Gylfi Magnusson Minister for Economic Affairs

European Integration in Swedish Economic Research
Mölle, Sweden May 18 2010

Mr / Madam Chairman, Distinguished Guests,

I want to begin by thanking you for this opportunity to talk about Iceland and the European Union. As you know, Iceland last year submitted an application for membership of the European Union and it is anticipated formal negotiations will start after the middle of this year.

The idea of Iceland joining the EU is not new. It was already discussed half a century ago, when the first steps toward what is now the European Union, were taken. Membership has since been discussed from time to time, especially in the early 1990s with the formation of the European Economic Area and the subsequent entry of Sweden and Finland into the EU.

The reason Icelanders have finally taken this step, after decades of waiting in the wings, is a complex one. Indeed, one could turn the question on its head and ask why Iceland has never applied before. Iceland was, until last year, the only state in our region that had never applied for membership, despite having an obvious right to do so. Iceland clearly has a great deal in common with other European countries. It is a country with a rich democratic tradition and deep-seated respect for human rights, a European culture, a sophisticated market-based economy and an enviable standard of living. It is very dependent on trade with the external world, especially the countries of Western Europe, with approximately three-quarters of Iceland‘s exports going to the EU. Iceland participates fully in all major European cooperative projects, including NATO, EFTA, the EEA and Schengen, in addition to its broad cooperation within the Nordic Region.

Iceland has however stayed out of the European Union itself, like its closest neighbours, Norway, which has applied twice but in both instances abandoned the process following a referendum, the Faroe Islands, which chose not to follow Denmark into the EU in 1975 and Greenland, which left the EU in 1985 – the only state to have done so. In view of this shared geographic anomaly, with the North-West corner of Europe staying conspicuously out of the EU, one might pose another question – whether there is anything in the nature of the EU or the states in the North Atlantic, that makes a large part of their inhabitants believe that they have little in common with the EU or are at least highly suspect of this great European institution that seems to enjoy much greater support in other European countries.

These North Atlantic states do of course have various things in common. When it comes to the economy, the main difference between them and the current EU member states is the relative importance of the utilisation of natural resources, especially fishing.

Be that as it may. It is now a fact that Iceland has finally applied for membership of the EU. An important catalyst that made this happen now rather than at some other time is the economic turbulence in Icelandic in recent years, in particular the collapse of the financial sector in October of 2008.

Before going further I will bring out a few important components of that story.

The problems of the Icelandic economy have had an effect far beyond the economic sphere. They have had a profound effect on Icelandic politics and culture. Icelanders now have good reason to criticise and rethink many aspects of Icelandic society, draw the right conclusions, learn from the experience and correct serious mistakes.

This we are indeed doing. An honest reckoning that makes those that carry responsibility accountable is critical for society, even though the process will neither be pretty nor comfortable. Alongside the reckoning, manifold changes need to be drawn up and put into action.

The Icelandic financial system collapsed under its own weight in the autumn of 2008. The damage was enormous. All is not yet accounted for but it is clear that capital owners will lose staggering amounts, tens of billions of Euros. The bulk of the damage, measured in Euros or krona, will land outside Iceland but the part landing on Icelandic shoulders will be especially onerous.

To name a few examples, it has been estimated that Icelandic pension funds will lose around a quarter of their total assets and that the net debt of the Icelandic state, financial liabilities minus financial assets, will have grown from nil to just over half of GDP. It is probably not far off to expect that the destruction of financial assets will, when all is counted – or should I say when the ash has settled – amount to four to six times the GDP of Iceland. This is unprecedented.

Icelandic authorities let go of the reins of the Icelandic banking system a little under a decade ago, with privatisation and light touch regulation in the spirit of laissez-faire policies. It was a stated aim of the government to make Iceland an international financial centre, despite the conditions being about as favourable as would be needed to change the country into a tropical paradise.

