Iceland’s growth performance has been impressive. Over the past decade, its real GDP has grown by 4% per annum, significantly bettering OECD growth over that period. As result, per capita GDP has recovered most of the ground lost in a preceding spell of sluggish growth, making the country the fifth-wealthiest in the OECD on that benchmark. Most of the rise in trend growth reflects productivity gains following the implementation of widespread structural reforms, which opened the economy and enhanced competition. Financial-market liberalisation and privatisation have unleashed entrepreneurial dynamism. Many companies have expanded abroad, and the country now plays a role that belies the small size of its economy. Labour markets have been increasingly opened to foreign participants, helping to reduce labour market tensions.

Iceland’s growth performance has considerably improved since the mid-1990s thanks to the widespread implementation of structural reforms. Financial-market liberalisation and privatisation, for example, have fostered entrepreneurship and investment. As a result, part of the previous relative decline in per capita GDP has been reversed over the past decade, and the country’s standard of living has remained among the highest in the OECD area. However growth has been volatile and accompanied by recurrent sizeable economic imbalances and tensions, only partly reflecting major aluminium-related investment projects. Consequently, a key challenge for policy is to enhance macroeconomic stability by ensuring an orderly unwinding of current imbalances and inflation pressures and avoiding their re-emergence in the future. Another challenge is to make sure that the financial sector continues to contribute to good economic performance by both minimising risks to stability and completing reforms in this area. Finally, the changing structure of the economy away from traditional activities like fisheries requires further efforts in the field of human resource development.

The objective of monetary policy is to stabilise inflation at about 2½ per cent. Actual inflation, however, has exceeded this target since 2004 and is expected to continue to do so for the foreseeable future. Monetary policy has reacted too sluggishly to the worsening outlook. Furthermore, increases in short-term nominal interest rates have not translated into comparable increases in real lending rates in the market. Higher interest rates and clear communication are needed to bring inflation back to the target and to strengthen the Central Bank’s inflation-fighting credibility.

This chapter discusses budgetary policies against the backdrop of Iceland’s longerterm fiscal position. With government finances in broad balance since budget consolidation in the mid-1990s, public debt has fallen significantly relative to GDP and is low by international comparison. At the same time, however, both the public expenditure and public revenue ratio to GDP have risen considerably. This reflects in part public spending overruns relative to budgeted values. Better expenditure control would both create room for tax cuts and allow fiscal policy to play a greater role in aggregate demand management. A problem in this respect is the lack of co-ordination and co-operation between the local and central governments.

This chapter discusses recent developments and policy issues relating to financial markets in Iceland. Overall, the sector is thriving, both relative to history and to conditions in other countries. This bodes well not only for those directly involved in the industry but for the country as a whole, as financial development is an important source of economic growth. Recently concerns have been expressed about the stability of the financial system; however the guarded assessment of financial supervisors and ratings agencies is that the system is broadly sound. A significant part of the credit for the vitality of the financial sector probably lies with government policy – in particular, the opening of the sector to international markets and the privatisation of the banks. Market liberalisation has been successful so far and should continue. In this respect a policy priority is to remove distortions in the market for home mortgage lending. In particular, the government guarantee for the Housing Financing Fund should be removed or neutralised; for example, by charging a fee. Iceland’s unusual reliance on indexation of loans is generally sensible for the borrowers and lenders involved and may have wider benefits. So restrictions on indexation of bank deposits and loans should be repealed. The financing of innovative start-ups is a difficult issue, where “best practice” guidelines are not obvious. Consideration should be given to use of less bureaucratic means of financing start-ups.

This chapter reviews Iceland’s performance in skills accumulation against the backdrop of a rapidly changing economic environment and discusses directions for further improvements. Since the late 1990s, the government has considerably raised expenditure on education, which is now among the highest in the OECD relative to GDP. Nonetheless, Iceland continues to have one of the largest shares of those in the working age population who have not attained upper secondary or higher qualifications, and educational achievements of 15-year olds are not outstanding relative to the country’s advanced state of economic development. This is all the more unsatisfactory because spending per student in the compulsory education sector exceeds the OECD mean considerably, even after controlling for differences in per capita GDP. Measures to improve outcomes include curriculum adjustments and an enhancement of teaching evaluation and quality. While ensuring that students acquire a satisfactory basic set of competencies, there is room for reducing the average duration of primary and secondary education, which is quite long by international comparison. In contrast to upper secondary attainment, that for the tertiary sector is above the OECD average, and higher education has to cope with an enormous rise in participation. With a view to maintaining quality in the face of these developments, the government has introduced legislation that is welcome. However, it does not address the issue of tuition fees, which are authorised in the private but not in the public sector.