Tuesday, 31 July 2012

Unemployment in Iceland

Two weeks ago, the Minister of Economy, Business and Industry (yes, he's all three!) Mr. Steingrimur J. Sigfusson wrote an article with the headline (translated) "Unemployment dropping fast". The reason: registered unemployment in Iceland had dropped down to 4.8%. That's pretty fine for an economy whose banking system collapsed in less than a week four years ago! Well done guys!

Not so fast! Sorry, but I'm constantly the pessimistic guy digging a bit deeper than just repeating what the headline data told us.

OK, so three weeks ago the registered unemployment rate in Iceland registered at 4.8%. That was the data for June. This column graph is copy-pasted from the monthly report by Directorate of Labour. "Atvinnuleysi" is "unemployment" in Icelandic. Click to enlarge.

The DoL data is based on how many people receive unemployment benefits. That can be pretty limited if a) the rules regarding unemployment benefits do not apply to those who want the benefits, b) there are people who have given up on looking for a job and left the labour market and e.g. went studying, c) people have left the country or d) people want to work more but cannot because there isn't a job available.

Another data source for unemployment is the data bank of Statistics Iceland. The monthly data there tell a bit different story than the ones from the DoL. They are after all better, yet not truly adequately, defined than data from the DoL. Important definitions by the Statistics Iceland include:

Employed. People are classified as working (employed) if they worked one hour or more in the reference week or were absent from the work they usually carry out. Individuals on birth leave are considered absent from work if they went on leave from a paid job, even if they have no intentions of returning to the same job.

Unemployment. Persons are classified as unemployed who have no employment and satisfy one of the following criteria:
1. Have been seeking work for the previous four weeks and are ready to start working within two weeks from when the survey is conducted
2. Have found a job which will begin within three months but could start working within two weeks. (Until 2002 the criterion was that it sufficed for the job to start within four weeks without it being investigated whether the person involved could begin within two weeks.)
3. Await being called to work and are able to start working within two weeks
4. Have given up seeking work but wish to work and could start working within two weeks.
Students, including those looking for an apprenticeship in a trade, are only considered unemployed if they have been seeking a job along with their studies or a permanent job for the past four weeks and are available to start work within two weeks of the surveys occurrence.

Outside the work force. People are termed outside the work force if they are neither employed nor fulfil the conditions for being unemployed. The labour force is considered to consist of employed and unemployed persons.

The graph below shows the unemployment according to the Statistics Iceland data. The data has been smoothed with a 12 month moving average. 

OK, so unemployment is coming down. But is that enough?

No, it isn't. What counts must be the total hours worked in the economy. And that dropped like a stone in the crash and isn't coming back up, at least not seriously.

Total weekly worked hours in the Icelandic economy. Although unemployment is slowly coming down, total worked hours isn't steaming upwards.

We can use these data on total worked hours and divide them on the total number of people in working age and the total labour force.

Total worked hours has dropped significantly as previous graph showed, down to 2004 levels. But since the labour and man force have grown since 2004, the average working hours per individual in the workforce has taken a considerable dive. And on the bottom it stays.

Suddenly, the 4.8% unemployment according to the unemployment benefits estimate isn't that impressive anymore. Weekly worked hours per individual in the labour force is damn stagnant and has in fact dropped significantly after the October 2008 crash and stayed down. Realise that if weekly worked hours drop by around 4.6 hours, as they have done, the total monthly worked hours drop by around 19.8 hours.

Give yourself that the average person earns perhaps 10-15 pounds per hour (2000 - 3000 ISK or so) and the total lost monthly wage income is around 200-300 pounds. That's around 38,000 - 57,000 ISK per month if the pound is 190 krona.

So what happened? Why is the unemployment coming down?
We can see on the two first graphs above that the unemployment, even according to the Statistic Iceland methodology, is coming down. Yet, the total worked hours per person is lingering at levels that can hardly be present in an economy that is returning from a bust. So what happened?

Emigration happened. And despair about getting a job, resulting in a huge number of people outside the labour force, happened.

First, emigration was quite noticeable after the collapse. Droves of people, both immigrated travel workers that moved to Iceland during the boom years and Icelanders, left the country. Of course, they are then neither registered as unemployed nor are they in the man or labour force. That drives down the rate of unemployment. Many of those people left simply because they couldn't get a job.

Immigrated minus emigrated people, in thousands. After the collapse in 2008, a noticeable part of the workforce has simply left the country. That has had positive impact on the data on unemployment.

Second, people lost hope. They simply left the labour market. Both the University of Reykjavik and University of Iceland said that record number of new students had been admitted into the universities. One can only speculate how many of those people got back in the classroom because they couldn't find anything else to do.

This actually shows in the data. A record number of people have left the labour force, simply because they cannot find anything to do. There are no jobs around, they lose hope about getting a job, stop looking and they are therefore unregistered from the labour force according to the Statistics Iceland methodology. And people outside the labour force are not unemployed according to the data - although in reality they may well be!

When the collapse in 2008 happened, the trend of people leaving the labour force had been going on for around a year already. After the October 2008 collapse, the trend has been all but upwards. At the same time, record number of people have registered themselves in tertiary education, quite likely because they have nothing else to do. 

Checking the number of people outside the labour force as a percentage of the total man force does not make much difference.

The lack of employment has pushed record number of people out of the labour market, no matter if one looks at the number itself or the ratio of labour force leavers to total man force. 

So I'm very very sorry. Although measured unemployment is coming down, the main reasons for it are not increased employment or increased number of employment opportunities - that would show itself in increased number of worked hours per individual in the labour force - but people giving up on looking for a job. They leave the labour force either by educating themselves or by leaving the country. Of those active in the labour force, the average income is in the meanwhile perhaps 200-300 pounds lower than it was in 2008.

Unemployment in Iceland is not 4.8%. That's lies, damned lies and statistics.

Sunday, 29 July 2012

Icelandic public pension zombies

I promised some time ago to get into the Icelandic pension system now that the Financial Supervisory Authority in Iceland has published its annual report on the system, taking into the account the figures as they were at year end 2011.

Few things you have to know about the system before we continue.

It's a classic three-pillar system. The State takes care of the basic social security. That pillar is a normal defined benefits system in the sense that this part is paid for with taxes.

The second pillar is a messy mix of defined benefits and defined contribution system. The second pillar is one part public but the other is private. The public part is backed up by the State and its benefits are predefined. The contributions are as well but the contributions fall way short of covering the benefits as we will see later in this post. This means that the defined benefits must be fulfilled with the State's money. And that's a lot as we will see later as well! In fact, it is so much that I believe the public part of the second pillar of the Icelandic pension system is as good as bankrupt. At least technically.