The banks could not handle their newfound freedom. They simply stepped on the accelerator and multiplied their balance sheets in a few years. Their lending was daring and ill-considered, especially lending to owners of the banks and related parties. Many people now go so far as to allege that the banks were robbed by their owners. It awaits the judicial system to pass a verdict on this.

The banks absorbed capital with ever-increasing speed in the first years of the new century. When one well dried up another was found, in the last instance online deposit accounts. Six years after the last state-owned bank was privatised, the financial system collapsed.

This collapsed financial system will of course never be resurrected. In its place a fundamentally different system will rise. The new system will be a great deal smaller, and first and foremost, domestic. Its entire framework has been re-thought and all major managers and owners replaced. Already, many radical changes to the law have been introduced and more are in the pipeline. The framework for the financial sector‘s supervisory institutions is changing and the institutions are under new leadership.

The new financial system will have the difficult task of working through the financial difficulties of a large part of their clients. The financial status or balance sheets of a great many Icelandic businesses and actually also families, is in many cases badly damaged by the expansion and subsequent bursting of the Icelandic asset price bubble. The fall of the krona further increased the problem, as many loans to businesses and parts of loans to families, were in foreign currencies, especially low interest currencies, such as the Yen and the Swiss Franc, and have now more than doubled, measured in krona.

The exchange rate of the krona fell by almost half in 2008. After a few months of substantial exchange rate fluctuation, the collapsed currency has now reached a degree of stability, with the aid of capital controls. In recent months, the exchange rate has even appreciated somewhat, although it still falls considerably short of what can be considered a reasonable long-term equilibrium exchange rate.

This last chapter in the tragic history of the Icelandic currency has had considerable effect on the discourse on European Union membership in Iceland. The Icelandic krona has always been a troubled currency. Both the exchange rate and prices have been highly volatile, with inflation in double-digits in most years. Since the Icelandic and Danish krona were finally separated shortly before the Second World War, the exchange rate of the Icelandic krona has dropped by 99.95% against the Danish krona. This is despite there having been inflation in Denmark as well.

Because of this, many people look toward the Euro as a more promising route to a stable monetary system for the Icelandic economy. Many have come to the conclusion that trying to attain such stability with an independent currency is practically hopeless.

Adopting the Euro is of course not an instant solution to Iceland‘s monetary problems. It will foreseeably take many years to adopt up the euro. First we need to join the European Union, then complete the ERM2 rite of passage and finally meet the Maastricht criteria.

But, battered as the króna may be, it is nevertheless undisputable that a common currency has both pros and cons. The discussion of the cons has become louder in Iceland, as it has elsewhere lately, due to the financial turmoil in several states within the euro-zone, in particular Greece, and the tension this has caused.

How well this turmoil is tackled by the European Union will undoubtedly have considerable effect on the discussion of the EU in Iceland. Should things go catastrophically wrong, even to the degree that one or more states leave the common currency, default on sovereign debt or parts of the European financial system collapses, as happened in Iceland, it will force everybody, not just in Iceland, to rethink the common currency and even the European Union itself. Fortunately, such eventualities can in my mind be prevented. I will allow myself to hope and believe that this will indeed be so, although certainly the various players in this saga will have to play their cards skilfully for disaster to be avoided.

One result of the current tension in the euro-zone could actually be that what I believe is the greatest weakness of the common currency will be dealt with, i.e. the shortage of automatic fiscal stabilizers that work across borders and the establishment of a permanent European equivalent to the IMF, which could play the role of lender of last resort for national governments better than the ECB or the IMF. Such changes would, in my opinion, be pivotal for the future of the common currency.

A side-effect of this would be the impact on the discussion of membership of the European Union in Iceland and especially people‘s evaluation of the desirability of adopting the common currency. It would, however, not change fundamentally the position of those who consider it very important for Icelanders to have a flexible exchange rate which reflects the local economic situation. This is a valid argument that needs to be taken into account. Although Icelanders have managed singularly badly to maintain their own currency since the first days of the republic, an independent krona does also have its advantages.

