Thursday, 24 January 2013

The Economic Truth on Iceland

The following article is the original text of the articles published on Sintetia in Spain. The Spanish versions can be found here (part 1) and here (part 2), kindly translated by the Sintetia staff. 

The Economic Truth on Iceland
There are truths and untruths in the media, the blogosphere and in the minds of people when it comes to what really happened in Iceland and its, acclaimed, economic recovery. To some extent, it has gotten the stamp of some sort of an economic “Wunderkind” by defying all probabilities and becoming a poster child about how to respond to major economic crises. But to spill the beans already: the picture is not as rosy as it has been painted.

Let’s start with some of the claims. According to a less than a five minute search on the internet, Iceland:
  • -          Screwed the creditors of the banks and let the banks fail, then nationalised them
  • -          Jailed the bankers of the failed banks
  • -          Kicked out the Austerity supporters, the Troika and the IMF in particular
  • -          Gave huge debt reliefs to the public
  • -          Set up capital controls which will be abolished very soon, even as soon as this year
  • -          Is now, consequently, growing and, especially in comparison to debt-laden Europe, doing quite fantastically!
  • -          Furthermore, not only is it growing but the prospects of the future are wonderful

So the lesson, following Iceland’s example, is to let the banks fail, nationalise them, increase government spending, shut the capital inside the economy and give debt reliefs to the people instead of the creditors of the banks.

Too bad this is not entirely according to the truth. Read on and I’ll show you how deep the rabbit hole really goes.

What goes up must come down
There is no need to describe in detail how on Earth this tiny, but very proud, nation managed to allow itself to be turned into nothing else than a hedge fund. In short, the utter majority of the nation was stricken hard by the “This Time Is Different” complex. The people, especially its bankers, considered themselves to be financial geniuses, not the least due to their Viking heritage, and went bonkers borrowing money and buying stuff. “Stuff” included not only general consumption goods and expensive cars but houses and stocks as well. News of stocks and houses were common and the general populace seemed to know awfully lot about which company in the stock exchange had gained most the day before. The equity index in the Icelandic Stock Exchange increased sixfold in four years: more than 50% per year on average!

But as the good advice goes: “when your neighbour buys stocks, it’s time to sell”. Too bad nobody, except a handful of sober persons, realised the truth in this.

The banks and the government
The Icelandic economic collapse in October 2008 was inevitable. No country has ever managed to build up its banking sector up to 10 times the worth of the gross domestic product and lived to tell the tail unharmed. When Kaupthing, the biggest Icelandic bank, went bankrupt it was the fourth biggest corporate bankruptcy in the world’s history! Glitnir’s bankruptcy was number 6 on the list, dwarfing Enron’s which occupied the no. 9 place.  Landsbanki’s failure was just cut short of the top 10, ending in no. 11. 

In a time span of less than a week, more than 90% of Iceland’s banking system, on the scale of assets, went down the drain.

Most of the rest followed in the coming months but was, contrary to the folklore outside Iceland, bailed out by the Government. SpKef and Byr, two savings banks, are cases in point. There, the Icelandic bankers’ gluttony was not lesser than in the case of the big banks. Nevertheless, the government gave them some cash, casting a terrible shadow on Iceland’s image as a country which does not bail out banks. Good thing nobody noticed. SpKef was later assimilated into New Landsbanki (a state owned bank) but Byr ended up in Islandsbanki (New Glitnir).

It is very important to realise one thing: the governments, both the “conservative” one prior, during and after the October crash, and the “left wing” one, which took over after the 2009 general elections, did everything they could – absolutely everything – to try and keep the banks afloat. And of course, the banks themselves tried what they could to save their faces by buying up their own stocks and thereby maintain their price (which, in their case, was quite close to being a market abuse). The savings banks that went off the cliff after the Big Three had closed down their shops were small enough to be rescued by the government but the Big Three in October 2008 were simply too large to be saved. That did not stop the government from trying everything it could do to throw out the safety net, including practically emptying the foreign reserves of the Central Bank when it tried to keep Glitnir afloat.

