Lessons for Iceland from the monetary policy of Sweden
FREDRIK N G ANDERSSON AND LARS JONUNG, LUND UNIVERSITY SWEDEN

Iceland and Sweden a comparison

Population: 330 000
GDP: 17 billion USD (2016)
Exports: 48% of GDP
Inflation: 2%
Currency: Króna (ISK)Monetary policy: inflation target.
Volatile monetary history (99 %depreciation since 1922)

Population: 10 000 000
GDP: 485 billion USD (2016)
Exports: 44% of GDP
Inflation: 2%
Currency: Krona (SEK)
Monetary policy: inflation target.
Regular changes in policy regime (10regimes since 1922)

Swedish monetary policyInflation target• Adopted in 1993
• 2% +/-1 percentage point
More than monetary policy rules• Fiscal policy rules• Labour market rules

Is inflation targeting a success?
Comparision with previous regimes* Price stability* Fiscal stabilty* Trust in policy* Policy makers and labour market participants have
kept to the rules of the inflation target.
* Greater price stability and trust in economic policy.

* Exchange rate stability* Real economic stability* Financial stability* Increased real economic volatility* Growing financial imbalances

International dependence
Riksbank is shadowing the ECB* Riksbank is shadowing the policy of the ECB.
* Small deviations cause large variations in the exchange rateof the krona (SEK).

108* 1997 – 2008: business cycle synchronisation* 2011 – 2018: financial integration

42

0

Riksbank

Bundesbank/ECB

2017Q1

2015Q1

2013Q1

2011Q1

2009Q1

2007Q1

2005Q1

2003Q1

2001Q1

1999Q1

1997Q1

1995Q1-2

1993Q1%

6

Difference between Riksbank and Bundesbank/ECB

International dependence
Riksbank is shadowing the ECB
Stefan Ingves governor of the Swedish Riksbank:”Our neighbour is an elephant. When it moves it affectsus”.
Swedish economy in 2018
* Best labour market since 1980s* Highest growth since the 1990s* Credit and housing boom. Higest debt and prices ever.
* Expansionary monetary policy and recond low exchange
rate for the krona (SEK).
Monetary policy 2011-2017: crisis policy without a crisis
due to international dependence.

Swedish monetary policy. Summary
Rules based (monetary, fiscal, and labour market): inflation target. Rules arefollowed.
Inflation stability but not real economic, exchange rate or financial stability.
Free capital flows makes it difficult to be monetary policy independent. TheRiksbank is shadowing the elephant (the ECB).
Crisis policy without a crisis is now causing growing imbalances.

Iceland. 100 years of political independence.
Which monetary system for the next 100 years?

Possible exchange-rate arrangements for Iceland,that is the króna (ISK)No optimal policy regime exists for all times and for all countries: Characteristics of the economy
matter. Iceland is an extremely small economy with a volatile monetary history. 99 % depreciation
Fixed exchange rate
A1. Truly fixed rates: a monetary union with a common currency (euro area)
A2. Fixed rate, adjustment possible but difficult: currency board (e.g., Hong Kong, Estonia, Bulgariaand Lithuania)
A3. Fixed, adjustment possible but difficult: commodity money (e.g., gold, silver)
A4. Fixed but adjustable (pegged rate): fixed exchange rate vs other currency or basket or
currencies (e.g., Bretton Woods, ERM)
Floating exchange rate
B1. Rules-based systems: inflation targeting (Sweden, UK, euro area), monetary targeting
B2. Rules-based systems: multiple goals (inflation, employment) (United States)(Bundesbank pre1999)
B3. Discretionary systems: no fixed rules

The trilemma vs the dilemmaTrilemma (old)Choose two of the following three:
Fixed exchange rate – free capital mobility – monetary independence
Dilemma (new) due to close financial integration

Choose between:
Free capital mobility but no monetary independenceorCapital controls and monetary independenceCapital controls?
No: Iceland is too small.
Closed capital markets would likely reduce economic growth in the long run.
Political economy of capital controls rejects the use of controls.
(Capital controls invite political corruption and evasion)

Fixed or floating?
No capital controls ⇒ no independent monetary policy ⇒ fixed exchange rate
Iceland tried inflation targeting. Major contribution to the great financial crash of 2008.
Inflation targeting does not provide monetary and financial stability in the future for an economy
as small as that of Iceland.
Flexible exchange rate not always a shock absorber. Sometimes shock amplifier.
Which fixed exchange rate arrangement for the ISK?
* Fixed but adjustable (pegged rates)?
* Currency board?
* Monetary union?

A currency board for Iceland!
Fixed but adjustable rate: invites speculative attacks, Iceland have tried this regime. It has failed.
Monetary union: no escape clause (or a very expensive one). Iceland rejects EU membership forthe moment. Thus Iceland cannot join the euro area in the foreseeable future.
Currency board: more stable than fixed but adjustable exchange rate. Includes an escape clause.
Has proven stable, delivering monetary stability. Estonia, Lithuania, Bulgaria in Europe. Hong Kongand Singapore in Asia.

A currency board for Iceland!
Positive: stability, rules-based, escape clause, well-tested. A currency board gives instant monetarycredibility. Icelandic interest rates will be (almost) identical to euro rates.
Negative: no monetary autonomy, in case of large asymetric shocks no lender of last resort.
A currency board for Iceland should be combined with other measures: Stabilization funds to buffer against real economic shocks (fishing, tourism, aluminium) Capital restrictions on commerical banks (to limit risk of financial crisis)
 Fiscal policy rules (supporting the currency board) Labour market flexibility (labour unions must accept the rules of behavior implied by thecurrency board).

Major advantages of a currency board for Iceland
Keep the national currency the króna. Fostering national identity.
Instant monetary stability and credibility.
The króna has depreciated sharply during the past 100 years – 99.95 procent.
For the next century Iceland should have a monetary system that delivers exchange rate stabilityand price stability and thus a more stable domestic economy, inducing growth and politicalstability.