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.

The Upcoming Problems of Housing Financing Fund

The Housing Financing Fund (HFF) in Iceland is a government sponsored entity that raises money on the capital markets and lends it onwards to Icelandic households in the form of mortgages. The total government guarantee on this fund is 950 billion ISK (58% of GDP and almost two times annual income of the State).

The problem is: the HFF is bleeding, slowly but securely. Consequently, it is a massive threat for the public finances because the government has to bridge the gap whenever its equity position runs down. And today, that position is only 1.4% of total assets.

HFF's accumulated losses since 2008 are 46.7 billion ISK. Its equity is supposed to be above 5% but as already mentioned, it is 1.4% now - down from 2.3% in June.

The government has already pumped 33 billion in new equity into the fund (in 2010) but that was swallowed whole in the fund's participation in the 110% act (you had part of your debt cancelled if your mortgage was 110% of the market value of the property). The fund has also tried to increase its net interest rate premium as we can see on the graph below. All the same, the fund now needs 12-13 extra billion ISK from the government.

The interest rate premium of HFF has increased slowly but securely since 2009. The red line is the fund's interest rate cost (the rate on HFF 44 which matures in 2044), the blue line is the rate it offers its borrowers and the green line the difference there between. The black line is 12 month moving average. 

The reasons for its demise: lack of common sense

The first reason for HFF's troubles is the fact that it is offering a rate of interest which households cannot pay in the long run!

You may have noticed on the graph above that the blue line stands at just above 4%. It stands at 4.2% to be exact. This however is not nominal rate of interest but real rate of interest!

All the mortgages from HFF are indexed - and if you want to know in more detail how Icelandic indexation on mortgages works, check this out - and carry therefore the real rate of interest. The most brilliant thing about the indexation of mortgages in Iceland is that it is not the nominal rate of interest which is upped parallel to the changes in the rate of inflation, but the principal of the loan is changed according to the annual rate of inflation.

So if you have a mortgage from HFF of, say, 1,000,000 ISK you will get it with 4.2% rate of interest. Assume that this is in November 2012. In November 2013 the annual inflation turns out to be 5%. That means that you now owe the HFF a mortgage amounting to 1,050,000 ISK which still carries the 4.2% rate of interest. You do not owe 1,000,000 at 9.2% rate of interest.

The Icelandic indexation basically postpones the full cost of the monthly payment. Instead of demanding that you as the borrower pay the original amount at 9.2% nominal rate of interest, you get a loan, automatically, amounting to 50,000 ISK and are asked to repay it later. This of course happens repeatedly, every single month to be exact (the amount changes of course depending on the rate of inflation).

Now, the trick is that this may not be so bad if the borrower can in reality pay back the loan. But that means the borrower has to find money to repay the original principal and the automatic loans as well which are so conveniently extended to him.

That is going to be a bit problematic for the average household. For even though the real rate of interest on HFF loans are 4.2%, the real wages in Iceland are not growing by that number. They are only growing by 1.1% per annum (since 1989).

So if you look at the households as a whole and consider their debts, which carry the real rate of 4.2%, and their wages, which grow by 1.1% per year, is it not likely that the ratio debt/wages will grow year by year?

Well, yes it is! And so they have! This happens not only because of new non-automatic borrowing but also because the households are given an automatic loan every single time there is inflation: inflation basically funds itself! This really smells a bit like a Ponzi-financed inflation. And that is truly what indexation, in its current form, of mortgages in Iceland is. Some day, a large chunk of this mortgage debt will have to be either refinanced at a rate of interest well below what it is today or simply straight forward cancelled. This is not sustainable!

Household debt in Iceland as a ratio of spendable income. The drop in 2011 can be explained to some extent by the illegal foreign-currency loans and the households' endeavour to use pension savings to repay debt.

The other reason for HFF's bleeding wound is the fact that it cannot pay its debts in advance: the bonds it issues have a no-early-payment clause.

