VoxEU Column Europe's nations and regions

Iceland's blend of old and new

Understanding Iceland and its current financial predicament requires some history and context. Here Iceland’s best known professor of economics explains the essentials.

Iceland has never been boring, far from it.

Despite its dearth of people, it thrives on its culture, a curious blend of old and new, from Njál’s Saga1 to Björk.2 This is one of the keys to Iceland’s ability to reclaim the thousands upon thousands of its young people who have studied abroad. At present, one percent of the country’s population attends universities in 36 different countries around the globe. If the past is any guide, most of these young people will return to Iceland to live and work. True, high-quality culture is more fun if you share first place in the United Nations Human Development Index as Iceland did, with Norway, in 2007.

Low-quality politics does not scare the young away, at least not yet. In the past, it is true, there were times when a number of them might have voted with their feet, but they didn’t. Well, Björk did, but that was irresistible pull, not push.

“Within at least calling distance”

Iceland’s politics, unlike its culture, is a somewhat unbalanced blend of old and new. Understanding Iceland and its current financial predicament requires some history and context. Since Home Rule in 1904, the rural areas have been overrepresented by a large margin in the Icelandic parliament, imparting a provincial, protectionist bias to economic policy and to the structure and functioning of the economy. Throughout most of the 20th century, each farmer was able to cast the equivalent of three to four votes in parliamentary elections. Until 2003, the provinces kept their majority in parliament even if nearly two thirds of the people now live in Reykjavík. The bias built into the electoral law resulted in a slow and lopsided transition from a quasi-planned economy toward a mixed market economy, and in a similarly reluctant depolitization of economic life, including the banks whose privatization was completed only a few years ago.

The privatization was long overdue, but its implementation was flawed; for example, a couple of major players in the ruling coalition that privatized the banks either became rich – very rich – or kept their seats on the banks’ boards after the privatization, or both. The editor of Morgunblaðið, a daily newspaper with close ties to the Independence Party, the largest political party, described the privatization process in a celebratory essay on the prime minister in 2004, presumably published with the subject’s prior approval. The editor wrote that, given that the then second-largest political party had secured its claim to the second largest state bank, the prime minister, now self-appointed Central Bank governor, “considered it necessary that Landsbanki would land in the hands of persons within at least calling distance of the Independence Party” (my translation, TG).

The main aim of the privatization ought to have been to sever completely the old ties between the political parties and the banks, as I advised the government in 1993 in a published report, but that was not to be.

Good sisters get along

The vestiges of the old differences between the rural areas and Reykjavík, whose population grew from 6,000 in 1904 to 180,000 today, manifest themselves in many ways.
Today, despite significant liberalization in recent years, they help explain a somewhat inward-looking, protectionist economic culture that gave too much say in economic affairs to politicians, especially rural politicians with far fewer votes behind them than elected representatives from Reykjavík. If by an emerging country is meant a country where politics matters at least as much as economics to the markets, a common definition, Iceland remains a contender.

This inward-looking economic culture, in turn, helps explain why four of the five political parties represented in parliament are still against Iceland’s entry into the EU and EMU even if, according to most opinion polls, the majority of the supporters of each of the five parties from left to right favours Icelandic accession. Presumably, this is why politicians against membership do not want a referendum, with one vote per person, to be held to settle the matter.

Judging by opinion polls, Iceland might well have joined the EU with Austria, Finland, and Sweden in 1995 had a referendum been held at the time. Had Iceland adopted the euro along the way, and perhaps even without the euro, the domestic part of the current crisis could thus have been avoided if, years ago, political leaders had managed to secure a better balance of power between town and country, for they are sisters – and good sisters get along.

A welcome correction

The recent financial turbulence and the increasing likelihood of a hard landing have strengthened popular support for Icelandic EU membership. Some employers’ associations, frustrated by the wild gyrations of the króna, have now at last come to the conclusion that the króna, the smallest independently fluctuating currency in world markets, is too volatile and that the euro is the sole viable alternative. Even so, employers in the fishing industry remain against membership, mostly out of fear that this would force Iceland to share its fish with other EU members. The króna has depreciated by a third since the beginning of 2008 while the national stock market index has likewise decreased by a third, and by more than a half since its peak a year ago.

The stratospheric rise of the stock market – by a factor of nine from 2001 to 2007, equivalent to a 44 percent average annual increase six years in a row – was clearly a bubble. An increase in general stock prices by a factor of nine in just six years is a world record, as pointed out by Professor Robert Aliber in a forthcoming paper presented at the University of Iceland in June 2008. A correction, therefore, was inevitable.

