The Return of Icelandic Economic Growth?

In early December, Statistics Iceland issued the GDP figures for 3Q 2011. The figures were, taking into the account how massive the global economic instability and lack of growth still are and the fact that Iceland’s banking system went magnificently bankrupt, rather surprising: 3.7% GDP growth over the first three quarters of 2011 compared to the same period the year before! Iceland was back on track, leaving Europe in the dustbin!!

The Central bank seized the opportunity and claimed economic recovery was already there. Therefore, people should not really be surprised about the rate hike in early November (rates stand at 4.75%), especially since the labour unions managed to squeeze out a considerable nominal wage rate increase and that would, “of course”, lead directly to higher inflation in the close future. The government did the same, claiming the honour for the recovery and politely asked those who were always complaining about high unemployment and debts while pointing out record number of people leaving Iceland, most notably to Norway, to keep quiet. The recovery was here, no need to continue whining!

Many were still rather sceptical, simply because the debt shock since 2008 was still around and due to mad indexation of mortgages the debt wasn’t going anywhere despite write offs of (illegal!) foreign currency denominated loans and other weak debt reduction schemes. But the “World In Balance Sheet Recession” paper by Richard Koo, author of the outstanding “Holy Grail of Macroeconomics”, just opened my eyes. Iceland was in a “Lehman Brother shock” and the balance sheet recession (too much debt) wasn’t going anywhere even though the figures of Statistics Iceland claimed otherwise.

Exhibit 16 in Koo’s paper fits the Icelandic economy like a glove! Substitute “Lehman” with “Icelandic banks” and the explanation is perfect.

The argument is as follows. The over indebtedness of Icelandic firms and households in 2008 was too great and balance sheet recession – a recession where firms and households in the economy cannot maintain normal economic activity due to high debts – was already on its way. That should not be surprising: the Icelandic non-financial sector was the most indebted one in whole of Europe and Icelandic households were close to the top of the list by indebtedness. Furthermore, the banks themselves were deleveraging (“deleveraging while delivering” was the punch line of Kaupthing just before it filed for bankruptcy) so macro deleveraging of the whole economy was the upcoming game in late 2007 and early 2008. That corresponds to the light-blue broken line on the diagram.

But the banks went bankrupt, not because of policy mistake like Koo says was the case of Lehman in US, but simply because there was nothing else in the cards. In fact, the government did its utmost to save the banks but, fortunately (if we look at Ireland) we simply couldn't. Sometimes it’s good to be impotent.

When the Icelandic banks went down under just a few weeks after Lehman the Icelandic economy was shocked and went down the solid dark blue line instead down the light blue broken path. The economy crashed! Spectacularly in fact, economic growth for 2008-2010 was -9.3%. 

Today, the growth of 3.7% is not because the “recovery is here” but because the economy has cleared the actual bank-bankruptcy shock out of the system and is edging closer to the balance sheet recession path (light blue line). This recovery is in other words the upward sling of the solid dark blue line.

So the growth is there, no reason to doubt that. But the problem is that the economy isn’t recovering like the Central Bank of Iceland and the government claim. The balance sheet recession is still there. And that can best be seen in the fact that investment is still a puny part of the economic activity: nobody wants to borrow for other things than possibly speculate a bit with housing while capital controls are still in place. While nobody is borrowing, nobody is investing in real capital and nobody is hiring or creating productive real capital. That can only mean one thing: a long term weak economy that is fighting over indebtedness of households and firms.

Investment is still at historically low levels despite "economic recovery". That implies balance sheet recession where firms and households are trying to minimise debt, i.e. deleveraging, rather than maximising profits.

First rule of balance sheet recessions: people try to deleverage their balance sheet and they certainly do not do that by borrowing and investing in real capital. Second rule of balance sheet recessions: we do not talk of them, because they do not confirm our little trouble-free economics.

The Icelandic Confederation of Labour, the Euro, the Krona and Icelandic Interest Rates

The president of the Confederation of Labour, Gylfi Arnbjornsson, along with the main economist of the COL, Olafur Darri Andrason, wrote recently a couple of articles in the newspaper „Fréttablaðið“, discussing the high interest rates in Iceland and the krona. This was parallel to a new economic report issued by the COL last week. Their conclusion: the krona is responsible for the high interest rates in Iceland – because it’s always falling in value against other major currencies (they don't answer the question why it is always depreciating) – and the households of Iceland, along with the rest of the economy, would benefit tremendously by enrolment of Iceland in the European Union and the adoption of the euro as soon as possible. That, the euro adoption, would secure the prevalence of low interest rates in Iceland, benefiting everybody.

I’m not convinced. I might be worried about the fact that the Union has, since 2000, been pushing for EU membership and the conclusion is wonderfully fit to their case. But beside that point, it was the methodology in their “research” that rang the warning bells in my head.

What decides interests?

The classical answer to that question is of course the demand-and-supply argument: demand of credit and supply of savings meet in equilibrium on the capital market and at the equilibrium the rate of interest is set.

Now everybody knows it isn’t that simple – beside this theory (the Loanable Funds theory) being open to some serious flaws (such as the Sonnenschein-Mantel-Debreu conditions). Joan Robinson highlighted the fact that there are three different types of factors that influence the rate of interest rates more than anything else: social, legal and institutional.

Social factors can e.g. be the age of the individuals in the economy. It is rather normal, up to a certain limit, for individuals to build up debt early in their lives, such as through student loans, and then repay their debt as they get older. In the social circumstances where majority of people in the economy are young, this borrow-young-repay-later structure would at least to some extent put upward pressure on interest rates in comparison to the situation where the majority people are entering retirement. And on the whole, Icelanders are rather young in comparison to many mainland European nations.

An example of a legal factor can e.g. be the crazy legal framework surrounding the Icelandic pension funds that I described in last post. Mix that craziness with the institutional factor of the pension funds being, as a group, a behemoth on the Icelandic capital market and the upward pressure on interest rates on the capital market is blatant.

Another example of an institutional factor: the krona. Adopting any foreign currency at all is an attempt to change that institutional factor, hoping, in our case, that it brings lower interest rates in the economy.

The fatal assumption of Olafur and Gylfi

It is impossible to reject immediately the theory that the krona has direct upward influences on interest rates within the Icelandic economy. But Olafur and Gylfi are playing a dangerous game in their articles: their conclusion is that the krona is the "main reason" or solely responsible for the entire interest rate differential between the Icelandic economy and mainland European economies (their conclusion says amongst other things: “it is therefore clear that the consequence of high flexibility of the tender of the nation is extremely high interest rates for households and firms.” - try to convince the British that flexibility of their currency increases interest rates). And their assumption is basically to ignore any other possible social, legal and institutional factors and only stare at the institutional factor that the krona is. Then they do their stuff.

Their “correct” conclusion – it is correct given their assumption – is that an EU membership and adoption of the euro would bring lower interest rates as good as immediately. And they point the cases of Lithuania, Latvia and Estonia to prove their point. But the assumption to only take the krona-factor into the account is so far away from reality that the conclusion will hardly be as bulletproof as they put it forward: we can prove (Arrow and Debreu did it), by assuming this and that, that the market economy is the best possible market organisation we can have but that conclusion doesn’t necessarily apply in the real world simply because the assumptions are absurd and are not of this world we live in. Assumptions matter, no matter what Milton Friedman thought.

