Iceland

   

Economic Policies

#15
Key Findings
With the aftereffects of economic crisis easing, Iceland falls into the upper-middle ranks (rank 15) with regard to economic policies. Its score on this measure represents a decline of 0.3 points relative to 2014.

Capital controls imposed following the financial crisis were rescinded without serious capital outflux or depreciation. Unemployment rates have remained at quite low levels. While labor disputes have led to wage increases and fears of inflation, price increases have in fact remained under control.

Tax revenue was high in 2016 thanks to one-time stability contributions from former bank stakeholders. Tax policy has become more regressive overall. Public debt levels are falling rapidly. Financial troubles at key public institutions threaten future fiscal sustainability.

The government has yet to propose a plan for restructuring the banking sector. Banking oversight was toughened post-crisis, but remains passive. The irrevocability of the government’s withdrawal of Iceland’s EU application remains in question.

Economy

#21

How successful has economic policy been in providing a reliable economic framework and in fostering international competitiveness?

10
 9

Economic policy fully succeeds in providing a coherent set-up of different institutional spheres and regimes, thus stabilizing the economic environment. It largely contributes to the objectives of fostering a country’s competitive capabilities and attractiveness as an economic location.
 8
 7
 6


Economic policy largely provides a reliable economic environment and supports the objectives of fostering a country’s competitive capabilities and attractiveness as an economic location.
 5
 4
 3


Economic policy somewhat contributes to providing a reliable economic environment and helps to a certain degree in fostering a country’s competitive capabilities and attractiveness as an economic location.
 2
 1

Economic policy mainly acts in discretionary ways essentially destabilizing the economic environment. There is little coordination in the set-up of economic policy institutions. Economic policy generally fails in fostering a country’s competitive capabilities and attractiveness as an economic location.
Economic Policy
7
Nine years after the 2008 economic collapse, Iceland’s economic policy has still not escaped from the fallout. Even if the capital controls imposed to stabilize the Icelandic króna following the financial crash were for the most part rescinded in 2017, the economy still feels the pinch of the harsh fiscal adjustment strategy, which imposed a retrenchment equivalent to about 10% of GDP between 2010 and 2017. The fiscal adjustment strategy meant that important public services were seriously underfunded as a result, especially health care and education. The relaxation of foreign exchange controls is almost complete. A novel, perhaps lasting part of the relaxation scheme involves an arrangement in the spirit of the Tobin tax. This arrangement requires foreign speculators – who want to benefit from higher interest rates in Iceland than abroad through carry trade – to place a certain portion of their deposits in special accounts that are tied for a certain period. The aim is to reduce short-term fluctuations in capital flows. This seems to have worked well thus far. Moreover, restrictions still apply to derivatives trading for purposes other than hedging and cross-border foreign exchange transactions not intermediated by a financial undertaking as well as certain foreign currency lending by residents to nonresidents. The relaxation was orderly and was not followed by a sudden outflux of capital or depreciation of the króna.

The Icelandic króna strengthened by 8% vis-à-vis the U.S. dollar during 2017 (i.e., during the period under review from November 2016 to November 2017), while remaining essentially unchanged vis-à-vis the euro. This followed the significant strengthening of the króna against both currencies during 2016 due to strong foreign exchange earnings from tourism, and the return of funds to Iceland that had fled the country before and during the financial collapse of 2008. During 2012-2015, the central bank held several auctions at which holders of offshore currency were invited to bring their money back to Iceland at a discounted exchange rate. It has been reported that several jailed bankers were among those who took advantage of these controversial central bank auctions. Tight fiscal and monetary policies remained in place during 2017, underpinning low inflation accompanied by full employment. Contrary to central bank and IMF projections, inflation remained below 2% during 2017. Even so, employers blame labor unrest, including strikes, for encouraging wage increases that threaten to cause an overall increase in prices. During 2018, a new round of general wage negotiations will take place against the background of substantial wage increases recently granted by the Wage Council to members of parliament, senior public officials and the president of Iceland. Though the president refused to accept the salary increase and donated it to charity.