The private part of the second pillar are the private pension funds. They are messy as well because laws no. 129 from 1997 define the benefits they must fulfil. In the case of old-age pension the funds must pay out the equivalent of 56% of average wages during the working life of the pensioner, given 40 years of working life.

The contributions are also "half-defined". There is a clause in the law that states that the funds can define the contribution needed to back up the clearly defined benefits but the mess is that they all follow the same basic contribution ratio: 12% of wages, up from 10% in 2005. The trick is that there is another clause - clause no. 39 -  that states that the private pension funds must "redefine" the pension assets of their members if the actuarial position is negative by 10% or negative by 5% for five years in a row (yep, the pension funds in Iceland are allowed to constantly be in the negative territory with their actuarial position!). The redefinition of pension rights normally means to simply write them down by whatever figure is necessary to get the actuarial position back into not-as-negative territory. However, the public part of the second pillar never writes down any pension rights since they are backed up by the State.

Right, this is some of the basics you need to understand what will follow. What follows scopes outs only the public part of the second pillar. My argument is that it is as good as bankrupt. You'll see why in a bit.

The bankrupt public pension system in Iceland
Again, the public pension system in Iceland is backed up by the State.

There were 668 billion ISK (5.5 billion USD) missing on the actuarial position of the whole second pillar of the Icelandic pension system in Iceland at year end 2011. The public pension funds were responsible for 547 billion (4.5 billion USD) of those 668 billion, the private funds the rest (121 billion ISK).

This might not sound serious but remember that the GDP of Iceland was around 13.4 billion USD in 2011. The total income of the State - federal and states - was 679 billion ISK (5.6 billion USD) in 2011. So the hole on the public pension system amounts to roughly one third of annual GDP or 80% of the income of the State. And don't forget, the State is the guarantor of the public pension system. A system which hole on the balance sheet is now 80% of the annual gross income of the guarantor.

Something missing on the State's balance sheet?
So there is a massive hole on the balance sheet of the public pension funds which the State is the guarantor for. This means that the money missing in the public pension funds should show up on the balance sheet of the Icelandic State, right?

Apparently not! Booked pension liabilities of the State - federal and states - are 163 billion less than the total hole in the actuarial position of the public pension funds.

There is something missing on the balance sheet of the State in Iceland. The guarantee on the public pension system seems not to be fully accounted for. Amounts in billion ISK.

This mismatch is something which generational accounting would fix. That has of course never been implemented although it seems pretty sensible. But hey, who knows! Maybe we get lucky and just accidentally trip over 163 billion ISK somewhere? I kind of doubt it however. Who cares anyway, 163 billion is only around one fourth of annual gross income of the State in Iceland.

Maybe they  can just monetise the whole thing by asking the Central Bank to print the whole lot for them! Too bad that might be inflationary and the pension rights are indexed to inflation. Wonder who would win that race, the dog or the tail.

The nutshell
The public pension system in Iceland is missing 547 billion ISK on its actuarial position. That deficit will in the end be borne by the State finances but they nevertheless seem not to be accounted for fully on the balance sheet of the State. The State is therefore seemingly so hiding a liability amounting to around 10% of GDP. Hiding public liabilities is an interesting sport.

But the public part of the second pillar of the Icelandic pension system is essentially not that interesting. It is technically bankrupt, needs to be restructured and I'm not going to spend too much time on it. The only question is when the public system comes down crashing and we all know that self deception can go on for a long time before the "sudden realisation" dawns upon everybody.

The more interesting part is the private part of the second pillar. We'll get into that part later.

Friday, 27 July 2012

Does The Teaching of Economics Take The Markets into Account?

A post I wrote for the Inomics Blog and was published yesterday. 

I'm working on writing up my thesis at the moment, will continue posting more on the Icelandic pension system after I've finished that or when I find time to!


I write to you from a disgraced profession” were the words of James K. Galbraith, the son of one of the most successful bestsellers of books on economic and financial matters. “Economic theory… failed miserably to understand the forces behind the financial crisis.”

For those of us who know or have studied mainstream economics theory, this sounds pretty much correct: despite the thousands of pages of economic theory we studied in our undergraduate programs, we had essentially no idea what the heck was going on when the crash belatedly arrived. What baffles most is that senior economists – including those who were teaching the undergrads – did not seem to have much of an idea either. Respect for economists collapsed parallel to world economic activity and one startling but clear observation dawned upon many: the market did not fit the description made of it in the textbooks!

That, to say the least, must be a problem. Mainstream economic theory assumes this and that to reach its conclusions about whatever the subject at hand might be. Included in those assumptions are quite a few quirks about the market(s) that seem to defy reality. Those assumptions are that the markets are “efficient”, where the e-word does not seem to mean the same thing as in everyday life, and that there are no cheaters, which the Ponzis and Maddoffs of the world and the “Lie-bor” scandal have taught us, again, is not the case. Also, everybody is “rational” or at least “rational up to (fixed) boundaries” but, again, rational in economics does not mean the same thing as in everyday life. Isn’t that a problem on its own that one has to keep different definitions of words in mind depending on whether one is on the subject of economics or speaking to one’s spouse?

The truth is that mainstream economics, especially the higher degree of it, is as good as useless when it comes to the market place. I will soon finish my PhD degree in economics and some potential non-academic employers that I’ve met ask me immediately how much market experience I have. I’ve got some and it calms them down but I did not understand vividly until recently why they were so focused on asking me the market-experience question right after they heard that I was earning a PhD in economics.

The reason is that many PhD students in economics are doing the type of economics that could never be applied to the markets! The stuff they are doing is mathematically proving the existence (not the size!) of some obscure factor in an even obscurer model of an economy that has not, does not and will not ever exist. Some employers have told me that they have had to “de-educate” newly graduated PhD students in economics for them to be valuable employees. Their mind had simply been trained in thinking about economics of a non-existent economy and not the one they were living in. Is it any wonder that most PhD students in economics are not immediately grabbed by the financial market – unless they know how to program in Matlab, R, C++ and SQL – and instead linger on in academia, sometimes just to find a job that pays the bills?

