Iceland warms to Europe

Thorvaldur Gylfason 21 July 2009

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It took a crash. Iceland’s recent application for EU membership signals that Iceland’s new government understands the country’s need to show its willingness to share its sovereignty with other EU members and to subject itself to the discipline that full EU and EMU membership entails.

Iceland’s application is overdue. The natural thing for Iceland to do would have been to join the EU with Austria, Finland, and Sweden in 1995 rather than let European Economic Area membership suffice and forgo the benefits of full integration. Norway had a good, if selfish, reason to remain outside the EU – oil. Some believed that Iceland’s riches constituted a comparable justification for shunning the EU, pointing to Iceland’s pension funds amounting to $100,000 per person in 2007 compared with the Norwegian petroleum fund, now pension fund, equivalent to $85,000 per person. Exhibit two was Iceland and Norway’s shared first place in the 2007 UN Human Development Index reflecting the purchasing power of national income as well as life expectancy and education.

But this was an illusion. Iceland’s currency, and hence also Iceland’s per capita national income measured in dollars or euros, was overvalued, partly due to excessive inflows of short-term foreign capital attracted to Iceland by a misguided monetary policy. Per capita, Iceland’s pension funds after the crash amount to perhaps one-half of Norway’s because the Icelandic króna has lost more than a half of its value on top of the decline in asset prices. Due to high inflation, the króna has lost 95.95% of its value against the Danish krone since 1939 when the two traded at par. High inflation for decades on end is always and everywhere a sign of shoddy policies and shaky institutions. Iceland was an accident waiting to happen (Danielsson 2008, Danielsson and Zoega 2009, Gylfason 2008a, Gylfason 2008b, and Zoega 2008).

Like Norway?

A bit of history may help explain the sudden political turnaround that produced Iceland’s application for EU membership. In Norway, the largest political parties have long favoured EU membership. The electorate, however, refused to go along in two referenda, in 1972 and 1994. In Iceland, it was the other way round. Opinion polls have shown a fairly consistent majority of the increasingly urban electorate in favour of EU membership. The parties, however, beholden to special interests, remained opposed. In 1994, unlike the Norwegians, the Icelandic electorate was not offered an opportunity to express its views in a referendum. The underlying problem was an electoral law that gave the rural areas, and hence the farm and fishing lobbies, disproportionate say in the political arena. A few years ago the Social Democrats came out in favour of EU membership; they are now the largest party in parliament with 30 percent of the vote behind them after the fall from grace of the long dominant Independence Party. So, the Icelandic parliament’s approval of a EU membership application with 33 votes against 28 and two abstentions signals a sea change.

Up against the wall

In addition to the usual arguments for EU membership, two new ones emerged after the crash. First, the story that Iceland, like Norway, was on its own such a smashing economic success that it could afford to remain outside the EU is now passé because Iceland turned out to be less rich than many people thought. Iceland’s rapid flow of income was for many years achieved partly by running down stocks through overfishing and – this may surprise you – neglect of education as well as by running up foreign debts that escalated out of control.1 The IMF-supported economic reconstruction program in place since November 2008 originally envisaged a gross public and private foreign debt equivalent to 160% of GDP at the end of 2009. This figure has since been increased to 200% and may have to be raised yet again to 240% of GDP, an unsustainable level of foreign indebtedness by any standard. Reducing such a heavy debt burden to a manageable level through amortisation would require great sacrifices.

How could this happen in a Nordic country? Let’s call a spade a spade – Iceland is not so much a scaled-down version of Scandinavia as it is of Italy, Japan, and Russia with a dash of Denmark. Iceland is a clan-based society more heavily permeated by politics than any other in Northern or Western Europe. From 1927 onward, the country was governed by two political parties, one or the other if not both at once, that could count on a hefty majority of the vote. The Independence Party and Progressive Party divided the spoils of office in all manner of ways. The government in power since May 2009 is the first majority government to include neither of those two parties and where, significantly, the ministry of justice is not run by either of them.

