Ladies and gentlemen
I am very pleased to address this meeting today. I had the privilege of being a staff member in this institution in the years 1977-1983 after I completed my university studies. The Bank’s headquarters were still in the centre of town in close proximity to Landsbanki that acted as its mentor in the Central Bank’s early years.
Most of the Bank’s working environment and tasks have changed in the quarter century since I left, mostly for the better. In those days, the Bank was entrusted with a wide variety of tasks and some of the goals defined for the Bank by law were actually in conflict. Inflation was rampant and overshadowed all other economic issues as well as being the primary topic of the political discourse. Every Icelander would at that time have rejoiced at the inflation rate that we have today and most would have thought it inconceivable that inflation could even be below 5 per cent as it is now, not to mention our inflation target of 2.5 per cent.
It is a sign of the changes that have taken place that today the Central Bank determines its policy rate without the interference of the Government, which in earlier times controlled both interest rates and the exchange rate. The Government is, however, determined to strengthen the Central Bank. At the Bank’s Annual Meeting a year ago it was announced that, after consultation between the Government and the Bank, that its foreign exchange reserves would be strengthened as well as its equity capital. This was implemented by a one billion euro bond issue of the Treasury last year, the proceeds of which were relent to the Central Bank to augment its foreign exchange reserves. In continuation of this policy, and in accordance with an authorisation in this year’s fiscal budget, the Government has decided to take a further step and allocate a substantial part of the Government’s deposit with the Central Bank to an increase in its equity capital by 44 billion krónur. This will greatly increase the Bank’s equity capital which stood at 48 billion krónur at the end of February.
It is good to see that while the economic debate has given way to other issues in the political arena in recent years, at the same time as the economy is undergoing structural reform and economic policy is developing positively, the economic debate has also been developing for the better. The times have passed when the Central Bank and other public institutions had a near monopoly on discussions of the economy. Today, there are a number of very able observers of the economy, such as the economic departments of financial institutions as well as a number of foreign observers, not all of whom, however, are sufficiently qualified.
Overall, the Icelandic economy is doing quite well and its prospects are promising. We have gone through an expansionary period of power construction and the housing market has been quite lively which has inevitably strained economic policy. At present, however, there is every indication that the economy is reverting back into balance with more quiet times ahead as witnessed i.a. by the recent forecast of the Central Bank that its policy rate will begin to decline this autumn.
The rate of inflation is expected to decline down to the Bank’s inflation target later this year. This will also mean that the current account deficit will decline and economic growth will be lower this year than in recent years.
It is quite normal that the economy slows down at this point and that everyone takes a deep breath. But we must ensure that the economy will not stop breathing altogether.
The Government has long been of the opinion that the economy would withstand this strong economic upswing and come in for a ‘soft landing’. The economy has been going through profound structural changes in the past fifteen years and is better equipped to withstand temporary fluctuations than before. There is no way that the latest Central Bank forecast can be interpreted to mean that the economy will suffer a ‘hard landing’.
The Treasury position is also very strong, in fact stronger than in most countries, both as regards its revenue surplus and its assets, since its debt has become negligible. Business balance sheets are also generally strong, especially in the financial sector. It should also not be forgotten that, although household debt has certainly increased, household assets have increased even more and as a result households’ net asset position has improved.
The expansionary period of past two years was largely foreseen, as is evident from the forecasts of the Ministry of Finance at the time. Inflation was forecast to rise as well as interest rates and the current account deficit. What came as unexpected was the strong impact of the changes in the housing market, especially the entry of the banks into mortgage lending.
Some observers have been of the opinion that the Government should not have carried out the tax cuts of recent years. This opinion has been refuted from this very podium by my predecessors in the office of Prime Minister, and with solid arguments. The strong fiscal position of the Treasury and its ample revenue, such as from the capital and corporate income taxes, have made it possible to cut the personal income tax without causing an expansion. There were those who said that the Government’s tax cuts were “a disastrous mistake”. This assertion has turned out to be untrue. It should be noticed that the funds disbursed by the Treasury to the public through tax cuts this year are probably far less than half of what business firms will pay in dividends in the same year. This is an indication of the gathering strength of the business sector.
