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its demise was inevitable is sure to remain intensely contested.1,2
However, this debate should not overshadow the important process of setting a
strategy for the recovery of the Icelandic economy and ensuring that the risks of
a future crisis are minimised.
To this end, it seems clear from the outside (and also to many in Iceland) that
the main anchor for its future strategy should be membership of the EU and, once
the Maastricht criteria are fulfilled, entry into the euro area.
This is not to claim that membership of the EU and the euro area is a panacea.
Indeed, the current members of the euro area are not immune to the international
financial crisis and important weaknesses in the financial stability framework
for the euro area have been vividly highlighted by recent events.
In particular, the combination of international banking with national-level
supervisory and stability systems has been shown to represent substantial risks to
European taxpayers. Indeed, Iceland and the existing members of the monetary
union would have much to gain from the promotion of cross-national consolidation
in the banking sector, delivering a smaller number of large banks that would
1 Buiter and Sibert (2008) provide an excellent account of the vulnerability of the Icelandic banking system in
view of the limited capacity of the Icelandic authorities to act as a lender of last resort in respect of the Icelandic
banks’ considerable foreign-currency positions. Portes (2008) argues that better crisis management by the
Icelandic authorities may have avoided the collapse.
2 This article is based on a presentation to the Reinventing Bretton Woods Committee conference held in
Reykjavik on October 28th 2008 ‘Testing Times for the International Financial System: Inflation, Global Turmoil,
New Challenges for Small Open Economies’
hold more diversified loan books, reducing exposure to country-specific and
sector-specific shocks. For this to happen, national governments will have to agree
ex ante on burden sharing rules in order to ensure that such banks would be
backed by a sufficiently large fiscal base. In related fashion, the supervision and
regulation of such banks would have to be designed in order to ensure that such
banks are operated on a truly pan-European basis rather than being organised as a
hierarchy of a parent national bank that takes precedence over its international
branches and affiliates in the event of a crisis.
Membership of the euro area also involves macroeconomic policy challenges
for member countries. The absence of a flexible exchange rate has the potential to
make the adjustment to country-specific asymmetric shocks more difficult. For
countries such as Iceland that are highly reliant on a small number of export sectors,
this can be a non-trivial problem. However, the flexibility of the Icelandic

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