Following the 2008 economic collapse, the government sought to strengthen the Financial Supervisory Authority (Fjármálaeftirlitið, FME). The FME had performed before the collapse in 2008 as though it had been “designed to fail.” The number of FME personnel increased significantly after the collapse. However, the FME’s annual budget was halved for 2013 and then again for 2014. By late 2017, the efforts of the FME and the special prosecutor had led to the successful prosecution of 35 individuals for legal violations connected to the 2008 crash. The Supreme Court sentenced these individuals to a total of 88 years in prison, equivalent to about 2.5 years per convict on average. The Office of the Special Prosecutor was abolished in 2016 and merged with the Office of the District Prosecutor under the directorship of the former special prosecutor.

The future of the banking sector remains uncertain. The government has not yet presented any concrete plans for restructuring the banks. At the time of writing, the government still owned a majority stake in one of Iceland’s three largest banks, Landsbanki, while creditors of the other two failed banks and foreign venture funds own substantial majority stakes in the other two banks, Arion Banki and Islandsbanki, that replaced the failed Kaupthing and Glitnir. Iceland is one of very few countries in the world without any foreign competition in its domestic banking sector.

Iceland applied for EU membership in 2009. The preceding government had signaled its intention to abide by EU standards and to strengthen Iceland’s institutional environment, including its regulatory policy. Due to disagreements between the government’s coalition partners at that time, the application process was put on hold in January 2013. In 2013, the government expressed its intention to unilaterally retract Iceland’s membership application. A formal withdrawal was announced in the spring 2015. However, the European Union and the Icelandic government seem to disagree on whether this means that Iceland has fully withdrawn from the process. Specifically, the European Union has questioned the authority of Iceland’s foreign minister to unilaterally withdraw an application approved by parliament. This question is most likely going to remain unanswered for some time.

Citations:
The Annual Reports of the Financial Supervisory Authority 2009, 2011, 2012, 2014, and 2017. (Ársskýrslur Fjármálaeftirlitsins 2009, 2011, 2012, 2014 og 2017).

Annual report on Competition Policy Developments in Iceland 2011. The Icelandis Competition Authority
(http://en.samkeppni.is/media/reports/ICA_2011_en.pdf).

Gylfason, Thorvaldur (2015), Iceland: How Could This Happen?, in Reform Capacity and Macroeconomic Performance in the Nordic Countries, eds. Torben M. Andersen, Michael Bergman, and Svend E. Hougaard Jensen, Oxford University Press. — Also available as as CESifo Working Paper No. 4605, January 2014.

International Monetary Fund, 2017 Article IV Consultation, IMF Country Report No.
17/163, 22 June 2017, https://www.imf.org/en/Publications/CR/Issues/2017/06/22/Iceland-2017-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-44998. Accessed 21 December 2017.

Labor Markets

#9

How effectively does labor market policy address unemployment?

10
 9

Successful strategies ensure unemployment is not a serious threat.
 8
 7
 6


Labor market policies have been more or less successful.
 5
 4
 3


Strategies against unemployment have shown little or no significant success.
 2
 1

Labor market policies have been unsuccessful and rather effected a rise in unemployment.
Labor Market Policy
6
Historically, labor market policy has managed to keep unemployment low. Just before the collapse in 2008 the unemployment rate was below 1%, reflecting an overheated economy. However, this was to change dramatically with the collapse. In 2010, the unemployment rate peaked at 7.6% before falling in 2011 to 7.1%. Thereafter, the unemployment rate declined gradually to 3% in 2016, and is expected to rise toward 4% over the next few years, a low rate compared with other European countries.

Iceland’s labor market legislation has essentially remained unchanged since 1938 with wage contracts negotiated by the leadership of labor unions and employers’ associations, granting both partners significant market power. Many wage contracts are due for renegotiation in 2018. There was great turbulence in the labor market in 2015 and 2016, such as a doctors’ strike and other labor disputes, particularly within the public sector (e.g., a joint strike by nurses, other specialized hospital staff, and several other public-sector unions). Most of these disputes were settled before the end of 2015 with collective agreements running to 2019 while others were settled in 2016. A few wage contracts expired in 2017. Many more will expire in 2018, including the wage contract with the Icelandic Confederation of Academics (BHM), and still more contracts will expire in March 2019. The renegotiation of these contracts will be complicated by several recent decisions by the Wage Council to grant double-digit, partly retroactive wage increases to members of parliament and senior public officials, including the president of Iceland. For this reason, a cloud of uncertainty hangs over wage developments, and thus also the prospects for inflation and unemployment over the next few years.

