This Survey is published on the responsibility of the Economic and Development Review Committee of the OECD, which is charged with the examination of the economic situation of member countries.The economic situation and policies of Iceland were reviewed by the Committee on 16 May 2013. The draft report was then revised in the light of the discussions and given final approval as the agreed report of the whole Committee on 7 June 2013.The Secretariat’s draft report was prepared for the Committee by David Carey and Wendy Dunn under the supervision of Patrick Lenain. Research assistance was provided by Roselyne Jamin.The previous Survey of Iceland was issued in June 2011.

Monetary policy remains accommodative despite output approaching trend and inflation running above target.

Iceland is a very small resource-based economy. It is highly volatile and has the smallest floating currency in the world. The labour market is flexible, reducing the costs of coping with this volatility. Icelanders are generally well educated, although the high school drop-out rate is a concern, and typically enjoy good health outcomes. Income inequality is among the lowest in the OECD. Government administration is efficient, especially when allowing for the absence of economies of scale in service delivery, and the overall tax burden is moderate.

Like other small, open economies with independent currencies, Iceland has long struggled with balancing its policy objectives within the context of the impossible trinity – exchange rate stability, monetary independence and capital mobility. Even after the move to inflation targeting, monetary policy failed to stave off the over-heating economy in the run-up to the 2008 crisis, and weak financial regulation enabled the destabilising expansion of the banking system. The subsequent fall in the exchange rate caused great pain for Icelandic households and businesses, but also has paved the way for Iceland to work its way out of the recession. The restrictions on capital outflows helped Iceland to regain exchange-rate stability during the crisis, but they risk causing distortions, and ensuring their orderly removal will be Iceland’s key policy challenge in the years ahead. When capital mobility is restored, sound monetary policy and prudential supervision and regulation will be essential. Policies to reduce exchange rate volatility may help anchor inflation expectations, but their scope is limited. Strong prudential supervision and regulation are instrumental for enhancing financial stability and, by discouraging the build-up of financial imbalances, macro-prudential policies hold some promise of augmenting the effectiveness of traditional monetary and fiscal policies.

In the wake of the financial crisis, the Icelandic government adopted a multi-year fiscal consolidation programme to lower public debt to more prudent levels and hence to reduce vulnerability to future adverse shocks. Considerable progress has been made in implementing the programme and debt has begun to decline. Remaining consolidation is mainly to come from reducing current expenditure. This, and the adoption of a budget law to increase discipline, would make the consolidation more sustainable. There are opportunities to reduce current expenditure by increasing efficiency, notably in the area of school education. More generally, the conduct of regular strategic spending reviews would help to identify savings, including by shifting resources to the government’s highest priorities.