The same applies to the conclusion of Olafur and Gylfi; their step-to-step process to their conclusion is so straight forward as it is exactly because of their assumption, i.e. to ignore all other possible factors (nota bene: that doesn’t make the conclusion in itself automatically wrong, only significantly reduces its explanation power for the problem why Icelandic interest rates are higher than in mainland Europe). If they would get the same result while taking other factors into the account I would be happy to believe their conclusion to be correct. But they don't so I can't.

But all this doesn’t change the fact that the question they indirectly ask themselves – how are we going to lower the rate of interests in the Icelandic economy – is the fundamental one regarding the economy and “the economic problem” as Keynes called it.

How would we decrease interest rates in Iceland?

Lowering the interest rates in Iceland would happen by influencing all the factors (social, legal and institutional) instead of thinking we can save the day with some sort of magic fix. We’ll hardly change the age-distribution of the nation in a swift manner. But we could educate people into thinking more vigorously about their consumption choices and their consumer debt. To change the mad laws about the pension funds would contribute a lot to lowering the interest rates and the same goes regarding the indexation of mortgages in Iceland. And finally, nobody can rule out the possibility that adopting another currency could lower the rate of interest. But nobody knows how much the adoption of foreign currency would contribute in the fight against high interest rates and quite frankly one can doubt it would significantly lower the rates after the legal and social factors have been corrected.

The discussion about how to lower the interest rates in Iceland must take place! High long term rates are the main reason, along with unlimited power of banks to lend out as much credit as they see fit, for economic instability.

But this discussion must take place without cries and propaganda. And to blame one factor solely is straight forward incorrect. It is as incorrect to solely blame the krona for high interest rates in Iceland as thinking that constitutionally forcing the EU member states to have balanced public budgets will solely fix the euro crisis.

Introduction To The Icelandic Pension System

Most people will roll their eyes when they hear that a pension system can have a fundamental part in bankrupting the households and private companies in any economy. Yes, pension systems all over the world are burdensome and, well, unlikely to work out in their current form due to too heavy burdens they put on the states' finances. UK, France, Italy, Greece, US and Denmark are just a handful of countries that are going to have to reconsider their pension systems. But that the pension system is to a large extent responsible for high debt of households: impossible!

Except in Iceland.

A very short introduction

The pension system in Iceland is a three-pillar system. The details are of course there but the basic structure of it is on its own enough to understand the essence and the crazy organisation of it. The State takes care of basic social security system; pensions for those that haven't built up their own savings, disablement benefits etc.. That's the first pillar. The second is the pension funds themselves which are divided into General ones and the Public ones. The Public pension funds have the explicit backing of the State while the General funds are not backed up by anything and must therefore, in case they cannot get high enough return on their assets, cut the benefits down. That they are obliged to do according to law and when their actuarial position [the balance between their estimated present value of assets and debts] hits -10% they must cut down their pension promises. Holland has +5% minimum in comparison. The third pillar is the voluntary pension savings.

The interesting part of the Icelandic pension system is the second pillar: the General and Public pension funds.

First the Public funds. In very short, they are for everybody that work for the State. Due to the State backing on the Public funds they are never obliged to cut back on their pension promises and in fact, according to law no. 1/1997, they are really nothing else than defined-benefits funds. The actuarial position of the Public funds is negative by around 440 BILLION krona. That's just short of 30% of GDP - which in comparison to many other countries isn't that bad!

Now the punch in the pension system in Iceland are the General funds. Their actuarial position is negative by around 200 billion, obviously showing the need to continue cutting down pension rights, but that's not the bad news. It's the laws that governs them that are.

The law on General pension funds in Iceland

I've mentioned before that the major economic problem of Iceland is high interest rates. High interest rates, especially for the long run, was the source of "the economic problem" of unemployment, fluctuating economic growth and general economic malices according to Keynes. And amongst the European nations, Iceland is always close to the top on the list of countries by the long-run interest in the economy. And I am gong to argue that this is because of the pension system.

The Icelandic pension system needs high interest rates. The law that the governing of the General funds is based on states explicitly that after a work life of 40 years, a pension fund shall secure the pensioner a pension that is equivalent to 56% of their average wages during their working years. To finance that, the pensioner himself and his employer contribute, in total, 12% of the pensioner's wages while he is working. No other contribution is forthcoming. And notice that the pension funds must, according to law, pay out pension that is equivalent to this bizarre ratio of 56% of average wages (I have no idea where this ratio comes from). The general pension age is 67 years in Iceland.

Now, Icelanders live, on average, for rather long - we've for a long time made it into the top 5 on the list of countries by life expectancy. The average Icelander lives for about 14 years after he begins receiving his pension.

Now we have everything we need to calculate how high (real) interest rates the pension funds need in order for them to be able to fulfil their legal obligation of paying out pension equivalent to 56% of average wages over your working age, given you live for 14 years and contribute 12% of your average wages to the pension fund. And the answer is: 1.8% real interest rates. On top of that comes cost of running the fund, other rights that the funds are legally obliged to fulfil such as part of disable benefits and pension in case of death of spouse and last but not least general wage increases during your working age. All this adds up to somewhere between 3-4% real interest rates. This is absolutely fundamental: the General Icelandic pension system needs 3-4% real interest rates if it is going to work out and the Public funds need even more. There is no coincidence that the pension rights in Iceland are discounted with 3.5% real rate of interest according to regulations.

A very important ingredient in the impossibility of the Icelandic pension system is the fact that the funds, as a group, are by far the biggest investors in any sort of financial instruments in Iceland. To name a few examples: they own most of the corporate bonds listed on the Icelandic Exchange, about 70% of the funding from the official Housing Financing Fund comes from the pension funds and they finance 30% of the outstanding bonds of the Icelandic State, registered in the Exchange. About half of all the mortgages in Iceland originate from the pension funds, either directly from themselves or through the Housing Financing Fund. They are, for a lack of a better word, a behemoth on the Icelandic capital market!

Now you're in position to understand how mad the situation gets. What happens when the majority of investors out in the market are legally obliged to get, at least, 3.5% real return on their investment in financial intermediaries? Of course, interest rates don't fall. Why should a pension fund buy a bond from the Housing Financing Fund, which it issues in order to finance mortgages to normal Icelandic households, on a lower rate of return than 3.5% if it is legally obliged to get that return? Would a pension fund finance a mortgage on lower return than 3.5%? Of course not: interest rates for housing in Iceland are around 4-5%, adjusted for inflation (REAL return). And the fault is of institutional origin: if Icelanders want to lower the rate of long term interest in their economy, all they have to do is to reconsider the structure of the pension system.

Long term interest rates in Iceland and the EZ (figures from OECD)

So there is a bizarre situation in Iceland. The pension funds are bankrupting not only the State itself - remember the 440 billion hole on the Public pensions' balance sheet - but directly doing the same thing to households that want to buy a flat or a house. 

I've called the Icelandic pension system a Ponzi scheme. I cannot find any better way to describe it.

The new Euro zone rules do more harm than good

The new plan about how to address the problems in the Eurozone is bound to fail. Quite frankly, the plan might well do more harm than good and speed up the breakup of the EZ.

