Banks: intermediaries or money-creators?

Peter Radford has a comment about whether banks are intermediaries or not on the Real World Economics blog, answering my comment where I say Krugman is disastrously wrong in his Banking Mysticism post. His comment is:

"I have just returned from depositing some cash in my local bank. An insignificant amount to be sure, but not the result of my being loaned to by that bank.

So.

Was that deposit a loanable funds sum? Is my bank an intermediary? Or is my deposit simply a recycled amount originating, way back, from a loan? If so, are the decisions of depositors like me completely irrelevant to an understanding of banking? Is that cash not really mine after all, and merely part of a giant flow from one bank to another? Did my decision have no macroeconomic effect?

I agree Krugman ignores – apparently – endogenous money creation. But banks gather deposits as fast as they can? Why? If they can simply create money why would I, as a banker, ever waste my time building branches to attract deposits? Why would I raise or lower interest rates to “attract deposits” if I never needed to?

Chick, in her book “Macroeconomics After Keynes”, pages 236-240, describes a difference between a “banking system” and an older, less sophisticated “bank”. She argues that the notion of being a ‘savings conduit’ (i.e. an intermediary) is outmoded once banking becomes so intertwined it can be called a system. She tries to make a great deal of this.

The issue, it appears is causation: does savings drive investment; or does investment drive savings? Chick sits squarely in the latter camp because of her Keynesian view, while Krugman seems muddled and appears to tend towards the former.

My life as a banker for 20 years would have been a whole lot more simple had I known that I was not running an intermediary. At least in part.

It appears to me – naively obviously – that banking is more complicated than either side in the Keen – Krugman discussion implies. Banks clearly create money. They recycle it too. And that recycling is called intermediation. Which, in turn, can be called being a conduit for savings.

Is this another case of two tribes not wanting to concede that there may be a middle ground?"

There is no middle ground
I am going to argue that there is no middle ground: banks are creators of money, in all instances.

First, transforming cash into bank deposit has, effectively, no effect on your net holdings of money-type assets. Cash is money just as bank deposit is accepted as such. However, there  is a great difference in cash-money and deposits-money in the sense that one of them is vulnerable for sudden lack of trust when depositors don't believe anymore to be able to use the bank deposit as money. That is when we see a classic bank run: people are despairingly trying to SELL their bank deposit to the bank itself and BUY cash instead. And the price therebetween is 1:1.

But that's exactly what you do when you take your cash-money to the bank, just the other way around. You sell it to the bank and instead the bank gives you a bank deposit, which is usable as money, and you get tiny rate of interest on it as well. As long as you think you can access your bank deposit whenever you want to use it as money, you're ok with that deal.

Note also that the rate of interest on the deposit is (should) be lower than the policy rates, which is the price of liquidity assistance from the central bank. The bank will be happy to buy the cash from you and sell you low interest deposit instead, not to lend the cash out (intermediary) but to fulfil either regulatory minimums or bank-specific needs regarding liquid assets. Those liquid assets can be the cash itself (the Austrian dream of 100% reserve requirement ratio) or the bank can sell the cash you just brought in to another bank or even the central bank itself and get liquid (central bank or other bank) deposit instead.

The question each economic unit has to ask himself is how liquid he wants to be. Cash is the utmost liquid asset and you can, as Keynes realised and built his Liquidity-Preference theory on, use it to store your wealth if you do not trust any other assets to hold your wealth in or if you want to make a speculative move on the price of other assets (you standing in the bank-run queue is essentially a speculation on your behalf: you think your bank-deposit asset will collapse in value and therefore you are trying to sell it to get more liquid asset, cash, instead in which you prefer at that moment to store your wealth in).

So when you brought the cash-money into the bank, you indeed had macroeconomic effect: you lowered the rate of interest (by obviously such a low amount it wasn't noticed but I hope you get my point) as you accepted an asset (bank deposit) that is not as liquid as cash. You selling your cash to the bank is a sign of your liquidity-preference being lower than when you held the cash.

My point is that banks are not intermediaries: you are not depositing your cash-money in the bank for it to lend it out to another person, you are selling your highly-liquid cash-money to the bank for not-as-liquid bank-deposit. The bank may well sell the cash you sold to it to the central bank for a liquid central-bank deposit or buy a much more illiquid CDS contract or whatever not, it hinges on the liquidity preference of the bank you just sold the cash to. And since this is a question of liquidity-preference of units but not intermediary process, the banks will ALWAYS create deposits parallel to creating bank-loans. Those deposits are then spent on other assets, both financial and non-financial, but they are always somebody's financial-liability in the system, no matter how you store that wealth, i.e. purchasing power.

