Download Iceland: Challenges and Opportunities

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Iceland: Challenges and Opportunities
Paper at the Mont Pelerin Society Regional Meeting
Iceland 21-24 August 2005
The Hon. David Oddsson
Leader of the Independence Party
Minister of Foreign Affairs, Iceland
Ladies and Gentlemen!
Members of the Mont Pelerin Society and guests!
The Icelanders are one of the few, perhaps the only, European nation with a
reasonably clear idea about its origin. This island in the North Atlantic
Ocean was settled mainly by Norsemen in the ninth and tenth centuries. It is
interesting that in the sagas and chronicles written three hundred years after
the event, the main explanation for Iceland’s settlement was that the
Norsemen disliked the heavy taxes imposed by Harold, the king who united
Norway. Obviously, kings were not held in great esteem by the immigrants
to Iceland. In the Saga of the People of Vatnsdal, for example, a Norseman
named Grim explains that he is off to Iceland: “I have heard good things
about the land — that livestock feed themselves during the winters, that
there are fish in every river and lake, and that men are free from the assaults
of kings and criminals.” Here, Grim equals kings and criminals. It is
remarkable indeed that in the three centuries that the Icelandic
Commonwealth lasted, the Icelanders succeeded in keeping tolerable order
without any centralized power. There were killings, to be sure, but not on the
same vast scale as on the European continent where large royal armies
fought one war after another. In Iceland, moreover, a remarkable literature
emerged. Iceland’s Nobel Laureate in literature, Mr Halldor Laxness, has
ventured the guess that an important reason for this was that the centralized
power of popes, emperors and kings did not reach out to Iceland, while
Iceland benefited from European civilization in that schools and monasterys
managed to confine our great epic tradition to paper and thus they preserved
it for posterity. Be that as it may, Iceland endured its own dark ages between
roughly 1300 and 1800, when it was under the yoke, first of the Norwegian
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king, then his Danish counterpart. The population stagnated at about 50,000
people. At the beginning of the 20th Century, Iceland was possibly the
poorest nation in Western Europe. It was so technically backward and
isolated that news about the death of the Danish king in 1863 only reached
Iceland many months after the event. Probably this is what it means to be
loyal beyond the grave!
The 20th Century, however, treated Iceland well. Danish and Norwegian
capital flowed into the country at the beginning of the century, enabling the
mechanization of our fishing fleet. While we experienced some setbacks
because of the Great Depression, the British occupation of Iceland in 1940
resulted in an economic boom, which only improved when American forces
replaced the British ones in 1941, in compliance with a treaty between
Iceland and the US. The post-war years were difficult, not least because of
bad economic management, but what helped us was, first, the assistance
received from the US, both direct and indirect, and secondly and more
importantly large harvests of fish. In the Icelandic waters, there are some of
the most fertile fishing grounds in the world. Gradually, we extended our
Exclusive Economic Zone, from 3 to 4 nautical miles in 1952, to 12 miles in
1958, to 50 miles in 1972 and, finally, to 200 miles in 1975. In each case, the
UK contested the extensions which gave rise to the so-called “Cod Wars”;
they all ended however in the international recognition of the extensions. In
the middle of the 20th century, foreign fleets had harvested half the total
catch in the Icelandic waters; at the century’s end, the Icelandic fishing fleet
harvested almost all of it.
But with the solution of one problem, another emerged: how to control
access to those fertile fishing grounds? It was fresh in our memory that in
the 1960s, we had overfished the herring stocks with the result that they
almost disappeared and a moratorium had to be imposed. We did not want to
repeat this disaster with cod and other commercially feasible fish stocks, so
that in 1984, after experimenting with other kinds of controls, we established
a system of indvidual catch quotas which soon became transferable. When I
became Prime Minister in the spring of 1991, a comprehensive law on ITQs
had recently been passed by the Parliament. But there was much pressure at
the time to change it. Some wanted no controls at all; others demanded a
resource rent tax on the fishing firms to constrain access. What we did
however, against all this pressure, was to allow the system of ITQs to
develop, with the result that Icelandic fishing firms are now profitable and
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strong. When some people complained to me that the owners of fishing
firms were obviously making a profit, I replied: Is that a problem?
I do not claim that the Icelandic system of ITQs is perfect. I would only say
that it works better than alternative systems of fisheries management,
including and perhaps especially the Common Fisheries Policy of the EU
which has been much criticized for its wastefulness and inefficiencies. Our
system works roughly this way: Each fishing firm holds a given percentage
of the total allowable catch in each fish stock in the Icelandic waters, where
the total catch is set annually on the advice of marine biologists. For
example, a firm may hold a 5% quota of the cod stock. This means that if the
total allowable catch of cod over the fishing season is set at 200,000 metric
tonnes, this individual firm may harvest 10,000 metric tonnes in the season.
