10 lessons from Icelandic monetary history
Monetary policy over the past few decades shall be assessed to the extent that this has not been done
previously, such as in the Central Bank’s 2012 report entitled “Iceland’s currency and exchange rate
policy options.”
An in-depth comparison shall be carried out of the advantages and disadvantages of monetary policy
frameworks according to Items 2 and 3, as regards the contribution of monetary policy, in concert withother economic policies, to economic and financial stability.

One hundred years of solitude
In Iceland’s campaign for independence, currency issues were never mentioned. It was automaticallyassumed that Iceland would remain in a currency union with the Nordic countries as an independent
entity — as the Norwegians had done when they separated from Sweden in 1905. Participation in
Nordic Currency Union was actually written into the agreement made when Iceland was grantedsovereignty in 1918. This currency cooperation was based on the gold standard, as most of the world’s
currencies did at that time.
Icelanders woke up as from a bad dream, however, after the war ended. Not only had the currency
cooperation among the other Nordic countries disintegrated, but Iceland began its life as a sovereign
nation by becoming insolvent. During the war, inflation ran amok, with the associated rise in the realexchange rate and imports, and afterwards, marine product prices fell, and the products themselves
became difficult to sell. Actually, this appears to have taken everyone by surprise. In summer 1920,
officials at the Icelandic Treasury tried to cash a mail order cheque from Íslandsbanki (then functioning
as the country’s central bank) in Copenhagen. The cheque bounced. Over the next winter, it proved
necessary to ration necessities in Iceland because of a currency shortage, until efforts to sell marine
products bore fruit and a loan from Britain could be negotiated.
Ever since the rubber check bounced in Copenhagen in 1920, there has been vociferous discussion of
exchange rate and monetary policy issues in Iceland — committees have been appointed, foreign
experts have been hired to write opinions, and the topics have been hotly debated from the chambersof Parliament to cafés and kitchens all over the country. And we are still at it.
Over the 100 years of Iceland’s sovereignty and full control of its own monetary affairs, a number ofthings have been tried. Icelanders have been in a currency union, used the gold standard, and tried a
fixed exchange rate with capital controls and an exchange rate peg within the Bretton Woods system.
Experiments have been done with money supply targeting, real exchange rate targeting, and a fixedexchange rate with shadow membership of the European Monetary System (EMS). Icelanders havealso tried an inflation target with a free-floating exchange rate and now, since 2009, a flexible inflation
target supported by capital controls. In the following summary, an attempt has been made to discusseach of these policies — how they have turned out and what has gone amiss with theirimplementation. The world has changed — Iceland has changed — over these 100 years, yetnevertheless, the economic principles are the same, and the same themes always reappear when it
comes to monetary policy conduct. As a result, it should not be inappropriate to try to learn somelessons from the experiments that we have undertaken to date.

In the view of the authors, the following 10 lessons can be learned from Iceland’s 100-year monetaryhistory.

Lesson 1 – Following the rules of the game is more important than which game isselected
All currency frameworks have their pros and cons, which have been discussed in innumerable reports
through the years. On the other hand, much less has been said about the ground rules for eachframework. The fact is, however, that it is not of principal importance which framework is chosen;
what is more important is to follow the ground rules required by each framework at any given time.
The reason Icelanders have generally lived with instability and inflation since becoming a sovereign
nation is not that they have always chosen the wrong monetary policy framework, or that they have
not yet found the one that best suits them. The reason is that they have not followed the ground rules
required by each framework — neither as regards application of economic policy instruments nor as
regards maintaining general economic stability. Because of this, each monetary policy framework thathas been in effect has disintegrated, and the nation has been forced to tolerate persistent instability
and the highest known interest rates in the Western world.
Iceland is not unique in this regard, however. Other countries have also found it difficult to abide by
the rules of the game. For example, the gold standard was abandoned because the ground rules
accompanying it — such as that inflation should be corrected with deflation — proved too costly in
execution and became politically infeasible as the twentieth century advanced. The same applies tothe Bretton Woods fixed exchange rate system, which collapsed because the United States no longer
wanted to follow the rules. Other countries also lost control of inflation after the fall of Bretton Woods
in 1971-1973, as Iceland did. The same happened within the European Monetary Union. Many member
countries, particularly in the Mediterranean region, have been unable to follow the ground rules
demanded by a common currency, and this has led to economic crisis. On the other hand, Iceland’s
deviation from the rules has been much more pronounced than that in other countries — it is as though
the country has not really even tried to follow the rules required by monetary policy at any given time.
Unfortunately, Iceland itself has borne the brunt of this.

Lesson 2 – Economic policy needs political support
In the 1920s, a new system of political parties emerged based on class struggle, one comprising fourmain parties. For some reason, conventional economic policy, which is based on applying monetaryand fiscal policy instruments so as to mitigate cyclical volatility, has never gained a foothold in this“new” system. Other political goals — employment issues, social welfare issues, regional policy, or
simply the desire to win the next elections — have always taken priority over the task of maintaining
economic stability. This can be seen in the fact that the country’s central bank did not have the politicalauthorisation to apply the policy interest rate until the beginning of the twenty-first century. It canalso be seen in the fact that fiscal policy has not been applied so as to maintain stability; for example,
by curbing spending during boom times.
This political assessment of interests is at odds with the interests of the nation, however, as the social
cost associated with not applying these instruments appropriately is enormous. This cost showed in
the imposition of broad-based capital controls in 1931-1960, in runaway inflation in 1971-1989, and in
the turmoil of 2001 and 2008. Developments in recent years cast substantial doubt on whether the
fiscal budget and Government actions, as well as the actions taken by Government institutions, have

given sufficient consideration to the inflation target. The Central Bank has generally stood virtuallyalone and unsupported in its fight against inflation, although the new Act on Public Finances has
improved matters in the past few years.
Iceland is a democratic country, and its elected representatives reflect the voters’ choices. The
problem lies not in individual persons or political parties but in the type of democratic culture
Icelanders have adopted. Perhaps this is also a question of democratic knowledge: whether voters
understand cause-and-effect relationships as they apply to economic affairs. It is clear, however, thatno monetary policy in a democratic country will be successful — at least not in the long run — without
broad-based political support.