This means that if households decide they want to refinance their HFF mortgages with another one, from e.g. a bank, the HFF will end up with a stack of cash it has no idea what to do with. That stack of cash will of course only yield 0-1% real rate of interest, if that, which is quite problematic for HFF because its issued bonds (the HFF 14, HFF 24, HFF 34, HFF 44 bonds) are irremediable and carry a 3.75% coupon rate.

Blatantly then, the HFF will slowly bleed out. Whatever money the government throws at it will practically be nothing else than a temporary bandage on the negative-net-interest wound which it slowly bleeds equity out of.

Truth is that the Icelandic Housing Financing Fund is in a Wile E. Coyote moment: there is nothing behind it other than the air and the Icelandic government's guarantee. The problem is that HFF cannot be allowed to go bankrupt for if it does it can be interpreted as a payment default of the Icelandic state.

It will be fun to be an Icelandic tax payer in the future! Also, if a condition for abolishing the capital controls is a deficit-free budget, good luck with that with HFF hanging around.

(Icelandic version first published on Pressan.is)

The Optimistic GDP Forecasts and IMF's Turnaround

Islandsbanki published its economic forecast for the Icelandic economy late in September. Their expectations: 3.2% growth in 2012 and increasing after that.

I sat down and looked at some other forecasts in comparison to get a feeling for the realism behind them. I cannot say that any of them is realistic for 2012 except the IMF one. And funny enough, IMF is in fact turning around on its policy on Iceland and the problem we have on "offshore" kronas. IMF isn't as optimistic about its wunderkind as they used to be when they threw that "Iceland and IMF" conference one year ago.

GDP forecasts range from 2.4% (IMF) to 3.2% (Islandsbanki) in 2012. CBI stands for Central Bank of Iceland.

OK, so the range for 2012 is 2.4% to 3.2%. That compares to 2.4% GDP growth the first 6 months of 2012 compared to the same period the year before. That means that to reach 3.2% growth (Central Bank of Iceland (CBI) and OECD expect 3.1% growth in 2012) the economy needs to grow by 4.0% in the second half of 2012.

4.0%. Right. Well, that's not going to happen. Islandsbanki's 3.2% expectation is way off, we can immediately write their 2012 forecast off. Same really goes for CBI's and OECD's 3.1% forecast.

The most interesting forecast is IMF's. It's interesting not only because it is the most realistic one but it also signifies a turnaround on IMF's behalf when it comes to Iceland.

IMF in 2011: "We nailed it!"
In August 2011, IMF projected 3.1% GDP growth in Iceland. It expected 2.5% growth for the full year 2011, which compares to the latest estimate of 2.6%. Well done! IMF generally expected "a tentative economic recovery": the inflation was rising, the krona depreciating slowly and uncertainty was (and is) still high due to the Icesave dispute. However, "access to international capital markets [had] been regained" and "outlook was for a moderate expansion" while "concerns persist about the sources of medium-term growth." IMF constantly mentioned the growth in private consumption, an economic factor that practically caved in in 2009 and 2010.

But the most prominent IMF position was that of the handle of the crisis. A whole conference was set up in October to celebrate the good job done and famous international economists came to Iceland to check out the crisis Wunderkind. In November 2011, IMF's eyes to the possible unorthodox handling of the crisis had opened and Iceland's case suggested "alternative way out of crisis."

Iceland had basically taught IMF that atypical "we must save the creditors!" policies weren't the only one available. Good stuff, very important that IMF realised this.

IMF in 2012: "We nailed it BUT..."
Now, IMF has realised that it may have to extend even further the Icelandic case of "let the creditors drown". The reason: the offshore kronas.

The offshore kronas are funds, denominated in krona, that are stuck in the economy behind the capital controls. Their sources can be of any kind, ranging to the Glacier bonds issued during the 2004-2007 Party to normal households' savings that are eager to get out of the economy on expectations alone that the value of the krona will collapse the instant the capital controls are lifted. Estimates of the whole offshore krona amount run from 400-1,000 billion ISK (25%-60% of GDP or thereabouts).

