Jon Danielsson, Director of the ESRC funded Systemic Risk Centre, London School of Economics.
When the Global Crisis struck in September 2008, all eyes were on the US (Eichengreen and Baldwin 2008). Iceland, however, was the first country to really suffer. Its three major banks collapsed in the same week in October 2008, and it became the first developed country to request assistance from the IMF in 30 years. GDP fell 65% in euro terms, many companies went bankrupt and others moved abroad. At the time, a third of the population considered emigration as a good option (Danielsson 2008).
Since then, Iceland’s economic recovery has been hailed as a miracle, especially by foreign commentators. It is therefore baffling to many that the Icelanders just voted out the government responsible for the post-Crisis recovery, returning the parties responsible for the pre-Crisis boom and bust to power. What’s going on?
The numbers look good
By first sight, the Icelandic economy looks to be doing surprisingly well. Inflation is 3%, unemployment is 5%, and the government budget is almost balanced. The currency stable and the economy grew 1.6% last year. The government is seen to have dealt firmly with foreign creditors and not bailed out its banks. Domestic creditors and the welfare system have supposedly been protected. Based on this record, the government could be expected to be the most popular in Europe. So why did it get voted out?
The positive economic statistics hide a multitude of sins, relating to government policies in the run-up to elections and bad economic management. OECD (2013) finds that Iceland suffered the worst percentage change in household market income between 2007 and 2010.
The rot underneath
The exchange rate of the Icelandic currency is firmly in the hand of the central bank since the country operates under strict capital controls (see Arnason and Danielsson 2011). Iceland is facing significant balance of payment problems. These will get worse over the coming years because large amounts of money owned by foreign entities are trapped in Iceland by the capital controls. When this money leaves the exchange rate is likely to fall. In spite of this, the exchange rate appreciated sharply in the run-up to the elections, reaching a peak right before the voting date. This temporarily stimulated the economy and held down inflation. Since the election, the currency has been falling.
There are other indications of future inflation, for example public sector wages have been rising in recent months. Based on past history, the most likely response of the Icelandic government will be to inflate away the impact of the salary increases.
Moreover, the national accounts that indicate a nearly balanced budget do not hold up to scrutiny. The recent slowdown in economic activity has reduced government revenue while actual and promised expenditures in the months before the election increased. Meanwhile, official statistics systematically exclude one-off items such as the continuous support for the government housing fund and unfunded pension liabilities. When those are included, the fiscal position of the government is precarious.
The main problem is lack of investment
The main long-run economic problem facing Iceland is its low and falling investment rate. Before the crisis, Iceland invested at the same rate as the rest of Europe, around 21% of GDP. Last year, the Icelandic investment rates fell to 14% of GDP, the fifth lowest in Europe. This is set to worsen. The Central Bank forecasts private-sector investment will fall 23% this year, whilst overall investment may fall by 9%.
Investment has been held back by three main factors:
- Capital controls.
- Political views on investment.
- Tax policy.
Following its crisis in the fall of 2008, the government, the Central Bank and the IMF considered capital controls necessary because of the large amounts of money held by carry traders – this exceeded 40% of GDP. The authorities felt capital controls were necessary to prevent the money from leaving, causing the exchange rate to collapse.
The controls were meant to be temporary – a few weeks at most. Years later, they are still present today, and getting stronger. The controls led to a collapse in investment for the very simple reason that any potential investor is worried about being locked in an unstable currency controlled by a less than competent government. Those with the ability to invest have preferred to keep their options open by keeping their funds liquid.
Investment has also been held back by political interference in economic policy. The outgoing government was composed of two parties: left-of-centre Social Democrats and the left-wing Green Party (the latest incarnation of the Soviet-leaning Communist Party). The government has been overtly hostile to private-sector investment – especially foreign direct investment. They have frequently intervened in individual investment choices.
Investment is also affected by the tax regime. Tax rates in Iceland, not surprisingly, have increased following the Crisis. Moreover, the tax regime has changed frequently, thus increasing the uncertainty for potential investors. This tax risk significantly contributes to low investment rates.
Welfare system and the protection of the poor
The outgoing government consistently maintained that it ringfenced the welfare system and protected the poorest in society. The Icelanders do not perceive it that way. After all, the OECD (2013) finds that market income inequality rose considerably in Iceland.
The welfare system has borne the brunt of the government’s economic policies. The pension system has been raided, especially affecting those with low pensions. Perhaps 1% of the population is dependent on charities for food. The health system has been scaled back, with co-payments increasing sharply. These policies have hit the poorest especially hard.
Loans available to Icelandic households have traditionally been inflation indexed or linked to foreign currencies. This meant that the post-Crisis debt burden increased sharply for many households. Iceland has seen significant debt relief, primarily because the courts have declared foreign-currency link loans to be illegal. This however has mostly benefitted the wealthiest parts of society.
Friendliness towards foreign creditors
The main reason why the Icelanders voted out their government was its deference towards foreign creditors. Iceland came under significant pressure from the IMF to accommodate foreign creditors, and the government gave in.
The most important dispute with foreign creditors is related to Icesave (see Danielsson 2010). Whilst an overwhelming majority of the population strongly opposed the Icesave settlement which cost Iceland 40% of its GDP, the government pressed ahead.
In addition, when resolving claims by foreign creditors to the remaining assets of the banking system, the government has handed the domestic banks to foreign vulture funds. Meanwhile, it has been accommodating to foreign creditors seeking to repatriate funds locked in Iceland because of the capital controls.
All of these policies were vocally opposed by voters. In the election campaign, foreign creditor friendliness was a major issue, and it is no wonder that the one party that most strongly opposed the Icesave deal – and the one that took the firmest position against foreign creditors – has emerged as the biggest victor in the election.
While it is surprising to many foreign observers that the Icelanders have chosen to return to the status quo ex ante, it is logical given how poorly governed Iceland has been since its crisis.
The voters opted for the same centre-right parties responsible for the pre-crisis boom. They want a government that:
- Implements sensible pro-growth policies.
- Firmly opposes EU membership.
- Takes a firm line against foreign creditors.
All while working to lift capital controls and further integrating Iceland into the world economy. Icelander elected the new government because they have more trust in their ability to deliver on this list than did its left-of-centre predecessor.
Arnason, R and Jon Danielsson (2011) Iceland and the IMF: Why the capital controls are entirely wrong”, VoxEU.org, 14 November.
Danielsson, Jon (2008), “The first casualty of the crisis: Iceland”, VoxEU.org, 12 November.
Danielsson, Jon (2010), “The saga of Icesave: A new CEPR Policy Insight”, VoxEU.org, 26 January.
OECD (2013) “Crisis squeezes income and puts pressure on inequality and poverty“, oecd.org.