It can manage its operations in such a way over the season that it maximizes
the quality and price of the catch, and minimizes the costs of harvesting it.
The quota is transferable. If a firm wants to extend its operations, it can buy
quotas from holders willing to sell. Indeed, the ten largest fishing firms now
hold a much higher proportion of the total quota than they did at the
beginning of the process in 1984. But this does not mean that the quotas are
in fewer hands, because most of those fishing firms have become joint stock
companies with many more owners than before. I am sure that at this
meeting others will describe our ITQ system in more detail. I would only
add a few comments on the political aspects of it. It is said that necessity is
the mother of innovation, and this is true in our case. We simply could not
afford to fail, as we have been traditionally dependent on the fisheries,
although the Icelandic economy is now diversifying. Politically, we could
not impose drastic changes in the fisheries. We could not, by one gesture,
deprive the fishing communities of their livelihood or render the investments
of the fishing firms valueless. Therefore, we had to give the quotas to the
fishing firms free of charge and let them trade with one another so that
slowly the fleet would be reduced down to an efficient level. It is no secret
that the system of ITQs has been quite controversial in Iceland. Some people
have felt that by giving the quotas to the fishing firms, we were handing the
common heritage of the nation to a group of people. My reply would be that
we were rather entrusting those who have displayed interest and ability in
harvesting fish with this common heritage, so that it grows, in the interest of
all. However, we had a few years ago, as a political compromise, to impose
a moderate resource charge on the holders of quotas.
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The management of the fisheries was not at all the only task waiting for me
when I first sat down in Government House in the centre of Reykjavik in the
beginning of May 1991. In previous years, government had run many special
investment funds in the name of regional development, enterprise and full
employment. Needless to say, those funds had largely failed in identifying
successful enterprises. Hundred of millions of dollars had been wasted in all
kinds of exercises. As you know, and this was confirmed by my own
experience, the ability to solicit money from government funds is not
necessarily the same as the ability to run an enterprise efficiently. One of the
first steps my government took in 1991 was to abolish many of those funds,
and to rein others in by stricter rules. This had the result that some
enterprises went bankrupt. Nobody wants bankruptcies, of course; they are
as unpleasant as dental repair; but they may sometimes be as necessary. I
think that our determination to stop throwing money at unprofitable
enterprises had a great effect on the way managers and owners of enterprises
thought. Slowly, they realized that they had to take responsibility themselves
for their operations; to rationalize, to cut costs, to attract customers. I
sometimes boast that perhaps my chief success in my first few years in
government was to empty my waiting room, to reduce the demand for my
services, as it were. Previously, the Prime Minister’s waiting room had been
full of people seeking all kinds of government favours.
There was another task waiting for me. Before 1991, labour relations in
Iceland had largely depended on government assistance. The employers and
labour unions had year after year negotiated wages for which there was no
economic basis, and government had printed money or provided other kinds
of subsidies to the employers to enable them to pay such wages, with the
inevitable result: There was chronic inflation in Iceland in the post-war
years, reaching 50% for a while in 1974, and almost 100% in 1983. Over all
this period, inflation was much higher here than in the neighbouring
countries. What we did in 1991 was to impose strict monetary and fiscal
controls so that inflation would fall down to the same level as in our main
trading partners. At the same time, we tried to avoid massive unemployment
by reducing taxes on enterprises. In order to facilitate moderate long-term
wage increases, government reduced the corporate incomes tax from 50% to
30% and abolished a special turnover tax on corporations. Nevertheless, the
years from 1991 to 1995 were difficult, with huge cuts in the total allowable
catches in most fish stocks, and some unemployment, although much less
than had been feared. But the monetary and fiscal constraints were
successful. Inflation fell: For the last fourteen years, inflation has been at a
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similar level as in our trading partners. At present, it is about 3.5%. I hope it
is not premature to say that the Icelandic economy has been cured of a
chronic illness. It is interesting that unemployment in Iceland is almost nonexistent, quite unlike many EU countries, where a large proportion
especially of young people cannot find jobs. In the 1970s, a so-called
“misery index” was much discussed, the sum of inflation and
unemployment. Iceland scores very low on this index indeed.
At the same time as we began to try to create monetary stability, we had to
clean up the fiscal mess left by our predecessors. We inherited a huge
government deficit which we gradually reduced, and in 1997, it was turned
into a surplus which has since been used to reduce the public debt. In 1995,
Treasury debt was more than 50% of GDP; whereas now it is less than 15%
of GDP. Moreover, we started an ambitious programme of privatisation.