The plan can be found here. The essence of it is to make it a constitutional duty to run a balanced government budget - that must be a German idea since, I believe, this mechanism is already in place in the German constitution. If there will be a violation of the -3% budget rule in the Maastricht treaty, some automatic process is to kick in to deal with the deficit. It is basically meant to be constitutionally impossible to break the -3% line. This they hope will stabilise the EZ - because as everybody knows, budget deficits are to blame for the crisis (no they are not!!) - and after a few years of stabilising austerity, Italy, Spain, Ireland and other peripheries will be just fine.

Sorry guys, ain't going to happen!

Budget deficits and public debt are not the only one to blame for the EZ crisis. Yes, Greece and Italy were running rather large deficits up until the crisis while public debt was monstrous in both economies. So it can easily be argued that the public finances cocktail in Greece and Italy, and even Portugal (which also had high private debt) was poisonous and one can easily argue that public debt is to blame in those economies.

But that's not the case in Spain or Ireland. Both countries were running a balanced budget, a lot more balanced than France. The crisis in Spain and Ireland wasn't because of public debt, as one can argue for in the case of Greece, Italy and Portugal, but private debt. The Spanish and Irish went on a private spending spree, buying and building houses as there was no tomorrow. When the private debt bubble collapsed the State got the financial sector straight into its arms and lack of private economic activity caused a skyrocketing public deficit. Has everybody forgotten AIB in Ireland and the Spanish cajas?

Public deficit as % of GDP in three countries, 1990 - 2007

The problem in the EZ isn't the the same all over it and therefore you cannot fix it with a uniform plan all over the EZ. That sort of plan is destined to fail; you can't fix a private debt bubble with fiscal austerity! On the contrary should you run deficits to get the private economy into investing and running the economy again. Japan is the most obvious case of the obvious need for government economic support after a private debt bubble burst.

Exactly because the new EZ plan rules out the possibility of supporting an orderly deflation of a private debt bubble with public spending the plan is not only destined to fail but may well speed up the break up of the EZ. If national governments cannot use the borrowing and spending power of the State to meet the need of economic support at the time of private debt deflation the discrepancy of economic activity between EZ members will only get worse.

Icelandic Indexation, Part II

In my first entry about Icelandic indexation of debt and credit, predominantly mortgages, I touched on how the cost of inflation is added onto the principal of the mortgage instead of being in the form of higher nominal rates as is the case in most other countries. The feedback I got from one of my readers was “I still don’t understand how this thing works, it looks nuts the way you describe it and it can’t be right.”

I’m sorry, but it is. But admittedly, I didn’t explain in enough detail how the principal first grows and then contracts only much later in the loan period. Second, I didn’t explain how or why the monthly payments are growing exponentially in nominal terms as the loan closes in on its terminal date. So I hope this post clarifies some of the grey zones that I left in the first part about Icelandic indexation.

An example

The best way to explain the functionality of anything is, in my humble opinion, always to take an example. To make things more coherent between this part of the story and the first I’m going to use the same loan and the same given figures. They were: an indexed mortgage of 20.000.000 ISK for 40 years at 5.0% real (NOT nominal) interest rates. Payments are monthly and calculated on an annuity basis, i.e. every single monthly payment (monthly payment = repayment of principal + interests) should be equal given a certain principal that is repaid over the loan period and fixed interest rates. Average inflation is 2.5% (which is the inflation target of Central Bank of Iceland).

The following screen shot from Excel shows how this mortgage would develop in the beginning, i.e. the first year of 40. Notice that the borrower does not owe “remainder of original nominal principal” but “remainder of inflation-compensated principal after payment” once he has dutifully paid the monthly payment. And that amount grows spectacularly in the beginning of the loan period.

Table 1: The development of an indexed mortgage in Iceland. Notice that the "remainder of the inflation-compensated principal after payment" grows even though payment has been carried out (click to enlarge).

In fact, it continues to grow, in the case of only 2.5% inflation, until month 212 (for almost 18 years!) when it finally tops in 24,055,720 ISK. Notice that at that time, the original nominal principal has shrunk down to 15,487,314 ISK. But again, that’s not what the borrower owes. He owes 24,055,720 ISK after having paid dutifully of the mortgage for 17 years and 8 months. And the original amount borrowed was 20,000,000 ISK.

Table 2: The principal owed does not begin to shrink in nominal terms until after almost 18 years in case of the mortgage listed in table 1 (click to enlarge).

But 2.5% inflation is low in Iceland. If we put more historically reasonable inflation rate of 5% (average annual inflation from 1990 to 2010 was 5.2%) the inflation-compensated principal doesn’t begin to shrink until after – hold your breath – 25 years and 11 months. By that time, the nominal amount owed has in fact more than doubled!

Table 3: 5% inflation is historically lot more realistic in Iceland than 2.5%. In that case, the amount owed more than doubles before it begins to finally shrink after almost 26 years (only 14 years left of the loan period, click to enlarge).

For a more detailed comparison, the graph below shows the development of the principal owed in the case of 2.5% annual inflation on one hand but 5% inflation on the other.

Graph 1: The development of the amount owed (ISK) on the mortgage in tables 1-3, given 5% annual inflation or 2.5%.

An enlightening graph is also the development of the monthly payments (payment = monthly repayment of [inflation compensated] principal + interests) in the cases of 2.5% and 5% inflation. The graph below shows the monthly total payments. In the case of 5% annual inflation over the whole loan period – remember the average annual inflation for the last 20 years is 5.2% - the monthly repayment grows by a factor 7. This is not a joke! From this graph one can also estimate that a person who borrowed money with an indexed 40 year mortgage 20 years ago is paying today about 2.5 times more than in the beginning of the loan period. Anyone who wants to bet this person to be bankrupt in 10 years? And does anyone want to think about the feedback between inflation and necessary nominal wages-after-tax? We’ll come to that in later posts.

Graph 2: The monthly total repayments grow exponentially. The higher the inflation is, the higher is the exponential growth. Notice that in the case of 5% inflation, the borrower will in the end pay 7 times higher nominal amount than he did in the beginning of the loan period.

But why does the principal not shrink?

Because the cost of inflation – the indexation – is added onto the principal instead of being included in higher nominal interest rates as is the case of almost every single mortgage system in the world (apparently Chile and Israel, of all countries, do something similar to this but I’ve never found the necessary data to do a complete comparison between the systems. The Central Bank of Iceland loves to make reference to those economies whenever it is challenged on whether the Icelandic system is clever or not. If somebody can tell me anything about the indexation of mortgages in Israel and Chile, please contact me, it would be most appreciated!)

I hope this explains somewhat better the madness of the Icelandic indexation. If you’ve got a feeling that this system cannot work out you’re most profoundly right! But the rabbit hole goes deep and we are getting closer on being able to discover it properly now that, I hope, the functionality of the indexation is somewhat clearer.

If there are any questions that are still left unanswered or you’ve got any other comments, leave them in the comment box and I’ll do my best to answer them. If there are a lot of troubling matters still left to be dealt with – beside the sheer shock of thinking men that some nation thought it might be a good idea to organise its mortgages in such a spectacularly mad way – I’ll try to clarify them further in later post(s).

But surely, I haven’t even begun introducing you to the madness of Icelandic economics. Wait until I explain the pension system!

Uncertain Future

Just to let everybody know that posting will be sporadic at best for the next few days as travels are coming up.

