Is Iceland too small?

Thorvaldur Gylfason, 19 August 2009

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Can Iceland‘s small size be blamed for the collapse of its banking system in 2008? Is Iceland perhaps too small to make sense and be sustainable as a sovereign state? My answers are no and no, not at all. True, its population of 320,000 makes Iceland quite small. Yet, of the world’s more than 200 sovereign or virtually sovereign states, about 40 are smaller – have fewer inhabitants – than Iceland. This is a sizable group and, on the whole, a rather successful one in economic terms.

Small can be beautiful

Let‘s begin with a bit of history. “Our shortage of people is our most serious social evil,” said Iceland’s national poet, Einar Benediktsson, almost a hundred years ago. He and others advocated massive immigration of foreign labour to Iceland’s shores to increase the population. They eyed no way of offering the Icelandic people a decent standard of life except by increasing their number to attain a critical mass. In this debate, the critical population mass was claimed to be larger than 100,000, Iceland’s population in 1925. Yet, medieval Florence and Venice flourished with 70,000 and 115,000 inhabitants. They were better situated in Europe and better served by sea lanes than Iceland was and could, therefore, easily make up for their small size through trade. Economic integration is vital to small countries. The population of ancient Athens was 200,000. Too small? Hardly.

Or take modern Barbados (pop. 300,000), independent since 1966, a prosperous and stable democracy where virtually every child completes primary and secondary school and life expectancy matches that of the US. Is Barbados too small? No. Barbados has not even felt it necessary to pool its currency with its eight neighbours comprising the East Caribbean Currency Union (ECCU, pop. 600,000). Since 1975, the exchange rate of the Barbados dollar has been kept fixed vis-à-vis the US dollar at a rate of 2 to 1 (and the ECCU, meanwhile, pegged the East Caribbean dollar to the US dollar at a rate of 3 to 1).

Is there a lower bound on population below which countries cannot stand on their own feet? Yes, but it seems to lie far below 300,000. The Faroe Islands (pop. 48,000) and Greenland (pop. 57,000) remain by choice an integral part of Denmark, but they have had full internal autonomy since 1948 and 1979. The Faroes could do without Danish support, but Greenland, with its small population spread over a vast and rugged coastline, is another matter (see Sibert 2009).

A world of small, open states: Small and closed is not an option

The world has become a bunch of small states. In 1914, the number of independent states around the world was 62. By 1946, their number had risen to 74. Today, the number is over 200. Along the way, the average size of countries measured by population has decreased from 32 million in 1946 to 29 million today (19 million if India and China are not included). The number of small countries has increased enough for half the countries of the world to have fewer inhabitants than Denmark (pop. 5.5 million). The EU has become a union of small states whose average population is 18.5 million and declining. Countries with fewer than one million inhabitants actually have a higher average per capita GDP than those with a million people or more – $14,000 compared with $11,000 in 2006 according to the World Bank. This does not suggest that economies of scale and scope, essential though they are, are the chief driving force behind economic prosperity in today’s world. There are other important forces at work as well (Alesina and Spolaore 2003).

Europe is not a country because people differ. The strife for a steadily improving standard of life through economies of scale calls for intensified economic integration. This centripetal force confronts a centrifugal counterforce that arises from many people’s innate desire to live with their own kin sharing the same culture, history, and language. It is not efficient to have too few, too large countries because large countries, with the obvious exception of Japan, as a rule have heterogeneous populations that may be prone to dissension holding back economic progress. Yet, the heterogeneity of its population has not prevented the US from achieving reasonable social cohesion and great success. The same has been true of China since 1978 and perhaps India since 1991.

Fuelled by free trade, small nations have increased in number. Without external trade, many small nations would be inefficient on account of their small size and would seem, on economic grounds, to need to merge with larger nations. Foreign trade relieves small nations of this need by enabling them to reap the benefits of scale and scope through trade.

This is how trade has helped increase the number of sovereign states over the years. Without vivacious trade, the costs of small size to many countries would almost surely outweigh the gains. The inability of a small country to benefit from specialisation by exploiting its comparative advantages would by itself be disastrous. With trade, however, the arithmetic changes.

