Should Iceland adopt the EUR?

Some time ago, I sent my answer to this question to the European Web - a quasi-official website which has the purpose of answering questions about the EU admission process of Iceland and other general EU considerations. What follows is a rough English translation of the answer, originally posted here: Ættu Íslendingar að taka upp evruna?

The timing of the posting of the answer was in fact quite fitting since the Central Bank just issued a tome - a 600+ page report - on whether Icelanders should adopt the euro or not. Their conclusion: they weren't sure. So am I, except I reach that conclusion in about one A4 page.

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Should Icelanders adopt the euro?

Each and everyone has to answer this question on their own. The reason is that adopting the euro or keeping the krona is to a large extent a question of how risk averse Icelanders are at the time of their answering. Economics will not be able to answer which of the two currencies are "better".

The Eurozone is based on the theory of Optimum Currency Area. In very short, that theory states that if different local economies are alike enough, such as in terms of culture, language and trade cycle, and they have a significant level of trade in between them, then it would be beneficial for those two local economies to adopt the same currency, first and foremost to decrease the cost of commerce (such as due to the need to exchange currencies all the time). 

The upside of this (hoped for) decrease in cost of commerce should outweigh the fact that if this common currency is adopted then the local economies are forfeiting their independent monetary policy. That in fact can sometimes be the aim since independent monetary policy is sometimes so fantastically badly conducted that it does the economy more bad than good. Adopting a foreign currency should therefore not only decrease the cost of commerce but also boost the credibility of the ruling monetary policy, thereby increasing general economic wellbeing.

It is here though where individuals' own risk aversion plays part. The author has sometimes drawn up the metaphor that keeping your own national currency, which is not pegged to another, is like buying a full insurance on your car. If you however choose to give up the independent monetary policy, then you are choosing to go for a very limited insurance on your car.

The metaphor is the following: a full insurance on one's car can cost a pretty penny. If, however, the owner of the car has an accident, which he had nothing to do with, the insurance company will pay the cost of repairing the car - minus the self-coverage. The owner knows this however so he becomes subject to moral hazard: him knowing that he will get most of the cost of repairment from the insurance company certainly does not encourage him to drive more carefully. If he's not careful, the chances of him actually having an accident increase.

A car owner which does not buy a full insurance does not become subject to moral hazard. The owner will have to pay the full price of repairing the car in such instances and therefore the limited insurance car owner has the incentive to drive more carefully. He can however still have an accident which he could not avoid no matter what. He can also still have an accident because he drove like an idiot, even if he hadn't bought the full insurance. 

The Icelandic krona and the euro are represented by the full and limited insurances here above. The car is the economy and the driver behind the steering wheel is the people in the economy, most importantly the policy makers - and banks. If the economy ends up in troubles, the "full-insurance" will kick in in the form of devaluing the currency. The self-coverage is higher inflation in case of massive devaluation and lack of foreign purchasing power. But the economy will be "repaired" with the devaluation. However, the "get out of jail card", which what the devaluation of the currency really is, also does not give the Icelandic people much encouragement to drive carefully. So keeping the independent currency can in fact introduce fluctuations into the economy, fluctuations that do not need to be there. Nevertheless, it is still possible, even if you drive carefully, to have an accident. And nothing stops you from driving like an idiot even if you don't have an full insurance. And when the accident happens, there will be no independent currency to devalue if you have the euro.

So the question which of the two currencies is "better" for the Icelandic economy is not only about whether Iceland is a part of the optimum currency area that Eurozone is meant to be - which in fact can be argued against, hence the euro crisis. The answer is also whether the Icelandic nation is risk averse enough to forfeit the "full insurance" that the independent currency is.

It can easily be argue that holding dearly onto a currency which has lost 99.95% of its value versus the Danish krona since 1939 is not the wisest thing to do. If the euro is adopted the handling of the economy must become much stricter. In that case, we are not only talking about fulfilling the Maastricht treaty on fiscal deficit and fiscal debts but we must consider the debt levels and debt issuance of private parties as well. The economic problems of the periphery countries are not only explained with reckless federal spending, such as in the cases of Italy and Greece, but with the expansion of private debt, such as in the cases of Spain and Ireland.

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My point: Iceland can still end up in dire economic straits due to private debts, even if we would adopt the euro.