It was Iceland’s “fool’s luck” not to be able to rescue the banks in October 2008. I don’t want to even consider the cost of rescuing the banks today, it would have been horrible! The 31%-of-GDP public deficit in Ireland in 2011 would have been a laughing stock compared to the gargantuan cost the Icelandic public coffers would have suffered if the banks had been saved.

The jails in Iceland are not full of “banksters”
So the first lore on Iceland – that it intentionally let the banks to bankrupt – is not according to reality. The reality is that the government tried to save them but could not. The one about all the jailed banksters is, well, not entirely true either.

Let’s take two examples:

The Al Thani Plot
Kaupthing famously got the brother of the emir of Qatar, Sheik Al Thani, to buy stock in the bank. Later, The Special Prosecutor (specially founded to deal with white collar crimes) charged the CEO of Kaupthing, Hreidar Mar Sigurdsson, and the chairman of the board of directors of Kaupthing, Sigurdur Einarsson for fraud (Einarsson is the son of late Einar Agustsson, ex Minister of Foreign Affairs and MP of The Progressive Party, the political party which had hands in the sales of Bunadarbanki which was later to become Kaupthing-Bunadarbanki and, in the end, Kaupthing... just an example of how close business and politics were and are in Iceland).

Why the charges of fraud? Well, apparently, the Sheik didn’t pay a dime for the 5% share in Kaupthing Bank, he simply lent his name to the fraudulent act and got 50 million USD for it! The Al Thani case is still in the courthouse but the charge against Olafur Olafsson, the CEO/chairman of the board of directors of Samskip and the third biggest owner in Kaupthing and a member of the team which bought Bunadarbankinn in the beginning, has been dismissed. The charge against Magnus Gudmundsson, the ex CEO of Kaupthing Luxembourg, was also dismissed. But the charges against Sigurdsson and Einarsson stand.

The Exeter Holdings Plot
Exeter Holdings was an asset holding company (we had many!) which was lent 1.1 billion ISK from Byr (the savings bank which got some cash from the government before finally being assimilated into Islandsbanki) which then was used to buy Byr stock of MP Bank and the men in charge of Byr. Then, Byr practically went bankrupt and went, hat in hand, to the government and got some cash from it, as already mentioned.

So Byr was used, just before it went bankrupt, to lend money to Exeter Holdings which then bailed MP Bank and the senior employers in charge of Byr out of their positions in the Byr stock. Very convenient to know that if your stock is just about to become worthless you can just lend some asset holding company ridiculous amount of money and bail yourself out.

The charged (Ragnar Z. Gudjonsson, CEO, Jon Thorsteinn Jonsson, chairman of the board of directors, and Styrmir Bragason, CEO of MP Bank) were originally all acquitted. But then somebody pointed out that one of the judges who acquitted them was connected to Byr: he was the Head of Legal Department in a company whose biggest owner was, you guessed it, Byr savings bank. The case was repeated, now with unconnected judges, and Gudjonsson and Jonsson got four and a half year (Maddoff got 150 years and a fine of 17 billion USD). Bragason is, as far as I’m aware off, still waiting his destiny.

The Exeter case is the most successful case which The Special Prosecutor has carried out. The Al Thani plot is, however, one where the scheme is so complicated that a single misstep by the Prosecutor can ruin the whole case. Another complicated case was the recent “Vafnings case” which was only partially successful for the Prosecutor. For although the charged, Larus Welding, CEO of Glitnir, and Gudmundur Hjaltason, head of Corporate Finance at Glitnir, were found guilty, the case was flawed: the prosecutor’s arguments were not fully according to the subpoena. So they only got 9 months imprisonment, thereof 6 months suspended.

