Smallness: Problem or Opportunity?Reflections of an Icelander

Professor Hannes H. GissurarsonTorshavn 22 March 2014

Iceland: Historical Highlights

• Settled 874-930• Commonwealth 930-1262• Under Norwegian, later Danish, king• Home rule 1904• Sovereignty, personal union with Denmark,

1918• Occupied by UK 1940, US taking over 1941• Republic, 1944, member of NATO 1949

Iceland: Main Facts

• Population 325,671 (1 January 2014)• 103,000 sq. km (same as East Germany)• GDP per capita (PPP) 1990: $21,297• GDP per capita (PPP) 2004: $33,716• GDP per capita (PPP) 2008: $39,477• GDP per capita (PPP) 2013: $39,996• Main exports: fish, aluminium, tourism, and

(in past), financial services

A Poor Nation, 874–1874

• Could only sustain 50,000 people or less, Malthusian Trap

• 1709: possibly 38,000; 1787: 39,190• Famines until 19th century; then emigration to

America• Poverty unfairly blamed on Danish colonial

rule• Agriculture held down fisheries; ruling farmers

hindered development of resources

Population, 1703–2014

1703175317721791181018291848186718861905192419431962198120000

50000

100000

150000

200000

250000

300000

350000

Population of Iceland

Iceland and Denmark, 1874–1945

18701875

18801885

18901895

19001905

19101915

19201925

19301935

19401945

0

1,000

2,000

3,000

4,000

5,000

6,000

GDP per capita in 1990 US$

IcelandDenmark

1940–1991, False Prosperity

• Profits, both in hot and cold war• Wider resource base by four extensions of

EEZ, finally to 200 miles in 1975• Overfishing, first of herring, then of cod• However, also some spontaneous economic

growth• Signs of economic decline in late 1980s• Turning point in 1991: Oddsson’s government

First day: 30 April 1991

1991–2004, Liberal Reforms

• Cutting subsidies• Stabilising economy• Liberalising and opening markets (EEA)• Privatising• Cutting taxes• Developing property rights to natural

resources• Strengthening pension funds

Main Tax Cuts

• Corporate incomes tax from 45% to 18%• Individual incomes tax from 30.41% to 22.75%• Turnover tax abolished• Special surcharge on office and trade buildings

abolished• Special surcharge on high incomes abolished• Net wealth tax abolished• Death duties (estates tax) reduced

More Revenue with Lower Rate

1990 1995 2000 200315

20

25

30

35

40

45

50

55

0.7

0.8

0.9

1.0

1.1

1.2

1.3

Corporate Tax Rate Corporate Tax Revenue % of GDP

Corporate Tax Rate

Corporate Tax Revenue % of

GDP

Development of ITQ System

• Open access to fishing grounds = overfishing• Gradual discovery: Effort quotas not efficient• 1975, individual quotas (% of total allowable

catch) in herring fishery• 1984, individual quotas in cod and other

demersal fisheries• Gradually, catch quotas became transferable• 1990, ITQ system made comprehensive• Profitable fisheries: Reduction of cost

Last day: 15 September 2004

2004–2008: Crony Capitalism

• 1991–2004 market capitalism: competition, independent judiciary, free media, economic power separate from political power

• 2004 battle about media law, Oddsson loses, Jon Asgeir Johannesson and cronies win

• 2004–2008 crony capitalism: Johannesson owned media, supported by politicans (and supporting them), cooperative judiciary

What Happened in 2008?

• Icelandic bank collapse no worse a crisis than in many other European countries

• Icelandic banking sector big, but so were such sectors in Switzerland and the UK

• The Icelandic bankers reckless, but not more so than in other countries

• Worked under same regulatory framework as in other EEA countries

• Vulnerable situation, crucial decisions

Irony: High Ratings Led to Bubble

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

A2A1

Aa3

AaaAa1

A1

Baa3

Baa1

External Debt: 2004 Crucial Year

1992 1996 2000 2004 20080

2000000

4000000

6000000

8000000

10000000

12000000

14000000

16000000

External debt in millions of kronur

Johannesson’s Bubble

1/1/05 1/1/06 1/1/07 1/1/080

1000

2000

3000

4000

5000

6000

Loans to Johannesson and croniesLoans to Exista and re-lated companiesLoans to Landsbanki main owners and related com-panies

Johannesson’s Manhattan Flat

101: Johannesson’s private jet

101: Johannesson’s private yacht

Systemic Risks in Iceland

• One specific risk to Iceland (SIC): too much cross-ownership, overvalued assets, Johannesson and his cronies

• Another specific risk to Iceland: field of operations all of EEA; field of institutional support Iceland alone

• General international risks: moral hazard; government mistakes; difficulty of pricing risk with new techniques

Three Crucial Decisions Abroad

• 24 September 2008, Fed refuses to make currency swap agreements with Iceland, makes them with Scandinavia at same time

• 7 October 2008, British Labour government closes the two Icelandic-owned banks in England, bails out all other banks at same time

• 8 October 2008, British Labour government uses anti-terrorism law against Icelandic companies, stopping all transfers to or from Iceland, making recovery impossible

Reconstruction or False Recovery?

• Key to reconstruction: sharp depreciation of currency enabling export industries to fuel recovery; and division of banks into “good” domestic banks and “bad” foreign banks

• However, petty, vengeful hard-left government came to power February 2009

• IMF became hand collector for British and Dutch governments in Icesave dispute

• Icesave deals twice voted down; finally, 2013 EFTA court decided on no obligation

Rough Waters Ahead

• Still much debt owed to foreign bank creditors• Hard-left government did not really cut

expenditure, only postponed investments• Hard-left government scared away investors and

tried to destroy the ITQ system, “suicidal” (WSJ)• Voted down in 2013, greatest debacle in

Icelandic political history, lost 27,7% of total vote• New centre-right government battle-scarred and

cautious

General Lesson: Less Uniformity

• Extensive regulation did not hinder crisis• Strict regulation of financial sector creates false

security• Harmonisation of financial companies creates

additional systemic risk• More correct pricing of risk, if competition and

diversity in markets, also smaller units• Only one realistic strategy: tax cuts and

economic growth

Athens: Much Bigger than Melos

Thucydides’ Classic Melian Dialogue

• 417 BC, Athenians demand that Melians surrender and pay tribute, or be destroyed

• Athenians: “You know as well as we do that right, as the world goes, is only in question between equals in power, while the strong do what they can and the weak suffer what they must”

• Melians refuse; and are destroyed• Irony of History: Later, Athens loses the war and

Melos is restored

Iceland’s Lesson: Needs Allies

• Left out in the cold, in 2008• Needs a shelter which is not a trap• EU more a trap than a shelter, witness Cyprus• Close cooperation with three Anglo-Saxon

neighbours a better shelter: US, UK, Canada• Necessary to reestablish ties with US• Maintain good ties with friendly neighbours

like Faroe Islands and Greenland

Final Reflections on Smallness

• We cannot help our smallness; our fate• Challenge, opportunity, not only problem• Low information costs, good cohesion without

coercion; open economy• Same challenge in Iceland and Faroe Islands:

Strong, vibrant economy creating jobs necessary; otherwise people leave

• Capitalism our only hope