The Icelandic Debt Relief

The hottest story coming from Iceland now is the one about the government-initiated debt relief to households. Here is my take on it, focused only on handful of all the questions and issues related to the act itself and, perhaps more importantly, the potential economic development in the future. Especially on that front we have a sea of unanswered questions. Is this going to be inflationary? What about economic growth, unemployment, investment levels, etc.? The balance of payments? Will this help or hinder the abolishment of capital controls?

First some useful links (in English) that I found. They are unfortunately not many... classic Icelandic lack of communication problem... (if you've got some others, please leave a comment):
FAQ on the website of the Prime Minister's Office
The news itself on the same website
Bloomberg - Creditors in Iceland Banks Face Pressure to Speed Up Settlement (by an Icelandic journalist).

The basics
Framsóknarflokkurinn (e. The Progressive Party, PP - they are conservative) promised to carry out a debt jubilee if it would be elected into power in the last general elections. They were. The other half of the coalition is Sjálfstæðisflokkurinn (e. The Independence Party, IP - conservative).

Those two parties did not agree on how the debt should be cancelled. The PP wanted to straightforward cancel it. They were talking about up to ISK 300 billion just before the elections, the actual amount turned out to be half that. The IP thought that cancellation would be impossible since it would either be simply illegal on the grounds of property rights and / or too expensive for the State in case the State was going to foot the bill for cancelling the debt of households. Their take was to use the tax system and create incentives for people to use the 3rd pillar of the pension system - the private pension holdings - to get tax-free additional income to be spent on paying down debt and only to pay down debt.

The outcome is a mix of both. ISK 80bn. (roughly GBP 400 million) of household debt will be outright cancelled. Additional ISK 70bn. are to become available via allowing people to use their 3rd pillar pension savings in the next three years, to pay down their household debts.

So what's the crack? 
Icelandic households will get ISK 150bn. (GBP 750 million) of their household "cancelled", spread over a four year period. I say "cancelled" because they are in fact paying down ISK 70bn. of it themselves, the only thing is that they get to use tax-free pension savings to pay down that part. And that makes perfect sense by the way: why save in an illiquid form at 2-3% real interest when you have debt to pay that charges a 4-5% rate of interest.

The rest, ISK 80bn., will be outright cancelled in four annual instalments although the borrower will feel the positive impact on his monthly payment burden immediately. Each household that has an indexed mortgage, partially or wholly, (check this link to see how indexation of Icelandic mortgages works), specifically declared to buy a property for own use (buy-to-let mortgages are excluded!) will get a maximum of ISK 4 million of the debt written off. Non-indexed loans get no write-off but the tax-free pension savings can be used to pay additionally onto the principal in the future. The tax-free pension savings can also be saved and later used to buy a flat. This is why they say that even current tenants will benefit from the measures. If the household got its debt cancelled via e.g. the 110% measure this will be accounted for and the current write-off will consequently decrease.

The following is a copy-paste from the slides about the measures. The way you should read this is the following. The x-axis is the time when an ISK 15 million mortgage was taken out. The graph (grey area) shows the nominal amount of that debt today (Remember, the principal of indexed Icelandic loans INCREASES in value parallel with the CPI. That's the reason why an ISK 15 million mortgage taken out in e.g. September 2001 would amount to about ISK 25 million today according to the graph). The blue area is the debt after the debt has been cancelled and the light brown (beige??) area is the amount of the mortgage once a 3 year private pension pay-down has been accounted for. So the decrease is read vertically and depends on when the loan was taken out. Click to enlarge.

The principal of an ISK 15 million mortgage and how it is affected by the jubilee, depending on when it is originally taken out

Now, most of the questions, and some answers, about how and why and what for and all that can be found in the FAQs from the Prime Minister's Office. So head over there to read further on how the whole thing is carried out. I would rather spend time on some other issues, such as:

Is this significant?
That depends on how you look at it I suppose. This jubilee is not gigantic in comparison to the debt that has already been cancelled since 2008. On that note, I honestly think this nice info-graphic, which is circulating on Facebook from a group that is politically, well, not keen on the current government, says it all. To give the current government some rightful credit (pun intended): their measures are more significant, by a mile, than the previous government's measures (because they had nothing to do with the pink part of the left column).

Comparison of how much household debt has been cancelled in Iceland since The Crash.