An obvious problem that arises from this is "when is a financial asset money?" How the newly created deposit is spent makes a difference on how much "money" ends up in the system. Do you spend it on a savings account (thereby moving a time-deposit, which is M1, into M3)? Or do you spend it on Treasuries? Or corporate bonds? Or stocks?

This was a problem that Keynes realised in the GT but he, as far as my knowledge goes, never addressed it properly but simply said (in footnote no. 66): "...we can draw the line between "money" and "debts" at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for "three months" one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. It is often convenient in practice to include in money time-deposits with banks and, occasionally, even such instruments as (e.g.) treasury bills."

To my knowledge, Treasury bills and Treasuries are generally not included in official money supply measurements.  But that's where bank-deposits, created parallel to bank loans, can end up if the owner of the deposit so chooses. Obviously, we can put "CDS contracts" or "stocks" or any other financial instrument in there as well according to this "definition" of money. And that is suddenly not "money" any more, even thought the debt and the deposit were created at some time in the past.

So banks are not intermediaries, not even partially so. They are simply, as Schumpeter so blatantly stated it, creators of purchasing power.

New Data on Income Distribution in Iceland

Statistics Iceland released this morning new data on disposable income in Iceland. Peeking at the info one can draw three conclusions:

First, the boom from 2004 until 2008 wasn't evenly distributed at all - not that it's surprising. The disposable income of the top 10% grew 33% in four years while the income of other groups grew 21-25% (the "80-90%" income group added 25% to its real disposable income, the bottom 10% added 21%). This had the obvious effects that the income ratios between the top 10% and the rest fell.

Second, although the Gini coefficient has gone down from 29.6 in 2004 down to 23.6 in 2011 (based on incomes of the years 2003 and 2010), the main source of the increased equality, according to the Gini, is that the top 10% have lost all their income increase. 

Third, the real disposable income of households has gone back to the level of 2004. There is basically no growth in real disposable income over 7 years! In the meanwhile, the debt of Icelandic households has grown by at least 20 percentage points if the ratio debt/GNP is examined. And the real disposable income is not adjusted for debt burden.

Graph 1: Real Disposable Income of Icelanders on fixed 2010 prices. 

Graph 2: Since most of the income growth during the boom years was in the richest group, the ratio of other groups' income to the top-income group fell; Iceland was edging closer to a Plutonomy. The ratio bounced back after the collapse, basically because the top earners lost all theirs.

Graph 3: An index of real disposable income of different groups. The growth of the Real Disposable Income that took place during the boom years is all gone. In the meanwhile, a conservative estimate of Households' debt at year end 2011 was 117% of GNP compared to 98% in 2004.

Graph 4: Debt of Icelandic households according to book-value of debt. The face value is somewhat higher, especially after the 2008 collapse. Today's Icelanders have to pay 20% higher debt with the same real disposable income they had in 2004.

Excerpts from the General Theory by Keynes

I've been reading the General Theory by Keynes due to the "policy chapter" (working title) of my PhD thesis. I had only read chapter 12 before but now that I'm working my way properly through book IV of the GT (chapters 11 to 18 on The Inducement to Invest) I realise what sort of genius Keynes was. Here are some excerpts, only from chapters 11 and 12 (I don't have much time and the number of quotes would grow quickly if I would include chapters 13-18, especially from chapter 13 where the liquidity-preference theory of rate of interest is introduced):

Chapter 11 - The Marginal Efficiency of Capital
"The most important confusion concerning the meaning and the significance of the marginal efficiency of capital has ensued on the failure to see that it depends on the prospective yield of capital, and not merely on its current yield."

"It is important to understand the dependency of the marginal efficiency of capital of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle."

"The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake in regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between today and tomorrow... The fact that assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality."

Chapter 12 - The State of Long-Term Expectations
"It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is  reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which out knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the the future, modified only to the extent that we have more or less definite reasons for expecting a change.

The state of long-term expectations, upon which our decisions are based, does not solely depend, therefore, on the most probable forecast we can make. It also depends on the confidence with which we make this forecast - on how highly we rate the likelihood of our best forecast turning out quite wrong."

"If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence."

Factor no. 4 of how we form the expectations of the future and on what they are based on deserves to be quoted at full length. Keynes's own italics are still there but my emphasises are underlined:


"(4) But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgement and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.


Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.


This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.


Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.


If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence  of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

"We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance."

And today's economic theory?
What I must admit finding amazing is that all that is written here above doesn't take a genius to write (although Keynes certainly was). I cannot help to feel that the meaning of the text here above can be agreed to be in some sense true by any commonly intelligent human being. That same human being would at the same time quite likely to be able to convey the meaning of this text to another person, maybe not using those exact words but conveying its meaning and feeling all the same. This is truly nothing more than common sense.

Nevertheless, today's economic theory is nothing of this sort. Just as an example, uncertainty about the future does not exist in today's ruling macroeconomic theory. It is disturbing how far away from the real world the ruling paradigm of economic theory is.

And is it any wonder, seeing today's ruling economics theory where the sensible economics of Keynes is completely and patently ignored with fully informed economic agents who take decisions based on "rational" expectations where there is no uncertainty about the future course of events, that we are in a world of economic mess?

Iceland and Keynes's Liquidity Preference Theory

Been reading up on Keynes's Liquidity Preference Theory (LPT) and plotted the graph below using data from the Central Bank of Iceland.

Notes and coins in circulation in Iceland has more than doubled as a % of GDP since September 2008. Last data point is January 2012.

The LPT rests on the fact that despite "no one outside of a lunacy asylum" would keep his wealth in money according to the classical theory of interest and money, we nonetheless do. The distrust that people have on their own expectations on the future push people to keep part of their wealth in highly liquid assets in order to "lull our sense of disquietude" of the future. And if the level of uncertainty was high or, somewhat similarly, our level of confidence in our own expectations of future course of events was low, the public and investors would be compelled to keep a high proportion of their wealth in interest-free money, due to their explicit level of liquidity.

Well, ain't that the case in Iceland! Uncertainty of the future is high; unemployment is at historical highs and investment in capital-assets is likewise at is lowest point ever. People urge for liquid assets even though the rate of inflation is currently at 6.3% and the demolition of the purchasing power of notes and coins equivalent, or thereabouts, to that.

Wonder if the proponents of unilateral foreign currency adoption in Iceland consider this? What happens if we don't have the ability to print the cash that the public's liquidity-preference demands?

Post Keynesian view on the Euro crisis

Some abstracts from a paper from the newest issue of Real-World Economics Review. The paper's title is "The euro imbalances and financial deregulation" by Vernengo & Pérez-Caldentey and can be found here: pdf file.

Some abstracts and highlights (italics are mine):

"More precisely, arguing from an aggregate demand perspective, this paper  shows that the crisis in Europe is the result of an imbalance between core and non-core countries inherent to the Euro economic model. Underpinned by a process of monetary unification and financial deregulation core-countries in the Euro Zone  pursued export led growth policies or more specifically ‘beggar-thy-neighbor policies’ at the expense of mounting disequilibria and debt accumulation in the non-core countries or periphery.  This imbalance became unsustainable and this surfaced in the course of the Global Crisis (2007-2008). Unfortunately, due to the fact that in a crisis governments must increase expenditure (even if only through automatic stabilizers) in order to mitigate its impact while at the same time revenues tend to decline (due to output contraction or outright recession), budget deficits are inevitable and emerge as a favorite cause of the crisis itself."

"In the face of a decline in ROA [return on assets] as in the case of non-core countries between 1990-1995 and 1996-2007 or for a roughly constant [return on equity] as in the case of both core and non-core countries between 1996-2001 and 2002-2007,   the levels of profitability (ROE) of the financial system can be maintained or increased by higher levels of leverage (or indebtedness). The levels of leverage were particularly high in some of the core countries. Available evidence on Germany provided by Bloomberg shows that leverage for the major banks increased on average from 27 to 45 between 1996 and 2007. As well data for 2007 for 14 of the major financial institutions of Europe (located in core countries) indicates that the average leverage ratio was 34 (with a maximum of 50).

The freedom of financial flows to move throughout Europe and abroad, low borrowing costs and easy access to liquidity via leveraging coupled with no exchange rate risk provided a false sense of prosperity in a low risk environment."

[Figure 2 basically shows how aggregate demand was maintained in the periphery countries by investment instead of exports-led growth as in the core countries. That investment was financed with bank-debt, from e.g. Germany and France, and caused furthermore a current account deficit in the periphery countries that had to be corrected sooner or later due to balance-of-payments constraints, see figure 3 below. Notice in figure 3 that the current account was never in the positive zone in the peripheries after the adoption of the Euro on interbank markets in 1999.]