Lesson 3 – Stability in the labour market is the cornerstone of price stability
A strike undertaken by eight labour unions on 2 January 1941 was a historical watershed. After thatdate, nominal wages generally rose much faster than can be considered consistent with appropriate
real wage growth. Real wage growth stems from productivity — how much increased value isgenerated by each hour worked. Underpinning productivity are technological advancements,
improved education, and strong social foundations. In the long run, productivity can be expected to
grow by 1-2% per year, and that is exactly the rate at which real wages have grown, on average.
Nominal wage rises in excess of this deliver only inflation.
In such a small, open economy as Iceland’s, where a large share of consumer goods are imported, it ispossible to achieve additional real wage growth if terms of trade and exports develop very favourably.
In addition, nominal wage rises in excess of productivity can generate purchasing power that stems
from a higher real exchange rate and lower import prices. These benefits are generally short-lived —and they generally reverse. Wage rises in excess of productivity are bound to erode Iceland’scompetitive position and cut into exports, while simultaneously encouraging imports. The result is acurrent account deficit that must be financed by borrowing abroad, but this can only be done for alimited time. Sooner or later, a current account deficit will push the country into insolvency unless thereal exchange rate is corrected with a currency devaluation, which generally causes inflation and brings
purchasing power back down to a realistic level.
In 1980, Jónas Haralz, then a director of Landsbanki Íslands, delivered a lecture to the Association ofBusiness Specialists and Economists on the reasons why Iceland was such a high-inflation country. In
his view, Iceland’s inflation stemmed from two main causes: on the one hand, fluctuations in fishing,which called for regular currency devaluations, and on the other, disputes about the division of thenation’s “spoils”, with inflation as a sort of “arbitrated ruling in a societal tug-of-war”. Jónas wasreferring to the long-standing objective of wage agreements, which had been to maintain the wage
differential between occupational groups. And because the groups themselves were generally not inagreement about what that differential should be, wage agreements would become a game of leapfrog, with each group in turn arguing for a “correction of wages.” The repercussions of this tug-of-war
showed in steep nominal wage rises well in excess the economy’s capacity to pay — which theeconomy then had to mitigate through inflation and a decline in real wages, often after a significant
drop in the exchange rate. 1

This lecture was later published as a chapter entitled Í ljósi reynslunnar (In view of experience) in acompendium of Jónas’ work entitled Velferðaríki á villigötum (A welfare state on the wrong path). Jónas H.
Haralz. (1981). Velferðarríki á villigötum: úrval greina frá áttunda áratugnum. (A welfare state on the wrong
path: a selection of papers from the 1970s). Reykjavík: Félag frjálshyggjumanna.
1

If Jónas Haralz was right, it is the tension between classes or occupational groups that is the root cause
of inflation, as the fact is that Icelanders do not agree on what the wage differential should be between
various groups in society: between labourers and university-educated employees, between flightattendants and land-based service employees, between teachers and people in retail or wholesaletrade, between members of Parliament and disability pensioners, between the Bishop of Iceland andregular wage-earners. There is no consensus on this in Iceland, unlike the situation in other Nordic
countries.
The fact is that the wage gap is generally rather small in Iceland compared to that abroad. It is also truethat the lowest pay scales in Iceland have risen much more than the wages of the middle-class in recent
years. Third, it is true that remuneration for education is much less in Iceland than elsewhere in theOECD, especially in terms of disposable income. And finally, it is a fact that the low inflation in Iceland
since 2014 has delivered enormous benefits to Icelandic wage-earners in the form of increased
purchasing power — because large nominal pay hikes have not triggered a surge in inflation.
Nevertheless, class unrest appears to be on the rise in Iceland, and it could easily lead to economic
instability, as it has done so often before.
A simple rule of thumb indicates that, with a 2.5% inflation target and 1-2% productivity growth,nominal wages may not rise more than 3,5-4.5% per year in the long run without destabilising policy.
Over the past five years, nominal wage rises have measured 8% per year. This is not sustainable.
Actually, no monetary policy framework will be successful in Iceland as long as this class unrest causes
nominal wages to rise at the pace seen in recent years and decades. Iceland can only ensure low
inflation in the long run if there is some sort of consensus among wage-earner groups on wage
decisions — because labour market stability is the cornerstone of price stability.

Lesson 4 – Icelanders long for a stable exchange rate but do not have the tenacity
required
Reviewing Iceland’s currency history shows clearly that Icelanders have generally preferred a fixedexchange rate. To this end, they have participated directly or indirectly in the pegged exchange rate
regimes on offer at any given time in Western Europe: the Nordic currency union, the gold standard,
Bretton Woods, or the EMS — until the creation of the euro in 1998. The roots of this desire probably
lie in the extreme impact that exchange rate movements have on the entire economy, where as soon
as the króna begins to move, funds are shifted between sectors, between consumers and companies,
between creditors and debtors, and so forth. Of course, it is abundantly clear that such exchange rate
movements can serve a positive economic purpose if they are aligned with the business cycle position.
Furthermore, a flexible exchange rate can provide a cushion against the impact of changes in export
revenues on the general economy. The rise in the exchange rate of the króna in the recent term is notin and of itself abnormal, given the boom in tourism. Nevertheless, businesses and the general public
are discomfited by these movements.
The Danes’ opinion on currency matters resembles that of Icelanders, in that they have had a unilateral
pegged exchange rate since 1981. This peg has been successful because the Danish nation is aware of
the ground rules that this entails, and there is broad-based agreement in Danish society that economic
policy should be conducted in accordance with it. There is also a widespread understanding that wages
in Denmark cannot rise in excess of wages in the countries to which the peg extends; they are correctedwith productivity. If such a thing happens, the real exchange rate will rise and erode the competitive
position, which will ultimately surface in a current account deficit that will derail the fixed exchange
rate regime.

