Macroeconomic Position of Iceland as of 2006 - Essay Example

Iceland: Land of Economic Fire and Ice YOUR FULL YOUR INSTITUION OR SCHOOL Iceland: Land of Economic Fire and Ice Promoted by its tourism board as the land of fire and ice, Iceland is an island nation with a population of approximately 300,000 citizens. It is located in the North Atlantic between Europe and the North American continent and is often overlooked because of its diminutive size. The nation’s capital city of Reykjavik, however, is generally known to be a sophisticated European capitol city that is increasingly popular with eco-tourists and other visitors. Its economy is quite strong, and the government policy needs to focus on keeping it that way. General Introduction to the Economy Iceland has a Scandinavian-type economy that is primarily capitalistic, yet there is an extensive welfare system that includes generous housing subsidies and the nation’s domestic economy is characterized by low unemployment and a remarkably even distribution of income. (Iceland 2006: 7) The national economy depends heavily on the fishing industry, which provides more than 60% of total export earnings and employs 12% of the work force. The government is very sensitive to the issue of declining fish stocks as well as to fluctuations in world prices for its main exports: fish and fish products, aluminum, diatomite and ferrosilicon. (Economy of Iceland 2006: 4) Iceland’s economy has been diversifying into manufacturing and service industries in the last decade and new developments in software production, biotechnology, and financial services are taking place. The tourism sector is also expanding, with recent trends in eco-tourism such as whale watching, hiking, and nature tours growing steadily. Iceland’s economic performance has been characterized as “impressive,” and is seen to be the direct result of the government “refocusing policies on financial stabilisation and market liberalisation.” (Suppanz and Laubach 2005: 1) Although Iceland suffered the same fate as other modern, industrialized countries in the global recession of 2002, its most recent recovery “has been much more vigorous than expected, as buoyant household demand has reinforced the stimulatory effect of the large-scale aluminum-related investment projects underway.” (Suppanz 2005: 1) In fact, the annual growth of GDP was a vigorous 4% in 2003 and 5.2% in 2004. (World Bank 2005: 1) Thus, it can be fairly stated that the overall economy of Iceland is very strong; perhaps too strong. A major concern among policy makers now is inflation. The robust financial and property markets are driving a wage/price spiral that is exceeding the initial policy moves of the Central Bank. As discussed in further detail within the assessment portion of this paper, the Icelandic position toward stabelisation and liberalisation has improved the economic environment and the resulting productivity growth has given rise to a per capita income that is increasing at a faster rate than other European countries. (Suppanz 2005: 2) Predictably, as the result of this growth in consumer income, equity and property prices have increased significantly. If policy does not get this under control, then a correction is sure to follow. With only modest budget surpluses and a high external debt by international standards (Suppanz 2005: 2), the effects of such an adjustment in prices would present a fiscal crisis. Economic policy needs to focus on maintaining controlled, sustainable growth without over-heating the markets. Descriptive Statistics A study of the available statistics will provide a more accurate understanding of the macroeconomic issues present, and guide the discussion of policy options to address the problems. The first area of study is that of domestic production. As noted previously, Iceland mainly exports fish and fish products, as it ramps up its manufacturing, service, and tourism industries. Although Gross Domestic Production (GDP) is not as high as it has been in times past, the data demonstrates a solid recovery from the 2002 recession: Figure 1, Central Bank of Iceland 2006: 5 Unfortunately, the graph also indicates the rate of national expenditure, which has grown at an alarming rate. When the 2003 economic activity “rebounded, the general government budget moved into substantial deficit.” (Suppanz 2005: 4) This will require policy adjustments. The increase in wages over the past few years, coupled with an unemployment rate of less than 2%, has fueled consumer spending. Noted below, the wage index for the latest period has increased by 8.3%, giving consumers a significantly higher level of disposable income: Figure 2, Central Bank of Iceland 2006: 3 Predictably, the increase in general economic growth is combining with low unemployment and higher personal income to cause inflationary pressures. The Central Bank effectively adopted a strategy targeting inflation in 2001, and succeeded in bringing “both 12-month consumer price increases and inflation expectations...down to the official objective of 2½ per cent. (Suppanz 2005: 3) As the chart below demonstrates, however, both consumer price inflation and core inflation are demonstrably higher than the rate targeted by the Central Bank: Figure 3, Central Bank of Iceland 2006: 4 Any casual observer can see that the current inflation rates pale at the comparison of the 2001-2002 era, but that provides little comfort for policy makers. The short-term downward motion is only a temporary pull-back within a longer growth pattern. This