This is important: one of the foremost defences of the indexation of mortgages in Iceland is that it, following Fisher's Theory of Interest Rates, should lower the rate of interest compared to non-indexed loans. Therefore, abolishing the indexation would only backfire and borrowers of indexed loans should be happy with their indexation; due to it, they are getting lower rate of interest than otherwise.
Too bad the data does not back that up (a recurrent problem in neoclassical economics)! The updated version of the graphs I posted in February - and some - are here below.
General nominal rate of interest of indexed and non-indexed loans in Iceland. The development from February continues: nominal rate of non-indexed loans is still lower than that of indexed loans. The two circles highlight on one hand the period of überhigh policy rates during the credit boom times and the now-longer period of economic contraction after the collapse.
General real (CPI deflated) rate of interest of indexed and non-indexed loans.
To figure out whether it is cheaper to borrow money in the form of an indexed loan or non-indexed one, simple compounded interest calculations can be done. Note that according to the Fisher theory and the defenders of indexation, the indexed loan should, for the longer term, be cheaper, i.e. the compounded indexed-principal should be lower than the non-indexed one.
Again, that is not backed up by the data.
100kr. that grows with compound nominal rate of interest. The non-indexed loan is, contrary to what neoclassicals say it should be, cheaper!
So I'm sorry, but for those of you Icelanders who have borrowed money via an indexed loan believing that you were getting a better deal: you're being conned! (But you've probably figured that out already.)
I was in fact asked to explain why this was to be expected as I had expressed my view was. The nudge came from Asgeir Danielsson, head of Department of Research & Forecasting at the Central Bank of Iceland. My reply was posted online on the website of The Icelandic Journal of Business and Economic Matters - Verðtrygging og vextir. My explanation was post-Keynesian and Minskyian in nature: the presumed abolishment of uncertainty in the loan contract was outweighed by the facts that CPI measurements are wrong - a well-known but largely ignored problem in CPI-indexed contracts - and cash flows were distorted by the way the indexation was carried out, leading to higher accepted rate of interest and widespread Minskyian speculation and Ponzi finances.
When Danielsson's reply came, I was very disappointed: he circumvents completely the question why the data is contrary to what neoclassical theory expects and focuses instead on my criticism on the ergodicity assumed in the Central Bank's (Danielsson and his team) economic model, which is a rather unimportant matter (that I admittedly should have skipped in my own article) when it comes to discussing indexation and the rate of interest.
On the problem of CPI measurements being incorrect, he shuns it completely: "A small deviation in the measurement of price indices - a deviation that is furthermore pretty well known [italics added] - does not change that conclusion [that long-term loans with fixed nominal rate of interest would have to carry very high uncertainty premium if they were going to have fixed rate of interest; ergo: indexation is needed!]
I cannot for the life of me agree with Danielsson! First of all, if Danielsson wants me to take him seriously, he needs to answer my concerns about the increased prominence of Minskyian speculation and Ponzi finances in the indexed environment. Furthermore, regarding the miscalculations in the consumer price index, nobody knows the exact deviation in the measurement. And since loan contracts - beside the pension rights! - amounting to roughly 110% of GDP (yep!) are indexed to the CPI I must admit that I find it important to know exactly how much the deviation is. One percentage point off - a deviation not uncommon in bigger economies - and the beneficiary (the lender) is being handed 18 billion krona per year on a silver plate! Merci beaucoup!
Can Danielsson please refer to any one source where I can find the estimate of the deviation? How exact is it? And if the deviation is "pretty well known" why is it not corrected for in CPI-indexed financial contracts?
This failure of indexation to deliver lower rate of interest needs to be explained! There is no reason to stick to indexing mortgages and other loan contracts if it is not delivering what its proponents are saying it should!