Teaching economics: what is it good for?
Economics teaching has to change! Economics as it is taught today is not producing highly skilled labour that can be a valuable input in the manic-and-panic markets that exist in the real world but not in the textbooks. Keynes was in fact quite close to being absolutely right: “the master-economist must possess a rare combination of gifts… He must be mathematician, historian, statesman, philosopher…”

Today, the trained economist is mainly a mathematician but the other four traits are forgotten or secondary at best. Worse than that, the trained economists is not a mathematician in the mathematics of real-life markets, full of chaos, uncertainty and feedback loops, but of orderly markets and rational behaving firms and individuals that never cheat and are never subject to influencing each other.

The trained economist is therefore trained in the mathematics of something that does not exist. He holds none of the traits that Keynes thought were necessary for the master-economist. If this is not changed respect for economics and economists will continue to dwindle and the potentials for wide affluence that the not-yet-science could deliver will never be delivered.

Tuesday, 24 July 2012

Q&A on Iceland

The Spanish radio station Colectivo Burbuja interviewed me on Iceland and the ongoing development of the economy amongst other things. The posted interview is here but the original text in English is below.


- What were the main reasons of the 2008 Icelandic crisis?
Debt! Private debt in particular! We went completely ahead of ourselves and borrowed massive amount of money. Most of the money went into consumption and buying up existing assets. We had massive housing and stock bubbles at the same time which came down crashing at the same time as well.

It is important to realise that the money we borrowed did not only come from abroad but was simply created out of thin air by the domestic banking system. This newly created money was then spent on stocks, houses, imports and extravagancies; we surely and literally lived on credit. And this credit was mostly created out of nothing by the domestic banking system. But when the creation of new debt slowed down and repayments of outstanding debts failed, the whole house of credit tumbled down and crashed.

-Which were the policies and the strategy of the government to try to dig out Iceland from the hole?
The government and other public bodies tried everything they could to keep the banks alive. A year or so before the crash the Central Bank expanded the allegeable base for repurchasing agreements, basically allowing the banks to come to the central bank and borrow money from it for whatever collateral they could find or create themselves!

The rules became so loose that Bank A could issue a bond, sell it to Bank B which took it to the Central Bank and used it as collateral for borrowed money from there. Bank B would then do whatever it wanted to with the money, e.g. lend it to Bank A if Bank A needed more cash. Bank A could also do the same thing for Bank B. This policy effectively made possible for any bank, as long as it had an accomplice, to borrow money from the Central Bank with a bond issued by itself! Those bonds were later, due to how fragile they were as collateral for loans at the Central Bank, called “love letters”.

When the perfect storm arrived in September and October 2008 the Government, and not only the Central Bank, tried everything it could to catch the falling banks. The major issue was to find foreign cash as the banks needed first and foremost euros and dollars to keep their businesses going. The government and the Central Bank went all over the world, including to Russia, to try to find bailout money for the banks. But the sheer size of the banking system made it impossible as they dwarfed the economy as a whole: at its top, the assets of the Icelandic banking system amounted to roughly 10 times the annual GDP. The British banking system is roughly 4.5 times the GDP of the United Kingdom in comparison.

In the end, the banking system collapsed because its relative size to the economy made it impossible to rescue. Iceland did not “allow” the banks to go bankrupt; we tried everything we could to save them but we could not.

-Should the Icelandic way to deal with the crisis become a model for the rest of countries with problems (Spain,Portugal...) ?
That depends on the structure of the payment system! One admittedly great feat accomplished in October 2008 was to keep the domestic payment system going although 90% of the banking system collapsed in matter of days. On this front, the Central Bank did well and fantastically!

The payment system in Iceland is rather special: everything goes through the same clearing bank, i.e. the Central Bank. In Britain for example, the clearing banks are independent banks, such as Barclays and HBOS.

This means that if Barclays or HBOS go bankrupt, a large part of the payment system in Britain becomes dysfunctional and shuts down! That would be the spark of the utmost chaos as people were not able to use their debit cards or transfer money to and from bank accounts. Commerce would collapse and with it the economy.

In Iceland however, everything goes through the Central Bank: a special entity which is a part of the Central Bank (called “Reiknistofa Bankanna” or literally “The Banks’ Calculation Office”) handles all the electronic payments such as online and debit and credit card transfers.

This structure of the payment system was a very important part of why we managed to keep the system going although 90% of the banking system collapsed in an instant. I do not know the organisation of the payment systems in e.g. Spain or Portugal but if the big banks such as Santander or Banco Espírito Santo are acting as clearing banks in the banking system, “The Icelandic Way” of “allowing” the banks to go bankrupt would be difficult to carry out.

So it depends to a large extent on the structure of the payment system whether banks can be allowed to go bust or not. In case of Spain and Portugal, I cannot say.

-Jón Asgeir Johannesson and Björgólfur Guðmundsson have been usually blamed as some of the main people who helped to cause the crisis, are they still influential in the economy and the politics?  
Yes and no. Johannesson allegedly still controls the biggest media corporation (his wife, Ingibjorg Palmadottir, is registered for 90% of its stock). Johannesson himself is not so prominent any more however. He probably does not want to, especially as he is being sued by the bankrupt estate of Glitnir Bank which he was a stakeholder in. The bankrupt estate is accusing him of practically using the bank to extend massive amount of credit to himself without any credible business plan behind the act. He himself personally owed the Icelandic banks 126 billion krona at the time of their collapse (remember this figure when the so-called debt forgiveness is discussed below) according to the research report of the Parliament.

Gudmundsson was one of the few major players that were actually declared bankrupt as many of them dodged legal action by holding their debts and assets in separate asset holding companies, thereby freeing themselves personally of any bankruptcy claims. Gudmundsson has all but disappeared from the scene although his son, Bjorgolfur Thor, is still in the news every now and then.

- Did somebody ring the alarms about the dangerous position Icelandic banks were in during the boom years before the financial system implosion? If so, why those voices were not heard?
Yes, multiple persons, banks and rating agencies did. In fact, the “mini crisis” of 2006 was sparked by sober foreign analysts, such as those of Danske Bank, pointing out that the expansion of debt that was taking place in Iceland had to stop one day. In Iceland, one of the most memorable persons who questioned the boom was an unknown doctor of psychiatry, Dr. Andres Magnusson. His analysis was basic, economics based and built on national account figures that everybody could find online.

Those voices were heard but ridiculed, both by politicians and the banks. The then Minister of Education, Thorgerdur Katrin Gunnarsdottir, famously said that one of the foreign analysts, Richard Thomas at Merril Lynch, “was in need of re-education” after having expressed his pessimistic view of the then Icelandic miracle. And as an example of how closely knit together business and politics in Iceland are, it should be mentioned that Gunnarsdottir’s husband, ex-handball star Kristjan Arason, was the CEO of Retail Banking at Kaupthing Bank. They dodged bankruptcy by moving their liabilities into an asset holding company called “7 Right” in February 2008, eight months before Kaupthing Bank went bankrupt.