[Germany goes through the 60% public debt wall in 2002.]

"Imbalances in a Monetary or Currency Union are bound to occur when its state members are economically heterogeneous and different.  Recognition of this fact requires  that the establishing Union must create as part of its constituent charter mechanisms to solve and clear the imbalances rather than making them cumulative over time as in the case of the Euro Zone. In practice this amounted to recycle balances from surplus to deficit countries to maintain the dynamics of aggregate demand. This implies that the creditor country should play an active role as part of an equilibrating mechanism [aka. fiscal transfers between countries] and that the brunt of the adjustment  should not be borne by the debtor country which happens to be the weaker and less developed country."

Inflation, Debt and the Icelandic krona

Just a little something, worked out from the OECD and Iceland Statistics data on M3 and Consumer Price Index in Iceland. Notice how high the correlation is and that the inflation is lagged by five quarters.

Growth in the money supply (M3) and change in the CPI over three year period (for smoothing). Notice that M3 growth leads. I haven't done the Granger-causality test but I find it highly unlikely that M3 growth does not cause inflation, at least if one looks at the graph.

It is also worth reposting this graph from The Icelandic krona and the Icelandic debt:

Growth of macroeconomic debt (in the ownership of the banking system) and the annual change in the USDISK cross.

 This I have done the Granger-causality test on:


Equation 1: GrossDebt
Heteroskedasticity-robust standard errors, variant HC1

                coefficient   std. error   t-ratio   p-value
  -----------------------------------------------------------
  const          0.0426658    0.0286018     1.492    0.1456
  GrossDebt_1    1.02175      0.175881      5.809    1.89e-06 ***
  USDISK_1      -0.318946     0.219615     -1.452    0.1562

Mean dependent var   0.315019   S.D. dependent var   0.231991
Sum squared resid    0.733335   S.E. of regression   0.151383
R-squared            0.599242   Adjusted R-squared   0.574195
F(2, 32)             33.95636   P-value(F)           1.23e-08
rho                 -0.218167   Durbin-Watson        2.411990



Equation 2: USDISK
Heteroskedasticity-robust standard errors, variant HC1

                coefficient   std. error   t-ratio   p-value
  -----------------------------------------------------------
  const          -0.141294    0.0387644    -3.645    0.0009   ***
  GrossDebt_1     1.00756     0.150647      6.688    1.50e-07 ***
  USDISK_1       -0.148002    0.206466     -0.7168   0.4787

Mean dependent var   0.153163   S.D. dependent var   0.250120
Sum squared resid    0.693631   S.E. of regression   0.147228
R-squared            0.673898   Adjusted R-squared   0.653517
F(2, 32)             32.08670   P-value(F)           2.26e-08
rho                  0.050441   Durbin-Watson        1.822156


For those of you who don't have a clue what the Granger-causality test is about it is to evaluate the causality between two (or more) variables.

The print-outs here above basically say that gross debt in the ownership of the banking system expands first and then the krona falls in value. In fact, the trade-off (the coefficient) is almost exactly 1:1. Equally as important, the causality does not run the other way, i.e. from devaluation to expansion of debt.

So the "common truth" regarding the krona being a useless currency "because it is always falling in value and it needs capital controls to survive" is simply straightforward incorrect. It is the creation and expansion of debt  in the banking system, simultaneously creating money which leads to inflation, that devalues the krona.

The devaluations of the krona have nothing to do with it being a "useless currency" but everything to do with the creation of debt by the banking system. The capital controls are of the same origin; they have nothing to do with the krona being a "useless currency" but everything to do with the creation of debt by the banking system.

Capital Controls in Iceland Strengthened

The Icelandic parliament made a move yesterday and boosted the capital controls. Policy makers made sure not to disturb the market and waited until 4pm yesterday to get the Committee on Economy and Business together to get the bill going. The opposition in the parliament promised not to interfere so the bill would be passed before the reopening of markets this morning. It was passed around 3am this morning.

The owners of government bonds. Only the government bonds are shown here, the bonds of the Housing Financing Fund are not, but the graph nevertheless shows well how foreign parties have stacked up their holdings of bonds of short maturity. The T-bill pie chart below shows the same thing.

Pie chart showing the owners of T-bills. Nicked from Market Information.

