As I am writing this I am getting ready to fly to Iceland. Iceland is a country that have had massive impact on my thinking and on my professional life over the last 6 years so it is always with a bit of a special feeling when I fly to Iceland.

Back in 2006 I co-authored a report on the Icelandic economy. In the report – “Geyser crisis” – we basically forecasted doom-and-gloom for the Icelandic economy. That report did not make me popular in Iceland and has taken some time to convince people in Iceland that I do not have anything against the country and the people living there. In fact I always enjoyed going to Iceland. However, whenever I go to Iceland some wild things seem to happen. A week or so after we published the Geyser crisis-report in March 2006 I went to Iceland. That was pretty wild in itself.

Then I went to Iceland again literally one week after the entire Icelandic financial system collapsed in October 2008. That was not a pleasant experience as that the Icelandic economy was on verge of collapse and the government was very close to default. The crisis had serious economic and social consequences and particularly 2009 and 2010 was very hard years for the Icelandic people. However, I am happy that the Icelandic economy has been in recovery for sometime now, the financial sector is back on its feet and the government has moved far away from default thanks to serious fiscal consolidation (a triple “fiscal cliff” to be exact).

The next time I went to Iceland was in April 2011 – one day after the Icelandic people had voted “no” in the so-called Icesave referendum. The Icelandic government and the elite in Iceland was in shock. However, I brought a positive message with me to Iceland. I was not overly worried and our macroeconomy forecast was relatively upbeat on growth. Luckily that have turned out to be more or less right in the sense that the recovery has continued (note I got a lot of things wrong in that report – most notably that we were far to negative on the outlook for unemployment).

So now I am going to Iceland again and yes I will be presenting a new forecast on the Icelandic economy tomorrow (Wednesday) in Reykjavik. However, this time around the feeling is not as tense as in March 2006, October 2008 or in April 2011. In fact “normality” seems to have returned to the Icelandic economy and even though I will not reveal anything about our new macroeconomic forecast for Iceland I will promise that it will not be a new “Geyser crisis” report.

Monetary debate takes centre stage in Iceland

In Iceland there has been a fierce public debate since 2008 about the future of the Icelandic króna and monetary and exchange rate policy. The Icelandic government has campaigned for EU membership and at a later stage euro adoption. Others have argued that Iceland should replace the Icelandic króna with the Norwegian krone or even the Canadian dollar. And most people in Iceland are skeptical about going back to a freely floating króna again and many seem to think that the free float played a major role in the Icelandic collapse in 2008 – I disagree with this view, but can easily understand the fears of a freely floating exchange rate for a country of 320,000 people. Furthermore, it is not surprising that most people in Iceland today are favouring getting rid of the króna. After all it is hard to argue hard that monetary policy has been successful in Iceland. In the 1970s and 1980s the country was struggling with very high inflation and there is no doubt that the inflation targeting regime that was put in place in 2001 did not work well and the Icelandic central bank surely has to take a lot of blame for the crisis. So the debate goes on.

I will not be weighing in on my views of the difference options being discussed in Iceland on currency and monetary reform directly. I think a number of the ideas being discussed have merits, but this is not the place and the time to discuss those ideas. Instead I want to describe the workings of the Singaporean monetary set-up. So why is that? Well, first of all there are some similarities between Singapore and Iceland – both are small (though Singapore’s population is 10 times as big as Iceland’s), very open high-income economies and both economies are highly sensitive to external shocks such as supply shocks, financial shocks and trade shocks. So maybe there are lessons to be learned from Singapore’s monetary regime that could be relevant to policy makers in Iceland. I am not necessarily arguing that Iceland should copy what they are doing in Singapore, but rather I try to broaden the debate regarding monetary policy in Iceland.

The exchange rate as policy instrument 

Here is how the Monetary Authority of Singapore (MAS) describes the Singaporean monetary regime:

Singapore’s monetary policy has been centred on the management of the exchange rate since the early 1980s, with the primary objective of promoting medium term price stability as a sound basis for sustainable economic growth.  The choice of our monetary policy regime is predicated on the small and open nature of the Singapore economy.

There are three main features of the exchange rate system in Singapore.

1. The Singapore dollar is managed against a basket of currencies of our major trading partners.

2. MAS operates a managed float regime for the Singapore dollar with the trade-weighted exchange rate allowed to fluctuate within a policy band.

3. The exchange rate policy band is periodically reviewed to ensure that it remains consistent with the underlying fundamentals of the economy.

