Readers Question: I trying to find appropriate policies that the Icelandic government could adopt to deal with the country`s substantial current account deficit. Do you know what policies they are using for the moment, and more importantly which policies they should adopt?
At the height of the crisis the Icelandic economy had a large current account deficit financed by capital inflows (mainly capital flows to Icelandic banks). Since the crisis these capital flows have dried up making it harder to finance the deficit. Recently the Icelandic economy has faced:
- Fall in GDP of 7% annualised
- Rise in unemployment to 10%
- Rise in inflation to 11% (partly caused by depreciation in currency making imports more expensive)
- Fall in current account deficit. The deficit in the third quarter was ISK 36 billion nearly halving from the ISK 65.3 billion in the second quarter. Unfortunately, I’m not sure what % of GDP the current account is.
- Depreciation in Icelandic Krona
Factors which are reducing Current Account deficit.
1. Depreciation in the Currency.
The economic crisis and loss of confidence in the Icelandic economy led to a withdrawal of foreign currency leading to a rapid depreciation in the currency. This makes imports more expensive and exports cheaper. Icelanders can no longer afford many imports. Even McDonalds have recently announced they are leaving Iceland because it would be too expensive to import the raw materials making an Icelandic Big Mac the most expensive in the world. The depreciation in the currency has gone along way to reduce current account deficit.
The drawback of a depreciation is that it reduces the standard of living for Icelanders. They can no longer afford many luxury imported items. It has also caused imported inflation, especially in raw materials like oil and fuel. However, the depreciation is good in that it is encouraging consumers to buy domestic goods. (Icelandic newspapers report that there is a surge of interest in ‘Viking ideals of making your own home dye e.t.c…”
The depreciation is not so much a policy as an inevitable market reaction to the economic imbalances.
2. Reduce Consumer Spending
The next very effective policy for reducing the current account deficit is to reduce consumer spending, and hence reduce spending on imports. High interest rates (corporate interest rates have touched 25% and deflationary fiscal policy both reduce consumers ability to buy imported goods and this reduces the current account deficit.
The obvious drawback is that it creates a fall in GDP and rising unemployment. It is a painful solution to the problem of a trade deficit. But, it is very effective. The issue becomes which is the biggest priority – reducing current account deficit or falling GDP.
3. Supply Side Policies.
In the long term, Iceland need to develop their exporting industries. In particular, they need to develop a ‘real’ economy rather than just the banking sector which was based on overly optimistic loans and projections. To improve productivity and develop new industry is no easy matter. Economists can suggest both:
- Free Market Supply side policies – e.g. reducing tax rates, encouraging labour market flexibility e.t.c
- Interventionist supply side policies e.g. more spending on education and training, subsidies to develop new industries.
But, both supply side policies are often easier said than done. At best, these supply side policies will have a considerable time lag before they start to improve the fortunes of Iceland’s economy and trade prospects. This does not mean they are not worth doing, but, they cannot fix a short term problem.