In other news, almost finished with Steve Keen's doctoral thesis, "Economic Growth and Financial Instability". It's brilliant! Minsky comes alive right in front of the reader's eyes, just by using a bit of nonlinear dynamic modelling.

Highly recommended text. You can find it, along with some other important macroeconomic and banking goodies, at Steve's website.

Iceland, The Euro, And High Interest Rates

An acquaintance of mine and me were discussing a newspaper article arguing for the adoption of the Canadian dollar in Iceland. Without getting into too much detail, the author of the article said the adoption of CAD beneficial for Iceland due to the fact that both economies were rich in energy and raw commodities (if you know Icelandic, the article is here). Furthermore, the Canadian banking system is one of the safest one in the world - which is true - and the currency is stable - which is also true, probably because the banking system is sound. One can of course make the same case about the Norwegian krona and the similarities between the economies of Norway and Iceland but anyway, adopting the CAD was meant to be beneficial.

I would like to stress that I don't have a clue whether Iceland should adopt a foreign currency or not, let it be the CAD, NOK, USD or whatever else. And the reason is simple: I, like everybody else, do not know which will be better because there is massive uncertainty in the decision ("unknown unknowns"). Furthermore, it hinges on the personal risk appetite of everybody.

My favourite analogy to explain this is that of the car insurance: if you buy a full-cover car insurance (you have an independent currency which you can devalue if the economy runs into trouble) you are tempted to drive faster (take risky economic decisions). But if you decide to turn down the car insurance (use a foreign currency which cannot be devalued if the macroeconomy runs into trouble) you'll have the incentive to drive more carefully. But of course, nothing says you will, you still might drive like a maniac or hit black ice and crash the car. And I trust Icelanders well to drive like maniacs - by soaking up private debt - even if we used a foreign currency.

We can endlessly, because of different risk appetites and the impossibility of quantifying them for a sensible mathematical model, argue which is better, to buy the insurance or skip it. And everybody would be "right". So quite frankly, I think the currency quarrel is rather futile, especially because it is not the fundamental problem of the Icelandic, or any other, economy. Discussing private debt and debt creation should come first, currency regime second. But that's never even thought of amongst neoclassical economists who don't know Minsky and the real-Keynes and still consider the market to be efficient and people rational. Please, give me a break!

Useless ideologies
But the quarrel is there, no matter how futile it may be. But in all honesty, this is not a quarrel anymore. The truth is that there is an ideological tug-of-war regarding the currency and the monetary question in Iceland where politics and extremism are rampant. There are roughly three camps: the ISK supporters, the EUR supporters and the smallest "lets adopt whatever" group, predominantly making the case for CAD, NOK or USD.


Customary to Icelandic public discussion - not that it's only Icelandic unfortunately - some people, from all camps, deny to accept the reasonable argument the other camps make. The ISK supporters mitigate or even deny the krona’s role in bankrupting the economy while highlighting the ongoing EUR debt crisis and the positive effects the ISK devaluation had on the current account. The EUR supporters mitigate or deny the fact that the devaluation of the ISK is assisting the economy to get back on its feet while ignoring the EUR debt crisis and highlighting the cases of Estonia and Finland who adopted the EUR and are doing fine.

All the groups have something worth noting. The problem is that the idealists either ignore their currency-opponents or answer them in empty phrases. Those zealots are a small part of all the groups but they are unfortunately quite eye-catching and distort the necessary discussion that has to take place regarding the future of the Icelandic monetary system. The end result will be, many fear, that no progress takes place in building up the Icelandic economy on principles that everybody can agree to are reasonable and wise.

I have to admit that the insistence of the EUR supporters is what strikes me most, no offence meant. Many of them are so utterly blind on what's going on in the Euro zone and the obvious need for a monetary reform that it amazes me! The official aim is to adopt the EUR through EU admission. Hopefully, we'll have a referendum about EU admission in 2013 or 2014. If the answer out of that referendum will be yes (I have personally not made up my mind), Iceland would enter the EUR "waiting room" (the  ERM2), peg the ISK to EUR with 15% band while trying to fulfil the Maastricht criteria. That would take us another 5 years at least, given how seriously far away we are from fulfilling the 60% public gross debt to GDP mark. So earliest adoption of the euro would be around 2020 or thereabouts (and no, you cannot hide behind the expectation theory of interest, making the case that if Iceland enters the ERM2, it would "effectively" mean that the EUR is the legal tender). And does anyone want to wonder what has happened to the Euro zone in 2020? Why apply to something today which is obvious to have changed significantly by the time we would finally be accepted?

So quite frankly, the official aim of adopting the EUR through EU membership is, well, not that smart. The only other possibility would be to adopt EUR unilaterally. But that wouldn't really be  a good idea either; to adopt a currency from an economy that's in a debt crisis? No thanks, CAD or NOK are obvious choices instead if we are going to adopt another currency anyway.


Any scapegoat will do
But the currency isn't the economic problem of Iceland. It's the debt and the high interest rates. Fix the debt and interest rates problem and the currency problem will be non-existent, no matter which tender is the legal one. But a lot of people think the ISK is to blame for the high interest rates, and consequently high debts, of household, firms and the State in Iceland. 


The classic argument is that since the ISK is so small there is a high liquidity premium on financial assets denominated in Icelandic krona in the form of high interest rates. And high rates, and Icelandic indexation, lead to higher debt. Some people honestly think this premium to be somewhere between 1.5% to 3.0%. Seriously, think about this: 150 - 300 points, the liquidity premium only! Two loans to the same borrower which are exactly the same except one is denominated in ISK and the other in EUR. The interest rate differential would be 150 - 300 points due to liquidity premium alone.

Not likely! But it's true, long term interest rates in Iceland have been 1.5-3.0% higher than in other major equally developed economies. And this is absolutely the major economic problem of Iceland. So why not blame one of the smallest currencies in the world and its lack of liquidity?


I'm sorry, but it's nonsense. The long term interest rate differential is not high because of lack of liquidity with the legal tender but because of a bizarre legal framework that a certain system is built on, a system that many Icelanders are quite proud of, possibly because they've been told it's one of the best ones in the world: the pension system.


More on that later.

The EFSF Explained In Plain English

In light of the newest argument about the EFSF being a Ponzi scheme or not (see Telegraph and Reuters), I remembered seeing this video not long ago. This must be one of the best non-economic explanation for the European Financial Stability Facility (EFSF). Kudos to the man/woman who thought up this joke.

But seriously, where are they're going to get the 1,000bn. euros from?

The Private Debt Problem In Europe

The real-world economics blog posted this graph today. It shows well that the euro zone crisis isn't really a public debt crisis, it's private. To see the indebtedness of Spanish and Portuguese companies at the top and the Greek firms at the bottom, given that they are not cooking their books too much, is revealing. Like Minsky always emphasised: private gross and net debt levels matter!

Non-financials' net debt to earnings (EBIT) ratio by country

Of course, from an Icelandic perspective, this isn't that interesting until we put the Icelandic data in there as well. And since the Central Bank of Iceland only just yesterday - what are the odds! - posted, for the first time, aggregated financial accounts for households and firms in Iceland, we can construct the same data.

Icelandic firms' net financial debt to earnings (EBIT). Net financial debt is estimated with Gross Debt - Total Deposits. 