The fundamental factor is that neither the Icelandic justice system nor the laws themselves are ready or meant for white collar crimes of the magnitude that took place before, during and after the collapse. And we certainly do not have an army of lawyers specialised in fighting white collar crimes, contrary to many other countries where experience and knowledge are abound. Combine all this together and the most likely, sometimes unfortunately and sometimes correctly, outcome of the “banksters’ cases” in Iceland is that they walk either entirely free or with only a firm slap on the buttocks. This is so not because they are all innocent but because the justice system is unprepared. This is, somewhat, a learning-by-doing process.

Iceland, the IMF and the austerity
There are some truths in the story that Iceland objected to the IMF’s original plans of “medium-term fiscal consolidation” as it was worded in the IMF reports on Iceland. However, the objections were rather half-hearted, especially before the “left-wing” coalition government got into power in early 2009. Lilja Mosesdottir, an economist with a PhD in economics from University of Manchester (her thesis: “The political economy of gender relations”) was one of the MPs that were loudest about the possibility that IMF might be applying the knife on the public finances in too large measures. Those objections were perhaps more prominent for the fact that Mosesdottir was, back then, an MP for the Left-Green Party (one of two parties in the coalition government) but left it to protest what she called the servility of the government towards IMF. So not everybody in Iceland was exuberant with IMF’s presence although the “left-wing” government seemed not to care too much.

IMF was however quite happy with how Iceland came out of the crisis, whether that was explicitly thanks to their policies or not. They were in fact so proud of the economic Wunderkind that Iceland proved itself to be – according to them at least, I’m not sure the Johns and Joneses of Iceland would agree – that they threw a conference to highlight the successes of the country. Cannons within the economics world gave speeches and the biggest cannon of them all was probably Paul Krugman.

Contrary to what one might think the conference was not an absolute muddle of self-appraisal and some of the talks were very informative and exemplary (Simon Johnson’s talk was absolutely spectacular!) And IMF did show that it had learned something! For example, it openly and very willingly admitted that capital controls are “in some circumstances” an appropriate reaction to a crisis. That, on its own, was a huge step forward compared to its thinking in the South-East Asian crisis in the late 90’s. You can check out a recording of the conference on the IMF website.

Ah, yes... the debt relief...
Right, let’s get one thing straight from the beginning: the Icelandic households did not receive a massive government-initiated debt jubilee!

What the households got from the government was “The 110% Measure” (if your mortgage was higher than 110% of the property’s market value, you would get the principal marked down to the 110% mark) and “The Abstract Debt Relief” which you were only applicable to enter if you were in “serious” debt difficulties.
The total household debt cancelled due to those government-initiated measures: 49.8 billion ISK. To make any sense out of that figure: the debt of Icelandic households just before the economic collapse in October 2008 amounted to more than 1,450 billion ISK. So the government managed to give the Icelandic households a debt jubilee on 3-4% of their debts. Hooray!

Then came the justice system’s surprise input.

It all started with some individuals trying to figure out what the heck had gone wrong. Somebody stumbled over the fact that foreign-currency linked loans seemed to have been illegal from 2001. That possible illegality had not stopped the banks from creating billions and billions worth of mortgages and car loans to individuals as well as general credit contracts to firms in Icelandic krona but linked to the exchange rate of a foreign currency. This was doubtful at best. In the end, the foreign-currency linked loans were deemed illegal after a fight which still isn’t over (they are still arguing which types of foreign-currency linked loans are illegal).

But here is a wonderful twist for those who think that the government was all into giving the households some debt relief.

After the foreign-currency linked loans had been deemed illegal by the Supreme Court the government stepped in and put into effect a retroactive law that had the effects that the banks got a lot more out of the loans than they should have had. Likewise, the households’ debt was higher than if the laws had not been passed.

Again the door of the court room was swung open and now the laws that the government itself had put into effect were in the bull’s eye. They were finally deemed illegal, exactly because of their retroactivity, and the households’ loans were corrected. And what they got: a correction amounting to 146.8 billion ISK – almost triple what the government gave them and that despite the fact that the “left-wing” government had tried to intervene with a retroactive law.

