Wednesday, 12 October 2011

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.

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