The Icelandic real economy has returned to its early post-war growth average of 3,5% to 4% after a dip that lasted from 1980 to 2002/3 (See Rannsóknarnefnd Alþingis 2010). The first years of the new millennium have also been characterized by fast growth in public and private consumption as well as public and private investment. In fact, Icelanders have invested and consumed much more than they produced during this period. The result was a current account deficit that had reached the unimaginable size of 20% to 30% of GDP in 2008.
The mechanism that led to and sustained the over-spending was complicated, yet simple: A very loose fiscal policy combined with a much more rigid monetary policy. This resulted in high interest-rate differentials vis-á-vis the rest of the world and in an inflow of carry-trade funds, and with it the appreciation of the local currency, the króna. The loose fiscal policy was partly a result of off-budget activities like the politically motivated investment in an aluminum production plant and associated power-generation facilities in East-Iceland. Partly, the loose fiscal policy was facilitated by the increased inflow of indirect taxes. As a result, governmental spending per person had increased by almost 40% in real terms between 2000 and 2009. Thus, the size of Iceland’s public purse was inflated along with the price of Icelandic assets (the stock market index had a nine times higher value in 2007 than in 2000).
It is useful to keep those facts in mind when we try to evaluate the impact of the announced fiscal austerity measures in Iceland. First of all, note that spending can be cut by almost 30% before real spending per person comes down to the levels of 2000. Furthermore, it is clear that the speedy growth of public spending at the beginning of the millennium was sure to produce some inefficiencies. There are, for example, seven institutions that claim to be universities in a country of 300.000 people. So there is scope for cuts that do not hurt users of public services. There is also considerable scope for refocusing the public sector. There are functions that should be extended, and there are those that should be contracted or eliminated.
Icelanders do not discuss the cuts proposed in the present 2011 budget in political terms. One could have expected a discussion on the desirability of a having the government involved in the provision of health care, etc. If there is a discussion along those lines, it does not surface in the public arena. The discussion is driven by those that fear they will be made redundant as a result of the cuts. Others that participate are spokespersons for municipalities that fear that the state will no longer offer as many salaried positions within its administrative boundaries. Hence, the debate evolves around short-term aspects of the cuts, not around principles or long-term choices.
There is not much that could be done at the European level to counteract the cuts in the public budget in Iceland. The budget is clearly overextended. It was inflated heavily during the last 5-10 years. Hence, the cuts should not be that hard to accept for the majority of the consumers of public services. It is understandable that the producers of such services protest when the government reduces the quantity demanded. We must hope that Icelanders start to discuss what they want in form of governmental services rather than to discuss how many hours of work they would like to sell to the government!
Rannsóknarnefnd Alþingis. Aðdragandiog orsakir falls íslensku bankanna 2008 og tengdir atburðir. Vol. 1. 9 vols. Reykjavík: Rannsóknarnefnd Alþingis, 2010