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.


  1. It is certainly quite entertaining the way that the poor old SeĆ°labanki's Annual Report blames all adverse circumstances on foreign currency relationships.

    However, something scientists get taught, although possibly not economists, is that correlation does not necessarily equal causation.

    I would suggest running your chart again with data on the money supply rather than the debt supply. Although they are certainly linked through the banking system, it is the money supply that is the causative factor for foreign currency trade relationships, not the debt supply.

    The real questions in order are, why has the Icelandic Money supply been so historically unstable, and as a follow up why has the regulatory framework surrounding the banking system in Iceland been so conspicuously unable to control the bank's lending and associated money creating practices.

  2. " is the money supply that is the causative factor for foreign currency trade relationships, not the debt supply."

    I'd halfway disagree on that point; it is not the money SUPPLY that matters but the money CREATION - but the last paragraph shows you know that of course.

    In a standard fractional reserve, the lion share of money creation is through creation of private and, of course, public debt since the creation of a bank loan simultaneously creates deposit. And that deposit is a part of the M3. So as long as the State is not going 1920s-German, the money supply is expanding predominantly because of expansion of private debt. But I'll run the data on money supply and post it, it'd be interesting to see the correlation therebetween.

    Regarding why the Icelandic banking system has always had free hands in expanding the debt as it pleases, there are maybe two important reasons for it. First, it happens automatically through the indexation of mortgages and other loan contracts as price level rises and second, there has somewhat been an a bit extreme trust in orthodox economic theory in Iceland for years and decades. And according to that theory, we best leave the banks alone when it comes to deciding how much debt they should create, they know best how much to create.

    But quite frankly, I think that's false. There should be more restrictions on bank lending and connecting it to capital account surpluses or deficits is probably the best idea I've heard of so far. And that applies to other economies as well.

  3. Well, yes if you want to be pedantic about it - I'd completely agree it's changes in the money supply (and associated debt supply from the banking system) that are the issue here.

    I should note that Fractional Reserve Banking is no longer being used, and it probably never was used in the form that is described in economic textbooks.

    Public debt doesn't automatically mean the creation of money. There are two types of debt in the economy - transfer debt, I lend you money, I no longer have money, you have it, no money supply implications, and as you quite correctly say Bank debt, which may or may not result in the net creation of money within the system. (It depends on the balance of repayment versus new lending.)

    The indexation of mortgages, doesn't and indeed can't increase the money supply in and of itself. In fact I would argue that one of the systemic problems it creates is to increase the ratio of debt to money.

    From the data i have on Iceland, I would say that all of the money supply increase in the 2000's came out of the banking system, as a result of uncontrolled lending. If you contact me, I can send you a draft paper I'm working on explaining exactly what happened. I'd certainly agree that blind trust in incorrect economic theories is probably a pretty good explanation for what's happened in Iceland - and elsewhere for that matter.

  4. Yeah sorry, I can be too detailed sometimes.

    Yes, effectively you're right on the part that indexation doesn't created money on its own. But it hinders the simultaneous cancellation of debt and money by automatically lending "money" (increasing the principal) to the borrower instead of demanding a nominal repayment, which depletes the cash/money amount that the lender has, whenever there is repayment. But I'd expect you're spot on: it does increase the ratio of debt to money (must admit I've never looked into that part of the functionality).

    Would love to read your draft paper, you can send it to me at