The strengthening is mainly in the form of including certain payments from the receiverships of the old banks. Repayments of bonds in the ownership of foreigners are also included. It doesn’t matter if the bonds are issued by private or public enterprises. Recently, foreigners have been moving into the bonds on the short end of the maturity, waiting to be able to get repaid in order to get their funds out of the country. Also, since there is a difference of the value of the Icelandic krona is 30-40% (or thereabouts) between the Icelandic currency market and outside it, there is a massive incentive to buy krona outside the economy, bring it to Iceland, buy bonds with short maturity, wait for the day of repayment and get paid according to the exchange rate in Iceland. One has to make hefty losses for the gamble not to be profitable.

The timing of the boosting of the capital controls isn’t a coincidence either. Tomorrow, Wednesday, a repayment of the HFF14 bond is due, roughly 6-7billion ISK (36-41 million EUR, according to the Central Bank of Iceland exchange rate). In May, another massive outflow is due. My old mates in the Research Team of Arion bank back home said it best in their Market Comment last Friday, from where this graph is nicked from. Good timing lads!

The Research Team of Arion bank made a rough estimate of the outflow of foreign reserves due to maturity and repayments of government bonds and government-guaranteed bonds. The loans of private parties are not included. 2012 only. Amounts in billion ISK.

So in short, the Central Bank is afraid of the early outflow of foreign reserves. The remedy is to erect the capital controls even higher than before in order to stop or mitigate the leakage of precious foreign currency and keep the country liquid. 

In the meanwhile, the Bank considers increasing the policy rates to fight inflation, even though higher interest rates cause more foreign reserves to flow out of the country. Furthermore, the captains of the Central Bank of Iceland do not realise that allowing banks to expand the pool of mortgages, fuelling a speculation boom in the housing market, causes outflow of foreign reserves.

The governor of the Central Bank of Iceland, Mar Gudmundsson, is one of the principal authors of today’s Icelandic monetary policy. Only the former governors of the Central Bank were sacked after the crisis in 2008, while their underlings were promoted to fill their places. One of those underlings, today’s deputy governor Arnor Sighvatsson and former main economist of the Bank, publicly “admitted” last week during the hearings of the case against the ex Prime Minister Geir Haarde that the Bank had been very concerned about the size of the Icelandic banking system already back in 2005, when its size was only 520% of GDP. The banking system doubled in size before it finally collapsed, right under the very nose of the Central Bank, creating in the meanwhile, amongst other things, a current account deficit of 25% of GDP in 2007 alone.

Those are the men we entrust to abolish the capital controls and preserve financial stability. Let us hope they know what they are doing.

The maturity profile of government debt. Nicked from Market Information.

We have a lift-off... no, wait!

GDP growth in Iceland was 3.1% according to new figures from Statistics Iceland. The recovery from the -6.8% and -4.0% contraction in 2009 and 2010 respectively looks healthy on paper. But the underlying growth is weak and not sustainable.

The growth seems to be mainly from increased investment. But "the growth in gross fixed capital formation is partly due to imports of ships and aircraft, with marginal impact on GDP. Excluding imports of ships and aircraft, gross fixed capital formation increased by 7.4% in 2011" according to Statistic Iceland. So sorry, that investment didn't create any wages within the Icelandic economy.

Investment continued to be mediocre in 2011. The jump in the last quarter was a one-off investment in the form of importation of ships and aircraft, thereby not contributing to wages or employment in the economy.

The sources of investment (as a % of GDP, 4 qrt. moving average). The State is certainly not doing anything to maintain the level of investment in the economy.

The state of the Icelandic economy is weak, despite the numbers seemingly telling us another story on the surface. The shock to the Gross National Income after the crisis in 2008 is still far from being reversed as the following graphs show. That will not happen until domestic investment projects start for real. They will not start however until interest rate is lowered and debt burden lessened. 

The Icelandic economy is stuck in a debt-and-interest-rate trap that causes sluggish investment and low economic growth. The new figures on economic growth do nothing but strengthen that view.

Gross National Income in Iceland (index=100 in 1945). The shock in 2008 will not be properly reversed until investment picks up.

The growth of Gross National Income. The shocks prior to 2008 were nearly always due to fluctuations in fish catches. This time around, it's due to debt and that debt is still around.

Historical Inflation in Iceland

This graph captures the reason why we are desperately looking for an alternative for the krona.

12 month inflation in Iceland and notable events regarding the krona. The devaluation of the krona is commonly blamed for the high inflation but the fundamental reasons are different: the simultaneous creation of debt and money by the banking system. Keep the creation of debt on a leash and the problem will be solved.

