by Hansjoerg Bloechliger

Iceland’s economy is riding high. Since the pandemic, the country’s growth has been one of the fastest of the OECD, driven by exports of energy-intensive goods and services and a strong rebound of foreign tourism. Relying on domestic energy sources, the country has largely been spared the power crisis that has strangled other countries, as shown in the Economic Survey of Iceland.

Unemployment is low and stable at around 3.5%, and labour participation of both men and women is again reaching historical highs. Economic growth is expected to moderate from 6.4% in 2022 to 4.4% in 2023 and 2.6% in 2024, still well above the OECD average.

Inflation remains stubbornly high

Yet everything is not cool in Iceland. Since mid-2022, headline inflation has been hovering at around 10%, much above the central bank’s target of 2.5%. Unlike in continental European countries, Iceland’s inflation surge was initially propelled by house prices. Those shot up by around 50% between mid-2020 and mid-2022, driven by the strong post-pandemic recovery and labour immigration. Inflation is now increasingly transmitted to the wider economy, notably the domestic service sector. Inflation expectations have de-anchored.

Three decades ago, Iceland succeeded in putting an end to entrenched inflation and repeated inflation bursts. It should do so again, tightening monetary policy further as needed to bring inflation back to the target and avoid a wage-price spiral. Fiscal policy should work in the same direction as monetary policy and avoid any stimulus, while limiting support to vulnerable households.

Structural reform could help raise productivity and tame inflation

Over the past few years reforms opened the tourism sectors to more competition. Despite these improvements, barriers to entry, notably for start-ups, are high. Foreign access to the computer service and construction sectors is more restricted than in any other OECD country. Professional licencing requirements were hardly eased as attempts met with resistance from vested interests.

The government should continue its efforts to improve the business climate. Strengthening competitive forces will not only help raise productivity growth – currently at 1%, which is around the OECD average – but also contribute to bring inflation down.

Building on Iceland’s natural capital and reducing carbon emissions

Iceland hosts more tourists per inhabitant than any other OECD country, exerting pressure on infrastructure and the environment. Climate change is altering a part of Iceland’s natural capital such as oceans and glaciers, jeopardising several tourism services. Iceland should continue to develop a balanced strategy for productive and sustainable tourism. It should remove the current tax privileges in the tourism sector, notably the reduced VAT rate, and it should introduce a tourism levy to fund local sustainable tourism infrastructure.

The government has strengthened climate policies over the past two years and carried out thorough cost-benefit analysis of abatement measures. Carbon emissions are declining gradually. Yet per capita emissions remain above the OECD average. The government should strengthen climate action further in a sustainable and efficient manner. It should notably strengthen carbon taxation and prioritise climate actions with low abatement cost per tonne of carbon.

References

OECD (2023), OECD Economic Surveys: Iceland 2023, OECD Publishing, Paris, https://doi.org/10.1787/b3880f1a-en.

By Hansjörg Blöchliger and Vassiliki Koutsogeorgopoulou, OECD Economics Department

Iceland went through a comparatively mild COVID-19 health crisis. Containment measures were less severe than elsewhere, and all domestic restrictions were lifted at the end of June 2021. Yet the economy suffered a lot. Following lockdowns and travel restrictions worldwide, tourism, Iceland’s most important export sector, collapsed with only around a fourth of foreigners arriving in 2020 compared to the previous year. GDP declined by 6.6% in 2020, and unemployment rose to 8%.

Even before the pandemic, other sectors had started to draw level with tourism as growth engines. The pharmaceutical industry continues to develop rapidly, and digital services such as data processing and storage benefit from Iceland’s low energy prices and cool and windy climate. Fisheries are climbing up the value chain with fresh seafood and aquaculture rising fast. Innovative carbon capture technologies help reduce carbon emissions and provide export income.

Figure 1. The economy was hard hit as foreign tourism collapsed

Macro policy supported households and firms

Like overseas, monetary and fiscal policy cushioned the blow for households and firms. In addition, the government plans to increase spending on infrastructure, digital and green transition, and research and development by around 0.5% points of annual GDP over the next few years, to ensure a healthy and sustainable recovery.

Yet public debt could continue to rise since Iceland, as a small open economy, is highly vulnerable to external shocks. To maintain fiscal space, the government should start consolidating once the recovery is firmly underway. Although Iceland’s population is young and active, the government should start addressing disability, pension and long-term care spending.

Structural reform could help boost productivity

Regulation is restrictive, hampering sound competition. Administrative burdens and an extensive licensing and permit system slow the entry of new and innovative firms. Skills gaps are considerable. To boost productivity and diversify the economy, regulation particularly in the tourism and construction sectors should be eased. The quality of education, from primary to tertiary, should be better aligned with the needs of economy and society.