issue has to be addressed at the highest policy levels. Assessment of Macroeconomic Policies and Options As Iceland has focused on leveling its financial landscape and opening its markets, it has created an imbalance in the economy. The resulting volatility threatens a return to the previous days of economic overheating. (Suppanz 2005: 2) With an eye towards a prosperous future, in terms of monetary policy, the Central Bank needs to address that discrepancy by increasing interest rates immediately. As America learned in the 1970’s, rampant inflation has devastating consequences on the national economy. Evidenced in Figure 3, the Icelandic inflation rate is climbing precipitously. Only a tight check of that condition will allow the leadership to position the economy for resolution of the issues. The economy in Iceland is robust and relatively stable now, but failure to get this situation under control could reverse those conditions rapidly. With a high standard of living, Icelanders are investing, buying real estate and purchasing consumer products. Real estate and housing values, as well as the investor loans that enable them, significantly impact inflationary pressures. As these markets heat up, it is a fundamental proposition that values are going to rise; simply as a function of supply and demand. The supply of property is finite, and the demand is growing. This increases value. If interest rate policy permits investors and citizens to bid up the prices because of the ease of obtaining relatively cheap funding, there will be an unsustainable bubble. When that bubble bursts, the economy will suffer significant damage. Accordingly, interest rates must be increased so that the money supply is restricted. This is the single most effective method immediately available to balance stability with opportunity. In terms of fiscal policy, Iceland needs to adjust its approach so that the monetary policy can be adequately supported without resorting to continued and severe hikes in the interest rate. Simply, this means tightening its budget maintenance, reducing its debt, and enhancing the environment for investment. Whether the scope analysis is a family budget or a national financial plan, it is always true that excessive spending is disastrous. As shown in Figure 1, the national expenditure is dramatically increasing. Current forecasts for modest surpluses will soon prove woefully inadequate if spending is not reigned in. Further, the Icelandic external debt is one of the highest in the OECD, “heightening the risks associated with sharp exchange-rate swings...or policy slippages.” (Suppanz 2005: 2-3) Manageable external debt is not a policy problem, but when that liability becomes too large it can negatively impact future stability, growth, and development. Finally, there must continue to be a positive climate for investment. In terms of real property values, Iceland will soon have investor problems. Unless the domestic productivity growth is stable and sustainable, investment becomes speculation. Historically, we know that rampant speculation fuels an overheated economy with potentially devastating results. As for a long-term monetary policy solution, Suppanz sets forth the idea that productivity growth can be enhanced through human capital development. (2005: 3) The idea here is that Iceland needs to diversify away from its dependence upon a depleting natural resource (fishing) and focus upon developing other production sectors such as technology- or information-based pursuits, as well as tourism. From a macroeconomic view, this makes perfect sense; dependence upon an exhaustible resource is not a formula for sustainable future development. Through development of theoretically infinite sources of production such as technology and information delivery, and making good use of its beautiful land and pristine waterways, Iceland can assure stability in its domestic output and have confident reliance upon that resource for the foreseeable future. Conclusion At this moment, the Icelandic economy is strong and durable. The production sector is sturdy, the labor market is very healthy, and inflation is not yet out of control. The economy, however, is not without threats to continued stability and growth. Iceland’s primary source of export revenue is a fishing industry imperiled by the vagaries of environment, availability, and distribution. The employment numbers are good, but any disruption of current output will change that immediately. Inflation, driven by overheating real estate and investment markets, is growing. These issues need to be resolved immediately. Through prudent monetary policy, inflation can be tamed. By implementing wise fiscal policy, expenses and debt can be reduced. The land of fire and ice needs to control the heat of its economy by applying cool restraint. With these two policy approaches, Icelandic officials will create the stable, secure, and prosperous future they need. References Central Bank of Iceland (2006). Economic Indicators: February 2006, 1-12 Economy of Iceland (2006). Wikipedia, Retrieved March 9, 2009, from http://en.wikipedia.org/wiki/Economy_of_Iceland Iceland (2006). Economy. In The World Factbook (Sec. 5). Retrieved March 9, 2006, from http://www.cia.gov./cia/ publications/factbook/geos/ic.html Suppanz, H. & Laubach, T. (205), Economic Survey of Iceland, 2005. OECD Policy Brief, 1-7 World Bank Group (2005). Iceland Data Profile. Retrieved March 9, 2006, from http://devdata.worldbank.org/external/ CPProfile.asp?PTYPE=CP&CCODE=ISL Read More