So in total, the Icelandic households have been given a debt jubilee of 196.3 billion ISK. That’s around 13% of the pre-crisis stock of debt they had, mostly coming from the fight against the illegal foreign-currency loans.

However, despite this cancellation of 13% of the total debt, the stock of households’ debt has grown again. And why is that? It’s not predominately because households have gone back on the spending spree they admittedly were on before the crash. It is because of the indexation of the principal of mortgages in Iceland: if inflation in Iceland is 5% the amount you owe the bank increases by 5% before you pay it back! On top of the rate-of-inflation-adjustment of the principal is a 4-5% rate of interest. 

And since the inflation in Iceland since October 2008 is 25%, one can understand why the debt of households in Iceland is not falling in accordance to what one might think with the 13% jubilee and general debt deflation in mind. In comparison to gross domestic product, households’ debt is now around 117% of GDP (year end 2011) compared to 127% of GDP before the crash.

So I’m sorry, but the (in)famous debt jubilee given to Icelandic households was a mere cough.

‘If I go there will be trouble, and if I stay it will be double!’
We’ve shortly commented on the existence of the capital controls and how IMF had realised that they were a powder keg that could be nice to have in the anti-crisis arsenal. Too bad for the South-East Asian countries they did not realise that earlier.

Generally, capital controls are considered to be a nuisance in economics, although in practice they have shown themselves to be quite an attractive choice when it comes to not only responding to an ongoing crisis but to stop the crisis from happening in the first place. Nevertheless, the issue is slippery and capital controls open up the possibility of malinvestment, favouritism (some get exceptions from the capital controls) and a black market with currency. None are favourable so it’s most often best to get rid of capital controls. At least, their application has to be scrupulously planned!

All this is too bad because the capital controls were erected in a panic in 2008 and now the IMF has, finally, realised that the “short term” nature of them might not be so short term (“while the external position [of the economy] is sound, it is vulnerable to the lifting of capital controls before conditions are right”].
In other words, if we lift the capital controls and allow the exchange rate to drop by maybe 25-50% (as it easily might do, the offshore exchange rate of the krona is about 40% weaker than the capital-controls-defended exchange rate within the Icelandic economy) the economy will go to hell! So much for the economic Wunderkind then!

Sorry, but if some seriously heterodox ointments are not applied to the exchange-rate problem, the capital controls are here to stay! And that’s problematic given their general negative impact on the economy, hence above.

The thing is that the heterodox ointments needed have been proposed already. They are just so heterodox that the government, the IMF and the country’s “Lords of Finance” don’t even want to consider it. This is so despite the fact that the ointments have been applied before in the economic history of other countries with such immediate and lasting improvements that they surprised everybody – except the people who applied them. The German Wirtschaftswunder is an excellent example of the heterodox ointments we are talking about.

But why the recovery?
The question why the economy rebounded has not been answered however. But Richard C. Koo gave the answer to that question two years ago with his “The world in a balance sheet recession” paper. And the answer was this: the Icelandic economy is in a “Lehman Brothers Shock” except of course in the case of Iceland we can say it was in an “Utter Banking Failures Shock”.

The argument is as follows. First, an economy experiences a (mad) debt bubble. When the Ponzi finances inherited in the debt bubble finally prick it, asset prices fall and the economy slows down, the threat is that a major financial institution goes under. That was Lehman Brothers in the United States but in the case of Iceland, it was the whole financial system.

That bankruptcy, obviously, brings a massive blow to the economy and it drops like a stone thrown off the edge of the leaning tower in Pisa. But when the economic panic recedes and commerce returns – people have to eat – the economy slowly bounces back from its lowest panic-ridden point. An exchange crash which brings an increase in tourism helps as well.

That natural bounce-back is the economic recovery of Iceland! There is nothing surprising to the economic growth in Iceland, it is an entirely normal response to an “Utter Banking Failures Shock”: the mere recovery from the absolute panic brings back the growth in output and with it, the economic growth. The problem is that the debts are still there and the underlying foundations can crack anytime.
Koo’s paper is extraordinarily clear on this point: the recovery from the “Utter Banking Failures Shock” is NOT a recovery from underlying debt problems which, in fact, caused the “Utter Banking Failures Shock” in the first place. And given how weak the economic foundations of Iceland really are, Koo’s answer is awfully correct.