First, we sold the government printing press, then the production line of the
government liquor stores, then the state shipping company and the state
tourist agency. Later, we sold the government publishing house, an
insurance company, some fish processing plants, the state pharmaceutical
company, the state fertilizer producer, some other factories and also stock
held by government in various companies, and so on. When we took office,
in 1991, two out of the three commercial banks were publicly owned. It was
a big step when all the important public investment funds were unified and
then privatised as an investment bank in two steps, in 1998 and 1999. It soon
after merged with the one private commercial bank. Another very important
step was when the two government commercial banks were fully privatised
in 2002 and 2003. It is only when we look back that we realize how much in
Iceland of what is sometimes called the commanding heights of the economy
was in the hands of government. The three private banks which have
emerged as a result of the privatisation process are all dynamic and
enterprising; they have all extended their operations to other countries.
I am happy to tell you that in July, just a month ago, a further big step,
indeed a gigantic step on the Icelandic scale, was taken when Iceland
Telecom was sold to the highest bidder, for one billion US dollars. I do not
believe that the main point of privatisation is to derive revenue; but I should
note that we have privatised for between two and three billion dollars, which
is a lot when you bear in mind that the ratio between Iceland and the US in
most things is one against one thousand. In other words, our privatisation
would amount to between two and three thousand billion dollars on the US
scale. You can imagine how much of a transformation of the Icelandic
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economy this implies. On a different note: it is interesting that the present
director of Iceland Telecom is the same person as was the first director of
the first company which I privatised as mayor of Reykjavik back in 1984. It
was the municipal fishing firm which then was operated with huge losses,
and is now a healthy and profitable private company.
There is little doubt that a part of the new-found strength of the Icelandic
financial market is derived from the pension system reform. We used to have
a pay-as-you-go system. But we have changed this into a fully funded
system. Essentially we now have three kinds of provisions for old age in
Iceland. First, there is traditional social security, old-age pensions paid by
the state, and financed by taxes. It is means-tested; those who have no other
income receive the most. In the second place, there are occupational pension
funds which are mandated, but not controlled by government, where you
accumulate pension rights by your payments into your funds. Thirdly, there
are voluntary, privately owned and inheritable pension schemes. We are told
by international experts that our pension system is amongst the financially
strongest and soundest in the world. Moreover, its has provided Iceland’s
corporate sector with much-needed capital for its great expansion over the
last few years.
Certainly, the favourable international economic conditions of the last few
years have helped Iceland. But they do not explain why Iceland has of late
consistently outperformed most neighbouring countries. What caused the
Icelandic boom? The extensive privatisation is without doubt one of the
main reasons for the growth and vigour of the Icelandic economy. But
another reason is, I believe, the reduction of the corporate incomes tax. We
found when we reduced the tax from 50% to 30% that in fact the total
revenue increased. I need hardly remind members of the Mont Pelerin
Society of the ancient truth that a small slice of a big cake can be much
bigger than a big slice of a small cake. Of course one explanation for the
increased tax revenue was that the economy was picking up after 1994-5, but
we must remember that this was a cause rather than a consequence: the
economy was picking up precisely because of the reduced tax rate. It took a
while to get political agreement on further reductions, but such an agreement
was reached, and we reduced the corporate incomes tax to 18% and
undertook various other reforms. This makes us quite competitive as a centre
for corporate activities. Recently, we have turned our attention to other
taxes. We have reduced and simplified the inheritance tax, so that it will
never rise over 5%, and we are gradually abolishing both the net wealth tax
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and a special high-income tax surcharge. During this election term we plan
to reduce the personal incomes tax by 4% and also to reduce the VAT, or
value added tax, at least on food. Nevertheless, I must admit that our tax
burden is too heavy, even if it is lighter than in the other Nordic countries.
But one reason for this is beyond our control: it is that some municipalities,
in particular the city of Reykjavik, under a left-wing coalition, have gone the
opposite way and raised the municipal incomes tax.
Some economists warn against tax reductions in the present conditions. They
contend that this will “overheat” the economy. I ask back: when is there a
good time for tax reduction? Never, according to some people, always
according to committed libertarians, and I would myself say: at least now
when the government finances are in good order. I look upon the present tax
reductions not as a matter of economic management, but rather as returning
to the people what they have earned by their own hard work. I try to explain
to economists warning against tax reductions, that we are not trying by them
to fine-tune the economy, but rather to implement a structural change, to
hand decisions over from government bureaucrats to the individual families
and enterprises. I may perhaps add here that a part of our reforms was to
increase the legal protection of individual rights, both in public management
and in the access to government information.
I should mention that some attribute our success over the last decade to our
membership, since 1994, in the European Economic Area. The EEA was
originally formed by the EU and EFTA countries, but now all the old EFTA
members have joined the EU except Iceland, Norway and Liechtenstein.
