Business

Frozen capital: how to boost Iceland’s economy

The discriminatory nature of the capital controls exit mechanism, could have a huge impact on Iceland’s economy, and on its people.

BY Shanker Singham   /  26 September 2016

As the issues of financial services passports, the single market and movement of people swirl around the media in the wake of the British vote to leave the European Union, one issue that has not been discussed is how the UK might deal, in this post Brexit world with negotiations with both the EU and EFTA countries where distortions damage UK interests.  Iceland, an EFTA member which is also an EEA member presents one of these issues.

It is well known that Iceland enacted capital controls in the wake of its fiscal crisis in November, 2008 some eight years ago.  What is less well known is that recent attempts by Iceland to exit that capital control regime have been damaging not only to the interests of foreign investors, but more importantly for the people of Iceland.  The discriminatory nature of the mechanism for exit has led to a continuing and high level of distortions in the Icelandic market.

When property rights are not protected – and the rights of foreign investors are surely the most basic kind of property rights – then economic growth cannot take place.  The three fundamental pillars of economic growth are open trade, competitive markets inside the border and property rights protection.  But the most important of these is property rights protection.  It is with property rights that firms compete, both nationally and internationally.  We have developed a mechanism to measure the impact of distortions on a nation’s GDP, in effect measuring the wealth destroying effect of internal economic distortions.  Iceland presents an interesting case, because it is a relatively open economy, with comparatively few distortions with the glaring exemption of its capital control regime, and specifically how that regime is being changed.  Of course the simplest way to remove the distortion of a capital control mechanism is to eliminate it completely.  Regrettably, the Icelanders are removing the regime in a discriminatory fashion, leaving its most pernicious effects in place for foreign entities, while improving the position for domestic entities. Given that this is adding discriminatory practice to an already distorted environment (because of a lack of property rights protection), there is an argument that far from improving the situation it actually worsens it, at least from a distortionary standpoint.

Our data (revealed in a forthcoming Legatum Institute paper) shows that removal of the capital control mechanism completely, in its entirety, could lead to an injection of between $5bn and $9bn into the Icelandic economy.  This translates into between $15,000 and $27,000 to each Icelandic citizen.  The graph below shows the alternative trajectories for the Icelandic economy if the distortions arising from the current situation were eliminated.  It is important to note here that these distortions arising from the status quo itself as well as the discriminatory manner in which the capital controls exit is being planned.


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chart1

Looked at another way, Iceland which has laboured after the fiscal crisis with a very high debt to GDP ratio, could lower its debt to GDP ratio to pre-crisis levels as can be seen from the graph below:

chart2

The increase in output of the economy would also lead to job creation.  We have estimated that the jobs created by the removal of this distortion could be as much as 30,000 jobs.

The damage done by Icelandic capital controls illustrates the harm that these mechanisms actually impose on economies.  While the original imposition of controls was done in the wake of a crisis of extraordinary scale, too many governments around the world embrace capital controls for much less significant reasons and underestimate the impact of this practice on their own economies. Rarely does this happen in an otherwise open economy and this enable us to use the Iceland case study to say something about the negative impact of capital controls and their discriminatory removal that has an impact on domestic economies.

A reduction in the current distortion in Iceland, which is now primarily driven by the discriminatory nature of the capital controls exit mechanism, could have a huge impact on Iceland’s economy, and on its people.

Shanker A. Singham is the Director of Economic Policy and Prosperity Studies, Legatum Institute

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