Wednesday, 28 December 2011

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.


  1. Sæll Ólafur

    Fín grein þó ég sé ekki sammála niðurstöðunni. Ég var einmitt búinn að lesa grein Koo fyrir nokkru og fannst hún einmitt mjög áhugaverð í samhengi við Íslands.

    Ég vil aftur á móti halda því fram að "deleveraging" á Íslandi sé að fara fram mun hraðar en t.d. í Japan í gegnum afskriftar- og gjaldþrotaferla og þá sérstaklega á árinu 2011. En það kemur í ljós.

    Varðandi fjárfestingarþáttinn þá kemur ekki fram í greininni hjá þér hvort línuritið sem þú sýnir neðst innifeli alla þrjá þætti fjárfestingar þ.e. heimila, fyrirtækja og hins opinbera. Gætir þú svarað mér því?

    Með kveðju
    Egill Jóhannsson

  2. Yeah, maybe deleveraging is progressing faster in Iceland than in Japan after the 1990 burst. Who knows. At least it's blatant that the indexation of mortgages is automatically working against that deleveraging process, however strong that process might be.

    The investment/GDP ratio is aggregate investment, private and public alike. I wrote another post where the private investment is segregated from the public, see

  3. Icelanders have resisted international pressure to make them fully reimburse the two governments. They are coping and if they continue to pursue the challenge by making ways, they will succeed. On the concern, how to start a small business in this situation is tough but challenging.