Már Guðmundsson: Challenges for the Icelandic economy Speech by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, at the 49th Annual General Meeting of the Central Bank of Iceland, Reykjavík, 25 March 2010. *  *  *  Madame Prime Minister, Madame Chairman, honourable Ministers, honourable Ambassadors, ladies and gentlemen: As we gather here for this 49th Annual General Meeting of the Central Bank of Iceland, the Icelandic economy is still recovering from overheating and the shocks of the recent past. The contraction in the economy is a part of this process, but it is rooted in three things. First, it was inevitable that the enormous expansion characterising the Icelandic economy in 2005– 2007 should subside. In line with previous experience in Iceland and other countries, it was highly likely that this would occur through a sharp drop in exchange rate and asset prices, followed by a temporary contraction in business activity and employment. Second, the Icelandic economy sustained severe blows as a result of the worldwide recession in late 2008 and early 2009. The third cause was the collapse of the Icelandic banks in the fall of 2008. When the banks failed, assets were lost, and Iceland’s relations with the international financial system were severely damaged. They remain damaged to this day, as our capital controls bear witness. The question of how to quantify the proportional contribution of these three causes to our current economic hardships is a persistent one.
The academic literature has identified that one of the main problems posed by public investment as a mechanism for providing cyclical momentum is the delay in its implementation, which is greater in the case of large projects. Although this may be of less importance in the long term, it is fundamental in the short term if the fund is to contribute to economic recovery (that is, to closing the output gap caused by the pandemic). Thirdly, the macroeconomic impact of the funds received (that is, the fiscal multiplier, which measures how much economic activity is generated by each euro spent) will also depend both on the overall economic situation and on the nature of the projects approved. Both the theoretical models and the empirical evidence available indicate that public investment expenditure has a larger and more enduring impact on activity than that of spending in other areas, such as government consumption or transfers to households.8 This is so, inter alia, because, in addition to increasing demand for goods in the short term (as occurs in other cases), public investment also helps to expand the economy's productive capital stock and, therefore, to support medium and long-term growth.9 In any event, the timing of the impact of public investment on activity hinges on the nature of the projects receiving the investment. For instance, although the effects of R&D expenditure are higher in the future, they may take longer to materialise than with other public investment projects.