OECD ECONOMIC SURVEYS: ICELAND - OECD Economic Surveys Iceland 2009. ORGANISATION FOR ECONOMIC CO-OPERATION

OECD Economic Surveys

Iceland

2009

ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT

The OECD is a unique forum where the governments of 30 democracies work together to

address the economic, social and environmental challenges of globalisation. The OECD is also at

the forefront of efforts to understand and to help governments respond to new developments and

concerns, such as corporate governance, the information economy and the challenges of an

ageing population. The Organisation provides a setting where governments can compare policy

experiences, seek answers to common problems, identify good practice and work to co-ordinate

domestic and international policies.

The OECD member countries are: Australia, Austria, Belgium, Canada, the Czech Republic,

Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea,

Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic,

Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The Commission of

the European Communities takes part in the work of the OECD.

OECD Publishing disseminates widely the results of the Organisation’s statistics gathering and

research on economic, social and environmental issues, as well as the conventions, guidelines and

standards agreed by its members.

Also available in French

Cover illustration: © Pat O’Hara/The Image Bank/Getty Images.

Corrigenda to OECD publications may be found on line at: www.oecd.org/publishing/corrigenda.

© OECD 2009

You can copy, download or print OECD content for your own use, and you can include excerpts from OECD publications, databases and multimedia

products in your own documents, presentations, blogs, websites and teaching materials, provided that suitable acknowledgment of OECD as source

and copyright owner is given. All requests for public or commercial use and translation rights should be submitted to rights@oecd.org. Requests for

permission to photocopy portions of this material for public or commercial use shall be addressed directly to the Copyright Clearance Center (CCC)

at info@copyright.com or the Centre français d'exploitation du droit de copie (CFC) at contact@cfcopies.com.

http://www.oecd.org/publishing/corrigenda mailto:rights@oecd.org mailto:info@copyright.com mailto:contact@cfcopies.com

TABLE OF CONTENTS

Table of ContentsTable of contents

Executive summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Assessment and recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Chapter 1. The financial and economic crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Iceland’s three main banks became vulnerable to a deterioration

in global financial markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Private sector balance sheets became vulnerable after rapid expansion . . . . . . . . . 25

An unsustainable, domestic-demand led economic boom developed . . . . . . . . . . . 33

The banks were unable to resist the deterioration in global financial markets. . . . 44

Aftermath of the collapse of Iceland’s main banks . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

Prudential supervision and regulation need to be strengthened . . . . . . . . . . . . . . . . 52

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

Annex 1.A1. Progress in structural reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

Chapter 2. Challenging times for monetary and fiscal policies . . . . . . . . . . . . . . . . . . . . . 61

The limits of monetary policy in a very small open economy . . . . . . . . . . . . . . . . . . 62

The future of monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

Substantial fiscal consolidation measures are urgently needed . . . . . . . . . . . . . . . . 83

Measures to increase public revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

Measures to contain public spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Boxes

1.1. Liberalisation of financial markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

1.2. Macro- and micro-prudential supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

1.3. Major recommendations of the Jännäri Report on prudential regulation

and supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

1.4. Recommendations to improve the financial system . . . . . . . . . . . . . . . . . . . . . . . 56

2.1. The new Central Bank Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

2.2. How synchronised is Iceland with the euro area? . . . . . . . . . . . . . . . . . . . . . . . . . 75

2.3. How loose is Employment Protection Legislation (EPL) in Iceland?. . . . . . . . . . . 78

2.4. Measuring the efficiency of social spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

2.5. Policy recommendations for monetary and fiscal policies . . . . . . . . . . . . . . . . . . 101

OECD ECONOMIC SURVEYS: ICELAND – ISBN 978-92-64-05451-6 – © OECD 2009 3

TABLE OF CONTENTS

OECD ECONOMIC SURVEYS: ICELAND – ISBN 978-92-64-05451-6 – © OECD 20094

Tables

1.1. External equity assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

1.2. International investment positions in OECD countries, 2007. . . . . . . . . . . . . . . . 23

1.3. Domestic Money Banks’ loan-to-deposit ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

1.4. Domestic credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

1.5. Estimated debt and external assets of non-financial firms . . . . . . . . . . . . . . . . . 30

1.6. Household net wealth composition and dynamics . . . . . . . . . . . . . . . . . . . . . . . . 31

1.7. Decomposition of general government revenue and expenditure . . . . . . . . . . . 41

1.8. Short-term economic developments and prospects . . . . . . . . . . . . . . . . . . . . . . . 51

2.1. Correlation coefficients with euro area real GDP growth

and inflation, 1997-2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

2.2. Correlation coefficients of underlying shocks between Iceland

and selected countries, 1997-2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

2.3. General government finances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

2.4. Local government finances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

2.5. Agriculture: Producer support estimate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

2.6. Estimated savings for selected fiscal consolidation measures. . . . . . . . . . . . . . . 101

Figures

1.1. Ratio of bank assets to GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

1.2. International investment position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

1.3. Lending and deposits by customer residence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

1.4. Stock-market developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

1.5. Stock-market capitalisation relative to GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

1.6. Cumulative growth in real house prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

1.7. Cumulative growth in the ratio of house prices to disposable income. . . . . . . . 29

1.8. Ratio of house prices to actual and imputed rentals . . . . . . . . . . . . . . . . . . . . . . . 29

1.9. Household debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

1.10. Financial leverage of the household sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

1.11. Composition of household debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

1.12. Real GDP growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

1.13. Share of the construction and financial intermediation sectors