Friday, 10 January 2014

An Icelandic "Fisher Moment"?

Irving Fisher is one of those economists that many know. At least, many economists know his work, and some of his work is better known, and acknowledged, than other. Fisher is the guy who brought us The Fisher Equation (real interest rates, nominal interest rates and inflation), the Quantity Theory of Money (PY=MV) and the International Fisher Effect (closely related to Interest Rate Parity between currencies).

He also (in)famously had the opinion, only a few days before the 1929 stock crash, that stock prices in the US had reached a "permanently high plateau". That was truly a "whoops!" moment.

But he had the guts to admit it to himself that he had been wrong. He sat down and came up with the Debt Deflation Theory, which not only is a sensible theory where private debts matter for the overall economy and where one's debt is not simply another's asset, therefore netting out on the whole, but it is also rather the opposite of what he had been doing before.

The reason why I'm shortly reviewing this is that we may just have had a "Fisher Moment" - when somebody sits down and produces a work which is contrary to what he had done before - amongst the Icelandic academics in economics. And the candidate: Fridrik Mar Baldursson, Professor of Economics at Reykjavik University. He's working with Richard Portes of London Business School.

Baldursson and Portes: post-crash
Baldursson and Portes just had a piece on where they point out that the Icelandic banks had "gambled for their resurrection". Today, "everybody" in Iceland "knows" this but nobody had put the effort into showing it properly with data, except maybe the Special Investigation Committee that looked into the banks and many, many, many other things after the crash. Too bad their 3,000 page report was only written in Icelandic (besides some excerpts) and never translated into a language, such as English, that would open it better for academic and other types of use outside of Iceland.

Anyway, Baldursson and Portes have an interesting piece on which is worth reading. They focus on the banks' attempts to save themselves by practically falsifying their share prices: buy the shares themselves and just before they cross the 5% mark of total holdings, which demands a public notification to the stock exchange with all the possible and impossible repercussions to their businesses if the general public actually learns that they are buying themselves, they unload their own stock onto somebody who is willing to take out a loan, at the bank itself, and buy the stocks. Of course, the only collateral is the stock itself. This the banks did repeatedly and Baldursson and Portes even hint at that this was the practice all the way back in 2005, whole three years before the music stopped.

Furthermore, the banks (or their managers, for "banks" do not take any decisions) focused on bailing out the owners of the banks before anybody else (check out the presentation for examples). What did William K. Black say again: "The best way to rob a bank is to own one." Well, touché, or what? The FSA in Iceland also gets a deserved piece of the action: "These numbers immediately raise the question of how – or even whether – the Financial Services Authority monitored lending to enforce rules on large exposures."

Baldursson's and Portes's article is most welcome. They use data from the report from the special investigation committee which, I believe, haven't been seen in English before. They also take time to point out how notoriously, even criminally, the banks were eschewing the market and bailing out their friends before anybody else. Well done!

But I'd like to point out at least two issues. And I should say immediately that I put the former point, here below, forward with only an access to the vox article and not the CEPR version, which is longer and more detailed. Slides can be found on CBI's website.

ONLY the banks?
Baldursson and Portes seem to have the opinion that it was only, or at least mainly, the banks that were gambling for their resurrection.

But that's not true! Everybody that were calling the shots were gambling for their resurrection!

Just an example: the Central Bank of Iceland. Besides the hard-currency loans to Glitnir and Kaupthing at the height of the storm in September 2008 the Central Bank of Iceland was desperately trying to keep the banks afloat. A mere glimpse at the outstanding REPO agreements between the CBI and the banks is enough to see the scramble for anything, just anything at all, that had any credit-clearing power whatsoever! The scramble for cash was so severe that the pool of all secure and applicable collateral was long depleted. To try and keep the banks afloat - "gamble for their resurrection" - the CBI expanded, or its managers to be exact, their definition of applicable collateral: financial institutions' own notes and bonds were made REPOable. And although the banks couldn't use their own notes and bonds that was easy to work around simply by adding another third bank, say a small bank or a savings bank (lets not get into any names...), and pay it a small fee for getting the cash from the CBI, using a note from the original bank, and then channel the cash straight to the note-issuing bank. And 'hocus pocus' the bank now has liquidity!

This merry-go-round was of course such a serious gamble of resurrection on behalf of the CBI that the banks' notes and bonds were nicknamed "Love Letters" (i. ástarbréf). When the tempestuousness was at its highest point the total "Collateral Loans" to financial institutions were just shy of the ISK 500 billion mark. And I'd like to remind you that ISK 500 billion is back in 2008 roughly 1/3 of GDP: this isn't just some notes and coins! Would you like to compare that ratio to e.g. TARP or QE1/2/3? I'm sure that would be a fascinating comparison.

For some reason Blogger does not seem to allow me to upload the graph. So I'm making a link to it instead, straight to CBI's website
CBI's outstanding "Collateral Loans" to financial institutions, millions of ISK

And on this topic: Gudrun Johnsen, a lecturer at University of Iceland's Business School, has recently stepped forward saying that she had tried to warn the FSA, the Central Bank and the Ministry of Finance back in 2005 about the troubled waters the Icelandic banking system was wading into. Nobody listened for "it would have been a political suicide to stop the party".

