A Loan, Not a Gift: On the Prime Minister, the Euro, and the Promise of Lower Interest Rates

This is the fourth piece in a series on Iceland’s economy and the case against trading away monetary sovereignty. It responds to the argument the Prime Minister, Kristrún Frostadóttir, made on the podcast The Rest Is Politics ahead of the 29 August referendum. I have a great deal of respect for her, and she set exactly the right standard for this debate: be honest, be calm, show people respect, and do not tell them they are foolish for their views. I intend to hold to that standard here. I also happen to disagree with her on this question, and because the disagreement is about facts and data, it can be settled with facts and data. What she chooses to tell the Icelandic public is hers to decide. What the evidence says is not.

Let me begin with what she gets right, because a fair argument concedes before it contests.

She is right that the changed world matters. The Arctic has become strategically central, the United States is a less certain ally than it was, and a small country with no army is entitled to feel the ground shift beneath it. I do not wave that away. She is also right — strikingly so — about something closer to home. Asked why parts of the business community oppose membership, she said that medium-sized and larger Icelandic companies “can do well in a closed system,” passing on price increases and protecting market share because domestic competition is limited. That is true, and it is one of the most important things anyone in this debate has said. Hold onto it, because I am going to come back to it — it is, as it turns out, an argument against her own conclusion.

And she is right, finally, about the standard for the debate. So here is the honest version of where I think her central economic claim goes wrong.

The promise: “interest rates will go down”

The Prime Minister called the currency “the biggest single issue” in the debate, and she made the argument plainly: the króna is volatile and costly, it can be an obstacle for Icelandic companies, and membership offers “the possibility that interest rates will go down to a lower level where it will be easier for general consumers here to afford housing.” To her credit, she immediately added a caveat most campaigners omit — that lower rates could also push property prices up. That honesty is exactly the tone she asked for, and it deserves acknowledgement.

But the promise itself — join, and interest rates fall — needs to be examined rather than assumed, because it is the single most repeated claim of the Yes campaign, and the historical record of what actually happens when a country like Iceland adopts the euro is neither simple nor reassuring. There are three problems with it, and they build on one another.

Problem one: the lower rates are real at first — and that is the trap

Here I must correct something I have seen argued on my own side of this debate, including in gentler form by me. It is sometimes said that there is no precedent for the euro lowering interest rates. That is wrong, and we should not say it. There is a precedent, and it is dramatic.

When the southern members joined the euro, their borrowing costs collapsed toward German levels. Greek ten-year government bond yields, which had run above 10% through the 1990s, fell below 4% by 2005. At the peak of the convergence, the market was charging Greece barely 20 basis points more than Germany — pricing a loan to Athens as almost exactly as safe as a loan to Berlin. Italy, Spain, Portugal and Ireland all saw the same compression. So a campaigner who says “the euro brings lower rates” has real history behind them. It happened, and it happened to exactly the kind of smaller, higher-inflation economies that Iceland resembles.

The problem is what the low rates were, and what they did. They were not a reward for sound fundamentals. They were a mispricing — the market’s assumption that euro membership had made Greek debt nearly as riskless as German debt, when it had done no such thing. The euro had removed the currency risk, and in doing so it hid the credit risk. Countries borrowed enormously against those cheap rates. And when the reckoning came in 2010, the market repriced sovereign creditworthiness with brutal speed. Greek ten-year yields, sub-4% five years earlier, reached 41.77% in March 2012. Italian yields hit 7.26%; the Italian–German spread blew past 550 basis points. The eurozone came within sight of breaking apart, and was held together only by the European Central Bank’s July 2012 promise to do “whatever it takes.”

This is the pattern the Prime Minister’s promise leaves out. The euro did lower interest rates — for about a decade — and the cheap money financed borrowing that became unpayable the moment the market remembered that a currency union is not a guarantee against default. The low rate was the bait. The removal of the exchange rate that might have absorbed the shock was the hook. A country that adopts the euro does not abolish its credit risk; it converts a visible, gradual currency risk into a hidden, sudden sovereign-repricing risk. The market always, eventually, reprices the actual creditworthiness of the borrower. It merely does so later, and all at once.

Problem two: the euro is not a shield against inflation — the evidence is recent and clear

The deeper promise beneath “lower interest rates” is lower inflation: the idea that anchoring to the European Central Bank imports price stability, and that stability is what pulls rates down. It is worth testing against the most recent evidence, because the evidence is unusually clean.

Consider the Baltic states — Estonia, Latvia and Lithuania. Small, open economies, each of which adopted the euro (Estonia in 2011, Latvia in 2014, Lithuania in 2015) precisely for the stability the Prime Minister describes. In August 2022, inflation in Estonia reached 25.2% — the highest in the entire eurozone. Latvia and Lithuania followed at just over 21%. The euro-area average that month was about 9%. Three small, open economies, all inside the euro, all holding the ECB’s anchor — and all three suffered the worst inflation in the union, roughly triple the average.

