The Return of Icelandic Economic Growth?

In early December, Statistics Iceland issued the GDP figures for 3Q 2011. The figures were, taking into the account how massive the global economic instability and lack of growth still are and the fact that Iceland’s banking system went magnificently bankrupt, rather surprising: 3.7% GDP growth over the first three quarters of 2011 compared to the same period the year before! Iceland was back on track, leaving Europe in the dustbin!!

The Central bank seized the opportunity and claimed economic recovery was already there. Therefore, people should not really be surprised about the rate hike in early November (rates stand at 4.75%), especially since the labour unions managed to squeeze out a considerable nominal wage rate increase and that would, “of course”, lead directly to higher inflation in the close future. The government did the same, claiming the honour for the recovery and politely asked those who were always complaining about high unemployment and debts while pointing out record number of people leaving Iceland, most notably to Norway, to keep quiet. The recovery was here, no need to continue whining!

Many were still rather sceptical, simply because the debt shock since 2008 was still around and due to mad indexation of mortgages the debt wasn’t going anywhere despite write offs of (illegal!) foreign currency denominated loans and other weak debt reduction schemes. But the “World In Balance Sheet Recession” paper by Richard Koo, author of the outstanding “Holy Grail of Macroeconomics”, just opened my eyes. Iceland was in a “Lehman Brother shock” and the balance sheet recession (too much debt) wasn’t going anywhere even though the figures of Statistics Iceland claimed otherwise.

Exhibit 16 in Koo’s paper fits the Icelandic economy like a glove! Substitute “Lehman” with “Icelandic banks” and the explanation is perfect.

The argument is as follows. The over indebtedness of Icelandic firms and households in 2008 was too great and balance sheet recession – a recession where firms and households in the economy cannot maintain normal economic activity due to high debts – was already on its way. That should not be surprising: the Icelandic non-financial sector was the most indebted one in whole of Europe and Icelandic households were close to the top of the list by indebtedness. Furthermore, the banks themselves were deleveraging (“deleveraging while delivering” was the punch line of Kaupthing just before it filed for bankruptcy) so macro deleveraging of the whole economy was the upcoming game in late 2007 and early 2008. That corresponds to the light-blue broken line on the diagram.

But the banks went bankrupt, not because of policy mistake like Koo says was the case of Lehman in US, but simply because there was nothing else in the cards. In fact, the government did its utmost to save the banks but, fortunately (if we look at Ireland) we simply couldn't. Sometimes it’s good to be impotent.

When the Icelandic banks went down under just a few weeks after Lehman the Icelandic economy was shocked and went down the solid dark blue line instead down the light blue broken path. The economy crashed! Spectacularly in fact, economic growth for 2008-2010 was -9.3%. 

Today, the growth of 3.7% is not because the “recovery is here” but because the economy has cleared the actual bank-bankruptcy shock out of the system and is edging closer to the balance sheet recession path (light blue line). This recovery is in other words the upward sling of the solid dark blue line.

So the growth is there, no reason to doubt that. But the problem is that the economy isn’t recovering like the Central Bank of Iceland and the government claim. The balance sheet recession is still there. And that can best be seen in the fact that investment is still a puny part of the economic activity: nobody wants to borrow for other things than possibly speculate a bit with housing while capital controls are still in place. While nobody is borrowing, nobody is investing in real capital and nobody is hiring or creating productive real capital. That can only mean one thing: a long term weak economy that is fighting over indebtedness of households and firms.

Investment is still at historically low levels despite "economic recovery". That implies balance sheet recession where firms and households are trying to minimise debt, i.e. deleveraging, rather than maximising profits.

First rule of balance sheet recessions: people try to deleverage their balance sheet and they certainly do not do that by borrowing and investing in real capital. Second rule of balance sheet recessions: we do not talk of them, because they do not confirm our little trouble-free economics.