Furthermore, is an economic growth of 2-3% something to be thrilled over? In the historical context: not really. But in comparison to southern Europe: most definitely! That’s maybe why the meagre growth Iceland has gained back is causing such a stir.

‘The long run is a misleading guide to current affairs. In the long run, we are all dead.’
So there you have it. The cosy picture drawn of the economic miracle of Iceland has serious stains on it. Despite the fact that the economy has, partially, rebounded to its pre-crisis level, the underlying foundations are so termite-infested that the slightest wind could blow the whole economy to kingdom come! That applies especially to the problem of abolishing the capital controls.

And although Iceland has clean energy, a happy populace, is growing again (at least for the moment) and many possibilities of being a paradise on Earth for the longer run, it is not that which matters. We must remember what Keynes taught us: “The long run is a misleading guide to current affairs.” And why is that? Because “in the long run, we are all dead.” To say that everything will be fine in the far future is useless if we die before the far future finally arrives.

But did we do something right? Yes, we did!

  • -          We did step up against the IMF and although it was half-hearted at best, it probably preserved most of what could be preserved of the welfare system and the general economic stabilisers of public expenditures.
  • -          We did introduce the debt jubilee and out of principle we must congratulate us for that for even though it was a downright band-aid on an open gunshot wound, it was at least done. So debt jubilees are possible (and quite frankly, some countries need a partial one, whether we want to admit that or not).
  • -          Last but not least: we saved the electronic payment system! To maintain the smooth operation of an electronic payment system in a country whose financial system is falling into atom particles is a terrific feat on its own!

Truth be told, the major lesson Iceland has for other countries is how to keep the electronic payment system alive during a massive financial storm. That lesson has gone completely under the radar and I don’t think a single foreign entity or a central bank has picked it up as of yet! It nevertheless, to a great extent, annuls the “Too Big To Fail” problem for the commercial banking system so the lesson is gargantuan and its worth inconceivable!

I will cover that lesson in more detail in my upcoming book, working title “Bad Economics: How Iceland’s stupid economic policies bankrupted the country” (an excerpt available here). In the book I will explain as well how the completely mad indexation of mortgages works, how the pension system is a major financial illness and why the Second Economic Crash of Iceland is around the corner. 

For the economic Wunderkind has cancer.


  1. Very interesting post.

    I wonder if you could comment more on how the system of payments was saved without saving the banks, or if you could point to more information about this. I've written in the past about the US situation, particularly the vague and false arguments for "too big to fail," and I'd love to hear more about this topic. As you say, it truly may be THE lesson Iceland has for the rest of the world.

  2. Thanks for posting this. The memes that Iceland jailed all their bankers, gave total debt relief and that their economy is booming has truly gotten out of hand. The thing is people *want* to believe it so bad and really I can't blame them. However having hope based on lies and half-truths is no kind of hope really.
    Keep up the wonderful work you are doing here. I really do enjoy your blog and have been following it for quite some time now.

  3. Olafur Margeirsson30 January 2013 at 12:43

    Cheers for the comments guys. I'll see what I can do about explaining how we managed to keep the payment system running despite the banking system turning to ashes. It might be a while until then though as I'm still getting some details on the actual processes involved confirmed.

  4. What would have happened if Iceland had been a member of the EU and with the Euro as its currency?

  5. Appreciate clearing up false Utopia of Iceland, but it seems even if what we are hearing isn't entirely true, they seem to be better off now by bailing out the people vs. the banks. The U.S. is still struggling and the citizens feel like victims since the banks got away with burglary and nobody has been held accountable.
    It's one thing to expose the 1/2 truths, but you should still be comparing the U.S. recovery to that of Icelands.

  6. so when do you think Iceland will remove capital control if ever?