)
0.25
(0.009)
-0.007 (0.0037)
2.38
(0.195)
-1.17
(0.195)
–
–
–
–
–
–
The Trade Impact of adopting the Euro
Our results imply
Impact of eliminating EUR/ISK volatility: 2% increased trade with Euro Zone
Impact of joining the EU:
28% increased trade with Euro Zone
Impact of joining EMU:
29% increased trade with Euro Zone
HM Treasury (2003) suggests that ‘it seems reasonable to assume that each 1
percentage point increase in the trade to GDP ratio increases real GDP per
head by at least ⅓ per cent in the long run’
Implies EU and EMU membership would raise Icelandic GDP by 2% each
A Scorecard for Euro Adoption
Can estimate the benefits of Euro adoption but costs are harder. How can a
judgment be made?
Comparison with other outs? Literature highlights 4 (measurable) factors that
determines economic costs/benefits of Currency union
Euro Adoption Ranking
Iceland
Norway
Sweden
UK
Trade Dissimilarity (ToT)
3
4
2
1
Asymmetric business cycle
4
3
1
2
Trade share
3
4
2
1
Size
1
2
3
4
TOTAL
11
13
8
8
On this basis Iceland seems to have less to gain (more to lose) than most other
Western European Outs (though Ireland would have a high score also)
Is currency volatility benign or malign?
Key argument for Iceland seems to be that currency volatility is required to
cushion macro shocks to the economy, but does it cushion shocks or create
them?
Engel and West (2004) propose a simple method to determine the extent to
which exchange rate volatility is related to volatility of economic
fundamentals
Exchange rate and Exchange rate Fundamentals (monthly 1995-2007)
Iceland
Norway
Sweden
UK
Volatility of fundamentals
0.8%
0.7%
0.5%
0.6%
fundamental volatility as share of
currency volatility
15%
27%
13%
20%
Notes: Exchange Rates against the Euro. Fundamentals based on Taylor rule specification, Discount rate = 1
Conclusion
Iceland’s significant and idiosyncratic macroeconomic volatility is the key
(economic) argument against adopting the Euro. But to what extent is the
Krona itself the cause of this volatility?