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Global Implications of U.S. Trade Policies for Reducing Structural Trade Imbalances Read chapter Read first chapter

2018 | OriginalPaper | Chapter

The Dutch Disease in Reverse: Iceland’s Natural Experiment

Authors : Thorvaldur Gylfason, Gylfi Zoega

Published in: Getting Globalization Right

Publisher: Springer International Publishing

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Abstract

For a long time, abundant natural resources brought Iceland a high and volatile real exchange rate with adverse effects on manufacturing and services. During 2003–2008, another national treasure, the sovereign’s AAA rating, was used by privatized banks to attract foreign capital, elevating the real exchange rate even further. The financial collapse and the associated collapse of the currency in 2008 left the country with a large foreign debt which offset some of the effect of the natural resources on the real exchange rate. In effect, this was the Dutch disease in reverse as witnessed, in particular, by a massive increase in the number of tourists following the financial collapse. This paper discusses the behavior of the exchange rate of the Icelandic króna before and after 2008 as well as its relationship to natural resources, capital flows, output, exports and imports, including tourism.

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Footnotes
1
See, e.g., Sachs and Warner (2001), Gylfason and Zoega (2006), Collier and Goderis (2012) and Sala-i-Martin and Subramanian (2013).
 
2
See Brunnschweiler and Bulte (2008), Lederman and Maloney (2008), Alexeev and Conrad (2009) and James (2015).
 
3
See Paldam (1997), Tornell and Lane (1999), Auty (2001), Mehlum et al. (2006a, b) and Robinson et al. (2006).
 
4
See Corden (1984), Corden and Neary (1982), Van Wijnbergen (1984) and Herbertsson et al. (2000).
 
5
See Baland and Francois (2000), Tornell and Lane (1999), Torvik (2002), and Boschini et al. (2007).
 
6
See Easterly and Levine (1997) and Hodler (2006).
 
7
See Arezki and Brückner (2011) and Arezki and Gylfason (2013).
 
8
See Ross (2001), Collier and Hoeffler (2009) and Tsui (2011).
 
9
See Mansurian (1991) and Manzano and Rigobon (2007).
 
10
See Gylfason (2001).
 
11
See Gylfason and Zoega (1999).
 
12
See Younger (1992), Burnside and Dollar (2000), Svensson (2000) and Djankov et al. (2008) and also Deaton (2013, Chap. 7).
 
13
Gylfason and Zoega (2003) and Goderis and Malon (2011) consider the relationship between natural resources and inequality.
 
14
Benigno and Fornaro (2014) use the term ‘financial resource curse’ to describe episodes of abundant access to foreign capital coupled with weak productivity growth.
 
15
See Gylfason et al. (2010), Benediktsdottir et al. (2011), Johnsen (2014) and Gylfason (2015, 2016).
 
16
See Calvo (1998) and Calvo et al. (2004) on how a sudden stop in international credit flows may cause financial and balance-of-payments crises. Calvo and Reinhart (2000) recommend dollarization as a way to eliminate the problems caused by the sudden reversal of capital inflows. Calvo (2007) argues that emerging economies should intervene in the credit market rather than relying solely on interest rates as a policy tool to reduce the likelihood of a sudden stop. Lane and Milesi-Ferretti (2008) discuss the impact of capital inflows on domestic variables.
 
17
Specifically, from 2007 to 2009 the real exchange rate fell by 35% based on relative consumer prices at home and abroad and by 50% based on relative unit labor costs. Source: Central Bank of Iceland, see http://​hagtolur.​sedlabanki.​is/​data/​set/​1wui/​#!display=​table&​ds=​1wui!1z9x=​1.​3.
 
18
Source: World Bank, World Development Indicators.
 
19
Since 1960, Iceland has had the OECD region’s second highest average rate of inflation, second only to Turkey. High inflation has often been seen to go along with high real exchange rates because the government hesitates to devalue the currency as expectations of inflation are not anchored and devaluation is likely to encourage inflation. As a result the government resorts to foreign borrowing instead, a common scenario in Africa and Latin America, for example.
 
20
In 2012, fish products accounted for 27% of total export earnings in Iceland, aluminum for 22% and foreign tourism, 24% (source: Statistics Iceland). Kristjansdottir (2012) describes the determinants of the geographical pattern of Iceland’s export trade.
 
21
The OMX15 covering the 15 largest corporations increased by a factor of six over the same period and nearly by a factor of nine from its bottom in 2001 to its peak value in 2007. See Aliber (2011) and Halldorsson and Zoega (2010).
 
22
Net investment, i.e., gross investment minus depreciation, was negative from 2009 to 2012.
 
23
Sources: Statistics Iceland (hagstofa.​is), Central Bank of Iceland (sedlabanki.​is), World Bank, World Development Indicators, and Trading Economics (tradingeconomics​.​com/​iceland/​stock-market). See also Halldorsson and Zoega (2010).
 
24
Gylfason et al. (2010) and Gylfason (2015) compare economic conditions in the Nordic countries during these years.
 
25
Source: Registers Iceland (skra.​is/​Markadurinn/​Talnaefni).
 
26
The model of this section differs from that in Gylfason et al. (1999) by having two factors of production rather than only labor. Here, however, we do not derive the growth effect of the abundance of natural resources but only the effect on the level of primary and secondary output.
 
27
Depreciation of capital is assumed away.
 
28
Paldam (1997) describes the impact of the Dutch disease in Greenland through wages.
 
29
Equation (7) implies that the sum of the growth rates of primary and secondary (tradable) output always equals the rate of growth of (tradable) consumption.
 
30
The VAR is stable because all roots of the characteristic polynomial lie inside the unit circle. The null hypothesis of the exclusion of real exchange rates from the current account equation and the change-in-the-number-of-tourists equation can be rejected at the 5% level of significance (probability = 0.0).
 
31
The generalized impulses look identical to impulses derived with the Cholesky decomposition. The latter imposes an ordering on the variables in the VAR and attributes all of the effect of any common component to the variable that comes first in the VAR system, which in our case is the real exchange rate.
 
32
Variance decomposition gives information about the relative importance of each of the random innovations for the forecast error for the four variables. The forecast error of the current account due to innovations to the real exchange rate is 9% in the first year after the innovation, 43.7% in the second year and then stabilizes at over 44%. The corresponding numbers for the number of tourists are 1.1% for the first year, 0.8% for the second year, then 7.9% for the third year, 18.9% for the fourth year before stabilizing at over 20%. In contrast to the importance of innovations to the real exchange rate for the standard error of the current account, innovations to the current account, number of tourists and other exports contribute much less to the standard error of the real exchange rate: the three innovations explain 2.3% of the standard error of the real exchange rate in the first year and just over 24% in year seven after the shock.
 
33
Moreover, these firms require foreign investors who have been hesitant to invest in Iceland due to the capital controls in place since 2008. Some start-up firms have left the country for this reason and others are considering whether to do so.
 
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Metadata
Title
The Dutch Disease in Reverse: Iceland’s Natural Experiment
Authors
Thorvaldur Gylfason
Gylfi Zoega
Copyright Year
2018
Book
Getting Globalization Right

Print ISBN: 978-3-319-97691-4

Electronic ISBN: 978-3-319-97692-1

Copyright Year: 2018

DOI
https://doi.org/10.1007/978-3-319-97692-1_2