To be sure, a fixed exchange rate is more difficult to pursue in Iceland than in Denmark, as Iceland’s
exports are less diverse. Iceland is an island, and it does not have the same economic connections to
any single currency, unlike Denmark, which is contiguous with Germany. It is also true that thecredibility of Denmark’s pegged exchange rate regime is guaranteed to an extent by the backing of theEuropean Central Bank. On the other hand, it has been an oft-repeated refrain throughout Iceland’s
history as a sovereign state that Icelanders have not had the patience needed to achieve their goal of
maintaining a fixed exchange rate. Unlike the Danes, Icelanders have been unable to maintain theeconomic policy needed to sustain a fixed exchange rate. As a result, they have often resorted to thetime-honoured Icelandic response of patching up their fixed exchange rate policy with capital controls.
The one exception to this is the beginning of the fixed exchange rate regime in 1989, which was
supported by a broad-based consensus in the labour market — known as national reconciliation — but
over time, economic policy grew looser and looser, and nominal wage rises took off again, resulting in
the collapse of the exchange rate regime in 2001.
Actually, every single upswing since World War II has ended in economic overheating and steep wage
cost increases for the economy, which have then been compensated for with currency depreciationand inflation. In this context, it is worth noting that even though the exchange rate collapse in 2008
cannot be considered anything but an adjustment following the overexpansion and outsized current
account deficit of the years preceding, in public discourse it was labelled a case of breached premises.
This breach appeared to be viewed as a mixture of accident and conspiracy that had to be “corrected”
with the payment of benefits. In this way, the nation appears now, as before, to be demanding a fixedexchange rate.
A fixed exchange rate is only possible through the pursuit of new economic policy practices —particularly to include fiscal policy and wage-setting in the labour market — because it will be
extremely painful for the economy to regain its competitiveness through nominal pay cuts. Perhaps
Icelanders can change their ways and adopt increased discipline, as they did to a degree in the 1920s,
when the objective was to participate in the international gold standard, or in the 1960s, when Iceland
was a full participant in Bretton Woods. The question arises whether this is actually feasible. Apartfrom this, it is clear that the demand will generally be made that long-term monetary policy entail
exchange rate stability.

Lesson 5 – The balance of payments is the axle of Icelandic economic policy
Surveying Iceland’s economic history from sovereignty to the present shows that developments in thebalance of payments have been the axle of Icelandic economic policy. The balance of payments is thesum of the current account balance and the capital account balance, which by definition is always zero.
Iceland’s balance of payments has been very volatile for two reasons. First of all, it is because of how
homogeneous Iceland’s exports have been, with one export sector generally driving the economy at
any given time. Early on, the fishing industry was the dominant sector, then financial services, and now
it is tourism. In Iceland’s history it has often happened that export revenues have dropped because offactors such as a decline in marine product prices or a catch failure, and the country has been facedwith a current account deficit. The second reason for this volatility is the fact that growth in domestic
demand always shows in strong imports, owing to the country’s small size. The impact will be evenstronger if this surge in demand leads to overheating, inflation, and pay hikes, which is such a classic
pattern in Iceland. Another result of this is a current account deficit. These two factors — fluctuations
in exports and an unwillingness to apply conventional economic policy instruments — have led to apersistent balance of payments problem. A current account deficit must be financed either withforeign borrowings or with currency sales from the foreign exchange reserves; otherwise, theexchange rate is bound to fall so that export revenues and import purchases will balance. If it is notpossible to borrow abroad but the exchange rate is held constant, the only outcome can be theprospect of insolvency, as happened in 1920, 1931, and 1945 — to which the response was to impose
restrictions on imports and/or to ration foreign consumer goods.
This balance of payments problem has only grown in recent years, following liberalisation of capitaltransactions and increased global capital flows. The downside of importing capital is that it often leads
to expansion and asset bubbles — and a large current account deficit. The effects are not entirely
symmetric, however. Imbalances build up gradually, alongside strong inflows, but frequently the
adjustment takes an extreme form: a sudden stop in capital inflows, as occurred in the winter of
2000/2001, or large-scale outflows of liquidity, as occurred in the autumn of 2008. Concurrent with
this, tourism has taken over from the fishing industry as the leader in export revenue generation, but
it is subject to the same risks. It is not difficult to foresee a downturn in the sale of trips to Iceland in
the wake of changes in the global economy, as has often happened in the fishing industry.
Iceland’s unstable balance of payments creates a significant problem for Icelandic monetary policy, as
the wide interest rate differential with abroad attracts foreign venture capital and upsets the balanceof the economy, as it did in 2004-2008. In 2001, a 20-30% depreciation of the króna sufficed to turnthe current account deficit into a surplus and normalise the foreign exchange market. In 2008, a 50%
depreciation was not enough, as foreign currency speculators had such large positions (about ISK 650bn) in the Icelandic financial system. As a result, Iceland was actually insolvent. Imposing capital
controls was therefore a last-resort solution at that time.
In her paper Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence,
Hélène Rey argued that independent monetary policy was actually impossible if global capital
movements were unrestricted: “ ... independent monetary policies are possible if and only if the capital
account is managed, directly or indirectly, regardless of the exchange‐rate regime.” 2
It is abundantly clear that the Central Bank must be manage developments in the balance of payments
in order to be able to ensure price stability and economic stability — and implement its monetary
policy. The Bank can do this in three ways. First of all, it can impose restrictions on inflows, with theaim of preventing foreign bond investors from pushing the exchange rate of the króna above its
equilibrium rate and building up large foreign exchange positions, as they did before the crisis. Thismethod can only be applied temporarily, however, as capital controls are in contravention of the EEA
Agreement provisions on free movement of capital. The second way is to use the foreign exchange
reserves (currently about ISK 650 bn) to prevent disturbances in the foreign exchange market. The
third method is to use macroprudential tools to impose limitations on debt and credit creation in thefinancial system that could otherwise jeopardise the balance of payments. Perhaps this can be viewed
as a re-design of the policy the Central Bank followed in earlier years with the use of reserve
requirements.
This is always a balancing act, particularly as regards coordination with conventional monetary policy
as entailed in setting the policy rate. Furthermore, it is necessary to find ways to achieve this without