The recent fall of the krona certainly deepened the financial crisis in Iceland but it has at the same time played an important role in bringing about a necessary adjustment of Iceland‘s trade deficit. After years of massive deficits, Iceland has been running a current account surplus since the autumn of 2008. This has been thanks to a slight increase in exports, with a further increase expected in upcoming years, and a great reduction of imports. This development has been a decisive factor in keeping up domestic demand in Iceland and has played a significant role in preventing the decline in GDP becoming as great as was initially feared. In 2009, Iceland‘s GDP fell by 7%, far less than initially projected and surprisingly close to the EU average. This year, projections were for a drop by an additional 2-3% with the economy returning to growth in the second half of the year. We still hope that can be the case, although it has to be admitted that nature has not been very helpful for the economy in recent weeks. The effects of that remain to be seen.

In this context, many have compared Iceland to Ireland. The Irish financial system has not collapsed, unlike its Icelandic counterpart, despite severe problems with toxic assets and an over-sized financial system relative to the local economy. It made all the difference for the Irish to have the ECB standing behind them and to have a stable currency. That certainly shows some of the benefits for a small country of being part of the Euro-zone. On the other hand, the Irish now need to achieve an internal devaluation. Experience shows this can be a slow and painful route to take. The fall of sterling against the euro makes it even harder for the Irish. History will determine whether the Irish, with the euro, will recuperate more quickly than Icelanders, with their krona.
One of the things that matter, when evaluating the pros and cons of a common currency for Iceland, is how similar the business cycle in the euro-zone is to the Icelandic business cycle. Historical data does not point to a great deal of correlation between the two. The Icelandic economy is, for various reasons, more cyclical than is the norm in the larger industrial states of continental Europe. This will unlikely change much in the short or medium term, even if the Icelandic economy presumably would become more tightly integrated with that of the EU if Iceland joins the EU.

To counteract this, the Icelandic labour market has also been quite flexible, both in labour market participation and working hours. Icelandic unions and employers generally have sought pragmatic solutions under challenging circumstances. These qualities of the Icelandic labour market would continue to be useful, should the euro be adopted in Iceland, and reduce the potential negative side-effect of a common currency. It should be noted that the Icelandic trade union movement has generally been very well-disposed toward Iceland´s membership of the EU and the membership is also generally well supported by employers outside the fishing industry and agriculture.

With the EEA Agreement, Icelanders enjoy most of the benefits and drawbacks of full European Union membership from the point of view of the economy. It basically brings the four freedoms to Iceland. To this there are three main exceptions. First, the monetary system or the common currency, as detailed already, second, the fishing policy and third, the agricultural policy.

For Icelanders, the fishing policy is of immense significance as fishing and fish processing is one of the most important industries in the country and produces well over a third of the country´s foreign exchange earnings. There is a great deal of opposition in Iceland to adopting the common fisheries policy of the European Union.

his is not surprising. Icelanders have by and large managed to regulate this industry and protect fish stocks more successfully than has been the case within the European Union. Although several aspects of the quota system used to control fishing in Iceland are contentious domestically, it is beyond doubt that it has in the main achieved its aim of efficient fishing and preservation of fish stocks.

In addition, it matters that Icelanders generally consider authority over the fisheries around the country as an integral part of independence and autonomy of the nation. The framework reached for the issue of fisheries during the negotiations on Iceland‘s entry to the EU will therefore have a significant effect on the probability of Iceland agreeing to join the European Union in a national referendum.

Agriculture matters a great deal less for Iceland than fisheries from an economic point of view, as the climate in Iceland is ill-suited for most types of agriculture. As in many other European countries, however, the political importance of agriculture is much greater than its economic contribution would suggest. This applies in particular to traditional and relatively labour intensive sectors like sheep rearing and dairy production.

ounteracting this is the fact that Icelandic consumers are long tired of high domestic food prices and limited supply of imported foodstuffs. Food prices in Iceland have in the last few decades measured among the highest in the world, although this has been temporarily relieved by the very low exchange rate of the krona. The outcome of negotiations on agricultural issues will therefore also have an important effect on the probability of an agreement on membership.