Here is also another graph showing the other side of non-financial debt, i.e. household debt. All three countries experienced the same: a massive private debt bubble!

Household debt as % of GDP

So the difference isn't that great between Spain, Portugal and Iceland. We're all fighting a private debt crisis. The public debt crisis is then bred by the private debt crisis: too much private debt is stopping private investors from getting investment and spending started again, leaving the States stripped of tax income from private economic activity.

Due to this, the public debt crisis is perhaps more severe in Portugal and Iceland since private parties are more indebted in those countries compared to Spain. Also, the State is more indebted in Portugal and Iceland as well (public debt closing onto 90% of GDP in both countries while around 60% in Spain).

But the foundations of the debt crises in Spain, Portugal and Iceland is private debt. In Greece and Italy, it's arguably public debt however. But no matter where the fundamental problem is, while the debt levels remain high in those economies, economic activity will be low. And while economic activity will be low, the public and private debt crises will just keep on growing, especially if nominal economic growth won't be higher than the interest rate on the debts of public and private parties.

Spanish, Portuguese and Icelandic private and public parties need to deleverage their balance sheets, just as private parties had to in Japan during the 90s after the "Swinging 80s" in Japanese stocks and houses. That deleveraging rushed in the Lost Decade: a decade of weak economic growth, low or negative inflation, ultra-low interest rates and high unemployment compared to the years before.

It is not unlikely that some sort of similar economic hardship will hit the three economies here discussed. And when Spain and Portugal end up in such situation, they will drag the rest of the euro zone down with them. Christine Lagarde is probably right: there is a serious threat of an European Lost Decade.

Steve Keen's Behavioural Finance Lectures

Those YouTube videos are arguably one of the best there are about economics. The lecturer is Steve Keen who wrote Debunking Economics. Those lectures are more or less his book and the then some. So every single one of them is worth watching if you want to understand real-world economics.

Steve has put the whole lot up in a playlist. You can find it here: Steve Keen's Behavioural Finance Lectures.

Enjoy and happy epiphany!

Which Books To Read About Economics

Somebody sent me an email the other day. The person wanted to know what kind of economics and which books I had been reading. The reason why he was asking was that he'd been reading Debunking Economics by Steve Keen - I highly recommend that text to everybody, never has there been a more comprehensive book about the nonsense that is taught to economic students - and thought I was making sense with the economics that came out of my pen. I have to admit, I felt a bit relieved to hear that. Maybe I'm "escaping from the old ideas, which ramify, for those brought up as most of us have been, into every corner of our minds." (One point to him or her who knows this quote without googling it).

I started thinking about which books were the most important in opening my eyes to real-world economics. I came up with this list, roughly in chronological order.

1. Manias, Panics and Crashes - Kindleberger
2. The Origin of Financial Crises - Cooper
3. Stabilizing the Unstable Economy - Minsky
4. Can "It" Happen Again? - Minsky
5. John Maynard Keynes - Minsky
6. This Time Is Different - Reinhart and Rogoff
7. Animal Spirits - Akerlof and Shiller
8. The Holy Grail Of Macroeconomics - Koo
9. Predictably Irrational - Ariely
10. Debunking Economics (1st ed., just finishing 2nd.) - Keen
11.When Money Dies - Fergusson
12. The Coming Generational Storm - Kotlikoff
13. Theory of Economic Development - Schumpeter
14. A Guide To What's Wrong With Economics - Fullbrook
15. Keynes: The Return Of The Master - Skidelsky
16. How Markets Fail - Cassidy
17. 23 Things They Don't Tell You About Capitalism - Chang
18. Keynes Betrayed - Tily
19. Crisis Economics - Roubini


I can recommend all of those books to everyone. The ones in italic are books that I remember had the utmost effects on my way of thinking about economics problems. I cannot stress how important it is for students, scholars and most importantly teachers in economics to read them! Also, anyone with interest in being able to distinguish between the bullshit and the real-world theory should read the ones in italic - especially Debunking Economics and How Markets Fail.

For those who want to have fun while learning about the markets and the craziness of economic theory I can recommend Predictably Irrational, The Big Short (Lewis) and Too Big To Fail (Sorkin) to name just a handful out of my head.

So start reading people, otherwise no good things are going to happen to this travesty that mainstream economics is today.

And remember: Hicks's IS-LM isn't a Keynesian model. Hicks himself admitted to that 30 years ago. Oh, and finally, in case you didn't know: the market demand curve doesn't slope downwards at all times, it can go up and down like a snake. Also, there is no market supply curve.

Icelandic Indexation

I've mentioned how I think the Icelandic way of indexation is doing more harm than good in Iceland but I've never actually explained how it works. So here goes. This post is not going to touch on the disastrous effects of Icelandic indexation but merely am I going to draw a rough picture of how it works in practice.

Naturally, and as expected, the idea with indexation of debt contracts in Iceland is to preserve the purchasing power of the borrowed funds. The classic analogy in Iceland is that if you lend a horse, you're meant to get a horse back. If people want to think about interests as well, the lender is meant to get the horse back and a pony. Likewise, if a bank in Iceland lends out 1,000,000 ISK the indexation to the Consumer Price Index (CPI) is meant to preserve the purchasing power of the 1,000,000 until repayment. And since the bank is lending out the savers' money (which isn't true but let's skip that detail for the time being) the savers get their lent-out purchasing power back when the loan is indexed. Simple, basic stuff.

Now, of course, this is done in many countries, most notably on federal bonds. Sweden, USA, France, Iceland and plenty of other federal states index their bonds - or at least a part of them - to the CPI. This is all fine, issuing indexed treasury bonds hinders the State from being able to print itself out of debt problem and increases the fate of investors in State's finances. Also, one can argue that issuing indexed treasury bonds is cheaper for the State since real rates are, at least in theory, lower on such contracts compared to where the rates are nominal.

The way indexation is done in Iceland isn't that different from other countries. The borrower issues a bond or borrows, say, 100 ISK and if the CPI goes up by 1%, he owes 101 ISK. Most indexed government bonds are bullet loans where the whole indexed principal is repaid at the day of maturity. There can be annual, semi-annual or quarterly interest payments as well and they can also be indexed. However, not many indexed government bonds are done in such a way that the treasury repays the indexation part (it would have been 101 - 100 = 1 ISK in the simple example mentioned above) every time there is a repayment of the principal, in the case of many principal repayments. And bonds where the borrower pays part of the indexation every time there is a principal repayment are very rare.

But even though the way and the idea of indexation is similar to what goes on in other countries, the conduct is black-and-white. The major differences between the Icelandic Way of Indexation compared to other economies are two. And both of them are crucial in making the mix so economically poisonous as it is.

First, the major issuer of indexed bonds in Iceland is not the government but households, predominantly through mortgages. At year end 2007, the last year which trustful data can be found for, the value of indexed loans in the Icelandic economy was about 1,600bn. ISK (the GDP was 1,300bn. ISK in 2007). Of those 1.6tn., households were responsible for repaying about 83% and most of this was mortgages. The rest was predominantly firms (15%) while the State was hardly there (2%). (Note: I'm counting the Housing Finance Fund's bonds as the debt of households for the simple fact that they are the principal borrowers of those funds, the HFF is merely an intermediary between the households and the capital market. Some people want to count the HFF bonds as State's responsibility because they have State's backing).