Essentially it involves economic, but not political, participation in Europe. I
believe however that our membership in EEA was more a consequence of
our changed policies than its cause. What we decided to do in 1991, was to
become an open, free economy. As a consequence, we joined the EEA. We
wanted to trade with Europe. But we privatised our public companies
without consulting Brussels; we stabilised our currency and reduced our
public debt without any help from Brussels; we cut taxes without Brussels
asking us to do this. Therefore our economic success cannot be attributed to
our membership in the EEA, although of course it has been beneficial for us
to gain full access to the European market. I also admit that I am one of
those who cannot see any need for the Icelanders, at least at present, to
follow our Nordic neighbours, Denmark, Sweden and Finland, into the EU.
Our influence on decision-making in Brussels would be minimal, while the
costs would be considerable. First, Iceland is one of the most prosperous
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countries in Europe so that it would have to make a net contribution to the
EU funds. Secondly, we have fought for and won control of the Icelandic
waters and we do not want to hand their management over to Brussels. We
have a reasonably efficient system in our fisheries, whereas the Common
Fisheries Policy is seriously deficient. In the third place, those of us who
value liberty and diversity, look with some suspicion to the centralizing
tendencies of the EU. For example, many politicians in the EU call for tax
harmonisation. What they mean by this is only harmonisation upwards, not
downwards. But we do not want to adopt the high corporate taxes which
prevail for example in Germany. Again, on the surface the euro is a good
idea. It is quite convenient to be able to use the same currency when
travelling around Europe, and to make calculations and contracts in the same
currency. But how do you respond to a boom in Ireland and a bust in
Greece? Economic adjustments are much more difficult in the euro area than
in the other large common currency area, the US, with its much greater
mobility and wage flexibility. While Iceland is an open economy, it has also
its own trade cycle. There is a Canadian dollar even if Canada and the US
are close trading partners; the Swiss maintain their own currency in the
midst of Europe; and New Zealand has not adopted the Australian dollar.
I believe that the best strategy for Iceland is to remain on friendly terms with
the European Union, and to trade with Europe, but to stay outside the
European Union. What may facilitate this strategy is that we have, since
1951, had a bilateral defence treaty with the US. It has been an important
part of our programme to maintain the friendly political ties and the military
alliance with the US. As you know, Iceland is situated between the continent
of Europe and America. An open economy has to be open to both Europe
and America, not closed to either of them or for that matter to any other
trading partners. We want open markets, not closed states.
Ladies and Gentlemen!
Since 1995, the growth rate of the Icelandic economy has been consistently
high, resulting in more than a 30% increase in real wages. In 2005, the
growth of the GDP is expected to be about 6%, and in 2006, only slightly
below that. Iceland is now a free and open economy which aims to be “free
from the assaults of kings and criminals”, as it was put in the Saga of the
People of Vatnsdal. But here I would like to return to the question to what
we can attribute this success. What greatly helped us in the years after 1991
is that we had a reasonably clear vision of what we wanted to do and, no less
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importantly, what we had to avoid. We learned not only from our own
mistakes, but also from distinguished visitors like Friedrich Hayek, Milton
Friedman and James M. Buchanan who demonstrated both the visible and
the invisible gains of economic freedom and why government is sometimes
the problem rather than the solution. A fruitful intellectual debate followed
their visits where we tried both to learn from them and to develop and
strengthen our own inherited scepticism of centralized power.
However, I am not an economist. I am a politician, and I have to obey
Bismarck’s maxim, that politics is the art of the possible. Sometimes we
have had to take one step back in order to take two steps forwards. For
example, my first government was a coalition of the social democrats and
my own party, the Independence Party, which supports private property and
free enterprise. In order to accept some measures that we deemed important,
the social democrats insisted on a high-income tax surcharge. We did not
want it, but we reluctantly went along with it. Now, in a different coalition,
we are quietly abolishing it. Another example is the resource charge on
quota holders. Many of us in the Independence Party did not like it. But we
thought it was of vital importance to create stable legal conditions in the
fisheries; and to bring this about, we made a compromise. Timing is also
very important in politics. Ideas must conspire with circumstances, as John
Stuart Mill put it. I do not think, for example, that it would have been
feasible to privatise the commercial banks in the early 1990s. First, we had
to open our market and that of Europe with the agreement on the European
Economic Area. We had to stabilise the economy by monetary and fiscal
constraint, and we had to privatise on a small scale before we did it on the
big scale. Now, however, many things are possible which did not seem
within reach in 1991. Another key word is continuity. We have now been in
government since 1991, and the political stability has been very important to
the economy. It is this continuity which has enabled us to sacrifice
unimportant short-term matters for the really important long-term principles.
I would indeed like to conclude by saying that we must never forget our
principles. The compromises are made precisely to further our principles.
When Milton Friedman came to Iceland in 1984, he held a press conference.
A reporter asked him, perhaps ironically, whether he had a solution to
Iceland’s problems in one word. Friedman said: Yes, I have. The reporter
asked, what this word was. Friedman did not hesitate: “Freedom”. In
Iceland, we have tried to take his advice.