Reminded me of Prince's words: "As long as the music is playing, you've got to get up and dance."

Baldursson and Portes: pre-crash
Times change and people, and their opinions, thankfully, with it. Baldursson and Portes seem e.g to have changed their opinions on the Icelandic banks since 2007.

In 2007 Baldursson and Portes wrote a report for the Icelandic Chamber of Commerce. The name of the report was The Internationalisation of Iceland's Financial Sector. There we can see them applaud the Icelandic banks and their strengths, short chain of command, their unusual yet profitable business model and responses to the 2006 mini crisis. Let's look at some excerpts, with some bold-font adjustments made by me:

There are macroeconomic imbalances, but their reflection in the external accounts is exaggerated. Despite problems with monetary policy and its effectiveness, the imbalances are being corrected, and the demonstrated, exceptional flexibility of the economy gives cause for optimism. We find that their effective response to the shock of early 2006 has made the banks much better placed now to cope with domestic macroeconomic shocks, credit events, and external liquidity constraints. They are well-managed, and their business models are strong.
We consider, therefore, that the current market premium on Icelandic banks is excessive relative to their risk exposure and in comparison with their Nordic peers. If this is in fact a country risk premium, we think it is not justified by Iceland’s economic situation. 
Considering that all three banks have relatively high capital ratios to compensate for this different nature of their business model, the returns are even more acceptable. In addition, a high proportion of salaries in Icelandic banks are based on performance [with rather obvious incentives for the staff to take increased risks], indicating that the cost ratios would be much lower with simpler and less profitable operations. Taking that into consideration, the effect of the re-estimation on returns with no return on equities is rather modest
After the initial shock [in 2006, the Geyser crisis], the Icelandic financial sector responded quickly and decisively:
  • deposit ratios are higher 
  • market funding has longer and more dispersed maturities
  • cross-holdings have been mainly eliminated
  • there is much greater transparency and information dissemination about the banks’ 
  • structure and activities.
On the same criteria, Icelandic banks come out well in a comparison with Nordic peers – and their overall and core profitability is higher. That is despite the high CAD and Tier 1 ratios with which they counterbalance their equity exposure. They are well hedged against volatility in the krona. Stress tests by the FSA indicate that the banks can withstand quite extreme movements in market variables specific to Iceland. The banks have negligible exposure to the US subprime market, structured finance products, and related financial vehicles that have hit many financial institutions hard recently. Most fundamental, the banks exploit strong competitive advantage, arising from their entrepreneurial management, flat management structures, and unusual business models
Yet in spite of their strong performance, Icelandic banks have lower ratings than their Nordic peers, and a much higher risk premium is being placed on their debt during the present turmoil. We see no justification for this in their risk exposure. This suggests that either the markets are not fully aware of their situation or markets place a country premium on the banks.

And their recommendations were nothing related to the banks, but rather "adopt-the-euro-and-collect-more-data-and-the-CBI-should-do-something-else-than-encourage-the-carry-trade" sort of a general advice. Some of them make perfect sense (such as decreasing the use of indexation) but those recommendations would hardly have saved the banks or stopped them from collapsing:

The possibility remains, however, of unilateral adoption of the euro as legal tender – ‘euroisation’. Euroisation would have potential advantages. In the ‘euroised’ economy, speculative attacks are no longer possible, so there is no currency risk, and domestic interest rates no longer incorporate that premium. There are typically lower transaction costs and greater transparency in policy. Using a stable foreign currency may itself implant or reinforce a ‘stability culture’. 
The CBI is on an inflation target of 2.5%. Inflation driven by housing prices has however remained above the target for some time. The CBI has not had an easy task given the strong demand growth in Iceland in the last few years. And fiscal policy has not been supportive of monetary policy. Yet the policy rate of the CBI is very high compared with trading partners of Iceland, and monetary policy appears to be ineffective. There are several underlying reasons. First, the Housing Financing Fund is a major obstacle to the transmission of monetary policy. We agree with many other commentators, including the IMF, that the HFF’s role should be changed so that it no longer competes with banks in mortgage markets. Second, price indexation of financial contracts is widespread and tends to weaken monetary policy. Third, the CBI has undermined its own policy by linking its decisions to exchange rate developments. The high policy rate leads to distortions in the financial system, such as the large carry trade. If only for that reason, we urge the CBI to reconsider its strategy.  
We strongly recommend efforts to improve the collection of data to account better for the balance of international income and the international investment position.

Now, people make mistakes. And that's fine, and quite frankly even necessary if one wants to learn the real gist of things. So maybe Baldursson and Portes are learning, just like Fisher did after he had spoken about the "permanently high plateau". Baldursson and Portes made a mistake back in 2007 and now it seems as if their eyes have, at least partially, opened. They even mention their 2007 report in the presentation as being "too uncritical".

Well done guys! Seriously, it takes guts to admit one was wrong!