The second peculiarity to notice is that most of this indexed debt is repaid according to a very uncommon formula where only a part of the indexation is repaid every single time there is a repayment of the mortgage.

When a household borrows and the principal is indexed, the household does not repay the whole cost of indexation at the day of last repayment, as is common with government bonds (bullet bonds). The household does not either repay the cost of indexation immediately - that's what Danske Bank thought in 2006 in its "Geyser Crisis" report - but only a part of it. The rest of the indexation is added onto the principal and is repaid in every single repayment that is left on the mortgage.

This sounds peculiar and it's completely normal if one doesn't get this immediately. After all, the paid specialists at Danske Bank didn't get it until some poor Icelandic household called them up and told them what was going on.

So let's take an example. A household borrows 20,000,000kr. for 40 years at 5% REAL interest rates (yes, those are extortionately high rates, but they are common in Iceland. I'll get to it in another post why they are so high, just bear with me). Repayments are monthly and lets assume average inflation is 2,5% (nominal rates are therefore roughly 7,5% on average). Monthly repayments are calculated on an annuity basis (given principal, no. of repayments and interests, the monthly repayment is meant to be nominally fixed as long as any of the assumptions, such as interests or the principal, don't change).

The monthly repayments of this mortgage is shown below in blue. In comparison, I've added another mortgage where the only difference is that the interest rates are nominal rates and the principal is not indexed. The real rates are the same on both of the mortgages at all times. Average inflation is the same in both cases but the fluctuations in the nominal mortgage's monthly payments are due to the fact that inflation fluctuates between 0% and 5%. This is of course common in nominal rates mortgages: if the inflation goes up, the nominal rates go up and squeeze the households so consumption and economic activity contract so inflation goes down again, the nominal rates do as well and consumption and the economy kickstart again. We've made a loop and the cycle begins again.

Monthly repayments for an indexed Icelandic mortgage and another that is not. Both mortgages bear the same real 5% rates at all times. 2,5% average inflation, fluctuating between 0% and 5%

This does not happen in the case of the Icelandic indexed mortgage. There are no short-term fluctuations of monthly payments but instead they grow slowly but exponentially.

The reason why there are no short-term fluctuations in the monthly payments is what I mentioned earlier: the whole cost of the inflation is not born immediately by the borrower of the indexed loan but added onto the principal of the loan. In the case of the borrower of the nominal rates mortgage however, the nominal rates go up so he must pay immediately for the cost of inflation. This has the effect that the nominal value of the principal of the indexed mortgage goes up in the beginning while it continuously shrinks in the nominal rates case.

The cost of inflation, i.e. to maintain the purchasing power of the borrowed funds, is added onto the principal of the indexed loan while it is paid in the form of higher nominal rates on the non-indexed loan. Therefore, the principal of the indexed loan grows first until the repayments get fewer and bigger share of the indexation is paid immediately. 

So this is the functionality and the nature of indexation in Iceland. I've said nothing about the effects but Paul Krugman called the way of indexation in Iceland "anti-social" in an interview with Egill Helgason of the Icelandic Broadcast Corporation (IBC, not BBC) straight after the Iceland Recovery conference thrown by IMF and the Ministry of Finance in Iceland.

He has no idea how deep the rabbit hole goes! Krugman is, with those words, only touching on the poisonous nature of those loans. In very short, they completely lay waste to the influence of the monetary powers over expansion of credit, inflation and long term financial stability just to name a few horrors. But the devastating effects of the Icelandic Indexed Mortgage will be explained a bit further here on this site later and to the detail in my book, Bad Economics.

Part II can be found here

Our President is a Lad!

OK this isn't about economics or anything - after all, I'm human and, even if some people may doubt it, I think about and follow other things than economics affairs.

Just wanted to share this with you. This is the president of Iceland, Ólafur Ragnar Grímsson, (try to say that fast!), inviting everybody who wants for pancakes at his home. Some other common people are in the video as well, inviting tourists over for a chat, meal or a drink if they fancy. And I promise you, this isn't a scam!

Now, of course, I expect Mr. Cameron or Mr. Sarkozy to do the same!

If you're interested in popping by, check out this website.

The Icelandic krona and the Icelandic debt

One of the most common fallacy about the Icelandic krona (ISK) is that it is responsible for the monstrous levels of private gross debt in the Icelandic economy. The argument is that because the krona is so small, there is enormous liquidity premium on it in the form of higher interest rates in Iceland than in most other Western economies. And since the krona has collapsed by 99% since it was introduced in 1918 on par with the Danish krona, the Icelandic economy is meant to be obviously better off with any other foreign currency, let it be the Euro, Canadian or American dollar, the Norwegian krona or what ever. (Update: and since debt is often indexed to Consumer Price Index in Iceland and the CPI goes up as the currency collapses, the currency collapses cause increased debt).

This is a fallacy. The gross debt of Icelandic private and public economic units has not been rising because the krona has fallen as spectacularly as it has but the other way around: the krona collapses because the gross debt of Icelandic private and public economic units is increasing. And I emphasise the word private!

The following graph describes the correlation and causality best. It shows that if the gross debt of private and public units in Iceland increases, the exchange rate weakens against the US dollar. The correlation over the whole period (no lags) 1972-2007 is 0.80 which is very high for such a long period. If the change of the USDISK cross (the number of ISK in one USD) is lagged by one year the correlation is unchanged. If the change in gross debt is however lagged by one year against the change in USDISK cross, the correlation goes down to 0.48. This implies that the causation is a lot stronger from increased gross debt of private and public units to the depreciation of the ISK rather than ISK causing gross debt of private and public units to increase.

Annual change in domestic gross private and public debt held by the financial system and the annual change in the nominal exchange rate of the ISK against the USD. Notice the high correlation

So the problem is not the currency or what currency Iceland uses. The problem is the expansion of debt, public and private! And since banks have always the incentive to expand debt in any economy or under any currency regime they work under, for the simple fact that they increase their profits on the interest difference of simultaneously created deposits and loans, the ISK will always depreciate over time if the banks are allowed to pump out credit according to their own will. The devaluation of the krona happens as the necessary restoration of international competitiveness has to happen after a period of binge credit expansion. If the economy uses a foreign currency, the banks will still have the incentive to pump out credit as they see fit - still leading to over expansion of private and public debt - and the devaluation that is needed to restore the competitiveness of the economy will have to be internal through lowering of nominal wages, i.e. Greek-style.

Nobody wants to see any kind of devaluation, not of the nominal exchange rate or of the internal one. But if the credit expansion of banks is not kept at bay at all times, either one will always happen. Changing the currency regime is futile in fighting the banks' incentive to expand credit.

Of course, we can change the currency regime if we want to. But if we do, we better realise that if we don't limit the ability of the banking system to expand credit in the economy, we will have to go through an internal devaluation sooner rather than later under a fixed exchange rate regime.

The Iceland Recovery IMF Conference

The Icelandic Recovery conference organised by the IMF and the Ministry of Finance in Iceland was not totally the "we did an awesome job in Iceland" thing I halfway expected it to be. I managed to follow most of the panels through the internet and I have to admit that Shafik from IMF surprised me: she seemed really reasonable, was quoting heterodox economic theory - with care but mentioning it all the same - and although she did seem to be a bit proud of the "feat" of IMF in Iceland, she was not bragging too much about it.