The Icelandic Confederation of Labour, the Euro, the Krona and Icelandic Interest Rates

The president of the Confederation of Labour, Gylfi Arnbjornsson, along with the main economist of the COL, Olafur Darri Andrason, wrote recently a couple of articles in the newspaper „Fréttablaðið“, discussing the high interest rates in Iceland and the krona. This was parallel to a new economic report issued by the COL last week. Their conclusion: the krona is responsible for the high interest rates in Iceland – because it’s always falling in value against other major currencies (they don't answer the question why it is always depreciating) – and the households of Iceland, along with the rest of the economy, would benefit tremendously by enrolment of Iceland in the European Union and the adoption of the euro as soon as possible. That, the euro adoption, would secure the prevalence of low interest rates in Iceland, benefiting everybody.

I’m not convinced. I might be worried about the fact that the Union has, since 2000, been pushing for EU membership and the conclusion is wonderfully fit to their case. But beside that point, it was the methodology in their “research” that rang the warning bells in my head.

What decides interests?

The classical answer to that question is of course the demand-and-supply argument: demand of credit and supply of savings meet in equilibrium on the capital market and at the equilibrium the rate of interest is set.

Now everybody knows it isn’t that simple – beside this theory (the Loanable Funds theory) being open to some serious flaws (such as the Sonnenschein-Mantel-Debreu conditions). Joan Robinson highlighted the fact that there are three different types of factors that influence the rate of interest rates more than anything else: social, legal and institutional.

Social factors can e.g. be the age of the individuals in the economy. It is rather normal, up to a certain limit, for individuals to build up debt early in their lives, such as through student loans, and then repay their debt as they get older. In the social circumstances where majority of people in the economy are young, this borrow-young-repay-later structure would at least to some extent put upward pressure on interest rates in comparison to the situation where the majority people are entering retirement. And on the whole, Icelanders are rather young in comparison to many mainland European nations.

An example of a legal factor can e.g. be the crazy legal framework surrounding the Icelandic pension funds that I described in last post. Mix that craziness with the institutional factor of the pension funds being, as a group, a behemoth on the Icelandic capital market and the upward pressure on interest rates on the capital market is blatant.

Another example of an institutional factor: the krona. Adopting any foreign currency at all is an attempt to change that institutional factor, hoping, in our case, that it brings lower interest rates in the economy.

The fatal assumption of Olafur and Gylfi

It is impossible to reject immediately the theory that the krona has direct upward influences on interest rates within the Icelandic economy. But Olafur and Gylfi are playing a dangerous game in their articles: their conclusion is that the krona is the "main reason" or solely responsible for the entire interest rate differential between the Icelandic economy and mainland European economies (their conclusion says amongst other things: “it is therefore clear that the consequence of high flexibility of the tender of the nation is extremely high interest rates for households and firms.” - try to convince the British that flexibility of their currency increases interest rates). And their assumption is basically to ignore any other possible social, legal and institutional factors and only stare at the institutional factor that the krona is. Then they do their stuff.

Their “correct” conclusion – it is correct given their assumption – is that an EU membership and adoption of the euro would bring lower interest rates as good as immediately. And they point the cases of Lithuania, Latvia and Estonia to prove their point. But the assumption to only take the krona-factor into the account is so far away from reality that the conclusion will hardly be as bulletproof as they put it forward: we can prove (Arrow and Debreu did it), by assuming this and that, that the market economy is the best possible market organisation we can have but that conclusion doesn’t necessarily apply in the real world simply because the assumptions are absurd and are not of this world we live in. Assumptions matter, no matter what Milton Friedman thought.

The same applies to the conclusion of Olafur and Gylfi; their step-to-step process to their conclusion is so straight forward as it is exactly because of their assumption, i.e. to ignore all other possible factors (nota bene: that doesn’t make the conclusion in itself automatically wrong, only significantly reduces its explanation power for the problem why Icelandic interest rates are higher than in mainland Europe). If they would get the same result while taking other factors into the account I would be happy to believe their conclusion to be correct. But they don't so I can't.

But all this doesn’t change the fact that the question they indirectly ask themselves – how are we going to lower the rate of interests in the Icelandic economy – is the fundamental one regarding the economy and “the economic problem” as Keynes called it.

How would we decrease interest rates in Iceland?

