Bidding Farewell to Capital Controls in Iceland

Alex Mabie, JHU:

This summer, the Icelandic government revealed that it is set to lift capital controls from its economy. This announcement was met with sweeping satisfaction across the country. What are capital controls, why were they so unpopular, and were they necessary?

The Icelandic economy is small, open, and primarily resource-based: built on fishing, aluminum smelting, tourism, and – more recently – financial services. For most of recent history, it has been relatively stable – even boring.

In October 2008, the Nordic island suffered the biggest banking crisis in history relative to the size of an economy. Its three main banks, Glitnir, Kaupthing, and Landsbanki, couldn’t avoid the deterioration in global financial markets following the September collapse of Lehman Brothers. Amidst the turmoil, investors scurried for the exits, beginning to convert their Icelandic assets into foreign currencies. As a result, Iceland’s currency, the krona, sharply plummeted in value.

Had no action been taken on the part of the Icelandic government, sustained currency depreciation would have posed deadly implications for its economy. Icelanders would have struggled to repay loans taken out in stronger, foreign currencies. Additionally, imports would have grown more expensive, fueling inflation. These inflated prices would subsequently induce an erosive effect on Icelandic households’ disposable income. Promptly following the failures of the three banks, the Icelandic government introduced capital controls in November to stabilize the krona.

Generally speaking, capital controls simply limit the amount of foreign capital that enters and exits an economy. In Iceland’s case, the policy prevented investors from selling off their Icelandic assets and converting their proceeds into a foreign currency, which would have exacerbated the downward pressure on the value of Iceland’s currency and fueled rampant inflation. The controls also restricted investors abroad in possession of krona-denominated assets from receiving hard-currency returns. Such returns would have given investors the opportunity to sell their assets for krona and then exchange these krona proceeds for other currencies. Overall, these measures reined in the krona’s deprecation.

The benefits of the use of capital controls in Iceland seem clear. However, the economic community is extremely divided on the issue. While some argue that controls were necessary to prop up the krona, others denounce it as a tool only effective in the short-term. Icelandic economists Ragnar Arnaso and Jon Danielson go further in asserting that the controls should not have been used at all.

According to Arnaso and Danielson, capital controls have only hurt Iceland. The two maintain that the controls have not only thwarted economic growth but that policy has also violated the civil rights of Icelanders. They point out that “any individual seeking to emigrate from Iceland is at least partially locked in by the capital controls by virtue of not being able to transfer his or her abroad.” They view this restriction as a blatant disregard to Icelanders’ civil rights and to democratic principles at large, citing Iceland’s legal commitment to the Freedom of Movement For Workers as mandated by the Four European Freedoms.

As far as the economics are concerned, Arnaso and Danielson say that capital controls have weakened the competitive position of Icelandic industry and undermined the trust of those who have invested in the Icelandic economy. A superior policy response would have been the imposition of special taxes on speculative flows of capital. This, at least, would have been an easier measure to scale back. More than anything, it is the continued presence of capital controls that irks Arnaso and Danielson the most. According to them, this has hindered a complete economic recovery.

Indeed, capital controls have been the most frustrating detail of the matter for Icelanders. A measure that was introduced as a temporary solution to Iceland’s shambled condition dragged on for nearly seven years, much longer than anybody had anticipated. Most of Iceland’s residents saw little merit in the existence of controls after their short-term capacities expired with the stabilization of the krona in early 2009.

Whether capital controls were truly necessary for Iceland’s survival remains to be seen. However, the beauty of our economic world (and perhaps its biggest peril) is that it is dominated by business cycles, peaks and troughs that shape the wealth of nations. We know that another downturn is inevitable; we just don’t know when it’s coming. Only then will Iceland have the impetus to implement a different recessionary tool, at which point policy makers in Iceland and around the world can assess how it sizes up to 2008’s capital controls experiment.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s