Why? Because their inflation was not the monetary kind the ECB’s anchor addresses. It was structural and imported — energy, food, supply chains, the particular exposures of small open economies. The euro did nothing to shield them, because the euro cannot anchor an inflation it did not cause.

This matters enormously for Iceland, because Iceland’s inflation is substantially structural too. It is manufactured at home — by the indexation regime that propagates the housing CPI mechanically through mortgages, rents and wages, and, until the country corrected it in 2024, by a housing-CPI measurement method that added nearly two percentage points a year to the headline for two decades. An anchor in Frankfurt does not reach a flywheel built out of Icelandic contracts. The Baltics are the warning: euro membership is not a shield against inflation for an economy shaped like ours. It anchors the kind of inflation Iceland mostly does not have, while doing nothing about the kind it does.

Problem three: for most Icelandic borrowers, the euro lowers the wrong rate

Now to the specific mechanism the Prime Minister invoked — easier mortgages, more affordable housing. This is where the argument, applied to Iceland specifically, meets an obstacle that does not exist in most countries: verðtrygging.

Most Icelandic mortgage debt is index-linked. The indexed borrower does not pay a high nominal rate; they pay roughly 3.5% real interest, with inflation added to the principal instead. So the “high” Icelandic interest rate that the euro promises to lower is, for the indexed majority, partly an illusion — they are not paying the 9 or 10% nominal rate that a non-indexed borrower pays. And here is the part that no amount of euro membership can change: that 3.5% real floor is set by Icelandic pension regulation — the statutory reference rate in Regulation 391/1998 — not by the currency. The euro can lower a nominal rate. It cannot touch a real rate that domestic pension law has fixed. For the bulk of Icelandic mortgage debt, membership would lower a rate borrowers are not really paying while leaving untouched the real rate they are.

We do not have to theorise about how Icelandic borrowers respond to interest rates, because they have just shown us. Between 2023 and 2025, as the Central Bank raised the policy rate to fight inflation, Icelandic households paid down roughly 290 billion krónur of non-indexed debt and took on about 523 billion krónur of new indexed debt. Faced with higher nominal rates, they did not cut back — they refinanced into indexation to keep their monthly payments down and push the cost onto their principal. That is the whole problem in a single statistic. The rate tool the Prime Minister wants to lower by joining the euro is a tool Icelandic borrowers already route around at home, because the indexed system lets them. Lowering the nominal rate does not reach them. It never did.

Her best point, turned around

Return now to the sharp thing the Prime Minister said: that some larger Icelandic companies “do well in a closed system,” passing on price increases because domestic competition is limited. She is right, and she has put her finger on a genuine disease. But look at what kind of disease it is. It is a domestic one — a small market with too few competitors, a three-bank lending oligopoly, a concentration of capital that lets incumbents charge more than an open market would allow. It is exactly the structural problem this series has argued lies beneath Iceland’s whole cost-of-capital picture.

The Prime Minister’s remedy for it is to import competition by joining the EU. But you do not need to join anything to break a domestic oligopoly. You break it directly — by lowering the barriers to new banks and lenders, by opening the market to cross-border competitors, by diluting the concentration that lets incumbents pass on price increases. Every one of those is a domestic reform, available now, requiring no treaty and no surrender of the currency. She has correctly diagnosed a problem Iceland made at home and can fix at home, and prescribed for it a cure that costs the country its monetary sovereignty. That is the pattern in miniature: a domestic ailment, an external remedy, and a much simpler solution left untried on the table.

“Keeping the option open”

The Prime Minister’s framing of the vote itself is that it merely keeps an option open — “you want to see what it looks like.” I understand the appeal, and I want to engage it on its merits rather than dismiss it.

There is something right in it and something missing. What is right is that a sovereign nation is entitled to look before it leaps, and a second referendum on any final deal is a genuine safeguard. What is missing is that opening accession talks is not a cost-free act of information-gathering. On the one issue that decides the question for Iceland — control of its own fishing waters — the answer is already substantially visible: the Common Fisheries Policy applies to members, France has already signalled it expects no permanent exemption, and no accession treaty in the Union’s history has granted the kind of permanent carve-out Iceland’s fishing economy would require. And the act of negotiating is not neutral: years of political capital and institutional momentum accumulate behind a process, so that walking away at the end is far more costly than declining at the start.