Benefits of being small

Small states can also do very well if their typically homogeneous populations manage to live together in peace and harmony. Not all small states have homogeneous populations, however. Cyprus and Mauritius are small island states with heterogeneous populations that get along well enough to be able to enjoy steadily improving standards of living. In Europe, centripetal forces had the upper hand in the nineteenth century when, in 1861, Italy was formed through the unification of several small states and Germany followed suit.

Some observers at the time thought Belgium and Portugal were too small to be viable as independent countries. The tables were turned in the twentieth century when centrifugal forces prevailed, facilitated by the worldwide liberalisation of trade after World War II. Iceland attained home rule in 1904 and transformed itself from economic parity with today‘s Ghana in 1900 to parity with Scandinavia in 1980 (Gylfason 2008a). Gradual liberalisation of trade from 1960 onward played an important role in Iceland’s transformation.

One consequence of the social accord that tends to go along with small size may be a shared interest in education, as children in cohesive societies are less likely to be deprived of schooling. Countries with 300,000 or fewer inhabitants keep their young people in school a year longer on average than larger countries, in the sense that the small countries have an average school life expectancy – i.e., the expected number of years of schooling that will be completed as measured by UNESCO – of 13 years compared with 12 years elsewhere.

Another consequence of small country size, especially in a strategic location, may be that neighbours may be willing to share the costs of national defence. France spends 2.4% of its GDP on national defence compared with 1.1% in Belgium and 0.8% in Luxembourg. This tendency may offset some of the higher per capita cost of public services in small countries. Moreover, and this may surprise you, small countries tend to have less corruption than large countries as measured by Transparency International. In 2008, the Corruption Perceptions Index – which ranges from 1.4 in Somalia to 9.4 in Denmark – was 4.6 on average in countries with 300,000 or fewer inhabitants compared with 4.0 in larger countries.

Small can be dangerous, too

Even if small countries can succeed by being open and peaceful, their small size presents challenges. Strong checks and balances are imperative in small, heavily politicised, clan-based societies to prevent relations between politics, banking, and business from becoming too cosy, not to say incestuous. Here Iceland failed. High-quality recruitment into political service and careful selection of key public officials, from abroad if needed, are also important in a small country with a small pool of appropriate local talent. Here, too, Iceland missed the boat.

This double malfunction helps explain the Russian-style expropriation by vessel owners of fishing rights in Icelandic waters in 1984 despite the fish stocks being a common property resource by law. This expropriation of catch quotas, legislated by parliament, set the stage for the subsequent, similarly motivated privatisation of Iceland’s commercial banks in 1998-2003 as well as the subsequent failure of the Central Bank and the Financial Supervisory Authority to rein in the banks when they proceeded to rapidly outgrow the country’s monetary and fiscal capacity to act as a lender, or borrower, of last resort (Gylfason 2008b). These mistakes were not inescapable consequences of Iceland’s small size. With better people in charge – a smaller, more competent, more responsible political class – and better policies and institutions, these mistakes could have been avoided. Russia’s somewhat similar problems surely have nothing to do with Russia’s size, but rather with state capture by entrenched political elites even under democracy.

Iceland’s transformation in the twentieth century was marked by many successes but also by some significant shortcomings, including the authorities’ failure to keep prices stable. After 1939, the Icelandic króna depreciated by 99.95% vis-à-vis the Danish krone. Fish stocks in Icelandic waters decreased by a half to two-thirds, partly due to overfishing, and foreign debt edged up and then exploded after the crash. Iceland’s recent application for EU membership aims to put the country on a stable path to strong recovery by firmly anchoring Iceland among old friends and allies in Europe. In view of its chequered history of money and banking, Iceland stands to gain especially from sharing its monetary policy and financial supervision with other EU members.

References

Alesina, Alberto, and Enrico Spolaore (2003), The Size of Nations, MIT Press.

Gylfason, Thorvaldur (2008a), “When Iceland was Ghana,” VoxEU.org, 25 January.

Gylfason, Thorvaldur (2008b), “Iceland’s blend of old and new,” VoxEU.org, 10 July.

Sibert, Anne (2009), “Undersized: Could Greenland be the new Iceland? Should it be?,” VoxEU.org, 10 August.

Topics: Europe's nations and regions
Tags: Banking crisis, Iceland

Thorvaldur Gylfason

Professor of Economics, University of Iceland and CEPR Research Fellow