For years, most opinion polls among Icelandic voters have shown a majority in favour of joining the European Union. Lately, however, opinion polls have presented a different picture and opposition to the European Union has increased. There could be several explanations for this. Basically, there has been no change in the possible pros and cons of Iceland´s membership of the European Union so the explanation is unlikely to be found there.

This change in sentiment can possibly be traced in part to the so-called Icesave dispute, which involves claims by the British and the Dutch governments due to deposit insurance covering one of the failed Icelandic banks. This dispute has been very trying for Icelanders. One of the factors complicating the dispute, and the Icelandic discourse on this, is how deeply most Icelanders resent the actions the British government resorted to when the Icelandic banks were about to collapse in October of 2008, in particular using anti-terrorist legislation to freeze assets. The use of this particular tool was entirely unjustifiable and frankly incomprehensible.

The Icesave dispute has not only affected the relationship of Iceland with Britain and the Netherlands but also created tension between Iceland and the other Nordic States, which have been dragged into the dispute due to conditions they posed for granting loans as part of the IMF package for Iceland. The European Union itself has not played a significant role in this dispute but is linked to it in the minds of many Icelanders. They resent the lack of understanding they believe the leaders of the other European nations and the EU have shown their cause during this dispute.

It is also part of the discourse in Iceland that the EU directive on deposit insurance is flawed, leaving intentionally vague the role of the state if the financial industry itself cannot pay for the cost of deposit insurance. This question is at the heart of the Icesave debate.

The demise of the Icelandic financial system also shows other weaknesses in the EU‘s framework for the financial system, including the so-called passport system of regulating cross-border banking activities. Furthermore, the story of the Icelandic banks also shows the urgent need for having in place ex ante a co-ordination mechanism to deal with troubled banks with substantial cross-border activities.

Although Icelanders clearly recognise that the fundamental factors that brought down the Icelandic banks were predominantly domestic, these weaknesses in the European financial framework that the Icelandic banks exposed have an effect on Icelanders perception of the EU.

The governments of Britain and the Netherlands have not directly linked the dispute about Icesave to Iceland´s application for membership of the EU, but individual politicians in these countries, especially the Netherlands, have done so, e.g. encouraged their countries to oppose the progression of the application unless Iceland accedes to their demands. Understandably, such threats are very hard for Icelanders to swallow and they have undermined support for EU membership in Iceland. The Icesave dispute has undoubtedly had a very negative effect on many Icelanders‘ attitudes to other European nations and the EU and has fuelled nationalism and isolationism.

Happily, the disagreement between Iceland and Britain and the Netherlands is narrowing and there is considerable will to resolve it. Once that is done, which hopefully will happen sooner rather than later, Icelanders will turn to other issues and the effect of this dispute on Icelanders´ views of their neighbours in Europe will presumably slowly recede.

Then we should be able to judge Iceland‘s EU membership on its merits. Then we will also know the results of the negotiations with the EU on the terms of entry for Iceland and will no longer have to base our analysis of the feasibility of EU membership on guesswork.

It should also be kept in mind that other countries have also seen fluctuating support for EU membership during the period of accession negotiations. I believe that at one time polls in Sweden showed 28% in favour – but in the end the majority voted for membership. The story in Estonia was similar. So, it is far too early to tell whether Iceland‘s effort to join the EU ends up as in Norway – or as here in Sweden.

