Money and Debt in Iceland and the New Prosperity

The collapse of the money supply in Iceland has been turned around, at least for the moment. That would support the view that the economy is not in the deadlock deflationary spiral it was in in 2010.

Money supply (M3) in Iceland, its 12 month change and the its acceleration. The turnaround is quite frankly amazing, and now the money supply growth has reached the level of the mid 1990s. 

Borrowers have returned to the banks: the growth of the money supply is propelled by the growth of new debt by banks. That has had the consequences of housing prices to rise again.

New mortgages and housing prices. The growth in new mortgages is mainly from banks. The good part of that story is that most of the new mortgages are non-indexed, i.e. what most other nations would consider normal. Not only does that strengthen the interest rate policy of the Central Bank considerably but the non-indexed debt is, contrary to what one might think from the Fisher hypothesis, with lower real interest rate on average.

House prices follow the growth of mortgages in Iceland as in any other country. The capital controls lock the funds of wealthy individuals in the economy as well, pushing them to invest in houses to rent instead of putting their funds into low-yielding bank accounts or bonds. The result is another speculation bubble in housing.

The momentum in the Icelandic economy is picking up. However, that momentum is quite unevenly spread out and quite worryingly based on housing speculation and the presence of the capital controls. Not only have the capital controls infused a bubble in the bond market but the money is finding its way into housing as well, pushing up both the rental price and the cost of buying. In the meanwhile, investments are still minimal.

The bottom line is that the new economic growth in Iceland and the ascent of housing prices aren't supported by fundamental economic activity but debt, capital controls and speculation. The momentum is good but the way forward is winding. Lifting the capital controls without shocking the economy won't be easy if investment does not return soon. In fact, if investment does not return soon, the economy is a goner.

The return of economic growth in Iceland is not supported by fundamentals such as investment in real capital. The foundations of it are therefore weak and mostly speculation and debt driven. Lifting the capital controls in such an environment will not be easy.