Also, in view of the rapid escalation of foreign indebtedness in recent years and the ensuing spending spree, the króna was bound to depreciate.3 This, too, is a welcome correction, painful though it is for many firms and households, especially those who took low-interest euro-denominated loans before the fall. For Iceland to be able to join the EU and EMU, the exchange rate of the króna must be right. There are indications that the króna may need to depreciate a bit more in real terms before it reaches a level that is consistent with sustainable external balance.4 Given the double-digit inflation rate at present, this would require a further depreciation in nominal terms. Once this correction has been completed and inflation has been brought back down below three percent a year, Iceland will be ready to join, provided that the necessary realignment of political forces takes place. Trying to talk up the króna, as some have done, is tantamount to trying to talk down the prospects of EU membership.

Where do we stand?

Iceland‘s per capita GDP continues to rank high among the high-income countries. In 2007, as noted before, Iceland shared first place in the Human Development Index with Norway, a ranking based on longevity and education as well as per capita income. As for the income part of the index, GDP per hour worked would be a better measure than GDP per person because the former takes into account the work behind the output.

Figure 1 shows GDP per hour worked in the OECD region. The numbers are taken from the University of Groningen database5 that includes internationally comparable estimates of hours of work.

Figure 1 OECD: GDP per hour worked 2007 (US$ at PPP)

We see that, in 2007, the PPP-adjusted GDP per hour worked in Iceland was $36 compared with $44, $45, and $46 in Finland, Denmark, and Sweden and $70 in Norway. The figure exposes the inefficiency (e.g., from excessive farm protection with food prices to match and lack of competition in some other areas as well, including banking) that continues to plague Iceland where it still takes a lot of work – like in Japan and the United States – to sustain a high level of GDP per person.

High prices and high interest rates reduce the purchasing power of households and compel wage earners to work long hours – and to borrow – to make ends meet. This lack of efficiency is an important part of the reason why Iceland needs to join the EU.

There are three main reasons for the relatively low labour productivity in Iceland.

  • First, there has been too little investment in machinery and equipment. Since 1995, investment in construction has doubled relative to GDP.6 The share of machinery and equipment in total investment has decreased from a bit less than a half in 1990 to a third in 2007. These trends are exacerbated by the fishing industry, whose fleet has not contracted significantly despite reduced catches, in part presumably due to overfishing, discarding, and illegal landings like elsewhere in Europe7 as well as stakeholder conflicts and the inequitable nature of the fisheries management system which the UN Committee on Human Rights has recently declared a violation of human rights and instructed the Icelandic government to rectify.8 Reduced catches without a corresponding cutback of input use mean lower productivity in the fisheries.
  • Second, despite great strides on the education front in recent years, the share of the Icelandic labour force (25-64 year olds) with no more than primary education is twice that of Denmark, or 37 percent in Iceland compared with 19 percent in Denmark, 21 percent in Finland, 23 percent in Norway, and 16 percent in Sweden.9 The long hours of work also seem likely to lower productivity and living standards.
  • Third, the LSP agenda – liberalization, stabilization, privatization – of recent years was carried out in ways that allowed the banks and their debts to grow far out of proportion to the size of the country while the Central Bank neglected to raise reserve requirements as needed instead of reducing them to accommodate the banks and neglected also to build up adequate foreign exchange reserves.10 These mistakes rendered the Central Bank unprepared to guarantee the stability of the financial system, let alone low inflation, as required by law. Lax fiscal policy did not help. Even so, thanks in part to its young people who keep returning home from abroad, Iceland’s medium-term prospects are bright.


1 Njál‘s Saga, with an introduction by Thorsteinn Gylfason, Worldworth Classics of World Literature, 1998.
2 Her 1990 disc Gling-Gló, sung mostly in Icelandic, is a local classic.
3 See my recent VoxEU column “Events in Iceland: Skating on thin ice?” See also Gylfi Zoega‘s VoxEU column “Icelandic turbulence: A spending spree ends.”
4 See Robert Tchaidze (2007), “Estimating Iceland’s Real Equilibrium Exchange Rate,” International Monetary Fund Working Paper No. 07/276.
5 See http://www.ggdc.net.
6 See Daniel Gros (2008), “Iceland on the brink?,“ CEPS Policy Brief No. 157, April.
7 See my VoxEU column “Dwindling fish: what’s the catch?“
8 See International covenant on civil and political rights, CCPR/C/91/D/1306/2004, 14 December 2007.
9 See OECD, Education at a Glance 2007, table A1.2a.
10 See Robert Wade, “Iceland pays price for financial excess,“ Financial Times, 1 July 2008.


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