Iceland

   

Economic Policies

#18
Key Findings
With the aftereffects of economic crisis easing, Iceland falls into the upper-middle ranks (rank 18) 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Capital controls imposed following the financial crisis were rescinded without serious capital outflow or depreciation. However, public services remain underfunded. Per capita GDP has rebounded to its pre-collapse level.

The unemployment rate has fallen to just 3%. The inflation rate is already above its targeted level, and new demands for long-delayed wage increases are likely to push it higher. Tax revenues have been stable at 42% of GDP, and public debt levels have fallen to sustainable levels after ballooning during the banking crisis.

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. R&D spending is very strong, and has helped spur the creation of new biotech, pharmaceutical and high-tech firms.

Economy

#19

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
Ten years after the 2008 financial collapse, Iceland’s economic policy has still not fully dealt with the fallout. Capital controls imposed to stabilize the Icelandic króna following the financial crash have for the most part been rescinded. The relaxation of capital controls was accomplished without a sudden outflow of capital or depreciation of the króna. Output per person has been restored to its pre-collapse level. Unemployment, at 3% in late 2018, is low. Even so, the economy is still dealing with the consequences of the harsh post-crash fiscal adjustment strategy, which imposed a retrenchment equivalent to about 10% of GDP between 2010 and 2017. Public services, especially health care and education, have suffered serious underfunding as a result.

In 2016, the Icelandic króna strengthened significantly 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. However, between November 2017 and November 2018, the króna depreciated by 17% vis-à-vis the U.S. dollar and by 13% vis-à-vis the euro. Fiscal and monetary policies are largely neutral as inflation increases due to full employment. At 3%, inflation exceeded the official target of 2.5% in 2018 and is projected to rise further as labor unions, under new and determined leadership, demand large wage increases in the next round of wage negotiations. These negotiations will take place against the background of huge wage increases 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 the increase to charity). The salaries of members of parliament increased by 111% between 2011 and 2018. The Wage Council has since been disbanded. The council did not keep minutes of its meetings. Under these circumstances, and in view of ever higher CEO compensation, the trade unions are not likely to accept the 4% increase currently on offer. Consequently, distributive justice will loom large in the upcoming wage negotiations.

The future of the banking sector remains uncertain. The government, which still owns two-thirds of banking sector assets in Iceland, has not yet presented any concrete plans for restructuring the banks. 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:
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.

Gylfason, Thorvaldur (2018), “Ten Years After: Iceland’s Unfinished Business,” forthcoming in Robert Z. Aliber and Gylfi Zoega (eds.), The 2008 Global Financial Crisis in Retrospect, Palgrave. Also available as CESifo Working Paper No. 7318, November 2018.

International Monetary Fund (2018), Iceland: Staff Concluding Statement of the 2018 Article IV Mission, September 25, 2018.

Labor Markets

#15

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
For a long time, labor market policy and labor market mobility within Iceland have kept unemployment low in general. Just before the collapse in 2008 the unemployment rate was below 1%, reflecting an overheated economy. However, this changed following the collapse, but less than might have been expected. In 2010, the unemployment rate peaked at just under 8%. Thereafter, joblessness gradually declined to below 3% in 2018, 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. 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, with many more due to expire between 2018 and March 2019. The renegotiation of these contracts will be complicated. Several decisions by the Wage Council in 2017 – including granting double-digit, retroactive wage increases to members of parliament, senior public officials and the president of Iceland – have caused resentment among ordinary wage earners, as have rising differentials between CEO compensation and average wages. For this reason, a cloud of uncertainty hangs over future wage developments. Therefore, inflation and unemployment seem likely to rise 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, https://hagstofa.is/talnaefni/samfelag/vinnumarkadur/vinnumarkadsrannsokn/. Accessed 22 December 2018.

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

Taxes

#19

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
Frequent changes of government since 2013 have not resulted in significantly changes in tax policy. Tax revenue was stable at 42% of GDP during 2017 and 2018, and is projected to remain at this level, other things being equal. Though new labor market agreements in 2019 could change this if the government, as the single largest employer, uses tax policy as a bargaining chip or if large wage increases trigger a change in tax policy.

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. In late 2018, parliament decided to significantly lower fishing fees while disadvantaged social groups (e.g., disabled people and pensioners) complain bitterly about being left behind.

Citations:
International Monetary Fund, 2018 Article IV Consultation, IMF Country Report No. 18/318, November 2018, https://www.imf.org/en/Publications/CR/Issues/2018/11/14/Iceland-2018-Article-IV-Consultation-Press-Release-Staff-Report-Staff-Statement-and-46357. Accessed 18 December 2018.

Indriði H. Thorláksson, “Veiðigjöld 2015. Annar hluti” (Fishing Fees 2015. Part Two), http://herdubreid.is/veidigjold-2015-annar-hluti/. Accessed 18 December 2018.