2

Fluctuating exchange rates cannot insulate economies from the global financial cycle, when capital is mobile.
The “trilemma morphs into a “dilemma” – independent monetary policies are possible if and only if the capital
account is managed, directly or indirectly, regardless of the exchange‐rate regime. Hélène Rey. (2018). Dilemma
notTrilemma:
The
GlobalFinancial
http://www.nber.org/papers/w21162

Cycle

and

Monetary

PolicyIndependence.

Accessedatimposing capital controls, which bring with them considerable economic cost. But therein lies theactual guarantee of stability for the future.

Lesson 6 – Financial stability must be the Central Bank’s second objective
On 21 September 2009, the Dutch central bank held a symposium bearing the title Towards a newframework for monetary policy? Lessons from the crisis. 3 In an address entitled Flexible Inflation
Targeting: Lessons from the Financial Crisis, delivered at that symposium, Lars Svensson, then-current
deputy governor of the Swedish central bank, maintained that inflation targeting in action must takethe form of what he called “flexible inflation targeting,” featuring a balance between the price stability
objective and resource utilisation that could be called “well balanced” monetary policy. Financial
stability in and of itself could never be one of the objectives of monetary policy, but must put
constraints on it. 4
It is possible to place Icelandic monetary policy during the period 2004-2008 into context with thisaddress by Svensson: at that time, Iceland had an enormous interest rate differential with abroad, a20-30% current account deficit financed with foreign debt by resident borrowers fleeing Icelandic
interest rates, and position-taking by non-residents seeking to benefit from Icelandic interest rates.
The task entrusted to monetary policy at that time was actually unmanageable. Attempts to achieve
the legally mandated price stability objective with the policy rate as the sole weapon in its arsenalcaused monetary policy to step outside the boundaries Svensson mentions above and to undermine
financial stability. It could well be that the Icelandic banks would have failed irrespective of whichmonetary policy regime had been in place, because they did not have a credible lender of last resort.
On the other hand, the cost of the collapse was much greater than it would have been otherwise
because of the severe balance of payments disequilibrium that had developed during the years
beforehand. This caused foreign exchange risk to escalate out of control. The aftereffects entailed
enormous private sector debt problems resulting from exchange rate-linked loans and the difficulty of
releasing the ISK 650 bn carry trade-related “overhang” that was stranded within the Icelandic financial
system after the capital controls were introduced in November 2008. Fortunately, much of this cost
could be shifted over to foreign creditors or the speculators themselves.
Financial stability generally refers to the assumption that financial markets can carry out their role asmarkets, by distributing capital and risk in the economy and ensuring secure payments. It therefore
carries great significance for a small, open economy because of the interactions between the financial
system and foreign exchange transactions. The reason is simple: When there are net outflows, money
flows from accounts with financial institutions via the foreign exchange market. Financial instability insmall, open economies therefore requires that monetary policy must be applied counter to thebusiness cycle in order to respond to capital flight and a steep drop in the exchange rate. As a result,
it is necessary to raise interest rates substantially and cut back on Government spending to normalise
the balance of payments, even though the economy is headed for a crisis. This is what the countries in
Nout Wellink, Lars Svensson, Marvin Goodfriend, Stephen Roach, Claudio Borio, Charles Goodhart, and Lex
Hoogduin. Workshop Towards a new framework for monetary policy? Lessons from the crisis. De
Nederlandsche Bank. (Accessed at https://www.dnb.nl/en/interest-rates-and-inflation/monetarypolicy/workshop-on-otowards-a-new-framework-for-monetary-policy-lessons-from-the-crisis/index.jsp)
4“One question is whether financial stability belongs in the loss function for the central bank, together with
inflation and resource utilization. I argued that a good way of handling this additional objective is as aconstraint on monetary policy rather than as a separate target variable that appears in the loss function.” Lars
E.O. Svensson. (2009). Flexible Inflation Targeting: Lessons from the Financial Crisis. Sveriges Riksbank.
Accessed at http://archive.riksbank.se/Upload/Dokument_riksbank/Kat_publicerat/Tal/2009/090921e.pdf
3Southeast Asia were forced to do, for example, after they sought assistance from the IMF during theso-called Asian crisis of 1998. These measures were extremely painful and controversial at the time,
but they worked well. The economic downturn was relatively brief, and Asian economies retained theirintegration with global financial markets. Iceland avoided some of this unpleasantness by imposing
capital controls with the approval of the IMF, which considered itself to have learned from theexperience of the Asian crisis in 1998. Perhaps it made a difference that in 2008, Iceland was the firstdeveloped country to seek assistance from the IMF in about three decades, and the Fund was therefore
determined to show that it would handle matters with moderation — that Icelanders would not beforced into a cold shower, as the Asian countries had been previously.
After the Icelandic financial crisis, an important change was implemented with the addition of financial
stability to the Central Bank Act in 2013 as the Bank’s second objective. It is now clear that theapplication of monetary policy henceforth will have to take account of financial stability, which willplace constraints on it — such as how large the interest rate differential with abroad can be without
resorting to new capital controls.