A massive PR campaign was started after the mini crisis in 2006 to strengthen the idea of the entrepreneurial Vikings from Iceland. Even the president – now just newly elected for his fifth consecutive 4-year term – participated in the PR. Many have and never will forgive him for being that cheerleader.

The reasons why people were so blind and unwilling to accept the fragility of the economic boom are one of the enigmas behind all booms-and-busts. “This Time Is Different” and “We Are Special Because of...” were phrases that everybody heard repeatedly, just as in any other credit fuelled boom in the past in other economies. The self deception was almost flawless. It did not help that the media in Iceland was, and is, owned by the business moguls themselves.

-Most journalists (for example Roger Bowles) point at the Icelandic Central Bank as one of the main causes of the crisis, What was the Seðlabanki role lead by Davíð Oddsson during the pre-crisis years? What could it have been done better to avoid the crash?
Personally, I don’t think it mattered much that Oddsson – a lawyer and an ex-prime minister who pretty much had his successor appoint him as the governor of the Central Bank – was in charge at the Central Bank. Oddsson had an army of economists under his control that should have known what was going on but they were all blind to the impacts of the debt build-up.

The Central Bank’s role was typical: to control inflation (the inflation target in Iceland is 2.5%) and to maintain financial stability. On both of these fronts, the Bank failed miserably. Since the 2.5% inflation target was adopted in March 2001 until October 2008 there were in total 17 months (out of 92) where the target was reached. Regarding maintaining financial stability, well, I don’t think I need to stress its failures there.

The Central Bank should have stopped the debt build-up as it was the private debts that brought the economy down. But the economists at the Central Bank, as in other central banks in the world, did not realise this problem since they were all educated in neoclassical economics where private debt does not matter and banks are simply just “intermediaries” between savers and borrowers and not producers of purchasing power as they are in reality. Iceland is the typical example of an economy that was ruined by bad economics.

-You have been very critical in your articles about the future of the Icelandic pension system, why?
Ah, yes! The pension system! Our glorious pension system!

The pension system of Iceland is one of the biggest ones in the world when compared to the domestic economy. Its assets amount to around 135% of GDP. Only Holland and Switzerland are in the same league.

The problem, however, is twofold. First, even though the gross assets of the pension system amount to this gargantuan figure, there is a hole in its balance sheet amounting to 40% of GDP. This means that the pension funds have promised to pay out money to future pensioners that they do not have and will not ever have.

This problem is well-known and widespread in Europe and North America. But it is the other part of the pension system problem that worries me. A lot!

The pension funds have to get around 3.5% real return on their assets if they are going to fulfil the promises they are legally obliged to. This means that pension funds will not lend out money or buy stocks or do whatever they are doing unless they are promised a return equal to 3.5% plus the rate of inflation. That means e.g. almost 9% in nominal terms now that inflation in Iceland is 5.4%.

As a consequence of the size of the funds, they hold more than half of the financial instruments registered in the Icelandic Financial Exchange. The problem that now arises is that because the pension funds are so big and are legally required to get this high rate of interest, they effectively push the rate of interest in the economy upwards!

One of the foremost reasons for high rate of interest in Iceland is the organisation of the pension system. In other words, the government cannot sell its bonds on the market unless it promises the buyers, which are to a large extent the pension funds, very high rate of interest. As a case in point, the interest rates on 10 year government bonds are 7.2% at the moment. And as high rate of interest bring high rate of financial instability, the pension system of Iceland is a real problem.

-Is Iceland still fighting a housing bubble? How many years of net income does a family need to buy an average size house/flat?
This is a tough one for when does the “bubble” definition start to apply to a market?

Yes, house prices are going up again mainly because the banks have begun to offer non-indexed loans (normal mortgages in other Western countries) to households to buy flats and houses. This has become very popular: people are borrowing money, again, to buy houses and the banks are creating this money out of thin air as they have always done, especially before the crash in 2008. Consequently, house prices have gone up again after having dropped by 35% in real terms, a very typical figure when house bubbles burst. But the upward movement in real house prices is very limited simply because inflation is still high.

No official figures exist regarding the second half of the question. However, a comparison can be made by using data from Statistics Iceland regarding the cost of housing in different countries. That comparison is shown in the following two graphs:

(Notes: Share of housing cost is calculated as the median of the proportion of housing cost which is calculated after the proportion of housing cost in total disposable household income as been calculated for each individual.
If a household uses 40% or more of its disposable income in its house it is considered to have a housing cost overburden. The second graph shows the proportion of people who have housing cost overburden. See Statistics Iceland for details.)

-The most common Icelandic loans are not variable interest ones but indexed ones, something not common at all in the rest of Europe, could you explain how those indexed loans work?
OK so normal (European) mortgages work in the following way: you borrow 100,000 euros to buy a house. Let’s say that you will repay the loan back in 20 years and every payment is equal to the previous one. Let’s assume a nominal rate of interest equal to 5%. That means that every monthly payment for the next 20 years will be 660 euros. This amount will not change as long as the rate of interest does not change. Some loans are tracker loans, meaning that they e.g. follow the LIBOR rate with some premium. So the final interest rate on those loans will be LIBOR + the premium that the lender sets.

The Icelandic indexed mortgages are considerably different! Let’s assume that you borrow 100,000 krona and you are going to repay it in the same way as the EUR loan above. This is a pathetically low amount as you would need around 30 million krona to buy the median house. But for the sake of argument, let’s just stick to similar figures.

The stated rate of interest on the indexed Icelandic mortgages is not the nominal rate of interest but the real rate of interest! And on top of that real rate of interest – which is most often fixed for the whole loan period – you have to add the current rate of inflation to find out the nominal rate of interest. So if the real rate of interest on an Icelandic mortgage is e.g. 4% (the cheapest loans during the boom had 4.15% real rate of interest) you have to add the rate of inflation on top of that to find the total rate of interest. The inflation in Iceland is now 5.4%. So the total rate of interest on that mortgage is 9.4%.

The peculiarities do not stop there. The inflation part of the total rate of interest is not paid back monthly as in the case of regular European mortgages but is added on top of the principal.

This means that if the rate of inflation over one year is e.g. 5% the original borrowed amount (100,000 krona) grows by 5% before you make a repayment. So imagine you borrow 100,000 krona on 1st of January 2011. On 1st of January 2012 the inflation over the last year is measured to have been 5%. That means you do not owe the bank 100,000 krona on 1st January 2012 but 105,000 krona. But of course, you only got 100,000 krona from the bank.

