Davíð Oddsson: The challenges of globalisation for small open economies with
independent currencies
Opening address by Mr Davíð Oddsson, Chairman of the Board of Governors of the Central Bank of
Iceland, at a conference on The Challenges of Globalisation for Small Open Economies with
Independent Currencies, Reykjavík, 1 June 2007.
* * *
On behalf of the Board of Governors of the Central Bank of Iceland I welcome the cooperation
between the Bank and the International Monetary Fund on organising the conference that is now
commencing. In fact I consider the theme of this conference very apt and take the liberty of stating that
a better location for such discussion could hardly be found. This claim is not only based on the fact
that Iceland is currently staging a kind of practical experiment in this field. While it can be argued that
such experiments are taking place in many other countries, the advantage of Iceland's experiment is
that its economic developments happen to have been quite notable over the past few years. Certain
aspects of recent events raise significant questions for this conference.
There is no question that Iceland was a relative latecomer to the top league of active market
economies: for a long time, Iceland's rules and norms did not qualify it for inclusion. But Iceland's
economic framework has been completely transformed in the space of a relatively few years and its
business world has undergone enormous upheavals at the same time. Looking at just the past four or
five years, there is no doubt that certain laws of economics have been stretched to their limits and, in
order to convince outsiders that the stakes have not been set too high, we have had to insist - and
rightly so, I hope - that Iceland's economic environment has various advantages that are not
immediately obvious to those who are accustomed to operating in larger and more restrictive
conditions. Here there is great flexibility, official measures are very transparent and channels of
communication are shorter, which enables easier decision-making so that households, businesses
and the authorities are quicker to respond to economic incentives or challenges than is the case
elsewhere.
To give you all a more complex and interesting topic to discuss at a conference such as this, the
government itself promoted a number of measures that will benefit Iceland and its people in the long
run. However, their timing and scope may have been more questionable. Thus the government itself
was mostly responsible for attracting the largest single investment that has ever been made in Iceland,
to which the state-owned power company, Landsvirkjun, had to respond by matching it with an
investment of its own on the same scale. The inflow of capital was enormous. As if this was not
enough, public sector involvement in housing finance was reformed around the same time; this
structural reorganisation had unexpected multiplier effects when the recently privatised commercial
banks eagerly followed that lead and ran ahead along the same path even faster than the policy
makers had expected.
At the same time, Icelandic banks and financial institutions have been establishing their influence in
neighbouring foreign markets and, to some degree, more distant ones. The banks have expanded
rapidly and are now very large relative to Iceland's domestic economy, and in fact by any measure.
Their international activities have also created a new situation that has sometimes been called "the
problem of explaining the Icelandic economy". Although I feel that this problem is overstated because
it must surely be temporary, it cannot be denied that the Icelandic currency itself, and its small size,
are recurrent themes. The economic factors I mentioned earlier have driven strong inflationary
pressures in Iceland, which have partly appeared in the form of higher measured inflation, but have to
some extent been contained by Central Bank policy rate decisions, which in turn have affected the
exchange rate of the Icelandic króna, at least for some while now. And in combination, these two
factors have raised yet another question that is relevant to this conference.
That is to say, these special conditions have inspired new investors, the carry traders, to venture to
our shores. These modern-day Vikings try their fortune in distant places in the hope of quick gain and
handsome returns, which they can no longer find closer to home. What will happen when these bold
hunters of yields and expectations suddenly lose their nerve? Or their appetite? Regardless of whether
this is caused by events that have occurred somewhere else and under completely different conditions
from here, or due to persistent rumours, speculation and theories about the situation in Iceland and
risks that have little or no foundation at that time. Will they load everything aboard and sail off, like the
Vikings in the past, with what they have managed to gather up, and look for shelter with their bounty
against real or imaginary threats? If this happens, might the high-yield countries suffer a shock? And if
so, will that shock be felt the most by the smallest countries, where investors naturally have the least
knowledge and confidence? Then the question will arise about the impact that all this will have on the
effectiveness of the Central Bank's policies for controlling inflation developments, and whether we
might be better off locked away inside one of the super-currencies, obeying the laws that apply there
and at the mercy of the decisions of others.
All these considerations and many others can stoke the fires of debate at this conference in Iceland.
Some people maintain that the incredible gains that Iceland has made over a very few years could
only have been achieved because the country had its own currency. Others say that the
consequences may be more difficult to deal with and more persistent precisely because the country
has its own currency and is not under the wing of a large currency area. Yet others claim that if Iceland
fixes itself against another currency and obeys the laws of others - interest rates based on what is
happening in France, Italy and Germany and not in Iceland - that this will produce a more cautious
attitude up here in the frozen north, the appetite for risk will diminish and economic developments will
take a healthier turn. Thus there are countless questions, of which I have mentioned only a few. Of
course I have taken care in these opening remarks to leave all these questions open for those who
follow. It is a particular pleasure to have lured so many distinguished guests here to do theoretical
battle about these questions. It is equally welcome to give our leading experts the opportunity and time
to ponder these issues and present their own views. So everything promises a rewarding outcome
from this conference. It has been organised with ample reason, in the right place and at the right time,
and with exceptionally qualified speakers.