Smallness: Problem or Opportunity? Reflections of an Icelander

1. Smallness: Problem or Opportunity?Reflections of an Icelander Professor Hannes H. Gissurarson Torshavn 22 March 2014

2. 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

3. 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

4. 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

5. Population, 1703–2014

6. Iceland and Denmark, 1874–1945

7. 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

8. First day: 30 April 1991

9. 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

10. 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

11. More Revenue with Lower Rate

12. 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

13. Last day: 15 September 2004

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

15. 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 Switzerlandand 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

16. Irony: High Ratings Led to Bubble

17. External Debt: 2004 Crucial Year

18. Johannesson’s Bubble

19. Johannesson’s Manhattan Flat

20. 101: Johannesson’s private jet

21. 101: Johannesson’s private yacht

22. Systemic Risks in Iceland • One specific risk to Iceland (SIC): too much cross-ownership, overvalued assets, Johannesson and his cronies • Another specificrisk 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

23. 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

24. 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

25. 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

26. 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

27. Athens: Much Bigger than Melos

28. 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

29. 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

30. 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