After having gone through a dramatic financial meltdown and two years of recession in 2009 and 2010, Iceland started to recover in 2011 and IMF estimates now indicate that economic growth should average between 2.5% and 3% over the short-medium term.

Yet the country is in a post-crisis transition and a number of systemic and structural issues still need to be addressed by the authorities in order to secure economic stability for the future. One of these issues is whether or not the krona should be replaced with a foreign currency.

A recent Capacent Gallup poll indicates that 70% of Icelanders effectively would like to ditch the Krona, which is seen as a source of instability. But which currency should be adopted? And, even more importantly, is the use of a foreign currency going to benefit the Icelandic economy?

Going Canadian?

A perhaps surprising answer to the first question emerges from the Capacent Gallup poll: Icelanders would prefer the Canadian dollar (also known as the Loonie) over the euro, the Norwegian crown, and the US dollar.

The idea to adopt the Canadian dollar seemed to have gained momentum earlier in March when the Canadian Ambassador to Iceland declared that the Canadian government would be prepared to discuss it.

Since then, however, the idea has lost some steam, with the Canadian government stopping the Ambassador from making further comments on the issue and the Iceland’s minister of economic affairs stating on March 21st that the adoption of the Canadian dollar is not on the table.

In the economic jargon, abandoning the domestic currency for a more stable and solid foreign currency is known as “dollarisation”. By dollarising, the domestic country adopts the monetary policy of the foreign country. This, in turn, has both costs and benefits.

On the benefits side, the stability of the foreign currency should help control domestic inflation and eliminate the risk of sharp devaluations of the domestic exchange rate. In turn, this should boost international investors’ confidence, allow the country to borrow on international markets at a lower rate, and also facilitate trade with the rest of the world. Ultimately, these effects can be expected to result in more investment and faster growth.

On the costs side, the loss of control over monetary policy means that the domestic authorities could no longer devaluate in response to extreme circumstances. Moreover, as money would be solely printed by the foreign central bank, the domestic authorities would lose the revenues from seigniorage (profits accruing to the monetary authority from its right to issue currency). The provision of facilities for lending of the last resort and backing of the domestic banking system would also be significantly reduced in the dollarised economy.

Whether or not benefits are larger than costs is in the end an empirical matter. However, benefits tend to increase, and costs decrease, (i) the higher the volume of bilateral trade between the two countries and (ii) the greater the use of the foreign currency in domestic markets.

Now, these two conditions hardly apply to the Iceland-Canada pair. In particular, Iceland is much more integrated with the European Union than with Canada. IMF data indicate that in 2010, 66% of Iceland’s total international trade was done with the EU and only 1% of the total was done with Canada. Even acknowledging that Canada does enjoy some significant degree of monetary stability and economic success, these simple observations suggest that Iceland should not go Canadian.

Going European

The obvious alternative would be to adopt the Euro, given that Iceland and EU are very integrated. However, this route is also not immune from complications.

First of all, Iceland is not yet a member of the EU and polls indicate that the majority of citizens are actually against joining the union. In these circumstances, Iceland would have to adopt the Euro unilaterally; something that the European Central Bank would forcefully oppose and try to discourage as much as possible.

But beyond that, Iceland’s large natural resource endowment makes it economically quite different from the core of the EU. Iceland’s business cycles are not likely to be synchronised with those of most other EU partners, and this could significantly increase the costs of having the euro as the national currency

In fact, in terms of economic structure, Iceland is more similar to Canada – and this could be the only solid argument to support the adoption of the Canadian dollar.

Staying Icelandic

Obviously, Iceland does have the option to keep the krona. The problem? Since its launch as an independent currency in 1920, the krona has not provided Iceland with much of an anchor against instability or a buffer against shocks.

Historical data indicates that the exchange rate has been highly volatile for nearly a century and that this volatility is a primary driver of the volatility of private consumption. Furthermore, while in standard textbook analysis devaluations can help boost exports, in Iceland this is not likely to be the case. With a small domestic market, firms in export sectors produce almost exclusively for exportation.

So, when a devaluation occurs, increased foreign demand for Icelandic products cannot be met by reallocating shares of output from domestic to foreign markets. Exports can be increased only by stepping up production. But in most of Iceland’s export sectors (marine products, aluminium) production is very inelastic. Devaluations therefore do not bring about a positive export boom. Instead, given that the private sector is highly leveraged in foreign currency, the depreciation of the krona produces strong negative balance-sheet effects.

Against this background, it is not surprising that Icelanders are tired with the instability and depreciation of the Krona. Yet, one should recognise the factors that have historically undermined the currency: fiscal dominance, inadequate monetary policy framework, and lack of discipline in policy-making more generally.

The crisis of 2009-2010 has resulted in new efforts to fix those weaknesses. This could then provide some firmer foundations to the Krona and strengthen its credibility. Exchange rate volatility could then be reduced with the adoption of a managed floating regime. This would be in line with the recently announced intention of the central bank of Iceland to become more active in the foreign exchange market. Still, the small size of the Icelandic economy will make it hard to manage a floating currency.

So, what’s the way ahead? From an economic perspective, Iceland is tightly linked to the EU. Certainly, its economic structure, largely based on the resource sector, makes it a bit of an outlier relative to the rest of the EU members. Still, given how important a trading partner the EU is for Iceland, the euro is probably the best possible anchor for the krona.

Pegging the krona to the euro would bolster the process of convergence prior to the “multilateral” adoption of the Euro and possibly smoothen some of the asynchronism between the EU and the Icelandic business cycle.

In this respect, the hard peg would pave the way towards full entry of Iceland in the EU and the monetary union. Economically, it is feasible and most likely convenient to both parties. But whether this idea will be able to gather political and popular consensus in Iceland is a different question.