None of the Icelandic participants surprised me that much. Gylfi Zoega (he taught me Macro II = IS-LM and such at University of Iceland) was wittiest and straightest to the point. His "some people call this lending to connected parties but we call it banking" comment was epic! Gylfi Arnbjornsson surprised me a bit though by making a fool of himself, grasping for clichés such as that the EUR would save the Icelandic economy and such. Most notoriously he said that Icelandic labour unions didn't fear the EUR in case of high inflation and interests in Iceland after EUR adoption - which he and other EUR ideologists think will be impossible - the economy would "just go for an internal devaluation." He said this while on panel with Krugman, too bad the webcast didn't show Krugman's face, I'm sure his jaw dropped down to earth's core when he heard this. 

Of the foreigners, Johnson was spectacular! He was so good that I went on Amazon while listening to him and bought his book "13 Bankers". Haven't started it yet, still finishing Steve Keen's Debunking Economics while working at the same time on my book and PhD. 

After the conference, EUR supporters were certainly not chuffed. Majority of economists that attended the conference celebrated the ISK for saving what could have been saved of the carcass of an economy that the Icelandic one is. Wolf and Krugman were probably the most notable players on the chess board that highlighted the role of the ISK in the "resurrection" of the Icelandic economy. That's all fair and square, any sensible person immediately sees the different effects of the exchange rate between Iceland and the PIGS. But it's true what the EUR supporters did point out: not many words were about how the ISK had a hand in getting us into this mess that we're in. Because it's true, ISK did play a role through e.g. carry trade and such. But blaming it totally for the stinking carrion we're trying to revive is a bit of an overshoot. And to say the EUR will do the reviving almost automatically through EU membership is so distant from reality it is in the domain of neoclassical-economics-nonsense. 

One thing that was not discussed to any extent was the systemic impossibilities that my book focuses on: the indexation of mortgages and the 3.5% real interest rate minimum the pension funds are legally required to demand. Krugman shortly mentioned that the indexation of mortgages made the inflationary way out of a debt-trap impossible, and that's absolutely true. But there was no mentioning of the dynamics of such an economic system or why it's bound to crash. 

I think none of the foreign guests understood how indexation of mortgages in Iceland is done. That suspicion makes it all more important for me to explain it in details how this devil-of-a-detail works so the effects on the macro-economy can be properly understood. I'm seriously thinking of sending Krugman a copy of my book when I finish it, hoping it would teach him something about this economy which he seems to like so much to make references to. 

IMF did a decent job in Iceland, nobody can take that away from them. If the Icelandic basket-case opened the eyes of IMF to heterodoxy - such as it's OK to let banks go bust if you do it with a bit of support instead of American "let Lehman go and don't anything to mitigate the effects but bail out the dominoes" way of doing things - it certainly was worth more than we can imagine to let IMF experiment with things in Iceland. But IMF didn't fix the underlying problem - astronomically high domestic gross debt - or point out the systemic factors that cause that problem: the widespread use of indexation of loans and the 3.5% real interest rate requirement of the pension system. Until those systemic factors are changed, there will be no Icelandic Recovery.

P.S. Check out the conference videos here. 

Is Debt Jubilee Necessary?

Some political pressure groups, especially the Organised Interest Group of Households, are calling for a partial debt jubilee on households' debt in Iceland. At least one political party, the Progressive Party, has also put forward an economic plan where they propose a faster "reorganisation" of household debt. Right after the collapse, they proposed writing down the debt of household by 20%. It's a flammable subject, to say the least.

It's an undeniable fact that households in Iceland are too indebted and it's increasing the financial instability of the economy. In comparison to other households, their debts are nearly double of those in the Euro Zone (EZ). The graph below shows the comparison (data from CBI's Financial Stability 2011 report).

Household debt, % of GDP

But levels of household debt are only half of the story. The cost of debt is the other part of it. And using long term interest rates as a proxy for the cost of household debt, one can get the data behind this graph - a simple multiple of annual interest rates (OECD quarterly figures) and household debt. Take note that this is not representative for cash flows.

Estimated annual cost of household debt as % of GDP

Now blatantly, this is madness! Absolute and utter madness! Annual cost of debt for household in Iceland was 4-8 times higher than in the countries used here for comparison. And in them, the economy came down crashing because of high debt levels. And the cost of debt maintenance is still too high. That is the real problem in Iceland.

But the theory says...
What has to be done in Iceland is simple: lower the debt burden. This means either to lower long term interest rates and/or lower the debt levels. One way of lowering the debt burden is debt jubilee of some kind. But that's not easy. There is considerable political pressure against debt jubilee because it would harm the (domestic) owners of the debt. And the major owners are: the pension funds. Other big owners are banks and Housing Financing Fund (a GSE).

Now, according to economic theory, that shouldn't matter then. The argument goes that one's debt is another's asset and so in the macro economy, the macro effects of debt cancel out, given that the creditor and the debtor are domestic parties - only foreign debt matters. And when the creditor and the debtor is the same as in the case of large part of Icelandic household debt, the debt levels should certainly not matter at all. The cash flows due to debt are simply going from the left pocket of the households to the right one, making the households, in macro economic perspective, indifferent on whether the debt is partially cancelled. And since this would represent a transfer of wealth from old people to young - the irresponsible young - the political atmosphere is certainly not leaning towards debt jubilee.

In the case of banks and the Housing Financing Fund, demanding some sort of debt jubilee would harm their balance sheet. That, the theory goes, could introduce lack of credit supply (zombie banks) and harm the economy through a credit crunch. An extreme case would be where the banks would collapse and the State would have to refinance them. This applies especially in the case of HFF which is in fact as good as bankrupt already. The State is essentially the households so debt jubilee would be a boomerang, shooting down households through increased taxes on its way back from cutting down the debt levels.

So the arguments against debt jubilee is that it would harm the households themselves through the pension system. Further danger would be through increased fragility of the banking system, harming the economy and the households themselves through higher taxes. Furthermore, some (mad) theory says that private debt levels don't matter anyway: one's debt is another's asset and the net effects are none, given that the creditor and the debtor are both domestic.

...and it's all wrong
All this isn't true. The theory is wrong: gross debt levels do matter! And once spiced up with astronomical interest rates, the soup becomes poisonous for financial stability and with it macroeconomic welfare.

There are many reasons for why the gross debt levels really matter. One is the fact that assets and debts of households are not homogeneously distributed. Even though households in aggregate may well be netted out of the whole sum (unlikely anyway), the fact is that intra-household distribution of debt and assets is not homogeneous. This means, in short, that one household may be the owner of the debt of 10 others. Because of this uneven distribution of debt and assets, the cash flows are not even between the households: they are concentrated towards a certain attractor. And if the gross debt of those 10 households is too high, they go under, thereby harming the economy as their consumption levels drop and bankruptcies increase.

Another reason for why the gross debt levels matter is that even though the debts and assets were evenly distributed between households, which they are not, the fact alone that there is maturity mismatch between assets and debts makes debt non-neutral. As an example, in Iceland the households must pay back their debts today but they won't get anything paid out of the pension system until the individuals are old enough. So what are they going to do about the debt until then? Assuming that gross debt and gross assets don't matter, even though they are evenly spread out between households, is saying the time stands still.