There is also a deeper point about the word she chose. Keeping options open is a real value — it is close to the reason I am voting No. But the euro is not an option you keep; it is an option you spend. Adopting it is one of the few genuinely irreversible moves a small economy can make: it abolishes the currency and the central bank permanently, with no exit. The truly option-preserving choice is to keep the sovereign levers — the currency, the capital tools, the fishery — and do the reversible, domestic work of reform. On her own chosen ground of optionality, the No case is the one that keeps the most options open.

Where this leaves the promise

None of this makes the Prime Minister’s motives suspect or her intelligence doubtful; I think she believes the case she is making, and she is making it more honestly than most. But the central economic promise — join, and interest rates and inflation come down for the ordinary Icelander — does not survive the evidence. The lower rates the euro brings are real at first and a mispricing that the market violently corrects later, as Greece and Italy learned. The inflation shield does not exist for a small open economy, as Estonia and its neighbours learned inside the euro. And for the indexed majority of Icelandic borrowers, the euro lowers a nominal rate they are not really paying while leaving untouched the real rate that domestic pension law, not the currency, has fixed.

The currency is costly and volatile — she is right about that. But the answer is not to hand it away for a discount that the record shows is a loan the market always calls back in. The answer is the harder, domestic work: end the indexation that defeats our own central bank, break the closed markets she herself identified, and lower the cost of capital at its structural source. That work needs no treaty, no euro, and no one’s permission. It needs only the steadiness to do it.

I like the Prime Minister, and I think she is wrong about this. Both of those things can be true. On 29 August, I am voting No — and doing the sums, in the open, is my way of showing the respect she rightly asked for.

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Sources and notes

• The Prime Minister’s remarks are from her interview on The Rest Is Politics: Leading (July 2026) as reported and summarised in Icelandic and English coverage (mbl.is; EU Perspectives, 2026). Quotations are taken from that reporting; readers should refer to the full podcast for complete context, and any direct quotation should be checked against the recording before republication.
• Icelandic policy rate and inflation. Policy rate 7.75% (raised May 2026); headline inflation 5.3% in July 2026, a seventh consecutive month above the Central Bank’s 4% upper tolerance limit, against a 2.5% target (Central Bank of Iceland; Statistics Iceland; Trading Economics; Landsbankinn Economic Research, July 2026).
• Peripheral euro convergence and crisis. Greek 10-year yields above 10% in the 1990s, below 4% by 2005, spread to German Bunds as narrow as ~20bp at the convergence peak; peak of 41.77% in March 2012 (some sources cite 43.92% intraday). Italian 10-year yields rose from ~4% to ~7% between April 2010 and November 2011, peaking at 7.26%, with the BTP–Bund spread exceeding 550bp in 2012. The ECB’s July 2012 “whatever it takes” commitment (Draghi) halted the crisis. (Bank of Greece; BIS Quarterly Review; Eurostat EMU convergence series via Apiar Data; Market Histories; Trading Economics.)
• Baltic inflation inside the euro. Estonia reached 25.2% annual inflation in August 2022, the highest in the eurozone; Latvia ~21.4% and Lithuania ~21.1%; euro-area average ~9%. Estonia adopted the euro in 2011, Latvia in 2014, Lithuania in 2015. (Eurostat; IMF; Estonian World, 2022.)
• Icelandic indexation and borrower behaviour. Indexed loans carry roughly 3.5% real interest with inflation added to principal; the 3.5% real reference rate is set by Regulation No. 391/1998. Non-indexed variable mortgage rates averaged ~9.5% in 2023 and ~10.6% in 2024 (EMF Hypostat 2025). Between 2023 and 2025, households repaid roughly ISK 290bn of non-indexed debt and originated about ISK 523bn of new indexed debt (Central Bank of Iceland data, via Jökull Sólberg’s analysis, 2026).
• The structural-inflation argument — the indexation flywheel and the pre-2024 housing-CPI (user-cost) methodology that added ~1.8pp/year to headline inflation 2001–mid-2024 (IMF Country Report 25/142) — is developed in earlier pieces in this series.
• Caveats. The convergence-as-mispricing argument is a widely held but not universal reading of the euro crisis; the counter-view is that better fiscal rules (now partly in place) would prevent a repeat. On fisheries, the historical record is clear: the CFP has rested on the principle of equal access to members’ waters since 1970, and no acceding state has ever obtained a permanent exemption over its own waters. The closest precedent — the UK, Ireland and Denmark on accession in 1973 — was a temporary ten-year derogation covering only the 12-nautical-mile coastal band, not the wider Exclusive Economic Zone where the fishing rent lies; that derogation was absorbed into the CFP and has had to be renewed roughly every decade since (most recently to 2032), which underlines that even the limited coastal carve-out is time-bound and EU-authorised rather than a permanent national right. Figures move over time and should be checked against current Central Bank of Iceland and Eurostat data.