Let’s assume now that on 1st January 2012 you repay 10,000 krona plus interest. That means that you owe the bank 95,000 krona after the repayment on 1st January 2012. Now the inflation between 1st January 2012 and 1st January 2013 is for example 10%, which historically is not such an unlikely inflation level in Iceland. That means you owe the bank 104,500 on 1st January 2013 (95,000 * 1.1 = 104,500). So you can see that as long as inflation is high, you kind of feel like a hamster in a wheel.

It is important to realise that the amount that is added on the top of the principal does in fact never exist. It is a simple accounting figure that happens only on the bank’s books. The bank will however profit from this accounting figure as it appears on its books as appreciation of the price of its assets and / or as interest rate income. So in Iceland, banks profit if inflation takes place. The higher the rate of inflation, the higher will the profits of the banking system be in Iceland.

Notice also that because it is the principal that grows by the rate of inflation the monthly payments slowly grow as time passes. In the example here above where 100,000 euros were borrowed at 5% nominal rate of interest, the monthly repayments were 660 euros, no matter the rate of inflation. The total amount repaid over the whole 20 years is 158,289 euros.

In Iceland, the first repayment of a 100,000 krona loan at 5% rate of interest would be 660 krona only if the rate of inflation is 0%. But if the annual inflation is e.g. 3% for the whole 20 years, the first monthly payment is not 660 krona but 662 krona because the principal has grown. The last payment, 20 years later, would be 1,192 krona or almost double the first payment. And the total repaid amount is not 158,289 krona as in the case of the normal European mortgage, but 216,241 krona. More than double the original borrowed amount. This is so because the interest rates on the loan are calculated on the original principal (100,000) plus any increments that take place due to inflation.

The argument for this system is to maintain the real purchasing power of the money that the bank lent out in the beginning, i.e. the 100,000 krona. But I have criticised those mortgages extensively and largely blame the way of indexation for why we can never have a stable economy in Iceland. There is not a shred of doubt in my mind that this indexation system destabilises the Icelandic financial system. But, according to neoclassical economics, this should not be a problem since “money is neutral” in neoclassical theory. But this is obviously a huge problem in my opinion! So again, the Icelandic economy is being turned into ruins by bad economics.

-Did the families really get a major debt forgiveness? What is the present level of debt of the families and the total Icelandic economy debt (including government, families and companies) compared to the 2007 level?
The newest figures I have seen regarding the “forgiveness” of household debt are from February 2012. By that time, households’ debt had been written down by 196.3 billion krona (1.24 billion EUR, around 12% of GDP). However, the majority of the write-offs were due to illegal foreign-currency-linked loans that the banks lent out but were later deemed illegal. So they had to write them off. The write-offs due to that factor alone were 146.5 billion.

The rest (49.8 billion ISK) was due to official expedients, such as the allowance to write off one’s mortgage down to 110% of the market value of the property used as collateral. But if your indexed mortgage had not risen above 110% of the market value of your property, you would not get any debt written off.

However, due to the peculiarity of indexing mortgages in Iceland, the 196 billion written off were weighted out with increases in the indexed principals of debt. Therefore, the bottom line is the same: households’ debt is still around 250% of disposable income, even higher than it was in 2007. As a proportion of GDP, households’ debt has decreased slightly from 120% in 2008 to 110% in year-end 2011.

Non-financial companies got a major debt relief however and that was more or less the banks’ own initiative to do so. Non-financial corporate debt as a percentage of GDP has dropped from around 325% in 2008 down to just below 200% in 2011. Most of it was simply written off but Icelandic firms are nevertheless still one of the most indebted ones in Europe.

Government debt skyrocketed during and after the crash, to a large extent to save the equity of the Central Bank which became technically bankrupt because of loses on its “love letters” (see above what the “love letters” were). In 2007, the gross federal debt was 43% of GDP. It was 115% of GDP at the end of 2011.

So the debt figures are roughly the following (in per cent of GDP, year-end 2011): households – 110%, non-financial corporations - 200%, the government – 115%.

-Who is running the Icelandic banks now?
Good question! We don’t know!

When the banks went bankrupt they went into receivership. The new banks that were established on the foundations of the old ones were partly done so with money from the government. The State holds 81% in the New Landsbanki, 13% in Arion (the New Kaupthing Bank) and 5% in Islandsbanki (the New Glitnir). The rest is owned by the old banks or their bankrupt estates to be exact.

The main owners of the new banks are therefore those who own bonds issued by the old banks as they are entitled to payments out of the bankrupt estates. The public has no idea who holds those bonds and have therefore essentially no idea who are the true owners of the Icelandic banks. There have been speculations that the principal owners are some foreign hedge funds or even some of the old Icelandic business moguls. But nobody knows for sure.

-You write frequently in your articles about the capital controls, what are the effects of those controls on the economy?
The major effects are on the exchange rate. The exchange rate of the Icelandic krona is artificially kept higher than it really should be by locking money inside the economy with the capital controls. This is in violation of the European Economic Area contract where the free flow of capital must be allowed as part of the “Four Freedoms”. But Iceland was hit by a systemic collapse so an exception is made for the time being.

-What are the consequences of the Icesave conflict? Is Iceland ready in case they lose the trial?
The consequences of the Icesave (“IceSlave” as it was nicknamed in Iceland) could be severe not only for Iceland but for the whole system of deposit insurance schemes in Europe.

Icesave is essentially an international quarrel between Iceland and the ESA (EFTA Surveillance Authority). The argument is whether or not there is a government guarantee on the bank deposit insurance scheme in an EU & EEA country. Iceland’s case is that there is no such guarantee but ESA disagrees and also withholds that the Icelandic government did not treat all depositors of the Icelandic banks equally when all deposits in Iceland, whether they were in the ownership of foreigners or not, were guaranteed but not deposits outside the Icelandic financial system.

The dispute is now on the desk of the ESA court. If Iceland wins, it could be a clear legal precedent in EU countries: all of a sudden the deposit insurance schemes in EU countries, implicitly considered to be backed up the public finances, could be deemed effectively empty or dysfunctional. Depositors’ trust in their domestic deposit insurance scheme could be severely harmed, even leading to bank runs.

