Friday, 25 November 2011

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!

Wednesday, 16 November 2011

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.

Monday, 14 November 2011

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.

Sunday, 13 November 2011

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?

Friday, 11 November 2011

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.

Thursday, 10 November 2011

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!

Tuesday, 8 November 2011

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.

Monday, 7 November 2011

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

Friday, 4 November 2011

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.

Thursday, 3 November 2011

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.