Lesson 7 – Macroprudential policy is the foundation of monetary policy for the future
The Central Bank became an independent institution in 1961, but independent policy rate setting was
not included at the time. Actually, it can be said that the Bank’s independence diminished in thisrespect when the so-called fifteen-member Landsbanki Committee was disbanded. That committee
had been designed to maintain distance from the Government and Parliament. The Bank wasnevertheless required to ensure a fixed exchange rate within the Bretton Woods system, and it
adopted reserve requirements to ensure balance of payments equilibrium. Under these reserve
requirements, the commercial banks had to place 18-27% of their deposits with the Central Bank. This
enabled the Bank to control credit creation in the banking system and manage developments in themoney supply, which then showed in general demand and imports. This appears to have been fairly
successful. There was reasonable stability during this period despite a surge in herring catches and an
overall upswing. On the other hand, the Bank’s power was subsequently taken away, and the Bank wasforced to loan out the capital it had received in the form of reserve requirements through the fisheries’
start-up lending scheme. This turned out to be one of the reasons inflation skyrocketed in the 1970s.
It has often been said that the Great Depression begat macroeconomics as a separate field within
economics, in part because of John Maynard Keynes’ book The General Theory of Employment, Interest
and Money, published in 1936. In the same manner, the Great Financial Crisis has given rise to
macroprudential policy as a separate field within economics and a hot topic of discussion in thediscipline. This new field is still relatively loosely defined, as there is not yet a single manifesto like that
presented by Keynes for macroeconomics. Macroprudential policy aims to maintain financial stability,
which is difficult to quantify, unlike price stability. Macroprudential tools also cover a relatively broad
area that overlaps both with conventional monetary policy — for example, where capital controls
belong is debated — and with financial market rules. It can be said that this new field is still evolving,
and work is now being done to develop the same type of framework for it as is currently in place forconventional monetary policy. 5 More detailed discussion can be found in the report written by Kristin
Forbes for the task force on monetary policy review: Macroprudential Policy after the Crisis: Forging aThor’s Hammer for Financial Stability in Iceland.

Cecilia Skingsley. (2016). Objective-setting and communication of macroprudential policies. Bank forInternational Settlements. Accessed at https://www.bis.org/publ/cgfs57.pdf

5The application of macroprudential tools centres not only on maintaining financial stability, however;this new way of thinking and/or methodology can also hone monetary policy by, for example, curbing
financial institutions’ lending and affecting developments in the money supply, as was done withreserve requirements in an earlier time. As is stated clearly in Kristin Forbes’ report and the abovecited paper by Hélène Rey, the problems associated with free movement of capital are not limited toforeign exchange market instability. They also lie in the fact that global capital flows into the financial
systems of the countries concerned, causing credit and asset price bubbles that subsequently derail
the economy, as was the case in Iceland in 1998-2000 and again in 2004-2008. The application ofmacroprudential policy centres on blunting the impact of foreign capital flows on individual financial
systems and shifting the transmission of monetary policy into the economy through the credit channel.
It is also the case that interest rates are not a particularly effective tool to combat financial bubbles.
Actually, raising interest rates exacerbates the problems associated with asymmetric information,
adverse incentives, or adverse selection. But as the interest rate level rises, “regular” investors
interested in financing “regular” production withdraw from the market. They are replaced by riskseeking speculators who want to profit on rising asset prices and are not deterred by the prospect ofborrowing at high interest rates, as an asset bubble always entails enormous profit until it finally bursts.
It has been said that an interest rate level that would suffice to curb an asset bubble would be so highthat it would paralyse the real economy and therefore be enormously costly.6 By the same token, sucha steep rise in interest rates would cause severe problems in the foreign exchange market, with anoverly high real exchange rate and a current account deficit, which would certainly undermine financial
stability. 7 This should sound familiar to Icelanders who remember the pre-crisis period. Perhaps, then,it is no surprise that Hélène Rey should go so far in her paper is to say that the use of macroprudential
tools is one of the prerequisites for countries to be able to pursue independent monetary policy. 8
But applying macroeconomic policy is no simple matter. There is little doubt that this newly emergedfield will become a pillar of the discipline in the future, but at this point there is little experience of it.
For example, applying reserve requirements in the old way is probably not beneficial, given thecomplex liquidity rules with which modern commercial banks must comply. The Central Bank tried, forinstance, to raise the required reserve ratio in October 2015 but reversed the decision two months
later, as it dried up the banks’ liquidity virtually overnight. On the other hand, it is clear thatmacroprudential policy is the area that currently offers the greatest potential to improve Icelandic
monetary policy, no matter what may happen in the future.