If Iceland loses the possible harm for the public finances could be prominent. However, there is also doubt whether the deposit insurance was to be paid out in the currency that the deposits were in (GBP or EUR) or in the currency of which the deposit insurance was denominated in, i.e. Icelandic krona. If Iceland loses and has to pay out pounds or euros, the country is as good as bankrupt. But if Iceland loses and can pay the insurance out in Icelandic krona, the country should do alright afterwards.

-Do you think the international media fully understands the Icelandic crisis, have they described it in a too romantic way?
Yes, my feeling is that they generally have. The Icesave dispute and how it was romanticised as an uproar of the Icelandic people against the international financial powers – when it was more of an uproar against the Icelandic government who was willing to sign almost any deal whatsoever – is one case in point. The so-called debt forgiveness is another.

The newest one is regarding the fact that GDP in Iceland, measured in Icelandic krona, is growing again (4.2% GDP growth between 1Q11 and 1Q12). Sure, there is economic growth measured in Icelandic krona but the question is whether the devaluation of the krona has to be taken into the account or not. Iceland’s GDP was 20.4 billion USD in 2007 but in 2011, due to the collapse of the currency, 12.7 billion USD. So are we back on track or not?

Yes, we’re growing again but we have a long way ahead of us before we make up lost ground. And my fear is that if we do not fix the dysfunctional banking and pension systems, we will never make up that lost ground. And that has not, perhaps understandably, been picked up by the international press.

-Is Iceland going to adopt a new currency? Which one would suit the best?
I sincerely do not know if we will. The currency question in Iceland is one of the economic and political questions that we have to answer before we can move on with our lives.

One option is to continue with the krona but many dislike that option wholeheartedly since they believe that the krona will do nothing but collapse again and again. So they want a “stronger” currency. The appetite of Icelanders to adopt another currency runs from the fact that the Icelandic krona has not been very stable in the past, to say the least. The krona has in fact lost 99.95% of its value against the Danish krona since it was established on a par against that currency in 1918. Most of the devaluation happened during the 1970s and 80s and not the early 2000s though.

The official direction is to enter the European Union and adopt the euro. That plan is understandably not considered to be very tasty by many people given the economic turmoil in the EU countries.

Another rather prominent idea is to unilaterally adopt a foreign currency. The menu of possible countries runs or has run from the Canadian dollar to the euro to the Norwegian krona back to the US dollar. The Canadian dollar idea is the most prominent one at the moment but historically the support for a foreign currency has almost been an object of fashion. So who knows, maybe in one year’s time we’ll be talking about some other currency and everybody would like to adopt that one.

Which would be the best one? I cannot say. Nobody can. I can however say that the main problem of the Icelandic economy is not its currency but the organisation of the banking and financial system. The economy will never be stable for the longer term if the financial system is not fixed and that has nothing to do with our choice of which currency we choose to use as the legal tender. We have to fix the financial system on our own, changing which currency we use will not do that for us.

-Iceland population is well educated, the demography is healthy, aluminium prices, energy prices and even water prices will go up on the medium term, there's a bright future.. but what are the main threats that will have to face the country?
In the near future, it is the economic crisis in the European Union. We need income from exports and tourism to rebuild the economy and a large part of our trade is done with European countries. So if Europe falters, so will we.

But even if European leaders solve their mess – let’s hope they will – the Icelandic economy is not out of the woods. Yes, the nation is well educated and many Icelanders that go abroad, for e.g. studies or temporary work, want to move back home. We have also plenty of renewable energy, clean water and territorial waters full of fish. So what is there to stop us?

Ourselves! There are powerful pressure groups in the Icelandic economy that want to keep the status quo in the financial system, even though that would be very suboptimal. Those pressure groups run from e.g. the representatives of the banks, pension funds and the old business moguls to and through the politicians. So as long as the old politicians are still in the Parliament, doing deals behind closed doors, I have little hope for true long term recovery. The crash in 2008 taught me to be very suspicious towards politicians, especially if they have been in the Parliament for long. Gunnarsdottir and Arason are just one extreme example of too much and blatant connection between politics and business, especially banking, in Iceland. Gunnarsdottir is still an MP.

More importantly, we need to get our heads straight regarding economics. The policy makers in the financial system are unfortunately following neoclassical economic theory that has no foundations in reality. They are also advising the MPs who naturally think that the neoclassical economists know what they are talking about. But since neoclassical economics is responsible for freak systems, such as the indexation of debt, we need to correct that mistake.

Icelanders need to renew further the political leadership of all political parties. We need to drop people that are doing deals behind closed doors and effectively representing special interest groups. We need new people into the Parliament who are willing to make unpopular but necessary choices such as regarding the pension system. And we need to sway away from economic policies built on the dreamt-up foundations of neoclassical economics.

If we manage to get this done, the future is truly bright for Icelanders. But without those improvements, especially the ones on the financial and pension systems, I am not so optimistic about the nation’s long term prospects. I would at least think twice before moving back home.

Tuesday, 17 July 2012

The Zombie Pension System

The term "zombie bank" is sometimes used for banks that are effectively in negative equity - technically bankrupt - but with assistance, sometimes from the State, or accounting gymnastics they manage to stay "alive".

Zombie banks are more often than not troublesome creatures for multiple reasons. One thing they try to do is to gamble for their own resurrections. That they do by investing in very profitable but risky projects that could possibly heave them out of the most severe equity problems. This gamble is considered "OK" from their point of view since the most dreadful thing that could possibly happen is that they would have to cheat a bit more on the accounting rules - maybe post a different LIBOR rate than the true one is? - or ask for more assistance from the State.

Zombie banks also suck capital from profitable investments. The capital that is used to keep them alive could be used for anything else, such as housing for the poor or lower taxes. This is effectively what Austrians call "malinvestments".

Finally, zombie banks are sometimes kept alive by the public administration if they are "too big to fail." The banks, zombies or not, are so systemically important that their bankruptcies would wreck havoc to the economy. This havoc could be for the shorter or the longer term, nobody knows. And exactly because nobody knows, no one is willing to stare the devil in his eyes and allow the capital sucking gamblers for resurrection to go bust. Least of all politicians who are more concerned about getting re-elected than anything else.

It is a lot better for the longer term to get rid of zombie financial institutions rather than allowing them to wander around in the economy, spreading economic disease. But "I'll be gone, you'll be gone" is a real problem in this case as in any other case when somebody has to take initiative in tough short term problems with huge long term benefits. There are normally plenty of ostriches around.