Now, the devaluations of the krona are normally blamed for the high inflation in Iceland.  But the reason for high inflation in Iceland is simpler and more obvious once one has looked a bit deeper under the surface. All the same, "what everybody knows is always the truth" and so the search for a currency "that doesn't collapse in value like the krona" has gained momentum since the 2008 Collapse.

No, the fundamental reasons for the historically high inflation in Iceland is not because of the devaluations of the krona. The reason for high inflation in Iceland is the expansion of debt and the simultaneous creation of money and purchasing power. One can trace this reason at least back to the early 1920s exchange rate crisis.

Edit: a short post on the connection between debt and ISK devaluations is here: The Icelandic krona and the Icelandic debt

Exports, Imports and Floating Krona

Been reading Leigh Harkness's papers recently due to my PhD and an idea of how to combine his optimum currency system with financial stability. From his arguments against the floating exchange rate system, I checked out the Icelandic data on imports and exports as a share of gross national income. The graph is below.

Exports and Imports as a share of Gross National Income in Iceland along with the growth of GNI from 1946. Notice how the series appear to break in 1960 when the import controls were abolished (we had a mess of import controls in Iceland 1930-1960, as somebody thought it would be a fantastic idea to react against shortage of income from abroad by preventing people to spend it on imports) and again when the krona was floated in 2001. 

Notice also that we had free flow of capital only during the period of 1994 to 2008. Yes, increased GNI during this time but imports more often than not higher than exports. That unbalance explodes after the privatisation of the banking system begins in 1997 and goes bonkers after 2001 when the krona is floated.

I find this interesting, I had never seen Harkness's website until late last year or so. I find his papers quite frankly too clear and how he connects the creation of credit to the current account deficit is so obvious I feel ashamed not have realised it fully on my own. Furthermore, his papers give an idea about what can be the outcome of a (Canadian) Dollarization in Iceland, although I have to admit that I find it unlikely it will happen since the political powers seem not to want to hear it as much as mentioned. Their direction is one way only: to Brussels.

Check out Leigh's site: http://www.buoyanteconomies.com/

New Current Account Figures for Iceland

New data on current account came fresh from the Central Bank today. Iceland is still in trouble: we're not running the positive current account we need to be running if we're going to be able to build up FX reserves and get rid of the capital controls some time. In fact, we're running a deficit - although nothing close to the madness that was going on 5 years ago.

Current account since on quarterly basis since 1991 (four quarter running average). I aggregate the stuff into two simple variables: net surplus on exports and imports of goods and services and then net income of financial assets (interests and such). Figures in millions of ISK.

This graph doesn't say much though, since the size of the economy and the price level aren't corrected for. If we use four quarter rolling average of GDP (data available since 1997), we get this graph. 

Current account deficit in Iceland. 2007 is what it is: we were really running an epic deficit of 25%!! I do believe we have the world record in that perspective, no other nation in the world has managed to run such a humongous current account deficit. 

So yes, we managed to run a surplus on goods and services of around 10% in 2011. But all of it went into paying the interests on external debt.

Foreign parties have around 400 billion ISK in the Icelandic economy. They can't get it out because of the capital controls. The interests on those 400 billion is maybe around 20-30 billion ISK per year. The net income from goods and services was 130 billion. One sixth of that went into paying for the "imprisoned" funds of foreigners. 

Somebody would claim that Icelanders should accept the fact that the krona needs to depreciate by maybe 10-20% to get the current account into proper surplus zone where non-indebted foreign reserves can be built up. They also need to lower the interest rates at home and give individuals and companies a chance to refinance their external debts with at-home created money, instead of ballooning out the coffers of foreigners by paying them interests. They should also consider just skip having the capital controls, let the krona drop if it wants to and stop paying interests on the "imprisoned" money that wants to get out anyway - it will one day, and by then there will be additional interests on the debt from today until whenever the capital controls will be lifted.

Finally, the net debt creation of the banking system, such as in the form of mortgages for speculation purposes, needs to slow down. It was the debt-creation (manufacturing of purchasing power) that gave us the capabilities of running a mad 25% deficit on the current account in 2007 and the story is repeating itself, once more, today, though the scale is thankfully smaller. But the purchasing power used for buying in imported goods is coming from somewhere and the bank-mortgages used for speculation are certainly responsible for some of it.

And on top of all this, the central bank has begun its new cycle of interest rates hikes in the hopeless fight against inflation in an indexed-mortgages economy.

What a basket case the Icelandic economy is when it comes to financial stability!!