Other arguments for the non-neutrality of gross debt include psychological and behavioural factors such as irrationality, non-neutrality of money, the endowment effects, procrastination and many more. None of them support the theory that gross debt is neutral.

Is debt jubilee the answer then?
So gross debt matters and Icelandic households are drowning in it. Naturally then, the question "is debt jubilee the answer?" pops up.

It isn't. Yes, debt jubilee would help and I have changed my view from before: Icelanders should go for a partial debt jubilee. But it matters how it's done. Debt jubilee is a serious nuclear-option: there will be collateral damage and it's as politically inflammable as one can imagine. Beside obvious questions such as the moral hazard question (does debt jubilee increase the will to get indebted later, trusting that you'll be cut down from the snare just in time?) and what is a "fair" debt forgiveness, a debt jubilee has to be carried out in such a way that in few years time the same problem won't be back. If we go for the "red button", we better make sure that households and economic units in general cannot en masse get themselves into such a hopeless financial situation that debt jubilee is the only way out.

Debt jubilee is not the answer but it's a part of it. Icelanders have leveraged the assumed assets they think they have in the banks and the pension system to such a degree that today's households are being pulled down into the abyss by a massive debt stone. As the households get sucked into the deep, so does the macro economy. It's time to cut the rope - decrease the leverage - but make sure the rope doesn't hook onto another debt-stone in a few years time. How that should be done is another matter and will be discussed later.

The Debt Mountain

Many economies, western as everywhere else in the world, are fighting some sort of debt crisis. It's sovereign in Europe but in US it's households and general private debt overhang. When discussing US and how the debt of households is dragging the economy down the drain, this graph, or some similar versions of it, is put forward (taken from here).

So the Great Depression hit the US economy when household debt was just about to hit triple figures as a percentage of GDP. The Great Recession started around the same ratio. Hardly a coincidence.

The Americans, and other major spenders, shouldn't be too tough on themselves because they are not the biggest debtors in the world. Nobody beats Icelandic households when it comes to debt. Today, due to the ongoing crisis, nobody even knows how much the households actually owe. The Central Bank is meant to publish quarterly figures about the debt of households and corporates but nothing has been done of that kind since September 2008. The reason they say is that the banks are still reorganising their balance sheets. Nobody knows the face value of debt in Iceland. 

Debt levels (face value) are known until September 2008 only. And given the annual figures graphed here below, nobody should be surprised that the Icelandic economy was hit by a sledgehammer.

Households's debt in Iceland, 1970 - 2007

Of course, this is certainly not helping the economy to get back on track, although most international bodies that have commented on Iceland think the majority of economic problems have been solved, at least to the extent that they shouldn't worry us too much. IMF is probably foremost amongst everybody in that group, celebrating the success it had with the Icelandic Program so much that it is even throwing a conference on it.

To be fair, IMF has made the same comment repeatedly regarding the debt overhang. Debt reorganisation must be carried forth more swiftly than it has been.

But nothing has happened. We got into this mess because we owed too much. We can't get out of this mess because we still owe too much. The Icelandic economy is shoulders deep in a debt recession that it cannot burst out of. Euro zone countries have asked private banks to allow Greece to get at least 50% debt forgiveness on its federal debt. Something similar, a widespread general debt forgiveness but not mere debt reorganisation, may well be necessary for the Icelandic economy to rebound. Desperate times call for desperate measures.

US Corporate Profits and Fiscal Deficits

Amidst the black-hole view on financial markets regarding Europe, Bloomberg reports that, "corporate profits are calming U.S. stocks more than any time in 19 years." John Farrall, director of derivatives strategy at PNC Wealth Management rightfully points out the obvious: "...corporate profits are supposed to be good." Others, some time ago, said that corporate profits were "freakishly high" and it was time to start buying equities again (with some caution). So what's going on? Why are corporate profits so high, during financial turmoil bested only by the Great Depression?


There is no great mystery where the corporate profits are coming from. Even though Obama may have missed his employment targets with the big spending, nobody can deny that he saved the corporate profits by putting, as Minsky called it, Big Government into play.


US corporate profits (08' - 11') and US Fiscal deficits (07' - 10') 
(1H profits 2011 are doubled to estimate full year 2011).

This isn't new. The same relationship was in place during the slowdown of early 1990s and 2000s. Corporate profits were lower back then because the government didn't support them as strongly as it's doing today. 


US corporate profits (90' - 93') and US Fiscal deficits (89' - 92')

US corporate profits (00' - 03') and US Fiscal deficits (99' - 02')

But what is Big Government? Minsky used this term. It is meant to demonstrate the power of the government - Big Government - to maintain aggregate cash flows in the economy during the times of economic problems. In an economy with Big Government, whenever business activity goes down, automatic stabiliser - unemployment benefits, public investment programs, etc. -  will kick in and governmental profit-maintenance be in place. The upside of this functionality is that serious deflationary depressions like the Great Depression are unlikely to happen. But the downside is an upside pressure on prices, i.e. inflation. 


What is important to remember is that this economic shield that Big Government provides can shatter. But it will take time.


If economic slowdown happens because of too much debt burden, the Big Government can't ensure that bad debts and assets will be cleared off corporate balance sheets. On the contrary, Ponzi financing (betting on asset prices to go up by higher percentage than the interest on the debt you're using to buy the asset in question) and clear speculation would actually show themselves to be profitable. Why? Because the government provides the cash flows needed to make such investments go on through. And blatantly, since politicians are inclined to be myopic, there is always a trend to "save the system" for the time being. 


Schumpeter's "creative destruction" is never allowed to do its job then. The fix is always only for the short term, every single time Big Government steps in. The bad debts and the hopeless investments, who started the slowdown in the first place, are bailed and never written off as they should be. Moral hazard increases, such as in the form of banks making speculation bets knowing that if they mess them up they will be bailed out by the State (Too Big To Fail) and the underlying problem, i.e. hopeless debt levels, is never fixed. This "kicking the can down the road" process continues until the problem gets so colossus in size that not even Big Government can't fix it. And then, a long lasting financial crisis takes place.


That financial crisis will continue until the debt burden, i.e. cash flows due to debts, has decreased in comparison to cash flows from sales (corporations) and work (labour). By then, private investors are again keen on investing and merry-go-round of cash in the economy becomes self sustainable without Big Government maintaining it with deficit spending. And employment goes up.


But this merry-go-around never started properly this time. The reason why Obama failed to get the employment going with all the billions of dollars that the federal state of US spent is that the private investors never got keen on investing again, until very late. The profits were there, provided by the State, but firms chose to use them to repay debt instead of investing. When they finally wanted to invest again, it was too late: Europe was crashing and businesses jumped back into the "let's be careful and see what happens" mindset. Investment decreased again. 


The best way to see how massive the debt repayment was, it's enough to check the Fed data on outstanding loans. Debt repayment was enormous and dwarfed the early 1990s and 2000s! Crucially, households repaid their debts as well, stopping the cash-flow round-about dead in its tracks. 


The overall result: stagnation, long-term useless and costly bailouts of banks who otherwise would have been forced to write off the bad debt that was causing the slowdown in the first place, and last but not least, 1.4 trillion dollar federal debt.