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. 

Should we adopt a foreign currency?

After the collapse in 2008, the hunt for a scapegoat began almost immediately in Iceland. The list was endless: the bankers, the politicians, the business moguls, the endless consumerism, the Central Bank, the corruption and so on. On that list was the Icelandic krona.

Now of course, most of the usual suspects were on the list of scapegoats for a reason. Yes, political corruption - in the form of "I know a guy who knows a guy who could do this for us" and "ahh, you're a member of that political party, well, then you'll get the job!" - is high and the level of debt-infused consumption was astronomical! And yes, the fact that Iceland tried to carry out an independent monetary policy with, at that time, the smallest free-floating currency in the world, is partially to blame for the crisis. We messed up big time (in my opinion, mostly by relying on bad economics).

Today, the "necessity" to adopt a foreign currency is very prominent in the general discussion in Iceland. And the foreign-currency vs. krona discussion is stark and heated. I think it's safe to say that not a week goes by without somebody, in a newspaper article or on a widely read news website, making the case that Iceland should or should not adopt another currency. Some economists, and of course politicians and others, thank the devaluation of the krona for the "rebound" in economic activity since the collapse. Paul Krugman has made this case. Others blame the krona for the high interest rates compared to our main trading partners and for the high inflation. In response to Krugman, Jon Danielsson, at the London School of Economics, said that Krugman deserved an F.

The politics in the discussion are almost too obvious as well. And since there is a tradition for hung parliaments in Iceland, the politics in the currency question can become a bit funny as well. As an example, today's government is a coalition between Social Democrats and Left-Greens. The Social Democrats want to join the EU. They blame the krona for every economic misfortune of Iceland and they want to adopt the euro (given an EU membership). The Left-Greens don't want to join the EU and the Minister of Finance, who is a Left-Green, has thanked the flexibility of the krona for the rebound in economic activity. Blatantly, this is absurd! I would love to be a fly on the wall during government meetings whenever EU and euro vs. krona are on the agenda.

The almost certain inevitability of mixing politics into the foreign currency vs. krona discussion makes the subject both flammable and, since it's natural for so many people never to give back an inch on their political convictions, open for tunnel vision of rather high degree. As an example of that, the president of Icelandic Confederation of Labour, Gylfi Arnbjornsson, recently said, during a conference he spoke at, that "we [Icelanders] shouldn't let the short term problems of dollar, yen and euro block our sight. The euro is like a rock in the sea compared to the Icelandic krona." The Icelandic Confederation of Labour want to adopt a foreign currency, preferably the euro. They blame the krona for high inflation in Iceland.

Now, no offence to Gylfi but I wouldn't call the lack of economical and political coordination in the Eurozone a "short term problem." In my opinion, this is an example of economic tunnel vision: OK, let's adopt the euro. But what next? Pay into the EFSF fund? It would possibly make some sense to adopt the dollar, we do trade somewhat in USD-denominated goods in international markts. But the yen? We hardly trade with Japan, why not the Australian dollar then?

I admit it freely that I don't know whether it would be beneficial for Iceland to adopt a foreign currency. Quite frankly, I think the fundamental problem of the economy of Iceland is not the currency or what currency we use. Yes, there is a moral hazard problem associated with using an independent monetary policy with free flow of capital and free-floating currency. The nation, especially the banks and the government, can go on a spending spree and let the currency take the hit later in order to rebalance the economy (this has been the normal course of events in Iceland). But at the same time, if a nation is using a foreign currency and there is a real exogenous shock (natural disaster, collapse of international markets with its main exports, etc.) it can be more easily met with an independent monetary policy through devaluation of the currency. And for a small "city state" like Iceland, population 320,000, nobody would care if we would run a "beggar-thy-neighbour" monetary policy for the rest of the universe's life.

So for a small state like Iceland, running an independent monetary policy is like getting a full coverage on your car. You'll get any cracks and scratches repaired. But will you have the discipline to drive carefully as well, given that you have full coverage? Historically, we certainly haven't, we've "gone Greek" for decades. And quite frankly I think we wouldn't resist the temptation to drive carelessly, even if we hadn't full coverage, i.e.if we used a foreign currency. Backed up by that pessimistic view, I sometimes think Jefferson was right: banking institutions are more dangerous than standing armies.

So one of the economic problems of Iceland is not the currency we use. It's the banking and financial system. If we had that under control, we could use whatever currency we wanted. It would be like putting a stone under the accelerator of our car: we couldn't drive carelessly.

Zombie borrowers and/or zombie banks?

According to those news (in Icelandic) the economy is shoulders-deep in a balance sheet recession. Apparently, the economy also seems to be under the influences of zombie-banking at the same time.