Lowering the interest rates in Iceland would happen by influencing all the factors (social, legal and institutional) instead of thinking we can save the day with some sort of magic fix. We’ll hardly change the age-distribution of the nation in a swift manner. But we could educate people into thinking more vigorously about their consumption choices and their consumer debt. To change the mad laws about the pension funds would contribute a lot to lowering the interest rates and the same goes regarding the indexation of mortgages in Iceland. And finally, nobody can rule out the possibility that adopting another currency could lower the rate of interest. But nobody knows how much the adoption of foreign currency would contribute in the fight against high interest rates and quite frankly one can doubt it would significantly lower the rates after the legal and social factors have been corrected.

The discussion about how to lower the interest rates in Iceland must take place! High long term rates are the main reason, along with unlimited power of banks to lend out as much credit as they see fit, for economic instability.

But this discussion must take place without cries and propaganda. And to blame one factor solely is straight forward incorrect. It is as incorrect to solely blame the krona for high interest rates in Iceland as thinking that constitutionally forcing the EU member states to have balanced public budgets will solely fix the euro crisis.

Introduction To The Icelandic Pension System

Most people will roll their eyes when they hear that a pension system can have a fundamental part in bankrupting the households and private companies in any economy. Yes, pension systems all over the world are burdensome and, well, unlikely to work out in their current form due to too heavy burdens they put on the states' finances. UK, France, Italy, Greece, US and Denmark are just a handful of countries that are going to have to reconsider their pension systems. But that the pension system is to a large extent responsible for high debt of households: impossible!

Except in Iceland.

A very short introduction

The pension system in Iceland is a three-pillar system. The details are of course there but the basic structure of it is on its own enough to understand the essence and the crazy organisation of it. The State takes care of basic social security system; pensions for those that haven't built up their own savings, disablement benefits etc.. That's the first pillar. The second is the pension funds themselves which are divided into General ones and the Public ones. The Public pension funds have the explicit backing of the State while the General funds are not backed up by anything and must therefore, in case they cannot get high enough return on their assets, cut the benefits down. That they are obliged to do according to law and when their actuarial position [the balance between their estimated present value of assets and debts] hits -10% they must cut down their pension promises. Holland has +5% minimum in comparison. The third pillar is the voluntary pension savings.

The interesting part of the Icelandic pension system is the second pillar: the General and Public pension funds.

First the Public funds. In very short, they are for everybody that work for the State. Due to the State backing on the Public funds they are never obliged to cut back on their pension promises and in fact, according to law no. 1/1997, they are really nothing else than defined-benefits funds. The actuarial position of the Public funds is negative by around 440 BILLION krona. That's just short of 30% of GDP - which in comparison to many other countries isn't that bad!

Now the punch in the pension system in Iceland are the General funds. Their actuarial position is negative by around 200 billion, obviously showing the need to continue cutting down pension rights, but that's not the bad news. It's the laws that governs them that are.

The law on General pension funds in Iceland

I've mentioned before that the major economic problem of Iceland is high interest rates. High interest rates, especially for the long run, was the source of "the economic problem" of unemployment, fluctuating economic growth and general economic malices according to Keynes. And amongst the European nations, Iceland is always close to the top on the list of countries by the long-run interest in the economy. And I am gong to argue that this is because of the pension system.

The Icelandic pension system needs high interest rates. The law that the governing of the General funds is based on states explicitly that after a work life of 40 years, a pension fund shall secure the pensioner a pension that is equivalent to 56% of their average wages during their working years. To finance that, the pensioner himself and his employer contribute, in total, 12% of the pensioner's wages while he is working. No other contribution is forthcoming. And notice that the pension funds must, according to law, pay out pension that is equivalent to this bizarre ratio of 56% of average wages (I have no idea where this ratio comes from). The general pension age is 67 years in Iceland.

Now, Icelanders live, on average, for rather long - we've for a long time made it into the top 5 on the list of countries by life expectancy. The average Icelander lives for about 14 years after he begins receiving his pension.

Now we have everything we need to calculate how high (real) interest rates the pension funds need in order for them to be able to fulfil their legal obligation of paying out pension equivalent to 56% of average wages over your working age, given you live for 14 years and contribute 12% of your average wages to the pension fund. And the answer is: 1.8% real interest rates. On top of that comes cost of running the fund, other rights that the funds are legally obliged to fulfil such as part of disable benefits and pension in case of death of spouse and last but not least general wage increases during your working age. All this adds up to somewhere between 3-4% real interest rates. This is absolutely fundamental: the General Icelandic pension system needs 3-4% real interest rates if it is going to work out and the Public funds need even more. There is no coincidence that the pension rights in Iceland are discounted with 3.5% real rate of interest according to regulations.

