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II. Economic policy
The main objective of economic policies is, as before, to maintain stability and create conditions for sustainable growth and rising living standards. Under current circumstances, the focus is primarily on preventing overheating which could threaten stability. This is the main task of monetary and fiscal policies.
In addition to maintaining stability, it is essential to continue the structural reforms that have been implemented in the recent period. The goal is to enhance market orientation in as many areas as possible. Such reforms as presently being implemented in the financial market area and the first steps are being taken in other areas, such as energy and telecommunications.
In preparing the incorporation of the National Bank of Iceland and the Agricultural Bank great emphasis was placed on ensuring their market positions, on securing a successful transformation and on safeguarding the financial interests of the Treasury. These changes are part of a comprehensive approach to the financial market and take account of each other.
The merger of the Industrial Loan Fund, the Industrial Development Fund, the Export Credit Fund and the Fisheries Fund creates two institutions, the Icelandic Investment Bank and the New Business Venture Fund. This eliminates artificial walls between sectors and creates strong institutions that will be able to operate efficiently in an increasingly competitive environment and to offer their customers favourable loans. At the same time, the state gradually withdraws from the operation of general credit institutions on the financial market but increases its participation in allocation of risk capital. This determination is underscored by the legal provisions that permit the sale of new equity in the National Bank of Iceland and the Agricultural Bank as well as the provisions that allow the sale of up to 49 percent of the equity in the Business Investment Bank.
Monetary policy
Monetary policy has been largely unchanged since September 1995 when the currency basket and fluctuation margins for the exchange rate were altered. The main elements of the policy are as follows:
Capital movements to and from the country have been unrestricted since the beginning of 1995. The experience of other countries indicates that unrestricted capital movements can cause difficulties in the implementation of a stable exchange rate. This has, however, not been the case here and exchange rate fluctuations have been limited compared to other countries.
Through its management of short-term interest rates, the Central Bank influences capital movements to and from the country. In the short run, the Bank can cause changes in capital movements to be reflected in international reserves and thus stabilise the exchange rate. There are, however, limits to both how large and small the Central Bank’s international reserves can become, so that eventually any disequilibrium on the foreign exchange market will affect the exchange rate. Interest and exchange rate policies are, thus, closely connected in the context of unrestricted capital movements. If the goal is to maintain a stable exchange rate the Central Bank’s interest rate policy must be oriented towards this objective. On the other hand, if the exchange rate is flexible to some extent some room is created for active monetary policy to counteract overheating or recession. In addition comes the traditional transmission of monetary policy through the impact of short-term interest rates on long-term rates, which in turn affect the expenditure decisions of households and firms. Unrestricted capital movements, therefore, by no means prevent monetary policy from functioning normally.
High growth and lower unemployment in 1996 and 1997 have brought the economy close to the limits that are compatible with price stability in the long run. These conditions call for a tightening of monetary policy. At the same time, the external conditions have improved because of expanding power intensive industry and the recovery of fish stocks. This implies that the real equilibrium exchange rate has appreciated and offers a choice between achieving this adjustment of the real exchange rate to the higher equilibrium rate through either increased inflation or a higher nominal exchange rate. This assessment lay behind the Central Bank’s decision not to lower interest rates as soon as it became apparent that the inflationary impact of the wage agreements would not be as strong as expected and capital inflows put upward pressure on the krona. Heavy intervention by the Central Bank on the foreign exchange market significantly limited the appreciation of the krona.
Monetary policy has been relatively tight since the Central Bank raised interest rates by 0.4 percentage points in September 1996. A differential of 2½-3 percentage points between domestic and foreign money market rates since this time underscores the relative tightness of policy. Following the Bank’s increase in interest rates the interest rate differential widened to 2.8 percentage points. It widened further at the beginning of this year, to a peak in excess of 3 percentage points, but has since narrowed because of rising interest rates abroad. The interest rate differential is currently 2½ percentage points. This policy should be assessed in light of the wage agreements concluded in March, which bordered on exceeding the limits compatible with continued stability. Negotiated wage increases were in the range 5½-6 percent, which is considerably higher than expected wage increases in trading partner countries. The outlook was for inflation to exceed 3 percent at an annual rate during the first months of 1997. However, developments subsequent to the wage agreements were favourable. Inflation was lower than forecast.
Inflation expectations, which could be judged from the differential between the yields on non-indexed and indexed securities with the same maturity, also declined rapidly. Significant capital inflows from April into July lead to an appreciation of the krona despite efforts by the Central Bank to stem the appreciation through purchases of foreign currency. Had this development continued, the need to examine the possibility of lowering short-term interest rates would have arisen. Other indicators, such as from the labour market and monetary aggregates, would, however, also have had to be taken into account in judging whether it would have been safe to lower interest rates without risking stability and the goal of low inflation. Lower inflation expectations and increased confidence in stability implied that an unchanged nominal interest rate differential against foreign currencies indicated a relatively greater tightness of the monetary stand. No response was, therefore, made to the rise in foreign interest rates over the summer months and the nominal interest rate differential continued to narrow, although the Central Bank was of the view that great caution was required because of the danger of overheating.
Developments in August were far less favourable. Currency flowed out of the country and the krona weakened by 0.7 percent in the course of the month. This weakening of the exchange rate corresponds to some loosening of the monetary stance. Inflationary expectations also rose according to movements in the differential between non-indexed and indexed yields. In addition, the increase in lending in July was substantial. Thus, the conditions have not been established that would allow changes to the Central Bank’s interest rate policy. Changes to instrumental rates, in either direction, will be determined on the basis of the development of those indicators, which the Bank uses most intensely in assessing circumstances. Treasury finances will enter the picture. The better the outcome in 1997 and the tighter the 1998 budget, the lower should interest rates be all other things equal. The same applies to local government finances.