In many ways, Icelanders are now at a crossroads. Generally, there is an argument to be made that Icelandic society is a very successful one, much like the societies of the other Nordic States. Iceland, despite a two to three year recession, has a very high GDP per capita and generally a very high quality of life; good education, health and pension systems. The country is peaceful, with a solid democratic tradition and a strong and blossoming culture. The distribution of income and wealth is fairly equitable, although certainly the rise and fall of Iceland‘s bubble economy has affected this, both while the bubble was expanding and when it burst.

This said, Icelanders have done many foolish things in recent years. We got on the wrong track, even derailed rather spectacularly, but the foundations of a good society are all still there and all still strong. These will allow us to mend what is broken.

All major production factors in the country are still in place and have not been seriously damaged by the crisis – human resources, infrastructure, production facilities and rich natural resources. The capacity to produce goods and services has not really decreased much, although resources must be to some extent reallocated. Long term prospects for the Icelandic economy are therefore good, although we are not out of the woods yet, there still being a great deal of work to be done in untangling the knots that the Icelandic bubble economy left behind.

So even if Iceland has applied to join during a period of crisis, it is not from urgent economic need that Iceland applies for membership of the European Union. The membership holds within it pros and cons, some economic, some not. Without the Agreement on the European Economic Area, the situation would be more difficult. A small country such as Iceland, a mini-state in the society of nations, is generally more dependent on trade and communication with its neighbours than a larger state. The iron laws of economies of scale call for greater specialisation in small countries than large. Isolation is not a promising option for Iceland.

One can even argue that the question of EU membership for Iceland – and even for other small European countries as well – is at the heart of it a question of the optimal size of a community. Does Iceland want to go it alone, developing its own solutions to the tasks that a society has to perform, depending mainly on trade to lessen the disadvantages of small scale and only selectively participate in the greater European community? Or do the people of Iceland want to integrate more closely with their neighbours, seeking common solutions to common problems and sharing some sovereignty and some burdens? The EEA agreement was a fairly large step towards the latter but did not bring us all the way.

Both as a EU member state and as a member of the EEA, as we currently are, Icelanders must unavoidably solve many problems themselves at a proportionately greater cost than larger states.

The public administrative system is an example of this. This matters in the discussion of Iceland´s membership of the EU and also the EEA. It is relatively expensive for a very small country to comply with all the demands made of states within the EU or the EEA. This concerns for example the adoption of Directives, providing detailed statistical information and participating in various cooperative projects. A system of governance and regulations that originate in and are designed for far bigger countries do not always suit the needs of a very small country that could manage with a simpler administration and regulatory framework.
To put this into perspective, keep in mind that Iceland is inhabited by a little over 300 thousand people. That is only slightly more than the inhabitants of Malmö. Now imagine that Malmö had its own language, government, legal system, head of state, coast guard, media, various national sports teams etc. Maybe even its own Eurovision contestant. This would unavoidably be more costly for Malmö than sharing the cost of all of this with the rest of Sweden.

Many of the costs of being small but independent would be incurred irrespective of EU or EEA membership but the cost of participating in the EU system of governance and responding to the various other demands that go with membership can be significant for a small entity. Of course there are benefits as well. After all it can also be fairly costly to develop home-grown rules and regulations for a small economy – often it is not worth the trouble even if such solutions can in theory be tailor-made for local needs.

That said, I generally think that small is beautiful! Small states can be very dynamic and cohesive, with short lines of communication and several other advantages that counteract the lack of scalar economies. Statistical analysis does not suggest that small countries in general do worse than their larger counterparts economically. If anything the evidence suggests that they on average do fairly well.

The task for Iceland – and the European Union as well – will be to ensure during the accession negotiations for Iceland that the advantages that this small country has enjoyed until now and has allowed Icelanders to build up and enjoy a good society are still preserved with Iceland as a member of the Union. These will then be complemented by the advantages for Iceland of participating fully in this great European endeavour. If we succeed in that, I am also certain that Iceland‘s entry will benefit the Union in many ways. Although small, Iceland has many valuable and even unique assets, both human and natural, that will in their own way complement the already substantial resources of the European Union.