Wage rivalry between labor unions remains a prominent feature of Iceland’s labor market, a phenomenon that helps to explain Iceland’s high inflation in the past and current fears that inflation may rebound despite favorable external conditions for price stability.

Citations:
Statistics Iceland website, https://hagstofa.is/talnaefni/samfelag/vinnumarkadur/vinnumarkadur/

Gylfason, Thorvaldur, and Assar Lindbeck, “Union rivalry and wages: An oligopolistic approach,” Economica, May 1984.

Taxes

#17

To what extent does taxation policy realize goals of equity, competitiveness and the generation of sufficient public revenues?

10
 9

Taxation policy fully achieves the objectives.
 8
 7
 6


Taxation policy largely achieves the objectives.
 5
 4
 3


Taxation policy partially achieves the objectives.
 2
 1

Taxation policy does not achieve the objectives at all.
Tax Policy
6
Tax revenue shot up from 42% of GDP to 58% of GDP in 2016 as a result of the stability contributions made by stakeholders in the old banks to the treasury. These contributions were a condition for being released from the capital control restrictions that had been in place since 2008. Tax revenue is projected to return to 42% of GDP in 2017 and remain stable thereafter. The government in office from January to November 2017 did not change significantly from the tax policy of the 2013-2016 government. Fishing fees remain far below potential as only 10% of the common property resource rent of fisheries accrues to the taxpayer while 90% accrues to vessel owners.

Citations:
International Monetary Fund, 2017 Article IV Consultation, IMF Country Report No.
17/163, 22 June 2017, https://www.imf.org/en/Publications/CR/Issues/2017/06/22/Iceland-2017-Article-IV -Consultation-Press-Release-Staff-Report-and-Statement-by-the-44998. Accessed 21 December 2017.

Indriði H. Thorláksson, “Veiðigjöld 2015. Annar hluti” (Fishing Fees 2015. Part Two), http://herdubreid.is/veidigjold-2015-annar-hluti/. Accessed 24 December 2017.

Budgets

#16

To what extent does budgetary policy realize the goal of fiscal sustainability?

10
 9

Budgetary policy is fiscally sustainable.
 8
 7
 6


Budgetary policy achieves most standards of fiscal sustainability.
 5
 4
 3


Budgetary policy achieves some standards of fiscal sustainability.
 2
 1

Budgetary policy is fiscally unsustainable.
Budgetary Policy
6
The 2008 economic collapse dramatically increased the country’s foreign debt burden. General government gross debt rose from 29% of GDP at the end of 2006 to 95% in 2011. Thereafter, it decreased gradually to 54% at the end of 2016, and is projected to decline further to 41% in 2017 and to 24% in 2022 (IMF, 2017). Reflecting a reduction in debts which stems in part from a stronger króna, interest payments on the public debt have declined from 4.5% of GDP in recent years to 3.2% in 2017. There is, however, a significant possibility that excessive wage increases will boost inflation and weaken the currency. This, in turn, would cause an increase in the debt burden again, other things being equal. Even so, according to the IMF, Iceland’s foreign debt burden would remain sustainable. Nonetheless, fiscal sustainability remains a serious concern for the government given the dire financial situation of several key public institutions, including the State University Hospital among others.

Three comments are in order. First, Iceland’s public debt burden is understated in official statistics because unfunded public pension obligations are not included, which is rare in OECD country data. Second, while the left-wing government of 2009-2013 increased fishing fees significantly and budgeted for further increases, the center-right government of 2013-2016 reversed course and reduced fishing fees against IMF advice, a policy continued by the center-right government of 2016-2017. This reversal reflects a change in public expenditure and tax policy from a progressive to a regressive stance. Third, many public institutions remain in a dire financial situation, including the State University Hospital, universities and schools at all levels, and the State Broadcasting Corporation (RÚV). Fiscal balance is not on a firm foundation when vital public institutions and infrastructure continue to suffer from long-standing financial neglect.

Citations:
International Monetary Fund, 2017 Article IV Consultation, IMF Country Report No.
17/163, 22 June 2017, https://www.imf.org/en/Publications/CR/Issues/2017/06/22/Iceland-2017-Article-IV -Consultation-Press-Release-Staff-Report-and-Statement-by-the-44998. Accessed 21 December 2017.

