According to Valdimar Hafsteinn, a folklorist and historian who used to work for the roads administration, the agency in the late 1970's even called in a medium to negotiate with irate elves who had objected to scheduled blasting at a road construction site near the city of Akureyri. Apparently, the perturbed pixies threatened to sabotage the project. The medium convened two seances, which led to a compromise: Bureaucrats eschewed explosives and the elves withdrew their opposition.

In the next few weeks, road authority contractors will gently move a cracked gray boulder known as Grasteinn, said to be owned by dwarfs, that blocks the expansion of a highway on the outskirts of Reykjavik. Viktor A. Ingolfsson, a spokesman for the road agency, defends his department's unorthodox expenditure -- ''hundreds, not thousands, of dollars'' -- describing it as a reasonable public relations expense: ''When Native Americans protest roads being built over ancient burial grounds, the U.S. listens. It's the same here. There are people who believe in elves and we don't make fun of them. We try to deal with them.''

Mr. Ingolfsson admitted that the road administration's image could do with some repair, ''since in the past we built roads wherever we wanted without much concern for the environmental impact.'' He added, ''A few beautiful spots have probably been saved because of elf stones.''

Icelandic taxpayers tend to support the odd concession to the elf lobby. Marianna Clara, a writer sipping cappuccino at a chic Reykjavik coffee house, said: ''We're a small nation. It's important to be proud of our culture. I think it's nice that the Government takes into consideration the people, their stories and the magic of the country.''

Magnus H. Skarphedinsson, self-described headmaster of the Elfschool, which offers half-day seminars on paranormal phenomena, expects the rock relocation to actually save the Government money. ''If you ignore the hidden people, the cost of construction doubles or triples,'' he said. ''Everything goes wrong. The workers get sick. The machines don't work.'' He was echoing a a claim so entrenched in Icelandic lore that it scarcely matters whether it's true or not.