So the Singapore dollar is neither a freely floating currency nor is it a fixed exchange rate. Rather the Sing dollar should be seen as MAS’s key policy instrument. However, while MAS is using the exchange rate as a policy instrument it is not trying to achieve a particular level for the exchange rate as such, but rather use the exchange to ensure “medium term price stability as a sound basis for sustainable economic growth”. So in that sense MAS is a flexible inflation targeter in the same ways as for example the Swedish Riksbank or the Australian Reserve Bank. But contrary to most central banks – including the Icelandic central bank Sedlabanki – which use interest rates to hit the inflation target – MAS instead uses the exchange rate.

I see two very clear advantages to this operational set-up compared to “interest rate targeting”. First, there will never be a problem with a lower zero bound. You can weaken the currency as much as you want. Second, as the exchange rate is freely floating within the “policy band” so the market will gradually be telling MAS was direction to move policy to ensure that it hits it’s inflation target (or any other nominal target). In reality one can think of this as parallel to Scott Sumner’s idea of using futures to hit an NGDP target.

Some have suggested that MAS is using this Basket, Band, Crawl (BBC) set-up to reduce volatility in the real effective exchange rate and to ensure that the real effective exchange rate is aligned with economic fundamentals. An early proponent of this view was John Williamson. An alternative interpretation instead stresses the nominal exchange rate and sees the nominal exchange rate as a tool to achieve nominal targets. This view has been most forcefully made by Bennett McCallum – See for example here.

This discussion is really similar to the impact of devaluations and revaluations. While most economists and commentators seem to think about devaluations as having an impact on the real exchange rate (competitiveness) I – and other monetarists – would instead stress the impact of changes in nominal variables – the exchanges rate, the money base/supply, prices and nominal GDP. See for example my earlier post here.

Empirical research have tended to support the McCallum view of the Singaporean monetary regime – see for example this paper. Hence, MAS conduct changes to the currency basket and band to ensure it’s nominal target (“price stability”), but MAS is not targeting the real exchange rate. In that sense MAS is “monetarist” in its thinking about the exchange rate regime.

Furthermore, it should be stressed that even though the Singaporean system probably has reduced currency fluctuation compared with a purely free floating Singapore dollar that is not the stated purpose of the policy. The exchange rate is a policy instrument and not the ultimate target of monetary policy.

A lack of transparency a key flaw

While I certainly think that Singaporean monetary regime has some clear advantages compared with “interest rate targeting” – particularly that there is no zero bound problem – I would also highlight some problems. First, one can certainly discuss whether the best ultimate target for the central bank is an inflation target. Obviously MAS’ is not a totally traditional inflation targeter in the sense that it targets “price stability” in a more broad sense. However, the important thing here is not the ultimate policy target, but the operational framework of using the exchange rate rather than interest rates to achieve the central bank’s ultimate nominal target (inflation, the price level or NGDP).

My second objection is more fundamental. I consider it to be a major problem with the way MAS conducts monetary policy that it is not very clear on “the numbers”. Hence, MAS is not clear about what “price stability” is. Is it zero inflation? Is it an inflation target and what kind of inflation measure are we talking about. Furthermore, while MAS is using a “basket of currencies” as the policy instrument it is not entirely clear what currencies are in the basket and what weights the different currencies have. Finally, MAS is not clear when it describes the “fluctuation band”. Is it 5% or 15%? We really don’t know. So if other central banks were to move in the direction of a Singaporean style monetary regime then I would recommend it to be much more specific on the numbers than MAS tend to be.

Further reading on Singapore’s monetary regime

Lin Tian gives a good overview in this paper.

Stefan Gerlach the present deputy governor in the Irish central bank and former colleague of Icelandic central bank governor Mar Guðmundsson in BIS discusses the relative merits of Hong Kong’s currency board and Singapore’s monetary set-up in this paper.

PS In the US the fiscal cliff discussion seem to be the only thing people can talk about. To me it is incredible that the importance of monetary policy is ignored in this discussion. The fiscal tightening in Iceland we have seen in Iceland since 2008 is around tree times as big as the ultimate fiscal cliff would be in the US. The Icelandic economy has recovered anyway. Why? Monetary policy…Somebody should write a paper about the Icelandic policy mix after the crisis and the fairly robust recovery in the economy despite strong fiscal consolidation.

PPS I think Icelandic policy makers could be inspired by lessons from Singapore. However, other countries might certainly also benefit from studying Singapore – in particular I suggest that the Czech central bankers fly to Singapore to learn about how to conduct monetary policy in a export-oriented small open economy.

PPPS and to my favourite football team in Iceland – Áfram Stjarnan!!

Update: I have had a great day in Reykjavik – so let me share this picture from my visit to the Icelandic central bank and here is my comments on capital controls.