Fostering innovation is crucial for strong economic performance in the digital era

Innovation outcomes remain weak in some critical areas, notably ICT. Despite generous R&D tax incentives, many smaller firms have not been inclined to innovate. Icelandic firms should also be encouraged to step up the adoption of digital technologies, which would help the country make the most of innovation niches. Improving framework conditions and easier access to finance for young innovative firms are important. At the same time, the provision of digital skills needs to be strengthened and knowledge exchange enhanced, through closer business-university collaboration on innovation.

Making climate action more cost-efficient and inclusive

Iceland’s per capita greenhouse gas emissions exceed the OECD average, partly because of emission-intensive aluminium smeltering. The government committed to reduce emissions from their 2005 level by at least 40% by 2030. Iceland’s climate policy should rely on effective carbon pricing, complemented by investment in low-carbon technology and participation in international projects to finance emission reduction in transition and emerging market economies. Revenues from carbon pricing could be redistributed to households and firms.

https://www.oecd.org/economy/iceland-economic-snapshot/

by Hansjörg Blöchliger, Vassiliki Koutsogeorgopoulou , Iceland Desk, OECD Economics Department

Over the years Iceland caught up rapidly with the richest OECD economies. Favourable external conditions and good macroeconomic policies helped foster strong growth, low unemployment, low inflation, and sustainable public finances. Iceland is also one of the most inclusive economies in the OECD thanks to high employment, little wage inequality, and a well-targeted social benefit system, suggesting that a performing economy and an egalitarian society can go together.

Yet the country was hit by several export shocks during the first half of 2019, and the economy turned sharply. Revenues from tourism have almost stalled, especially after the Icelandic low-cost airline WOW went bankrupt. Seafood exports also declined as a specific specimen disappeared from the country’s fishing grounds. Over the summer, the Central Bank gradually lowered interest rates by 1% percent point to 3.5%. Growth is projected to reach 0.2% in 2019, rebounding to 2.2% in 2020.

The rapid slowdown has exposed Iceland’s structural weaknesses. The economy relies heavily on tourism and seafood, which together make up almost 60% of total exports. The gains in competitiveness, achieved after the 2008 financial crisis, have been exhausted by now. Product market regulation is stringent and the administrative burden for start-ups is high, holding back creative young firms. Restrictions to foreign direct investment are among the highest in the OECD, dampening potential productivity gains through more intensive knowledge transfer.

The government should set up a comprehensive action plan to open up the economy more, prioritising reforms that foster competition, level the playing field between domestic and foreign firms and attract investment from abroad. In addition, wages should be linked closely to productivity developments, to maintain competitiveness.

Productivity would also benefit from addressing a decline in student performance and better matching adult skills to the labour market. Iceland has a highly equitable education system and a large share of its workforce is well-educated. Yet it could make education more responsive to labour market needs, to avoid people having the wrong skills or being overqualified. The business sector hardly supports tertiary education. A reform of university funding could help attract more private R&D activities and increase the quality and performance of higher education.

Reference:

OCDE (2019), OECD Economic Surveys: Iceland 2019, Éditions OCDE, Paris, https://doi.org/10.1787/c362e536-en.

Mr. Jon Pareliussen, Economist, Sweden/Finland desk, Economics Department

The Nordics are rightly renowned for being inclusive societies with low inequality compared to other OECD countries. However, some of the largest inequality increases over the past few decades took place in Sweden, Finland and Denmark. A newly released article  building on previous OECD work discusses how market forces, demographic trends and redistribution together shaped the income distribution of the Nordics.

It may seem like a paradox that the Nordics, which are very open economies, heavily integrated in global value chains and front-runners in the use of new technologies, have not seen even more widening distributions of market incomes. However, the extent to which skill-biased technological change and other forces widening the earnings distribution of workers will actually drive up inequality depends on a number of factors, and key policies and institutions in the Nordics play a dampening role. First, institutions such as unions and collective bargaining, employment protection legislation and minimum wages dampen the direct effect of market trends on earnings. Second, higher demand for skills are met by publicly-funded higher education, increasing the supply of skilled workers and thus holding back skills premiums. Third, a widening earnings distribution among workers coincided with increasing employment, limiting the overall effect on inequality.