Lesson 8 – Controls erode well-being
In 1843, Jón Sigurðsson (the leader of the movement for Iceland´s independence) published an article
in the third volume of Ný félagsrit (New Social Writings) under the title Um verslun á Íslandi (On tradein Iceland). This is without doubt one of the most influential articles ever written in the Icelandic
language, as it outlines a new political policy for Iceland, with principal emphasis on free trade in thespirit of Adam Smith. He says in the introduction that the Danish trade monopoly had caused Icelanders
Avinash D. Persaud. (2009). The Role of Policy and Banking Supervision in the Light of the Credit Crisis.
Accessed at https://academiccommons.columbia.edu/catalog/ac:130761 and Frank Smets. (2014). Financial
Stability and Monetary Policy: How Closely Interlinked? European Central Bank. Accessed at
http://www.ijcb.org/journal/ijcb14q2a11.htm
7
Philip Turner. (2017). Did Central Banks Cause The Last Financial Crisis? Will They Cause The Next? Institute of
Economic and Social Research. Accessed at https://www.niesr.ac.uk/publications/did-central-banks-cause-lastfinancial-crisis-will-they-cause-next
8
Hélène Rey. (2018). Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence.
Accessed at http://www.nber.org/papers/w21162
6

to “lose the confidence in themselves that is necessary to all, and with it the solidarity and thewillingness to help themselves; they have lost the global will for all industry and become cottagers ...”In Jón’s opinion, free trade was the prerequisite for national freedom: his countrymen should seek out
international markets and not close themselves off from them. Because of his campaign, the remnantsof the Danish trade monopoly (which stipulated that only subjects of the Danish state were permitted
to trade in Iceland) were abolished in 1855. Later, Jón presented a retroactive invoice to the Danes anddemanded that they reimburse the profit they had made on the trade monopoly. It is somewhat
paradoxical that as soon as Icelanders had rid themselves of the shackles of Danish rule, one of thefirst things they did was to bind export trade down with homemade fetters.
As has been described here, it was persistent balance of payments problems that pushed Icelanders
further out onto the thin ice of capital controls and Government intervention in the economy in 19301960. And it was not until 1994, when Iceland joined the European Economic Area, that thesehomemade fetters were loosened entirely. The adoption of capital controls does not necessarily
involve blocking capital transactions, however; transactions continue and the relationship between
foreign trade and the capital account remains unchanged. On the other hand, the controls politicise
capital transactions, since capital transfers are either subject to a politically determined exemption
process or are undertaken by the state itself. The politicisation of capital transactions also tends toresult in intervention in how the capital is utilised within the country. Thus investments become
determined in the political arena rather than on the free market, which generally leads to misallocationof capital. Someone should follow in Jón Sigurðsson’s path and prepare an invoice for the impact thecapital controls have had on the country, but the worst part is that the only place to send it would beto Icelanders themselves.
The imposition of the capital controls in 2008 was an emergency measure, and it could be argued that
it was necessary during the reconstruction phase. 9 But that work is now done, and the fact remains
that, as Jón maintained, capital controls turn Icelanders into “cottagers”, in addition to being financiallycostly. But at the same time, it can be argued convincingly that it is unacceptable to permit utterly
unrestricted movement of global hot money through the foreign exchange market or the financial
system, and that such movements should be restricted with macroprudential rules of various types.
To reference Hélène Rey again, the effectiveness of monetary policy depends on managing the capital
account. On the other hand, global integration of the Icelandic capital market brings enormous
benefits. Not only does global capital trade deliver lower long-term interest rates for Icelanders, but it
also provides necessary risk diversification in many areas. An example of this is Iceland’s large pension
system, with assets totalling ISK 3,900 bn, only one-fourth of which is invested abroad. It would be best
if that foreign ratio were closer to 50%. 10 The solution is clearly that the pension funds should invest
abroad, and in their place, foreign investors will enter into long-term obligations in Iceland.
Capital controls can be particularly harmful to small markets, as they discriminate between investors
by nationality and thereby lead to reduced turnover and a more homogeneous group of market agents.
This, in turn, causes uneven price formation and creates an oligopoly in the capital market, as domestic

9 For further discussion, see Ásgeir Jónsson and Hersir Sigurgeirsson. The Icelandic Financial Crisis: A Study into the World´s Smallest Currency Area and its Recovery fromTotal Banking Collapse.
10 Ásgeir Jónsson and Hersir Sigurgeirsson. (2014). Áhættudreifing eða einangrun? Um tengsl lífeyrissparnaðar, greiðslujafnaðar og erlendra fjárfestinga (Diversification ofrisk or isolation? The relationship between pension savings, the balance of payments and foreign investment). Accessed at http://audfraedi.is/utgefin-,

rit/frett/2015/04/27/Ahaettudreifing/ or Friðrik Már Baldursson and Richard Portes (2018). Restoring trust in Iceland: Iceland‘s IMF programme, in Thröstur Olaf
Sigurjónsson, Murray Bryant, and David Schwarzkopf (eds.), The Return of Trust? Institutions and the Public after the Icelandic Financial Crisis, pp. 111-127, Emerald
Publishing.

financial institutions are the only participants. The result is wider credit spreads. In the small, thin
Icelandic capital market, competition issues must be taken seriously, as three commercial banks and a
few large pension funds dominate price formation.
As is well known, the restrictions on outflows imposed in 2008 were lifted in March 2017. They remainenshrined in law, however, so that they can be reinstated if the need arises. On the other hand,somewhat earlier, in June 2016, restrictions on capital inflows were introduced and a 40% special
reserve requirement was imposed on investments in Icelandic bonds using new inflows of foreign
currency. Such restrictions are based on a model from Chile in the 1990s. The main drawback of theserestrictions is that they appear to be based on the assumption that investors’ nationality determines
whether they can be considered patient or stable long-term investors. For this reason, the said
restrictions apply only to foreign investors. It is true that domestic investors are generally more loyal
to the country. But this does not change the fact that investors show their time criteria mainly throughwhich investment options they select. For example, those investors that buy long-term Icelandic
corporate bonds must intend to own them for the long term, as there is a very limited secondary
market for such securities in Iceland. The same cannot be said of those who buy short-term Treasury
bills, for instance. Experience from other countries shows that domestic investors can be just as
impatient as foreign investors, and nationality is therefore a very imprecise measure of patience.
It is beyond doubt that the inflow restrictions entail economic costs, although they may strengthenmonetary policy transmission via the interest rate channel. The IMF has recommended against the useof inflow restrictions under the conditions currently prevailing in Iceland. 11 In their reports for the task
force, Kristin Forbes (2018) and Sebastian Edwards (2018) concur with this view. Instead, they advocate
the use of more precise and pointed tools in the spirit of macroprudentiality, which would aim atmanaging capital transactions in the spirit of good economics rather than prohibiting them.
Restrictions would then be used only under duress, as in a financial crisis. They must not become an
inalienable part of Icelandic monetary policy once again.