The zombie pension system of Iceland
A new annual report by the Financial Supervisory Authority of Iceland shows it in black ink on white paper how severely bankrupt the Icelandic pension system is. At year end 2011, its actuarial position was negative by 668 billion ISK. That amount is equal to 135% of the government's gross income in the same year and 40% of GDP. This deficit compares to a deficit equal to roughly 13% of GDP in case of the United Kingdom. And the Brits are worried about their own system.

The hole in the actuarial position has grown from last year's 651 billion ISK. The main reason why the gap isn't bigger than it actually is is that the funds wrote off at least 130 billion of pension rights in 2010 and 2011. Well done guys, you are fine representatives of the ever lasting Icelandic pension system!

The Icelandic pension system is a zombie pension system. It is actuarially bankrupt by 40% of GDP and its organisation is a major barrier for economic reconstruction of the country. This applies both to the defined benefits and defined contribution systems but the State backs up the former part.

Nevertheless and so very well according to the ostrich's behaviour, the leaders of the pension system and the politicians have postponed it for many years to rebuild the system. Instead, they have gotten themselves into the ultimate lie where they sincerely believe their own nonsense about the system being one of the pillars in the economy of Iceland. But that pillar is instead a rotten one!

But some of them probably don't care. The politicians and the current leaders of the pension funds will all be gone when the pillar finally collapses and the economy with it. Politicians' pension rights are backed up by the State and are furthermore fatter than the rights that are given to the everyday working man. The leaders of the pension funds can in the meanwhile play around with the money they are entrusted with. A gentleman called Helgi Magnusson is one of them. He is the Chairman of Pension Fund of Commerce but eloquently enough, he is also a personal holder of roughly one billion ISK worth of stock in Marel Ltd. The company produces e.g. food processing units. The Pension Fund of Commerce is a major stockholder too, owns roughly 8.8 billion ISK and has repeatedly strengthened its holdings in the company after the collapse in 2008. Very convenient for Magnusson the stock owner.

But it is not the criss-crossing of personal wealth of directors of the pension funds that I am going to investigate further. The pension system in Iceland is a zombie system that cannot go on. It is a quintessential case of a Ponzi scheme. The worst thing is that the Ponzi structure was not and is not the actual plan of the directors and politicians, it simply just happened to be the case even though the initiative behind the system is to secure the income of thousands of pensioners. But exactly because people never planned to con the system, they feel so burned when somebody points out its flaws.

The newest report by the FSA in Iceland is material for multiple pages of analysis on the Icelandic pension system. They will be posted in small packages in the coming days and weeks.

An Icelandic version of this post first appeared on my Icelandic blog.

Monday, 16 July 2012

A bit more on the living standards

A very quick note on the living standards in Iceland and the question of how far they collapsed in 2008.

I implied that the answer to the question depends on whether one measures the wages in Iceland in foreign currencies (SDRs) or in the Icelandic krona. The ISK-denominated wages haven't crashed anything close to the SDR-denominated wages. So the question is: which one is a better measurement?

The fact of the matter is that it must be a personal matter. A family of four living in Iceland who never travels to foreign countries does not feel the pain of the krona collapse as much as the one who goes to Spain every summer.

And as almost always, there are politics behind which measurements you want to use. If you want to claim that living standards in Iceland have collapsed due to e.g. the wrong government policies, you pick the SDR-denominated wages. If not, you use the other figures. If you want to say that unemployment in Iceland is low at the moment, you compare it to Spain. If you want to say that unemployment in Iceland is high at the moment, you compare it to the historical average.

Anyway, I was looking for data for my PhD and came up with this comparison shown in the graph below. I must admit that I find it quite remarkable how the Gross National Product plummeted in the crash while the Gross Domestic Product only dipped a bit more than slightly.* And here comes another weird question: why is it so that US statistics use GNP so often while European stats use the GDP? Why isn't GDP or GNP used in all countries? Which one is "righter"?

GNP of Iceland dipped considerably more than the GDP. Which one is a better measurement of nation's living standards?

Then it is the comparison matter. How is Iceland doing in comparison to other economies? According to the Better Life Index by OECD we seem to be doing all right. Life in Iceland is not all too bad really, at least if you compare it to other countries. But if you want to say that life is horrible, you don't compare it other countries. You compare today's life with the credit-fuelled good times of 2007.

A screen shot from the Better Life Index website of OECD. Check out Iceland's figures here.

So what are we talking about again? How much living standards fell or how to define living standards?

Back to work, have to finish this thesis one day!

*For those of you who do not know: Gross National Product is the sum of value of all products and services made by the citizens of a country, no matter where they are in the world. Gross Domestic Product is however the sum of value of all products and services made within the borders of the country.

A car made in France by a German company is therefore a part of the GNP of Germany but part of the GDP of France.

Thursday, 12 July 2012

Living standards in Iceland: Collapse or not?

The international press has been rather predominantly positive when it comes to judging the extent of the economic recovery of Iceland. The 4.2% GPD growth (1Q11 to 1Q12) is prominent and the fact that unemployment is not measured in double digits, and actually even slowly coming down, is something that amazes the international press.

I've raised my concerns regarding this rosy picture before. This post however is to check if another "eye-brow raiser" from Iceland, Heidar Mar Gudjonsson who has amongst other things supported the idea of Iceland adopting the Canadian Loonie, is right or not.

Basically, Gudjonsson said that "living standards" (i. lífskjör, according to this source, I haven't read the original one) had moved back 20 years due to the collapse of the krona. We can argue what is meant by "living standards" but based on this opinion of his he said that the Central Bank of Iceland was basically not correct when it claimed that recovery was back and sound. Einarsson and Sigurdsson, two economists at the Central Bank, replied saying that although living standards had dropped in the crisis they had never gone down as far as Gudjonsson estimated. They claimed living standards in Iceland were back down to 2004 levels.

A month ago, I wrote on a similar topic. The data I used there were on a quarterly basis so they weren't really usable here. So I dug into the data bank of Statistics Iceland and OECD and came out with the figures below.

Basically, Icelandic GDP measured in SDR and deflated with the G7 inflation index that the OECD publishes - this is an estimate of the true SDR inflation, I know! - has collapsed from almost 170 in 2007 down to 100 in 2010 (data was missing for 2011). In the meantime, GDP measured in ISK (deflated with the Icelandic consumer price index) topped in 2008 and is beginning to come back up again, hence the 4.2% GDP growth figures.

GDP in Iceland. The idea of "The Icelandic Miracle" is based on GDP measured in the domestic currency. Data from OECD and Statistics Iceland. My estimates.

