Events in Iceland: Skating on Thin Ice?

Summary

Recent events have commentators discussing whether Iceland is in danger of an economic meltdown. This chapter examines the situation in detail, explaining the sources of today’s financial woes and why, despite serious need for reform, Iceland’s fundamentals are strong.

Is Iceland in danger of financial collapse? The Wall Street Journal recently commented that ‘Iceland looks like an ideal bearish bet’. But many economists disagree. A bit of political history may help illuminate recent developments.

For decades, beginning in 1927 when a farmers’ party gained a majority in parliament with the support of just a third of the electorate, the Icelandic economy was more heavily regulated than most in Western Europe, with the possible exception of Ireland. Interference and planning were the norm; enterprise and markets were viewed with scepticism if not hostility. Without much exaggeration, the state tried to restrain almost anything that moved. The state owned the largest commercial banks and used them to allocate scarce funds to favoured industries and firms; undervalued foreign exchange was rationed the same way. Domestic saving dried up, which necessitated external borrowing on a large scale because, for nationalistic reasons, foreign investment was kept at bay (and banned from the fishing industry, a ban still in force).

A radical liberalization of the policy regime in the 1960s helped modernize the nation by reducing subsidies to the fishing industry and devaluing the krona. Even so, the liberalization was incomplete; for one thing, it left the banks in the hands of the state. Besides, the tight, almost suffocating, embrace of producers and the government remained intact, an embrace that helps explain why, to this day, the Confederation of Icelandic Employers remains unwilling to advocate EU membership and thus go against the wishes of the senior coalition party in government, the sole mainstream centre-right party in Europe so disinclined.