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.

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