However, Gudjonsson on one hand and Einarsson and Sigurdsson at the Central Bank on the other were more referring to wages rather than GDP. And when it comes to Icelandic wages measured in deflated SDR, the data is rather clear: the purchasing power of Icelandic wages abroad bottomed out in 1993 and we were pretty close to reaching that bottom again in 2009. So Gudjonsson is very right when it comes to living standards measured in the foreign purchasing power of Icelandic wages: they have crashed!

Data shows that wages in Iceland measured in deflated SDRs are back down to 1997 levels or thereabouts. Gudjohnsson estimated they were back down to 1993 levels, probably using another currency basket than the SDRs. In the meanwhile, the wage index measured in deflated ISK is slowly making its way up again, just as the economists of the Central Bank of Iceland claim. 

So now we can start arguing which one is a better measurement of the living standards in Iceland, or in fact any other country: the domestic-CPI deflated purchasing power of domestic wages measured in the domestic currency or the foreign-CPI deflated purchasing power of domestic wages measured in the foreign currency?

And for pity's sake, is this really a wise definition: "the recession is over if GDP growth measured in CPI-deflated domestic currency is not negative for two consecutive quarters"?

Wednesday, 11 July 2012

Austerity and Interest Rates

In light of Spain's toughening of austerity measures, it's worth doing a bit of data cracking and comparisons on budget deficits and government bond interest rates.

First, this is how the projected budget deficit of Spain compares to other economies. Data comes from the newest issue of The Economist (Iceland's budget deficit figure is full year 2011). According to the WSJ, the aim is to get Spain's deficit down to 6.3% this year (instead of previous target of 5.3%) and 4.5% in 2013. By 2014, the deficit is to dip back under the 3% Maastricht line: 2.8%.

Projected budget deficits for 2012. Data from The Economist

The aim of the game is to get the interest rates down so Spain (and the EZ as a whole) doesn't collapse. That makes sense, looking at this scatter plot below: an obvious negative correlation between budget balances and interest rates, meaning that if a country is suffering increased budget imbalances, the interest rates on its government bonds tend to go up.

"Don't spend your money or we'll charge you extra high interest rates"

But oops, that's not what it seems to be when we look at countries with their own currencies and not the euro. They seem to be able to spend all they want without fearing higher nominal rate of interest. Yes, I know the 1970s and 1980s stories. But in times of dull economic activities, as is the case nowadays, it seems quite all right for the government to spend all it wants as long as the economy is using its own currency.

"You can spend your money all you want, as long as you can create it yourself"

Both scatter plots above have outliers that could possibly be bending the fundamental relationship. So if we skip some notable outliers (Iceland, Norway [who has positive budget balance amounting to 13% of GDP anyway?], Greece, Spain, Italy) we get the following scatter plot.

"Please borrow and spend, we'll charge you lower rate of interest if you do so!"

Two things to notice about this final plot:
- it seems the relationship between budget balance and the rate of interest on government bonds is positive, completely contrary to neoclassical theory: if the state increases its budget balance, it will be charged higher rate of interest.
- all the EZ economies, except Germany, are above the trendline. Denmark is of course pegged to the euro, we can argue whether we should put it with the EZ economies or not.

So those fiscal-neoclassicals (commonly but incorrectly known as "Keynesians") out there might be right but maybe only half-right: we can end this depression now if we use the public finances to increase monetary demand in the economy and give people a chance to repay their debts, but only if the economies in question have their own currencies; the EZ economies would find this spend-and-survive strategy "a bit more" difficult.

Good luck Spain on cutting down the deficit, get unemployment down to humane levels and end this depression. You're going to need it!

Tuesday, 10 July 2012

Interest Rates and Indexation

Back in February, I highlighted the fact that contrary to what the (neoclassical) economists held while defending widespread indexation of loans, and in particular mortgages, the interest rates on indexed loans were not lower than on normal CPI-non-indexed loans but on the contrary higher.

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!

Monday, 9 July 2012

Is Iceland OK now? Economic figures comparison

I have been silent for a while here, apologies for that, as I'm on a vacation in France and working on the last draft of my PhD thesis on the sideline. Some exciting updates - from a nerdy point of view - coming up though and once the thesis is out of the way I'll get into proper research for the book I'm (supposedly) writing on the Icelandic economy.

Anyway, the hottest buzz on and about Iceland nowadays is that it's out of the recession.Gylfi Zoega, one of the foremost professors of economics at the University of Iceland, and a member of the monetary policy committee at the central bank of Iceland, said the recession was over. Krugman, who seems very fond of Iceland (come on over again and spend your dollars, we need them!) said that the country had broken all the rules, contrary to Ireland, "and things are not too bad."

Not too bad indeed: 4.2% GDP growth between 1Q12 and 1Q11. Iceland is back on track! How about "une petite coupe de champagne?"

Anyways, I've got my (usual) doubts and I've expressed them repeatedly (such as here, here and here). So as I was paging through the newest issue of The Economist I decided to use the figures at the back there to throw up this comparison of economic figures from all over the world.

Figures from the newest issue of The Economist. Iceland's figure are from Statistics Iceland or calculated by myself. The CA/GDP figures are estimates for 2012, same goes for the Budget Balance figures. In the case of Iceland, I use the total CA/GDP figures (-7.0%) but some want to exclude the old banks from those figures since they are in receivership. If skipped, the figure drops down to -0.1%. Click to enlarge.

This table can be fuzzy to read on its own to judge between the economic health of the economies in question. So I used the figures there to construct the following simple comparison table.

The following table does nothing but to give "points" to countries according to their relevant position to the other ones. As an example, the GDP growth in Greece is worst, so Greece gets 1 point for GDP growth. China is on the top, so they get 18 points for GDP growth. Likewise, only Iceland has worse current account deficit than Greece so the Mediterraneans get 2 points for that comparison. The total points of all the countries are then summed up in the right most column.

Looking at this table, Iceland's 4.2% GDP growth isn't so impressive any more. Like I said almost a month ago "well, yes, there is growth" but unfortunately, there seems to be not much  more. Iceland's "not too bad" economic performance is still pretty damn bad.

The comparative rankings of economic figures, using the data in the previous table. Norway wins (98 points) followed by Germany (82) and Sweden (80). Greece loses (23 points), Spain gets 29 points and Italy 34. Iceland is next (35 points).

The "economic points" of each nation (same data as in the table). Well done Iceland, you're in league with the best!

P.S. When are we going to start talking about the budget imbalances of Netherlands? Is 5.1% budget deficit just a-OK because Spain is rocking it at 6.5%?

(edit: 21:50) Initial calculations were wrong on the budget deficit comparison. That has now been corrected.