As mentioned above, the differential between domestic and foreign three-month money market rates at the beginning of September was a round 2½-percentage point. The differential for five-year government notes was even higher at close to 3 percentage points. Indexed yields, on the other hand, are typically 1-2 percentage points higher than in countries where indexed government securities are issued. This differential is higher than is desirable in the long run. However, no lasting success will be obtained form efforts from the Central Bank to lower short-term interest rates in the absence of clear indications that this would be compatible with continued stability and low inflation. The underlying cause of the problem, too low national savings, must be addressed directly. The quickest and most reliable way to increase national saving is to improve government finances.
Fiscal policy
The 1998 budget proposal reflects the main focal points of the Government’s economic policies. For the second year running a surplus is projected, following continuous deficits since the mid-1980s. A fiscal surplus for two years in a row underscores the success that has been achieved in economic policy implementation and is in conformity with the initial policy declaration of the coalition Government of the Independence Party and the Progressive Party. The first step towards balance was taken with the 1996 budget. It is important to aim for additional fiscal surpluses over the coming years to strengthen national savings, lower treasury debt and reduce the interest burden earlier debt accumulation has caused. A stronger fiscal position has also made it possible to lower household taxation and increase expenditure on health care and education.
In co-operation with the social partners, the personal income tax system has been revised in order to reduce marginal effects. Both the possibilities of lowering tax rates and of diminishing the means testing of various benefit payments was examined. This work, carried out under the auspices of the Marginal Tax Commission, led the Government to decide to lower the personal income tax considerably during 1997-99. In addition, it was decided by law that the amount of tax-free income would rise by 2.5 percent per year over the next three years. In addition, the rate at which child benefits decline as a result of higher earnings was lowered with the aim of reducing the marginal impact of child benefits, following earlier steps with the same aim taken in 1996. Furthermore, the Government decided last spring on changes to social insurance payments that sharply reduce the marginal effects of these payments, inter alia in connection with extra payments related to the purchase cost of medicines and the exemption from payment of the user fee for state radio and television. The Government has also recently decided to lower the marginal effect of student loans by lowering the repayment rate -in relation to gross income- of loans. These decisions represent important steps towards lowering marginal taxes and reducing means testing.
Economic stability has made it possible to look further ahead and begin to prepare for foreseeable demographic changes, not least related to the changing age composition of the population. The Government is having work done on reviewing the pension system in order to strengthen its basis further and increase the variety of options for long-term saving. This ensures that working life earnings will suffice for retirement. The future role social insurance will first and foremost be to provide a social safety net for the most severely disadvantaged, including the disabled, with minimal other income.
Recently, it has become better understood and accepted that fiscal balance is necessary for economic stability. Furthermore, in many countries emphasis has been placed on shrinking the public sector and on allowing private initiative to flourish. This has also been the case in Iceland. As the financial markets have been liberated co-operation between domestic and foreign individuals and firms has grown rapidly. Icelandic firms have increasingly invested abroad, following years of stagnation, foreign investment in power intensive industry has resumed, which in turns calls for large scale investment in power plants. There is no doubt that these developments spur growth and employment creation. Important steps have already been taken to reduce state influence on financial markets, inter alia through the incorporation of some state-owned financial institutions and their eventual privatisation.
Until fairly recently, the Icelandic economy was, like the economies of the other Nordic countries, going through a difficult stretch. In order to strengthen economic foundations and spur economic growth and employment creation, it has proved necessary to implement various restrictive fiscal measures not only in Iceland but also in other Nordic countries. It is generally accepted that a flourishing economy, with a growing number of jobs and rising value added are preconditions for improvements in welfare. A recent Nordic report confirms that the measures that have been implemented in recent years have led to strong economic growth, declining unemployment, falling interest rates and fiscal balance without serious distortions to income distribution, partly because of special measures aimed at protecting those most seriously disadvantaged. Through effective measures the basis for economic activity, as well as that of the welfare society, has, thus, been strengthened.
The Government has been largely successful in achieving its economic goals. Economic stability prevails, and economic growth is higher than among neighbouring countries, against which comparisons are most frequently drawn. Wage agreements for the next three years have been concluded without threatening price stability. Households have benefited from these achievements, as the projected 20 percent increase in real disposable income between 1995 and 2000 underscores.
These achievements are noteworthy, not only in an Icelandic context, but also internationally. Thus, Iceland, one of very few European countries, has recently met all the conditions of the Maastricht treaty concerning fiscal deficits, government debt, inflation and interest rates. This has also led the US ratings firms Moody’s and Standard & Poor’s to twice raise their credit ratings for the Icelandic Treasury in the recent period, on the basis of the significant success that firm and responsible economic management has achieved. In addition, economic policy has strengthened the relative competitive position of firms as surveys by two foreign companies show; Iceland’s ranking is now considerably higher than 5-10 years ago.
While the success is certainly palpable it is necessary to bear in mind that it was not automatic. The economic history of Iceland provides many examples of lax economic management, particularly in good years. It is, therefore, essential to strive to secure the economic stability that has been achieved, as it can easily be squandered. A strong fiscal position that aims to lower state debt in the coming years is a precondition for continued economic upswing in Iceland.
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