Lesson 9 – Success lies in prioritising objectives
In 1959, Robert Loring Allen, professor of economics at the University of Virginia, wrote a paper on
Icelandic economic policy bearing the title The vulnerability of Iceland’s economy. The opening words
read as follows:“Iceland is in a constant state of economic crisis. The country has attempted to achieve greater
increases in the real standard of living than is justified by the productivity of the economy. The country
has simultaneously invested at a phenomenally high rate, frequently in activities which have notcontributed significantly to the growth of the economy. This pressure on Iceland’s resources has
resulted in a host of problems: chronic inflation, malfunction of the price system, government deficits,
loss of its competitive position in world markets (at prevailing exchange rates), chronic balance of
payments deficits, and policies which have not only failed to ease the situation but have evenaggravated it.” 12
Even though Icelanders have certainly gained ground in the 60 years since this was written, it remains
clear that certain factors described in this paper are still at play. It appears as though Icelanders are
11 International Monetary Fund. European Dept. (2017). IMF Executive Board Concludes 2017 Article IV Consultation with Iceland. Accessed athttps://www.imf.org/en/Publications/CR/Issues/2017/06/22/Iceland-2017-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-44998

The Vulnerability of Iceland's Economy Robert Loring Allen FinanzArchiv / Public Finance Analysis
New Series, Bd. 19, H. 3 (1958/59), pp. 441-462.

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unable to prioritise in terms of macroeconomic objectives, and it appears to be widely believed that
Iceland can achieve more objectives simultaneously than is possible — or that monetary policy has
been tasked with achieving far more objectives than it actually can, such as ensuring a higher standardof living than is warranted by economic productivity.
The fact is that, as an athletic trainer might say, if one sets one’s sights on too many, and perhaps
opposing, objectives, the result will be that none of the objectives are met. This is also the case with
monetary policy. The practice of applying economic policy instruments arbitrarily, using what isconvenient at any given time so as to achieve various different objectives in turn, as Iceland did in the
1970s, led to a fairly miserable outcome: inflation, unemployment, and instability.
At bottom, monetary policy centres on printing money (mostly in dematerialised form), or rather,ensuring the value of printed money that has no intrinsic value. A wrong approach or a misapplicationof monetary policy can do considerable harm to the economy. On the other hand, monetary policy
cannot ensure stability in the economy all by itself — not in terms of exchange rate stability, pricestability or employment stability. Actually, many of the tasks that the general public believes to bewithin the sphere of monetary policy do not belong there at all: long-term real interest rates, longterm GDP growth, living standards, or income distribution. No country will grow wealthy by printing
banknotes! What monetary policy can do is to ensure price stability within a given framework.
Achieving other objectives depends on other aspects of the economy. It is this acknowledgement of
the limitations of monetary policy that is the true foundation of inflation targeting — and allows theCentral Bank to concentrate on what it can do rather than chasing goals that are actually beyond its
grasp.
Achieving economic objectives often requires short-term sacrifice costs, such as a trade-off between
inflation and unemployment. But such sacrifice costs disappear over time. Countries can have varying
attitudes, understanding, or perhaps tolerance for inflation. For example, the Germans have little
patience for inflation, probably as a result of the runaway inflation during the period between thewars. Other countries, such as the United States, have more tolerance for inflation and have placedcorresponding emphasis on other monetary policy objectives, such as maintaining employment levels.
These differing attitudes towards inflation led, among other things, to a split between these twoparticipants in the Bretton Woods system in the early 1970s. But there still came a time when the US
had to make a choice. In 1979, Paul Volcker became chairman of the US Federal Reserve Bank. Inflation
was 15% at the time, but Volcker beat it back down to 3% in three years’ time with tight monetary
policy; however. unemployment soared to 10%. The unemployment rate declined again in the years
to follow, but inflation has remained low ever since. Once again, as any trainer would say: no worthy
goal can be achieved without some effort and hardship. In other words: no pain, no gain.
According to public choice theory, politicians have a commitment problem when it comes to large,
difficult, and potentially unpopular decisions. As in the story of the Little Red Hen, everyone wants to
eat the cake but no one wants to go to the trouble of baking it. Democracy can easily morph into an
auction market, where each bidder tries to bid higher until the final outcome is far above economic
reality. It was partly for this reason that central banks were given independence from government
authorities, so as to ensure clear prioritisation of objectives, which is a prerequisite for long-term
stability. After the sizeable pay hikes and steep rise in the real exchange rate over the past four years,
Icelandic monetary policy is faced with a new test now that the business cycle seems to be heading
downwards, partly because of cooling in the tourism sector. The question arises whether Icelanders
can adopt more goal-directed governance practices.

