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On the fringe of Europe: Iceland's currency dilemma

  • Economics
  • Political Science


CESifo Forum Summer 2006 CESifo Forum 2/200641 Special ON THE FRINGE OF EUROPE: ICELAND’S CURRENCY DILEMMA TRYGGVI HERBERTSSON* AND GYLFI ZOEGA** Introduction The United Kingdom approached its negotiations with the European Union (EU) in the 1960s and 1970s with some hesitation similar to what we wit- ness today around the euro. There were those claim- ing that EU membership was essential for trade and prosperity while opposing voices insisted that it would impinge on political and economic sovereign- ty. The attitudes revealed by the groups opposed to further integration could be characterized as an “island mentality” in that the proponents have a strong urge to maintain the identity of the nation and its independence in most spheres, yet are afraid of being left out and excluded by their neighbours. The island mentality is if anything stronger in Iceland where the same issues are currently being debated. The arguments proposed for and against joining the EU and adopting the euro mirror those raised in the UK but the debate is even more inter- esting because the choices faced are starker. Iceland has only 300 thousand inhabitants, which is roughly the population of the London suburbs of Ealing (305.019) and Camden (210.661) or the German cities of Bonn (302.200) and Karlsruhe (276.600). Iceland is to a greater extent than the UK dependent on trade, its labour market is even less integrated with continental Europe and its economic shocks are more asymmetric. A rather half-baked solution was concocted fourteen years ago when Iceland joined the European Economic Area – negotiated between the EU and seven EFTA states in 1992 – guarantee- ing the freedom of movement of goods, services, labour and capital within the areas.1,2 In this article we will not discuss the costs and bene- fits of EU membership for Iceland. Instead, we focus on the choice of an optimal currency regime, which we find interesting due to the very small size of Iceland’s economy and the fact that the healt

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