Koo (Holy Grail of Macroeconomics) showed how the demand for loans was the main reason for the lost decade in Japan. He also made the case that the same problem had been prominent during The Great Depression in US and in Germany during 2000-2005. Other notable economists, such as Roubini, have also mentioned this.

Rough translation of the news is:

"Birna Einarsdottir, CEO of Islandsbanki, says that low demand for loans is the main reason for low growth of credit within the financial system. This was one of the points the made during a financial conference organised by the Islandsbanki.

Birna said that the loan-and-risk committee of Islandsbanki had agreed on the lion's share of loan applications they had received in 2011. About 74% of applications were agreed upon immediately but only 3% denied downright. Birna also said that those figures were a testament of firms adopting to higher standards set up by banks.

Loan applications in 2011 mirror the state of the economy according to Birna."

Teaser (Rates)

Iceland's economy is a high-interest rates economy. Keynes, when he was influencing debt management for HM Treasury, always emphasised that high interest rates were the "economic problem." He first focused on the short rates but later he turned his attention to the longer rates.

Surely, one can only imagine what Keynes would have said about the "economic problem" of Iceland had he seen this graph.

Long term interest rates in Iceland and the Euro area (OECD figures)

Essentially, this sums up the economic problem of Iceland in one single graph. Iceland is killing itself with high interest rates! And the Icelandic economy is more indebted than most, if not all, Euro countries. So the debt burden is awesome! 

Of course, there have been many attempts to explain this huge interest rate difference. The most common ones are:

- Iceland uses the krona as a legal currency and due to lack of liquidity on international FX markets, the interest rate differential between the Icelandic economy and other economies is high (it's a liquidity mark-up)

- Icelanders are big spenders and not much for saving. Using the "loanable funds" theory (supply and demand analysis) one then sees immediately that interest rates are and should be high compared to other economies where people are saving.

Personally, I think both of those are explanations are lightweight. In fact, I think the second one is straightforward wrong: the second you introduce a fractional reserve banking system into the economy the loanable funds theory is useless. The majority of this interest rate differential, something that I would like to claim that Keynes would have called THE economic problem of Iceland, is explained differently than most people think. 

The major influencers are the Icelandic pension system and the mortgage system of Iceland. 

Those are the structural deficits that are the major reasons for why Iceland collapsed. And they are still in place. Therefore, the crash is still ongoing and the economy not on "a path of recovery" - at least not for the long run -  as the Governor of Central Bank of Iceland seems to think.

More on this later.

Why Am I Blogging?

Some people would call me young. When I was even younger, I was studying BSc economics at the University of Iceland. I graduated in May 2008. My final work was a 25k word dissertation about the comparisons between the Icelandic banks and the Scandinavians. My final conclusion: despite some possible liquidity problems, the Icelandic banks seemed fine in comparison with their Nordic peers. Six months later I, and many other people, was proven awesomely wrong. What I had learned in my undergrad studies crashed in front of me and left me with a feeling of being completely lost. Something wasn't right.

I left to England in September 2008 to study masters in Money & Banking at the University of Exeter. I continued directly into a PhD in economics, emphasising financial instability and foreign direct investment. During the academic year 2009-2010 I read Kindleberger's Manias, Panic, and Crashes. Everything remotely connected to the topic of financial crises ended on my night table. When I read Cooper's The Origin of Financial Crises I came across the name of Minsky. Naturally, I ended up reading Minsky's Stabilising an Unstable Economy. That was a complete eye-opener and from there I realised that something was seriously wrong with my undergraduate courses. I drowned myself in books and papers by authors such as Minsky, Keynes, Schumpeter and Keen. 

The knowledge I gained from reading those authors instead of mainstream economics made me certain that the crash of the financial and economic system back home in Iceland wasn't a coincidence or collateral damage from the global financial crisis. There were structural deficits in the Icelandic economy that made it even more prone to crises than the common fractional reserve banking systems of other countries. No matter if the global crisis would have happened or not, the Icelandic economy would have crashed anyway. The timing was just a coincidence.

I started blogging in Icelandic in April 2010 about diverse economic matters ranging from pointing out what I considered structural economic madness to contemporary matters such as the Icesave dispute. To some people I seemed to make sense and I got emails from people that thanked me for putting their own thoughts down in a more concrete way than they thought they could do themselves. Others said I was being ridiculous and just "one of those bloggers" who thought they knew what they were talking about. Somewhat as expected, most of the negative comments I got were from other economists or people that had in some part built up or maintained the system that I was accusing of being the root of the whole economic problem.

So here I am, starting a blog about what happened in Iceland during and before 2008 and why the crash was inevitable given the structure of the economy that is in place in Iceland. I hope some people will find this informative and interesting. More importantly, I hope people will learn from this blog not to do "Icelandic economics." Because they're "neat, plausible and wrong."