Lesson 10 – Inflation targeting should be feasible for Iceland
Iceland has several unique characteristics that clearly complicate monetary policy conduct. The
economy is extremely small. Its export sectors are homogeneous and prone to cyclical fluctuations.
Most of its financial markets are not highly liquid, which results in spotty price formation. Not only is
the currency area small, it is right between the world’s two largest currency areas — the US dollar andthe euro — which is bound to make it extremely difficult to pursue independent monetary policy.
Prices are highly susceptible to exchange rate movements, and the foreign exchange market has
proven difficult to manage. Conventional transmission of the policy rate along the yield curve also
appears very limited, which further narrows the scope available to monetary policy.
There are other factors as well. Icelanders demonstrate a decided herd mentality in their consumption
decisions, which causes wide fluctuations in private consumption. The country also has limited humanresources to do everything that needs to be done, such as running healthcare, education, andgovernmental systems — not to mention managing monetary policy. Perhaps it is no wonder, then,that the Central Bank’s Special Publication no. 7 from 2012, entitled Iceland’s currency and exchange
rate policy options, expresses certain doubts about whether it is possible for Iceland to maintainindependent monetary policy successfully in the first place. 13
Anyone discussing Iceland’s monetary policy concerns is bound to acknowledge these problems. In anutshell, it can be said that Icelandic monetary politics have focused primarily on manipulating theexchange rate of the króna, directly or indirectly. On the other hand, it is clear that the chief problems
facing domestic monetary policy are not the systemic drawbacks Iceland has inherited through history
and geography — factors that are not going to change. The biggest problems are institution, political,
or perhaps societal: they centre on fiscal policy decisions, collective bargaining agreements, and overallsocietal consensus. It is possible to call this an institutional failure, something that is not written into
the country’s DNA but can be changed if the will is there. It is also worthwhile to warn against Icelandic
singularism, as Jón Sigurðsson did in his time: “Many tend to focus on Iceland alone in the entire world
and to reject the idea that other countries’ experience could apply there.” 14 Iceland is small, but ininternational context the other Nordic countries are also small, and they, too, depend on commodities
exports. So the difference between Iceland and its Nordic neighbours exists but is not vast.
A look at the economic history of the Nordic countries — Denmark’s pegged exchange rate, Sweden
and Norway’s adoption of an inflation target after 1990, or Finland’s entry into the EMU in 1998 —shows that these countries were grappling with issues similar to those faced by Iceland: inflation,
instability, and labour market unrest. They have worked through these problems successfully,
however, and have incorporated the ground rules of monetary policy (no matter which particularpolicy was selected) into their social covenants.
Outside the Nordic region, the ground rules of inflation targeting have proven successful in democratic
countries, in part because they demand transparency and public responsibility, which is consistent
with the ground rules of an open democratic society. More specifically, inflation targeting is based ona simple division of tasks: the Government sets the target, and the Central Bank implements it. In 2001,
Parliament approved the 2.5% inflation target almost unanimously, but there are numerous signs thatthe institutional commitment to price stability does not exist. It is also clear that Icelanders have found
it very difficult to comply with the ground rules of this monetary policy framework.
Central Bank of Iceland. (2012). Special Publication no. 7: Iceland’s currency and exchange rate policy options
Accessed at https://www.sedlabanki.is/utgefid-efni/rit-og-skyrslur/rit/2012/09/17/Serrit-7-Valkostir-Islands-igjaldmidils-og-gengismalum/
14
Jón Sigurðsson. (1843). Um verslun á Íslandi (On trade in Iceland). Ný félagsrit (New Social Writings). Vol. 3.
13

Originally, when Icelanders sought sovereignty and then independence, it was not assumed that thecountry would pursue independent monetary policy. That role was more or less forced on Iceland after
the collapse of the Nordic currency union. Nevertheless, people believed steadfastly at the time that
Iceland could stand alongside the other Nordic countries in all respects, including monetary policy.
Monetary sovereignty always represents value, as has been proven by the Great Recession and its
aftermath. But the question whether the country wishes to wield this sovereignty — or sacrifice it forother overriding interests — must also be a matter of cold logic at any given time.
There is nothing to indicate that inflation targeting cannot work successfully in Iceland, as it has in theother Nordic countries, if we can reach a reasonable societal consensus on the ground rules
accompanying such a framework. It is also the case, as any trainer can confirm, that the best thing
about performing poorly at something is that poor performance gives one great scope for
improvement. Institutional reforms relating to monetary policy implementation have certainly
delivered improvements until now. For example, there are signs that entrusting a separate Monetary
Policy Committee with taking interest rate decisions has enhanced the credibility of the Central Bank’s
monetary policy. 15 It is also beyond doubt that the targeted use of macroprudential tools in the past
few years has strengthened monetary policy. The same is true of the new Act on Public Finances, which
to some extent has curbed Government spending growth. There are enormous interests at stake here
for the general public. The past four or five years’ success in maintaining price stability has delivered asignificant rise in purchasing power, and interest rates have fallen markedly. This gives rise to thequestion whether this success is a harbinger of lasting change or merely the calm between storms.
But the belief that Icelanders can stand beside other countries as equals, provided that they take thegame seriously enough, should not be limited to athletic competition. Icelanders should be able topursue credible economic policy just as its Nordic neighbours do — if they will only take the groundrules seriously. It is in this belief that the task force on monetary policy review presents its proposals
for reforms to the current monetary policy framework.

See the paper by Central Bank Chief Economist Þórarinn G. Pétursson: Central Bank: Working Paper no. 77:
Disinflation and improved anchoring of long-term inflation expectations: The Icelandic experience. Accessed athttps://www.cb.is/publications/publications/publication/2018/03/09/Working-Paper-no.-77-Disinflation-andimproved-anchoring-of-long-term-inflation-expectations-The-Icelandic-experience/15