Research and Innovation

#13

To what extent does research and innovation policy support technological innovations that foster the creation and introduction of new products?

10
 9

Research and innovation policy effectively supports innovations that foster the creation of new products and enhance productivity.
 8
 7
 6


Research and innovation policy largely supports innovations that foster the creation of new products and enhance productivity.
 5
 4
 3


Research and innovation policy partly supports innovations that foster the creation of new products and enhance productivity.
 2
 1

Research and innovation policy has largely failed to support innovations that foster the creation of new products and enhance productivity.
R&I Policy
6
Combined public and private research and development (R&D) expenditure in Iceland totaled 3% of GDP in 2006, one of the highest levels among OECD members. About 40% of this expenditure was provided by the government. This high level of R&D investment reflects the ongoing transformation from an economic focus on agriculture and fisheries toward manufacturing and services. In particular, this has included the creation of new private firms in biotechnology, pharmaceuticals, and high-tech manufacturing. The economic collapse in 2008 affected this for sure and R&D expenditure decreased to 1.8% of GDP in 2013. The ratio increased to 2.2% in 2015, but remains far below the pre-collapse level. More recent figures are not available.

Citations:
https://hagstofa.is/talnaefni/atvinnuvegir/visindi-og-taekni/rannsoknir-og-throun/

https://www.rannis.is/starfsemi/arsskyrslur/

Global Financial System

#22

To what extent does the government actively contribute to the effective regulation and supervision of the international financial architecture?

10
 9

The government (pro-)actively promotes the regulation and supervision of financial markets. It demonstrates initiative and responsibility in such endeavors and often acts as an international agenda-setter.
 8
 7
 6


The government contributes to improving the regulation and supervision of financial markets. In some cases, it demonstrates initiative and responsibility in such endeavors.
 5
 4
 3


The government rarely contributes to improving the regulation and supervision of financial markets. It seldom demonstrates initiative or responsibility in such endeavors.
 2
 1

The government does not contribute to improving the regulation and supervision of financial markets.
Stabilizing Global Financial Markets
5
In part because of its small size, Iceland has never made a substantial contribution to the improvement of the international financial, or other comparable international institutional, framework. However, the government has taken significant steps to address the extreme instability in the domestic financial system.

First, the government in office during 2009-2013 significantly strengthened the Financial Supervisory Authority (FME) and established a Special Prosecutor’s Office. The Special Prosecutor’s Office was charged with investigating legal violations related to the financial crash, including breach of trust, insider trading, market manipulation and false reporting. By late 2017, the Supreme Court had sentenced 35 individuals to a total of 88 years in prison for offenses relating to the economic collapse. The Special Prosecutor’s Office was merged with the District Prosecutor’s Office at the end of 2015 under the directorship of the former Special Prosecutor.

The government has sought to strengthen financial supervision by encouraging the FME to impose tougher standards. For example, prior to the crash, banks commonly provided loans without collateral, but this practice has since stopped. It was common practice to extend loans to well-connected customers to purchase equities, with the equities themselves as sole collateral. Presumably, this is no longer being done. However, other practices have not ceased. For example, banks continue to be accused of acting in a discriminatory and nontransparent manner with some customers allowed to write off large debts, while others are not, without appropriate justification for discriminating among customers. A number of Iceland’s most prominent business figures avoided bankruptcy following the crash because banks annulled their losses. Under new management, since the proactive director of the FME was replaced in 2012, the FME lacks strong and clear leadership. The FME has once again adopted a passive, non-intrusive strategic approach. According to a February 2017 poll, conducted by opinion research firm Gallup, the banks are the least trusted institutions in Iceland. Only 14% of respondents expressed confidence in the banks, compared with 22% confidence in the parliament, and 19% confidence in the FME.

The present government has yet to propose a plan for the reorganization of the banking system. This means that the future ownership structure of the banks remains uncertain, particularly the division between private and public ownership as well as between foreign and domestic ownership. Foreign competition in the banking sector remains absent, offering huge monopoly rents to bank owners, a unique feature of Icelandic banking which helps explain why bank ownership is so coveted among Iceland’s clan-based business elite.

Citations:
http://www.gallup.is/nidurstodur/traust-til-stofnana/
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