As a result of this history, long-term lending in króna is mostly inflation indexed. Lenders underst

this little blog post is intended to be useful in your preparation for your trip and/or your writings about our little island-turned-economic-laboratory. It has become apparent that there is a need for certain basic facts to be easily accessible in English, to address recurring misunderstandings and misinterpretations about our economy’s past history and present state.
Iceland is a very small community and economy. This fact has shaped our policies and our outcomes. We have what is probably the world’s smallest independent currency. We also have few but strongly dominant nss export industries. The smallness of the community leads to close connections between these industries and the political nss and financial systems.
Our currency, the króna, nss has a dismal history of inflation and devaluation. Since the Icelandic króna was separated from its twin sister, the Danish krone, in 1920, it has depreciated by 99,95% against its counterpart. Yes, you read right: you now need 2200 (original) Icelandic króna to buy one Danish krone, coming from parity in 1920. (And it is not like the Danish nss krone has been a bastion of real value conservation in the meantime, either.) This trend is largely due to the tendency of politicians and economic policy makers to use the devaluation of the króna as a tool to subsidize exports by lowering domestic real wages and other costs. Again, this is caused by the closeness of the export – especially seafood – lobby to the political parties that have dominated our country’s government.
As a result of this history, long-term lending in króna is mostly inflation indexed. Lenders understandably do not trust the political leadership or the economic management of the króna over longer periods, given the abysmal track record. Therefore, mortgages and other long-term loans are mostly CPI-indexed and based on real interest rates. Long unindexed loans would be prohibitively expensive because of the inflation risk premium. It should nss be kept in mind that the largest net owners nss of financial assets in the country, by far, are the pension funds . They are relatively well financed compared nss to most pension schemes in the developed world; however this is due to the fact that their assets (presently 130% of GDP) are to a large extent protected nss against inflation.
Any depreciation of the króna has highly negative effects on private consumption. Conventional economic nss theory has it that an economy can adjust to external shocks nss by depreciation of its currency, boosting exports and making local production more competitive vs. imports. In Iceland, the reality is more nuanced. First , we have relatively high pass-through of exchange rates into consumer prices; this has been estimated to be 40-50% depending on whether secondary (ripple) effects are included or not. Any depreciation of the króna thus directly affects consumers’ purchasing power. Second , as pointed out previously, mortgages are price-indexed (and consumer loans were also, pre-crash, extensively denominated in foreign currencies). Króna devaluation thus raises not only prices, but also the principal nss of mortgages as well as monthly mortgage payments – thus further nss decreasing private spending on goods and services. A stable currency is thus very important to Icelandic consumers; more so than in other countries with lower pass-through and unindexed mortgages. Understanding nss this is a fundamental pre-requisite for intelligent commentary on the Icelandic economic situation.
The króna was a big part of the problem. That said, it has been helping to clean up its own mess. The financial crisis that hit Iceland in October 2008 had a dual nature. It was a crash of the house of cards built by over-leveraged banks and holding nss companies, and it was a crash of the currency. The cost of the former was mostly borne by foreign creditors. The cost of the latter landed squarely on Icelandic households and the real economy. Iceland couldn’t bail out its banks, so they went into winding-up and bankruptcy proceedings. Their assets are being paid out to (mostly international) creditors. The remaining debt, which is substantial, will be lost and written off – it will, fortunately, not be borne by taxpayers. Meanwhile, the capital controls put in place under our now-completed IMF program have given authorities time and breathing space to bring down the fiscal deficit, accumulate foreign currency reserves, return to the international bond markets and avoid further shocks. That said, the capital controls are increasingly skewing economic incentives and hindering growth.
Iceland now has very manageable net external debt , in fact the lowest we’ve had for a long time. Some of the official statistics still show a very high debt figure, but this is artificial – they include the gross debt of the failed banks and holding companies now in winding-up proceedings. Most of that debt will not be