birgir isleifur gunnarsson : iceland in a global setting keynote speech by mr birgir isleifur gunnarsson, chairman of the board of governors of the central bank of iceland, at the euromoney conference on the nordic financial markets and investment opportunities, stockholm, 13 september 2002. * * * mr. chairman, ladies and gentlemen. it is a pleasure to participate in this ambitious conference on the nordic financial markets and investment opportunities. i will in my remarks today mainly focus on aspects relating to iceland. size separates iceland from the other nordic countries, denmark, finland, norway and sweden. other factors separate the nordic countries as well. finland is a member of the european union and the economic and monetary union, emu, as well. denmark and sweden are members of the european union but are outside the emu. norway and iceland are outside the european union but maintain very close ties to it, particularly through the european economic area agreement. that agreement makes norway and iceland a part of the single market of the european union, which entails among other things that they are obliged to maintain financial market legislation, which fully conforms to that of the european union. the nordic countries have different monetary regimes. finland is a member of the emu, denmark is linked to the emu through an erm ii agreement entailing that the danish krona is very closely tied to the euro. sweden, norway and iceland have chosen an inflation - targeting regime as their monetary framework ( iceland in march 2001 ). thus, price stability is the main objective of monetary policy in all of these countries and has in fact become the recognized single target for monetary policy in numerous countries. the reason for this emphasis on price stability is that it creates the best conditions for balanced growth and increased welfare. the icelandic financial market has developed very rapidly over the last ten to fifteen years. it is a small market by definition, but has nevertheless the same institutional set - up as larger industrial countries. aside from the central bank, these include commercial banks, savings banks, securities companies, various investment funds, insurance companies, large and important pension funds and last but not least a stock exchange - linked with the other nordic exchanges - where the shares of 60 to 70 icelandic companies are listed and traded on regular basis. supervision of the activities of all of these institutions is in the hands of a unified financial supervisory authority that has broadly the same legal powers and follows the same methods and standards as supervisory agencies in other european countries.

this area is slow and with current set - ups we are not going to get far without having the main reserve currency country on board. this raises the question that i will turn to next : in the absence of global ( or regional ) reforms, what will individual soes have to do in order to reap the benefits of cross - border financial integration in safe manner? in order to answer this question, we need to understand how cross - border financial integration affects the ability of soes to preserve both monetary and financial stability. 1 first, a simple theory. if we have a world made up of one very large country and several very small countries, with full cross - border financial integration ( in the for a more expanded version of what follows, see my published work, in particular gudmundsson ( 2008 ) and gudmundsson ( 2016 ). economic sense of these terms rather than the legal one ), and assume that relative risk premia are constant, then long - term interest rates in the small countries will be pegged to long - term rates in the large one. this, of course, is an “ unrealistic ” theoretical simplification. but it gives us a reference point to start to think about these issues, and it indicates the direction we might be heading in as global financial integration progresses. in this type of world, the small countries could still have independent monetary policy of a sort, provided that they have a flexible exchange rate regime. they could pick their own inflation targets and set their own short - term rates that would affect economic activity in the short run and inflation in the long run. in this case, monetary policy works mostly through the exchange rate channel. if exchange rates are “ well behaved ” and the financial sector is sufficiently regulated and supervised, then a floating exchange rate and “ keeping your own house in order ” is sufficient for independent monetary policy and financial stability. the problem is, however, that exchange rates are sometimes far from being smooth reflections of underlying fundamentals. the evidence suggests that foreign exchange markets exhibit excess volatility and that exchange rates diverge from fundamentals for protracted periods. in some sense, the existence of carry trade can be construed as evidence of this, as it involves betting that interest rate differentials are not fully compensated by exchange rate movements ; i. e., that uncovered interest rate parity does not hold, except at long horizons, and then often through sharp and disorderly corrections. this, in turn