But let me turn to another subject. The euro has been the subject of much discussion of late. There are those who have maintained that the adoption of the euro in place of the Icelandic króna would solve all problems of business, households and public entities. This view is illusory. First of all, it is completely unrealistic to contemplate the adoption of the euro without membership in the European Union. All experts agree on this and have pointed out that the unilateral adoption of a foreign currency in place of the domestic one lacks the necessary credibility for economic policy.
The question of formal adoption of the euro in place of the Icelandic króna is therefore a question of whether Iceland should become a member of the European Union. That should be an easy question to answer following the publication of the new report of the Europe Commission.
Second, it is by no means assured that the adoption of the euro would solve any economic problems in Iceland. On the contrary, new problems would arise in place of old ones. As the Icelandic economy is small and open to outside fluctuations, we must always expect more instability than other nations. We will not solve this problem by replacing the króna with the euro and thereby abandon the possibility of conducting our own monetary policy. This would mean that instead of currency fluctuations we would have labour market instability where changing unemployment would be dominant. Would it be better to have increased unemployment instead of exchange rate fluctuations? This is a question that must be answered. My answer is no.
Third, the misunderstanding has arisen that if companies register their financial accounts in euros that it will signal the demise of the Icelandic króna. Nothing is further from the truth. As Finance Minister, I was responsible for the legislation in 2001 which allowed companies to draw up their annual accounts in currencies other than the króna, subject to certain conditions. This did not signal the end to the króna but was intended to meet the reasonable request of firms to adjust to changing circumstances associated with increased business abroad. Today, Icelandic companies can draw up their accounts in any currency they like, subject to certain conditions. Most companies that have done so have chosen the US dollar.
Let us not forget that a decision to change currencies or become a member of a larger currency area is a very dramatic step to take. Such decisions have been rejected in referendums both in Denmark and Sweden. The currencies of those two countries are a good deal closer to the euro than the Icelandic króna. This is not a question of romantic nationalism in favour of our currency which in any case does not have a long history in its current form. The issue here is to find the most favourable solution for our currency in the context of our small, open economy, at the same time safeguarding our economic independence and making it possible for us to deal with domestic business cycles that, to judge from experience, generally do not coincide with cycles in other larger economies. There is no better alternative today than to keep the Icelandic króna, whatever may turn out later. The Central Bank is entrusted with the task of pursuing its inflation target and safeguarding the value of the currency.
The euro will not perform any miracles for economic policy. The important thing is to conduct a rational and a responsible economic policy.
Ladies and gentlemen
The government has placed great and increasing emphasis upon education, research and innovation. In the past ten years, the fiscal appropriations for universities and scientific research have doubled in real terms. The five-year agreement signed by the Minister of Education and the rector of the University of Iceland at the beginning of this year covers instruction and research and calls for a threefold increase in fiscal funding over the period.
The Government intends to increase appropriations to public funds that encourage competition in science and technology and make it possible for Icelandic companies and the scientific community to cooperate in ambitious applications for science and innovation grants from abroad. The main strength of Icelandic research is that we have qualified people with a sound international education and connections, people that possess ambition and initiative to use their knowledge to achieve results on an international scale.
I mention this here because research and innovation have created able and enterprising high-tech firms that have achieved commendable results in foreign markets when the domestic market has not been large enough to ensure continued growth.
We Icelanders have achieved a high standard of living and built a good knowledge base. But we are determined to achieve more. The conditions in this country are favourable for conducting scientific research and furthering technological development. Economic stability in concert with political stability creates the foundation of innovation.
The competitive position and the living standard of nations are primarily based on their ability to look ahead into the future, seize opportunities and make use of knowledge in an organised manner.
Ladies and gentlemen
In closing, I wish to thank the Governors of the Central Bank for good cooperation in the past year. I thank the staff for their valuable work and cooperation in the past. The Central Bank plays an important role in our society and I wish it well for the coming year.