While they could, the two parties hushed up scandal after scandal in the state banks where, of course, they ran the show (and the smaller opposition parties, now in power, sheepishly went along). They regulated the fisheries by presenting hugely valuable catch quotas, a common property by law, free of charge to boat owners who almost surely, and secretly, filled their party coffers in return.2 When time came, at last, to privatise the banks, two of the three were handed on a silver plate to party cronies, including one with a known criminal record. The new owners ran the banks to the ground in record time, inflicting on their foreign creditors financial losses equivalent to up to five times the country’s annual GDP in addition to the enormous damage done to the people of Iceland. This may help explain why many Icelandic politicians were not particularly keen on EU membership. Czech President Václav Havel wrote some years ago that only criminals had something to fear from EU membership. Get my drift?

Rebuilding trust

The second new argument concerns the need to rebuild cohesion, confidence, and trust. The people of Iceland have expressed their anger at the political establishment, banging their pots and pans loudly enough in the streets to bring about a change of government. Even before the crash, opinion polls showed that only 30% of the population had confidence in the parliament or the judicial system that the political class created in its own image. The populace understands perfectly well what happened. Aided and abetted by politicians, the owners of the banks robbed them in broad daylight (in the method described by Black 2005). And not just the banks: one of the largest insurance companies as well as the national airline suffered the same fate as the banks and had to be nationalised, and no doubt others will follow. Writer Einar Már Gudmundsson captures the essence of these goings-on by recounting a parable of a cannibal flying first class (Gudmundsson 2009). When a stewardess hands him the menu, he looks at her and says: Nothing on the menu strikes my fancy. Could you please show me the passenger list?

Iceland’s recovery from the crash must rest on two pillars. First, the government must effectively implement the reconstruction program supported by the IMF as well as by Denmark, Finland, Norway, Sweden, Russia, Poland, and the Faroe Islands. The EU membership application ought to send an encouraging signal to the world community that Iceland intends to clean up its act. Second, the authorities must uncover and squarely face the causes of the collapse, including the massive failure of policy and institutions and the conspicuous absence of checks and balances. For this to be done properly, Iceland needs an international Commission of Enquiry. The government, however, is unwilling to appoint an international commission, preferring its own domestic investigative committee and thus risking a deepening crisis of confidence if the committee fails to convince the public that it has adequately exposed the rot that caused the crisis. There is a mountain of popular mistrust against the domestic investigation. Under pressure, the government tardily accepted an offer of help from Eva Joly, a renowned French-Norwegian magistrate who led the biggest fraud inquiry in Europe since the Second World War, involving France’s leading oil company, Elf Aquitaine.

I believe the people of Iceland comprehend that foreign assistance and understanding in a time of crisis need to be earned. We demand full disclosure. We hope that Iceland’s friends and neighbours in Europe will not leave us out in the cold on account of an inept political class that created the mess, refused to apologise for any wrongdoing, and insists on running the cleanup as well as the investigation into what went wrong.

Footnotes

1. The share of the Icelandic labour force with no more than primary education is 37% compared with 16-23% in Denmark, Finland, Norway, and Sweden. Source: OECD, Education at a Glance 2007, table A1.2a.

2. The UN Committee on Human Rights, the international community’s highest authority on human rights, ruled in 2007 that the Icelandic fisheries management system, by its discriminatory nature, constitutes a violation of human rights and has instructed the Icelandic government to change the system. The Icelandic government’s official reaction was that the UN Committee had misunderstood the matter.

References

Black, William (2005). The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry, University of Texas Press.

Danielsson, Jon, 2008, “How bad could the crisis get? Lessons from Iceland”, VoxEU.org, 12 November.

Danielsson, Jon and Gylfi Zoega, 2009, “Government failures in Iceland: Entranced by banking”, VoxEU.org, 9 February.

Gudmundsson, Einar Már (2009). Hvíta bókin (The White Book), Forlagid, JPV útgáfa.

Gylfason, Thorvaldur (2008a). “Events in Iceland: Skating on thing ice?” VoxEU.org, 7 April.

Gylfason, Thorvaldur (2008b). “Iceland and its financial predicament: History and context” VoxEU.org, 10 July.

Zoega, Gylfi (2008). “Iceland’s historical moment”, VoxEU.org, 27 November.

 

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Topics:  Europe's nations and regions

Tags:  Iceland, EU membership

Professor of Economics, University of Iceland; Research Fellow, CESifo and CEPR Research Fellow

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