Change of heart?

The electoral defeat of the center-left Icelandic government this spring baffled many outsiders. After all, the conventional wisdom goes, was this not the government that took over a country with a collapsed banking sector and collapsing economy and turned it around with the help of a successful International Monetary Fund program?

In fact, when Iceland graduated from the IMF program in August 2011 it was with flying colors, according to officials who announced the country to be its star pupil. Thus, such a clear rejection by voters surprised many - especially the margin: The combined electoral strength of the two coalition parties went from 51.5 percent down to 23.8 percent - a record loss in Iceland for any government since independence.

The first obvious reason for the results is one we've heard before: "It's the economy stupid." The famed recovery that began in 2011 actually faltered over the winter. Purchasing power has stagnated and domestic demand has contracted during the last two quarters. Now, keep in mind that Iceland's GDP had diminished by 10 percent in 2009/10 and the average household's purchasing power declined in excess of 20 percent both through inflation and higher taxes.

Therefore, a handsome recovery was not only desperately longed for and expected by the public but also promised by the government. When it failed to materialize, voters got the impression that the country was just stuck in a Malthusian trap (named after economist Thomas Robert Malthus who argued that technological advances resulted only in more people - the ed.) with a young fast-growing population but a stagnant economy.

Winning formula

The second reason is an appendix to the first: Populist policies to fix the problem. The clear winner of the elections, the Progressive party, which is traditionally the agrarian party in Iceland, rode to victory on the platform of using "vulture funds" money to write down household mortgage debt. It is a simple but winning formula. About 85 percent of household debt is inflation-indexed and the average homeowner has seen the principal of his loan rise in excess of 40 percent due to the inflationary wave that followed the collapse of the Icelandic krona (ISK) in 2008. At the same time, the asset recovery of the failed banks has actually been much better than forecasted.

A small proportion of the asset pool belonging to the estates is ISK-denominated, but these assets are nevertheless a large proportion of the Icelandic financial system and amount to about 30-40 percent of Iceland's GDP. The majority of outstanding claims on the estates have been bought by "vulture" hedgefunds and it is with them that the government will have to strike a bargain concerning the conversion of these ISK assets at substantially lower exchange rates than the official Central Bank rate Thus, the story line goes, it is only natural that the proceeds from such a bargain should be used to write down household debt. Whatever the validity of the argument, it became an effective slogan.

However, the two reasons mentioned above may explain a loss but not the hemorrhage the governing parties suffered in the election. There are many more deep-rooted reasons for the defeat. This outgoing government was the first purely left-wing government since Iceland's independence in 1944 and whose electoral victory in 2009 came on the back of a dramatic banking collapse. Therefore, the election was seen as historic chance by the intellectual left to implement various changes in Iceland that had been discussed over and over in cafes and parlors but never really had a majority in parliament.

Thus the banking crisis of 2008 became a pretext for pushing various fundamental changes in Iceland's society that had nothing to do with banking or stabilization policies. This included a new constitution, the abolition of the quota system in the fishing sector and various other reforms that were bound to create divisions within a nation long used to consensus politics.

Real reforms?

Now, making changes can be a good thing and opinions may differ on all these issues, although from an economist's point of view most of these changes did not enhance efficiency. Nevertheless, there is no doubt that after the financial collapse there was an outcry for reform; that the crisis should lead to a new and better Iceland. Whatever the goals may have been, the reform processes that were put into motion were all stillborn. They were steered by narrow-minded ideologues that both side-stepped expert advice and the usual consensus politics of Iceland. However critics were dismissed either as ill-informed or accused of having a hidden agenda. This same methodology also led to a confrontation between the government and the business community and the labor unions who maintained that the government was hell-bent on destroying rather than creating jobs.

At the same time, real economic structural reforms were sidelined. There were no policy initiatives concerning issues such as abolishing the capital control mechanisms, redesigning the financial system and redefining the framework for a stabilization policy for the world's smallest currency area. Had these initiatives appeared, they would have required a bi-partisan approach and ultimately would have been unattainable given the bitter war that was waged on other policy fronts.

The success of the IMF plan may actually be debatable and the heap of praise coming from Washington is becoming ever more questionable, but at least it was a plan. After the program ended in the fall of 2011 the clocks simply stopped in Iceland. The outcome of these past two years was just a lot of huffing and puffing in parliament that meant nothing to the public that was just trying to get by in a dismal economy. Electoral revenge was subsequently taken in the last election.

Tough task

Now the task of building a new Iceland awaits the newly formed center-right government. The task is not easy. The political discourse is now dominated by all kinds of feel-good policies, goals and promises to the public, many of which are mutually exclusive or not even attainable. It is for example impossible to simultaneously promise the abolition of capital controls and low inflation and higher purchasing power in the short run. Nor is it possible to maintain fixed exchange rates while simultaneously stimulating domestic demand - if exports are lacking.

It is quite clear that the creditors of the defaulted banks will have to take significant haircuts on the their ISK-denominated assets as they convert them into hard currency. Pouring these funds back into the economy to pay down household debt will seriously complicate any efforts to make the ISK convertible again in a free market and will undermine price stability.

The main problem now facing Iceland is that the same structural flaws concerning systematic risk have not been addressed - leading to regular currency crises. Looking past populist fantasies and left-wing clichés, there is no real discussion of wide-ranging institutional reforms that would enable Iceland to re-integrate into the international financial system, which is a pre-condition for long-term growth. Hence, capital controls are likely to linger.

In hindsight, the two years that have passed since the IMF program was implemented will be considered as precious time lost. Hopefully, that is an epitaph the new government will be able to avoid.

Ásgeir Jónsson is Assistant Professor of Economics at the University of Iceland and the author of "Why Iceland?: How One of the World's Smallest Countries Became the Meltdown's Biggest Casualty." He previously worked as Chief Economist at Iceland's Kaupthing bank.