With a relatively modest overall impact from market forces, explanations for increasing inequality must be sought elsewhere:

• Demographic trends have been relatively strong drivers of inequality in the Nordics. Household structure, with more single-headed households has widened income dispersion in Denmark, Finland, Norway and Sweden. Ageing has increased inequality significantly in Finland, and immigration has increased inequality in Norway, Denmark and Sweden.
• Redistribution through taxes and transfers has weakened significantly in Denmark, Finland and Sweden, notably due to less insurance transfers (i.e. unemployment, sickness, disability insurance) and only partially offset by more assistance (i.e. means-tested) transfers. Income taxes have played a less important and more heroegneous role, as progressivity increased in Sweden while it decreased in Denmark and Iceland.

Technological and demographic pressures are set to continue going forward, and these challenges need to be embraced. Continued flexibility and constructiveness of the social dialogue and improvements to education are essential to seize opportunities from technological change and avoid a widening wage distribution. Making social insurance and welfare transfers more flexible and agile would improve workers’ protection in a rapidly changing world of work. Improving benefit system design so that work always pays, notably in Denmark and Finland, and linking benefits to real-time income registries are important steps to this end.

The Nordics demonstrate that equity and efficiency can be compatible if incentives are right. Low inequality and strong safety nets can even be an advantage in today’s globalised world, which requires constant adaptation. Reaping the full benefits from globalisation and technological progress requires broad support, which is easier to muster when the social dialogue is constructive and representative, when everyone is given opportunities to fulfil their potential, risks are shared and losers compensated.

References:
Pareliussen, J. K., Hermansen, M., André, C. and Causa, O. (2018), Income Inequality in the Nordics from an OECD perspective, Nordic Economic Policy Review 2018.

 

by Urban Sila, Iceland Desk, OECD Economics Department

Icelandic labour market is flexible with high labour market participation, low unemployment, and labour supply dynamically responds to the economic cycle. Iceland is the most highly unionised country in the OECD and wage bargaining is a cornerstone of the economy. Strong unions have contributed to very low inequality, high inclusiveness and gender balance. Successful social pacts have protected the lowest paid workers during crises, and on occasion helped fight inflation.

Paradoxically, however, the Icelandic bargaining model has been less successful in times of economic boom, and Iceland suffers from recurrent bursts of social tensions and labour unrest. During such periods trade unions approach collective rounds fragmented and with little regard for wider consequences of their demands. Wage demands by one union trigger topping-up demands by others, resulting in excessive awards. Recently, Iceland has again experienced a period of elevated tensions. In the 2015 bargaining round, doctors and teachers obtained three-year wage awards of around 25-30%, which led to demands by other unions for 50% pay increases. A bitter dispute erupted resulting in negotiated three-year nominal wage awards – that set the minimum over the settlement period – of more than 20% on average. Wages have been rising steeply ever since and together with króna appreciation, this has caused external competitiveness to plummet (Figure 1).

Iceland is a very small open economy prone to boom and bust cycles, and the pro-cyclical wage pressures add fuel to these harmful dynamics. The recently released OECD Economic Survey of Iceland 2017 argues for changes to the structure of collective bargaining to help sustain the benefits of the system for future generations.

Labour negotiations often break down because parties differ in their view of the economy. They frequently disagree even on what exactly has been agreed in the past. Iceland has been through a challenging decade during which trust in politicians and among the social partners has been undermined. Trust and mutual respect can however be rebuilt by active and regular participation of the social partners in a tripartite macroeconomic council – to discuss issues of collective bargaining, welfare policy and social reform. Greater trust can also be fostered by setting up a “technical committee” that can provide impartial and accurate statistics on wages, economy, productivity and competitiveness to be used as a reference point in negotiations.

Wage coordination in Iceland is low. Labour unions tend to be very small and a large number of agreements need to be reached, creating the potential for co-ordination failure. Other countries ensure wage coordination for example by letting the sector that is exposed to foreign competition negotiate first, while other sectors follow (Nordic countries), or by linking wage increases to developments in neighbouring countries, to maintain competitiveness (Belgium). Recognising the Iceland specific context, the OECD Survey proposes that at the beginning of each negotiation round peak worker and employer organisations together issue “wage guidelines”, taking into account the information provided by the technical committee.

A strong role of the state mediator is needed, however, to underpin such a system. The Icelandic state mediator is relatively weak compared to other Nordic systems. The state mediator should be seen as a promotor and protector of the wage guidelines and when issuing conciliation proposals, they should be in line with the wage guidelines.

References

Holden, S. (2016), “A new model for wage formation in Iceland”, Report commissioned by the SALEK group, preliminary version, 9 August 2016, mimeo.

OECD (2017), OECD Economic Surveys: Iceland 2017, OECD Publishing, Paris.

OECD (2015), OECD Economic Surveys: Iceland 2015, OECD Publishing, Paris.