A very important ingredient in the impossibility of the Icelandic pension system is the fact that the funds, as a group, are by far the biggest investors in any sort of financial instruments in Iceland. To name a few examples: they own most of the corporate bonds listed on the Icelandic Exchange, about 70% of the funding from the official Housing Financing Fund comes from the pension funds and they finance 30% of the outstanding bonds of the Icelandic State, registered in the Exchange. About half of all the mortgages in Iceland originate from the pension funds, either directly from themselves or through the Housing Financing Fund. They are, for a lack of a better word, a behemoth on the Icelandic capital market!

Now you're in position to understand how mad the situation gets. What happens when the majority of investors out in the market are legally obliged to get, at least, 3.5% real return on their investment in financial intermediaries? Of course, interest rates don't fall. Why should a pension fund buy a bond from the Housing Financing Fund, which it issues in order to finance mortgages to normal Icelandic households, on a lower rate of return than 3.5% if it is legally obliged to get that return? Would a pension fund finance a mortgage on lower return than 3.5%? Of course not: interest rates for housing in Iceland are around 4-5%, adjusted for inflation (REAL return). And the fault is of institutional origin: if Icelanders want to lower the rate of long term interest in their economy, all they have to do is to reconsider the structure of the pension system.

Long term interest rates in Iceland and the EZ (figures from OECD)

So there is a bizarre situation in Iceland. The pension funds are bankrupting not only the State itself - remember the 440 billion hole on the Public pensions' balance sheet - but directly doing the same thing to households that want to buy a flat or a house. 

I've called the Icelandic pension system a Ponzi scheme. I cannot find any better way to describe it.

The new Euro zone rules do more harm than good

The new plan about how to address the problems in the Eurozone is bound to fail. Quite frankly, the plan might well do more harm than good and speed up the breakup of the EZ.

The plan can be found here. The essence of it is to make it a constitutional duty to run a balanced government budget - that must be a German idea since, I believe, this mechanism is already in place in the German constitution. If there will be a violation of the -3% budget rule in the Maastricht treaty, some automatic process is to kick in to deal with the deficit. It is basically meant to be constitutionally impossible to break the -3% line. This they hope will stabilise the EZ - because as everybody knows, budget deficits are to blame for the crisis (no they are not!!) - and after a few years of stabilising austerity, Italy, Spain, Ireland and other peripheries will be just fine.

Sorry guys, ain't going to happen!

Budget deficits and public debt are not the only one to blame for the EZ crisis. Yes, Greece and Italy were running rather large deficits up until the crisis while public debt was monstrous in both economies. So it can easily be argued that the public finances cocktail in Greece and Italy, and even Portugal (which also had high private debt) was poisonous and one can easily argue that public debt is to blame in those economies.

But that's not the case in Spain or Ireland. Both countries were running a balanced budget, a lot more balanced than France. The crisis in Spain and Ireland wasn't because of public debt, as one can argue for in the case of Greece, Italy and Portugal, but private debt. The Spanish and Irish went on a private spending spree, buying and building houses as there was no tomorrow. When the private debt bubble collapsed the State got the financial sector straight into its arms and lack of private economic activity caused a skyrocketing public deficit. Has everybody forgotten AIB in Ireland and the Spanish cajas?

Public deficit as % of GDP in three countries, 1990 - 2007

The problem in the EZ isn't the the same all over it and therefore you cannot fix it with a uniform plan all over the EZ. That sort of plan is destined to fail; you can't fix a private debt bubble with fiscal austerity! On the contrary should you run deficits to get the private economy into investing and running the economy again. Japan is the most obvious case of the obvious need for government economic support after a private debt bubble burst.

Exactly because the new EZ plan rules out the possibility of supporting an orderly deflation of a private debt bubble with public spending the plan is not only destined to fail but may well speed up the break up of the EZ. If national governments cannot use the borrowing and spending power of the State to meet the need of economic support at the time of private debt deflation the discrepancy of economic activity between EZ members will only get worse.