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.