Thursday 6 November 2014

The State of the Icelandic Economy

Despite the long silence I am quite healthy and fine. As I've got time from my PhD work - hopefully in its final stretches - I've got time to revive this blog, at least for this one time. Not the least because the Icelandic economy is, according to the governor of the central bank, in such a state that many other countries "envy" Icelanders.

Or so the story goes.

On the surface
True, on the surface, the economy is doing pretty splendidly! Unemployment is down, economic growth - this incomplete and deficient measurement of prosperity - is up. Inflation is down and has been kept down for a long enough time for the Central Bank to lower its policy rates, now 5.75%.

Inflation (source for all graphs: Statistics Iceland)

GDP growth

This is the story told by numbers. But, unfortunately, these numbers are not the whole story. They tell a part of it but the don't tell the whole of, just like the surface doesn't tell us what is under it.

In the murky waters
First, let's check out the inflation figures. Inflation in Iceland is heavily influenced by the supply-side factor that the exchange rate is. Roughly one-third of the CPI, which is the basis of the inflation figure as it is measured in Iceland (let's not argue here whether we should use RPI, CPI or whatever else as a measurement of inflation) is from imported goods. Therefore, the stability, as of late, of the exchange rate is a huge factor why the rate of inflation has gone down so much.

(Let's not forget that the value of the exchange rate has been influenced to be stable below what it otherwise would have been: the CBI has been buying FX, therefore kept the value of the ISK down. But, at the same time, the CBI has been careful to try and keep the exchange rate as stable as it can. So "weak but stable" can be used to describe what the CBI has been doing on the FX market.)

So supply-price factors, kept in check by a stable exchange rate and low nominal wage increases, have contributed to the stability of consumer prices. But the other reason for low inflation is simple: lack of demand!

People are not spending as much as they used to. Gone are the days of consumer-pulled GDP growth like in late 90s and pre-2008 when consumption was growing almost at double figures annually and pulling GDP growth with it. But nowadays, the consumption growth is hardly half of its former glory and GDP growth is pulled by the tourist.

Consumption in Iceland, quarterly data

This lack of consumption is normal given that real wages are only just now getting back to their pre-2008 levels.

Median real wages in ISK thousands (2013 prices)

And the basis of any long-term prosperity, investment, is sluggish at best. I reckon it would have to be at least third higher than it actually is to be considered normal.


So sluggish is investment in fact that the stock of real capital is depreciating. And last time I checked, it is pretty darn difficult to maintain production with machinery that is gradually depreciating.

Stock of real capital (2005=100) 

And then comes other not so rosy pictures and developments: doctors are on a strike, rental prices are increasing fast, there is a shortage of affordable housing (at least, judging from the media) and 4,500-6,000 people gathered outside the parliament a few days ago to protest. So whatever the governor says, "envious" economic situation is in the eye of the beholder.

My overall judgement on the economy hasn't changed and is the following.

The external sector, tourism in particular, is responsible for the GDP growth. Hotels are popping up due to this, explaining the small increment in investment that there is. The growth in tourism was fuelled by the fall in the exchange rate of the currency and has allowed the central bank to gather some FX ammunition. In the meanwhile, lack of domestic demand and stability of the exchange rate has lead to a fall in the rate of inflation. Unemployment has come down, mainly due to effective demand being held up from the external sector.

In the meanwhile, investment is low which for the long term will keep the economy down compared to its potential. Investment is low because there is huge uncertainty about what and when something will happen to the capital controls. The consequential changes in the exchange rate of the currency can have devastating effects on any investment project (inflation, wage demands, changes in interest rates, etc.). Ergo: nobody invests while nobody knows what and when something will happen to the capital controls (Business Iceland, a union of employers, advocates an immediate abolishment of the capital controls but I, in July, compared that to blowing up a dam with the whole nation below it. So, basically, forget it!).

Talking about proper long-term recovery in Iceland is fictional while the capital controls are still there and the plan, however vague and unbelievable it is, is to lift them. But the capital controls are exactly what keeps the current situation viable: behind them, people know what the exchange rate is going to be in the nearest future, they don't have to face the reality of potentially massive outflows of capital and politicians can complacently talk about something else than the economy.

The capital controls are the culprit behind the lack of investment, which is what keeps the long-term prospects of the economy down, but, thanks to them, the exchange rate is stable, inflation is down and the weak stability in the economy is their offspring. Like my former boss and teacher put is so eloquently: "This is all kept together by the capital controls."

Their declared abolishment, however it is going to be done, is going to be like going cold-turkey for the heroin addict.

Has anyone actually considered this: maybe it would be better, from an economic point of view, to simply accept and declare that the capital controls will be there?

Then people would not have to be so uncertain about them going or how they would go. Immediately, investment planning would become more viable. "Since the capital controls are going to stay we can make a long-term plan about the cash flows of the investment project" might somebody think. Investment would pick up, sustainable economic growth as well and effective demand from something else than just tourists come back.


  1. TBH, I doubt any investor would dare to invest a penny while Icelanders themselves are under pressure from their own government, and can't even pull their money abroad out of the country. The Central Bank states that if an Icelandic citizen wants to take all his resources, s/he has to officially immigrate but not yet be living in another country for the past 6 months - sounds like some sort of trap. They will probably not let the full amount leave Iceland, without imposing some sort of a tax or such. No investor in his right mind would invest when these shady kind of things are happening to own citizens.
    Seeing how EU is doing right now, it is probably not a very good idea for Iceland to join. I remember one solution discussed for capital controls to be lifted was to take another currency, like a Norwegian krone. But I guess, it cannot be arranged without Norway looking at a good profit...
    Do I understand it right that if Iceland joins the EU, the capital controls will have to be automatically abolished, because of the EU policies? And then, will ISK lose in value significantly?
    You have a great blog! Keep up the good work :)

  2. Thanks Olga, glad you like it.

    To be clear, I am referring to real capital investment when I'm suggesting that it might just as well be better, from the investment point of view, to declare that the capital controls are here to stay. Since most real capital investment is "bolted down" the investor is, practically, declaring that s/he will not pull his/her money out of the country, capital controls or not (yes, bolted down machinery can be used as collateral and that money then pulled out of the country, but you get the gist).

    And regarding the difficulty for the average Icelander using his Icelandic money abroad: unless you're buying a house or any such huge investment for ordinary people, you're fine! My Icelandic debit and credit cards work fine here in the UK and I'm charged no serious capital-controls fees for using them (just the normal bank fees of using a debit/credit card abroad, which are hefty in general, no matter the country of origin of the cards).

    So the everyday Icelander doesn't feel the squeeze of the capital controls: the current account, in the balance of payments, is not closed, it's just the capital account.

    And Iceland is not going to join the EU any day soon. Not with this government. I even think they've actually pulled back the application to join so even if we wanted to join, which is not certain anyway, we'd have to start the application process all over again.