The Icelandic economy is prosperous and flexible. With its per-capita income growing at double the OECD rate since the mid-1990s, it is now the fifth-highest among member countries and more than a quarter above the OECD average. This impressive performance is attributable to extensive structural reforms that deregulated and opened up the economy, thereby unleashing entrepreneurial dynamism, as evidenced by an aggressive expansion of Icelandic companies abroad. Improved growth performance has been accompanied, however, by mounting tensions and imbalances in the economy. With financial-market liberalisation facilitating access to credit, and reducing its cost, aggregate demand has increasingly outstripped potential output, despite a substantial inflow of foreign workers. As a result, inflation and the external deficit have soared. Foreign indebtedness is the highest among OECD countries. This has made the economy vulnerable to changes in foreign investor sentiment, especially in the context of fragile global financial-market conditions.

Economic activity slowed through the first quarter of 2007, reflecting tight macroeconomic policies and the maturing of major aluminium-related investment projects. However, it revived subsequently as expansionary policy measures in the run-up to the general election in May rekindled demand and inflation pressures at a time when tensions and imbalances in the economy remained substantial. The further tightening of the monetary stance in the autumn should cool down the economy gradually in the period ahead. But the economy remains vulnerable to changes in foreign investor sentiment, especially in the context of fragile global financial-market conditions. Consequently, the key challenge for policy in the near term is to restore macroeconomic stability by ensuring that steady progress is made in unwinding both internal and external imbalances. In addition, with a view to sustaining Iceland’s favourable growth performance, steps need to be taken to strengthen the ability of both monetary and fiscal policy to moderate macroeconomic volatility and prevent the re-emergence of such imbalances. In a longer-term perspective, a key challenge for policymakers is health-care reform. Although the overall fiscal position is better than in many other OECD countries, health care (which is largely government-funded) is a major source of public spending pressures. Health outcomes are very good, but there appears to be room for enhancing cost-effectiveness.

In response to renewed inflationary pressures, monetary policy needs to remain tight until inflation expectations have moved back to and are well anchored at the policy target. While excessive inflation has persisted despite large increases in the policy rate, monetary policy has the capacity to stabilise the economy. The Central Bank’s communication strategy has greatly improved but arguably policymakers have continued to react too slowly to new information and to be overly optimistic about the inflation outlook. As well, reforms in the financial sector, above all the long-awaited restructuring of the Housing Financing Fund, and refinements to the inflation targeting framework would strengthen the transmission mechanism of monetary policy. In view of these considerations, unilaterally adopting the euro and thereby sacrificing a potentially effective stabilisation tool would not seem warranted currently.

Strengthening the fiscal framework would provide the means for both restraining the growth of public expenditures and helping automatic stabilisers work more efficiently. After reviewing current conditions in Iceland and discussing the pros and cons of fiscal policy activism, the chapter explains how better fiscal rules could improve the efficiency of public spending as well as lead to greater stability over the cycle. The final section lays the argument for extending fiscal rules to local governments.

Health outcomes and the quality of health care are very good by international comparison, while income-related health inequality appears to be smaller than in most other countries. However, the health-care system is costly and, according to OECD estimates, public expenditure on health and long-term care could reach 15% of GDP by 2050 if no restraining measures are taken. This highlights the importance of raising cost-effectiveness and spending efficiency more generally. To this end, it would seem advisable to remove impediments to private provision and open up the health sector to competition. At the same time, the introduction of cost-sharing should be considered where it does not exist (as in hospitals), although concerns about equity need to be taken into account. This would relieve the burden on public finances, as would the introduction of spending ceilings, cost-efficiency analysis and activity-based funding arrangements. The high cost of pharmaceuticals should be reduced by promoting competition and the use of inexpensive generic drugs.