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

Iceland: Historical Highlights Settled Commonwealth 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

Iceland and Denmark, 1874–1945

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

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

External Debt: 2004 Crucial Year

Johannesson’s Bubble

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