Budgets

#18

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. Though it gradually decreased to 37% by the end of 2018 and is projected to further decline to 24% by 2023. Reflecting a reduction in the public debt-to-GDP ratio, which stems in part from a fairly rapid expansion in output since 2011, while interest payments on the public debt have declined from 4.5% of GDP in recent years to 3% in 2018. However, in late 2018, there were indications that excessive wage increases were beginning to boost inflation and weaken the currency, which could increase the debt burden, other things being equal. Even so, according to the IMF, Iceland’s foreign debt burden should remain sustainable. Nonetheless, fiscal sustainability remains a serious concern for the government given the dire financial situation of several key public institutions, such as the State University Hospital.

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 2009 – 2013 government increased fishing fees significantly and budgeted for further increases, the center-right 2013 – 2016 government reversed course and reduced fishing fees against IMF advice, a policy continued by the center-right 2016 – 2017 government and the left-right government formed in late 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, schools and universities, 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, 2018 Article IV Consultation, IMF Country Report No. 18/318, November 2018, https://www.imf.org/en/Publications/CR/Issues/2018/11/14/Iceland-2018-Article-IV -Consultation-Press-Release-Staff-Report-Staff-Statement-and-46357. Accessed 18 December 2018.

Research, Innovation and Infrastructure

#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 led to the creation of new private firms in the biotechnology, pharmaceutical and high-tech manufacturing sectors. Such export-oriented firms were helped by the depreciation of the króna (which lost a third of its value in real terms following the 2008 crash), but then hurt by the króna’s gradual real exchange rate recovery (which recovered its earlier overvalued pre-crash level), before once again benefiting from the depreciation of the króna during 2018. The economic collapse in 2008 led to a cut in R&D expenditure, which fell to 1.8% of GDP in 2013. According to the most recent available data, R&D expenditure was 2.1% of GDP in 2016, still far below the pre-collapse level. This is evidence of the long-lasting damage caused by the 2008 collapse, which compelled public authorities to drastically cut public expenditure and then change the composition of public spending following the country’s recovery – changes that would have been difficult to implement during normal times.

Citations:
Statistics Iceland, http://px.hagstofa.is/pxis/pxweb/is/Atvinnuvegir/Atvinnuvegir__visinditaekni__rannsoknthroun/FYR05101.px/table/tableViewLayout1/?rxid=7cf14630-6835-4bcf-86df-b6e4f6fc92ec. Accessed 21 December 2018.

Rannis (The Icelandic Centre for Research), https://www.rannis.is/starfsemi/arsskyrslur/. Accessed 21 December 2018.

Global Financial System

#26

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 System
5
In part because of its small size, Iceland has never sought to make 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 of the domestic financial system, including steps that have attracted international attention and have been held out as an example for other countries.

The post-crash 2009 – 2013 government 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, fraud, and false reporting. By late 2018, the Supreme Court had sentenced 36 individuals (30 bankers, 3 executives, 2 auditors and a cabinet secretary in the finance ministry) to a total of 88 years in prison for crash-related offenses, with an average jail term of 2.5 years. The 88 years of total prison time have not been evenly divided among the banks, however: Kaupthing got 32 years, Glitnir got 19, Landsbanki got 11 years, Savings and Loans got 12 years, and others 14. The uneven distribution of sentences across the three main banks (even if they were very much alike) may create concerns about unequal justice. At the end of 2015, the Special Prosecutor’s Office was merged with the District Prosecutor’s Office 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, the owners of the banks were their largest borrowers. This is no longer the case. Further, 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 privileged 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. Due to bank secrecy, such debt write-offs are impossible to ascertain. 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 2018 Gallup poll, the banks are the least trusted institutions in Iceland. Only 20% of respondents expressed confidence in the banks, compared with 29% confidence in the parliament and 28% confidence in the FME. The government decided in late 2018 to incorporate the FME into the central bank, marking a return to the arrangement that produced weak bank supervision in the past.

The 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:
Jensdóttir, Jenný S. (2017), “Ákærur og dómar vegna hrunmála” (Indictments and Verdicts in Crash-related Cases), Gagnsæi (Transparency), Samtök gegn spillingu (Alliance against Corruption), http://www.gagnsaei.is/2017/12
/29/domar1/. Accessed 18 December 2018.

Gylfason, Thorvaldur (2018), “Ten Years After: Iceland’s Unfinished Business,” forthcoming in Robert Z. Aliber and Gylfi Zoega (eds.), The 2008 Global Financial Crisis in Retrospect, Palgrave. Also available as CESifo Working Paper No. 7318, November 2018.

https://www.gallup.is/nidurstodur/thjodarpuls/traust-til-stofnana/. Accessed 21 December 2018.
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