The Icemen Cometh

It's beautiful, but the climate is vile. Resources are few and history books tell of dismal poverty. Yet tourism booms, the capital swarms with the international clubbing crowd, housing prices are soaring and economists talk of a new "tiger" of Europe.

Ireland? Nope. Iceland. With 6 percent growth, the country outstrips most of Europe. Its stock market was the Continent's best in 2004. Just last week, the Swiss International Institute for Management Development rated Iceland the most competitive economy in Europe. Says Prof. Stephane Garelli of IMD, "They are doing just about everything right."

As Icelanders see it, the recognition is overdue. Despite its diminutive population--293,000--Iceland has been busily shedding its cod-and-Viking image for more than a decade. Since the mid-' 90s, the country's center-right government has pushed free-market reforms--privatizing banks, ditching price controls and slashing taxes. Companies now pay just 18 percent on profits, down from 50 percent. "The same economic laws apply whether a country is small or large," says Finance Minister Geir Haarde. "We are experiencing the fruits of a very determined and consistent policy."

Like the Irish, the Icelanders play to their strengths. Heavy industry makes little sense for an island isolated in the mid-Atlantic, halfway to America. Instead, the country has focused on such sectors as high technology, where the brainpower of a highly educated work force compensates for distance. (How better to spend those long winter nights than surfing the Web?) Along the way, the capital of Reykjavik has become home to a slew of niche companies selling their expertise to the wider world in arenas from software and pharmaceuticals to prosthetic limbs.

And if Iceland is short on conventional resources, it's rich in geothermal energy--think volcanoes--and untapped hydropower, a big draw for energy-hungry industries. Environmentalists may agonize, but the country's empty (and cheap) hinterland is a lure for companies like U.S. aluminum giant Alcoa, which recently sank more than $1 billion into an outsize smelter fueled by its very own hydroelectric plant in the island's volcanic northern wilderness. "Other aluminum companies are queuing up to take a look," says Ingi Ingason of the Invest in Iceland agency.

Ireland built its success on membership in the European Union, with its subsidies and massive development aid. Iceland has not. (The prospect of sharing its fish, still a hefty export, with EU rivals has kept the country out of the union.) But that hasn't meant isolation. Iceland joined the European Economic Area in 1994, giving it easy access to the EU's internal market. "From a business point of view, we are already part of the EU," says Frederik Sigurdsson, founder and CEO of TM Software, which boasts 400 employees in Iceland, continental Europe and the United States.

Fellow Europeans can testify to that. Loaded with cash that cannot be fully absorbed at home, Icelandic bankers and investors have been pushing abroad. The giant Baugur holding company, born out of a single discount store in 1989, has snapped up some of Britain's premier retailers, including the famous Hamleys toyshop. Iceland's largest bank, Kaupthing, has doubled in size every year since 1996 and now draws more than 60 percent of its income from abroad. Recently, it took aim at London's venerable investment bank Singer & Friedlander.

Iceland's emergence has brought some very contemporary anxieties, of course. A housing boom pushed up prices more than 25 percent last year. Low unemployment (3 percent) and labor shortages have occasioned a spasm of immigration. Walk into any fish-processing plant or construction site and the chatter may be as much in Polish as Icelandic. Foreigners now make up 3 percent of the population--not much, but a big change for a once homogeneous society. The new affluence is pro-ducing wider income-gap disparities, but so far the world's oldest democracy hasn't lost its egalitarian character. "It's like the American Dream," says Lilja Mosesdottir of the Bifrost School of Business. "Everyone still believes that they can make it."

Small economies are famously susceptible to economic buffeting, and economists see a squall ahead. "The economy is overheating and there's very little slack left," says Hannes Suppanz, an economist with the Organization for Economic Cooperation and Development in Paris. On the other hand, the OECD pays tribute to Iceland's "un-expected degree of economic dynamism." Don't expect a meltdown. But perhaps it's time for Iceland to cool down a bit.