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Devalue, restructure and be master of your own fate

My Times column on the economy of Iceland:


I spent part of last week in Iceland, the antithesis of Greece. It’s been a hard winter and a cold spring up there, but despite the stiff northerly breeze off the Arctic ocean, economically speaking Iceland is basking in real warmth, while Greece shivers in financial winter. Iceland teaches a very acute lesson for Greece, Britain, Europe and the world: independence works.

Iceland and Greece had equally terrible crashes seven years ago, yet Iceland is now growing rapidly, running trade and budget surpluses, with minimal unemployment and strong pension funds. A settlement with the creditors of its three failed banks is imminent, and exchange controls will soon be lifted.

The country’s fundamental advantages (fish, tourism, geothermal energy, and a highly educated workforce) were untouched by the financial crisis. With the help of a sharp 60 per cent devaluation, Iceland set about working its way through austerity to prosperity. It cut public spending, hiked interest rates and at the behest of the International Monetary Fund brought in exchange controls to stem inflation. Helped by the cheap krona, tourist numbers have doubled in five years, and the fishing catch is at a record high with stocks of capelin and cod sustainable.

With a banking sector nine times its economic output by the early 2000s, and a reputation for borrowing money abroad to buy dodgy assets such as football clubs, also abroad, Iceland’s economy was caught hard and early by the credit crunch. Yet Swiss and Scottish banks were larger than Iceland’s in relation to their GDP. The world chose to save Swiss and Scottish banks, while Iceland’s were allowed to collapse. That, many Icelanders now think, looks like a blessing in disguise.

Beset by seemingly false rumours of Russian mafia money being laundered through Iceland, and without any strategic interest in helping the country as there would have been during the Cold War, the world left Iceland to its fate.

In September 2008 the United States Federal Reserve refused a currency swap to Iceland (while offering it to the other Nordic countries), which started a bank run. Gordon Brown then made it worse by describing Iceland as virtually bankrupt, refusing liquidity support to its banks’ British branches, and — shockingly — using anti-terrorism legislation to freeze Icelandic bank assets in the UK.

Mr Brown’s government then unilaterally compensated British depositors in Icesave, the overseas branch of Landsbanki, one of Iceland’s biggest banks, and sent the bill to the Icelandic government.

Icelanders refused to pay, twice confirming this in referendums, and two years ago the European Free Trade Area (EFTA) court ruled that Britain’s action was illegal, which put an end to the episode. In practice, the overseas branches of the banks were sound and creditors would have recovered most of their money.

In short, Britain behaved abominably towards Iceland during the crisis; I am amazed they let me into the country last week. The world allowed Iceland to fail because it was small. It has a population the size of Cardiff. But it turns out that there is no safe haven for small countries as part of a larger entity.

Contrast Iceland’s experience with that of small countries that had sought shelter in the embrace of the EU: Greece, Cyprus, Ireland, all still at various stages of denial or debilitation or serfdom. “We are,” says Professor Hannes Gissurarson, who is writing the definitive report on the crisis, “masters of our own fate.”

The big advantage Iceland had over Ireland and Greece was that it could devalue its currency and become competitive. Iceland is also outside the disastrous common fisheries policy of the EU, which means it can run a far more sustainable and economically efficient policy, involving transferable quotas. This means that fishermen have a strong incentive to be good stewards of fish stocks and keep the value of their quotas high, so it works as a conservation tool as well as promoting economic efficiency.

As a member of EFTA and the European Economic Area, Iceland is outside the EU’s external tariff so it can trade freely with the world as well as the EU. Last year it signed a free-trade agreement with China. An MP from the governing party was in London last week to invite Britain to join them in a similar status, and thereby to assume leadership of a trade-only bloc of European nations.

True, an Icelandic firm must apply EU rules if exporting to the EU, but then it has to apply American rules if exporting to America, and neither if not exporting at all. Iceland represents itself on the World Trade Organisation, whereas Britain is represented mainly by the EU trade commissioner, a Swede. The notion that being outside the EU means you don’t get to write the rules of world trade is back to front. The EU is increasingly at the mercy of others’ rules set at the supranational level anyway: regaining our independence would increase our influence there.

Iceland’s entire history confirms the benefits of independence. Having developed self-governance as a commonwealth in 930AD —ie, without a king or a bureaucracy but with the earliest of all parliaments, the Althing – it then succumbed in 1262 to the temptation of seeking “shelter” as part of a larger entity. It negotiated protection from the Norwegian king.

Big mistake. The shelter became a trap as later monarchs – of Denmark by now – imposed agrarian feudalism on the country. Every citizen was forcibly registered to a farm and no foreigner was allowed to overwinter, effectively stifling all attempts to develop trading partnerships, start industry, or even get fishing. Briefly in the 18th century, when a volcanic eruption left the island starving, there was interest in Britain getting Iceland from Denmark in exchange for a small Caribbean island, but we decided against it: probably just as well. Only in the 19th century did Icelanders begin to exploit their rich fish resources and later their cheap energy, quickly becoming one of the world’s richest countries.

Iceland reminds us that size does not matter nearly as much as most politicians pretend. Small countries often thrive. Look at New Zealand, Singapore, Estonia, Kuwait. They can be that much more nimble in their decisions. And if a country of 320,000 people can have the confidence to thrive alone in the North Atlantic, trading with the EU but not enmeshed in it, why on earth cannot the world’s fifth largest economy?

By Matt Ridley | Tagged:  rational-optimist  the-times