On 28 September, IMF issued a Concluding Statement. There, we can see IMF arguing that "significant reduction (or elimination) of the “overhang” of liquid offshore krona" is one of the preconditions for lifting the capital controls. That was always known. What is a turnaround is the way IMF is now willing to do it:

"To accelerate [reducing the stock of liquid offshore krona] it is necessary to strengthen the incentives for holders of liquid offshore krona to participate in the liberalization strategy. A key step will be to curtail expectations that capital controls will be lifted soon, including by removing a reference in legislation to a terminal date for the controls. In addition, the strategy should clarify that the conditions under which liquid offshore kronas are allowed to exit will become less favorable over time

And they continue:

"Once incentives are in place, the authorities could open the next channels envisaged in their strategy—bond swaps and an exit tax. The objective of the bond swaps would be to reduce the stock of offshore krona before introducing an exit tax and ultimately lifting the controls. Swapping short-term krona-denominated assets into long-term euro-denominated bonds would distribute the pressure on the balance of payments over several years."

This is a turnaround. IMF is now accepting the not-so-unlikely possibility that in order to ever lift the capital controls in Iceland, the Icelandic authorities basically have to fry the creditors even more. IMF padded Iceland on the back for not rescuing the banks in 2008 and thereby let the creditors of the banks take the hit. Now, they are directly saying that Iceland would need to take one more step and straightforward threaten the holders of liquid offshore krona: "the strategy should clarify that the conditions under which liquid offshore kronas are allowed to exit will become less favourable over time."

IMF changing?

The funny thing is that those ideas are old. One of the MPs of Iceland, Lilja Mosesdottir, has for a long time urged a more critical stance on the offshore krona issue. She has spoken about a German-1948-type adoption of a "new krona" (assets in ISK redenominated in a new currency, which's exchange rate is a function of the nominal value of the asset being redenominated, e.g. 1:1 for low amounts, wages, etc. but 10:1 for high amounts and offshore krona) and an "exit tax" if offshore krona owners want to swap them out for EUR or any other foreign currency. She in fact used to be in the government but went rogue due to what she felt was the government's softness towards IMF. 

Now, IMF has basically taken up her stance.

And why? Maybe because they are afraid that their Wunderkind isn't in the good shape they hoped to.

But maybe because they are generally accepting the fact that "debt that cannot be repaid, won't be repaid" and creditors should simply accept it. That would be the most wonderful thing if IMF finally realised that and actively applied that policy in its future bailouts.

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.

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.

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!

Iceland's prepayment of bailout money

A very quick note on Iceland's prepayment of IMF and Nordic bailout money since I got a few retweets on the matter.

Basically, the treasury is extending its liquidity profile. The cost is higher rate of interest, expectedly so. In May, Iceland issued a 1.0bn. USD bond bearing a rate of interest of 6%, fixed. It matures in 2022. This money is now spent on the prepayment of IMF and Nordic bailout loans, maturing in the next few years. As far as I can figure out, those loans carry a rate of interest of 3.25%.

So, yes it looks good on paper that we're prematurely paying back the money we got in 2008. But we're doing so with even dearer money, almost double as expensive in fact. People may have different thoughts about how much liquidity is needed but no one can deny that interest rates of 6% for a sovereign are, well, high. Mortgage rates in US are considerably lower in comparison and the fact of the matter is that the demand during the bond issuance was quadruple the supply! Well of course, it's a sovereign offering interest rates of 6%! Adam Smith's "prodigals and projectors" come to mind.

More importantly, can we seriously expect the income of the State, measured in USD, to grow on average by 6% per annum? I cannot see how that's going to happen, especially when everybody expects the krona to collapse the moment the capital controls are lifted!

Is anybody whispering "Ponzi" back there? Maybe we should have offered a bit lower rate of interest...

The maturity profile of the Icelandic Treasury, foreign currency denominated debt only (not external debt). The 2022 column is the 6% USD bond, issued last month. From the Central Bank of Iceland.