The headline ("heimsmetið") is a reference to the prime minister who said that his government's jubilee was a "world record". The left column is debt that was cancelled during the coalition rule of last government. The colours represent the following: purple (12bn) - special interest benefits, pink (155bn) - correction due to illegal FX-indexed loans (this came through the justice system and had nothing to do with the former government), orange (8bn) - special debt measures, yellow (48bn) - the 110% way (any debt above 110% of your property value was written off), grey (15bn) - increased interest benefits, blue (70bn., the IP's campaign colour) - Tax-free pension savings, green (80bn., the PP's campaign colour) - debt jubilee.

So in comparison to the previous write-off of debt in Iceland, governmentally initiated or not, the current jubilee is not so huge.

However, it is significant from the point of view of proving that this is politically possible! And that's something for other nations to learn from! Jubilees do not need to be a thing of biblical times! (But of course, that does not mean that they are always a smart move!)

But how are they paying for all this?
Right, that's a bit hazy to be honest. The short answer on the list of FAQs on the website of the prime minister's office is a classic nonsense answer that doesn't add any value:

"How is the debt relief financed? The Treasury will collect increased revenues in the next four years to cover the cost of additional state expenditure resulting from these actions. The actions will therefore neither be financed by additional Treasury borrowing nor with the granting of state guarantees."

Right, so the no-bullshit answer is that you're going to increase taxes - or "collect increased revenues..." Then just say it!

Where are they going to "collect increased revenues"? From the old banks. Through taxation. Specifically, they are going to tax the estates of the old banks, i.e. the bankrupt banks since 2008. Their liquidation process is going veeeery slowly, to a large extent because of the capital controls and the tug of war between them and the liquidation process of the old banks: the capital controls hold it back but the estates have to be liquidated in the end before we can abolish the capital controls. Well, that's a nice one: like being a driver with two back seat drivers, one demanding you drive faster and the other demanding that you slow down. Which one are you going to make unhappy?

The government is going to make the old banks unhappy. Besides outright taxation on the them to pay for a debt jubilee for households, they are considering changing laws that would force them to speed up the liquidation process.

I've got two immediate concerns about this.

First, those are two birds in the bush but not one in the hand. Are we definitely sure that they can tax the old banks? This sentence alone from the slides says it all (slide 56): "The committee [behind the debt jubilee] assumes that the measures will be fully funded over a period of four years" (i. "hópurinn gefur sér þá forsendu að aðgerðin verði fullfjármögnuð á fjórum árum.").

Great going guys, I do this all the time as well! I always just book my vacation to French Polynesia and just assume that I can finance it! ISK 80 billion!? Pennies mate, I'll pick them up off the floor one day!

And even if they can tax the old banks specifically (there are some concerns about whether it would be constitutionally possible or not), won't the old banks, which are the main owners of Arion and Islandsbanki, not just pass at least part of the cost onto their customers? Competition in the banking industry in Iceland isn't great you know.

Second: OK, if we can tax the old banks to get cash for a debt jubilee, couldn't we have used the money for something else? Like not practically shutting down the Icelandic public radio? Or pay decent wages to doctors, nurses etc.? Not putting myself up against the debt relief as a principle, just pointing out that we didn't have to spend all the cash on it.

Or maybe we can tax them even more and spend that tax income on something nice!?

But how do they actually do this?
1. The mortgages are split up into "primary" and "secondary" parts.

2. The primary part (about 87% of the mortgage to be written down) is the new debt of the borrower. This loan has the same loan stipulates as the original loan, i.e. same rate of interest, indexed to CPI, etc.

3. The secondary part is interest and indexation free. There are no payments of that debt. Both of the loans are on the balance sheet of the borrower and the financial institution that owns the original loan. The total payment burden therefore contracts immediately and not over four years.

5. Annually, the State buys back 25% of the original amount of the secondary loan from the financial institution (hence the fact that this will take four years to finish). This is roughly ISK 20 billion annually, hence the total ISK 80 billion write off. The debt is then written off. The income to fund this is meant to come from the estates of the old banks themselves.

What about the economy?
The government estimates that with all this they will manage to get household debt below 100% of GDP. Such a debt level is still quite high and may still be a barrier to economic growth and financial stability, especially since interest levels in Iceland are stupefyingly high in comparison to other economies.

Nevertheless, this should help. Analytica, a consulting company back home, reckons the effects of the jubilee will be the following for 2014 only:
- economic growth: +0.1%
- inflation: +0.1%
- current account balance: -0.2%
- consumption: +0.4%
- investment in new properties: +2.0%

My take in short
Now, there are some good things about this measure.

First of all, they did it! Jubilee is here, well done guys! You proved this is politically possible and economically this does not seem to be an absolute nonsense. So this opens up the possibility of doing this in other countries. Whether that would make economic sense has to be discussed for each economy. Some very indebted households will feel quite relieved and this will have positive impact on the economy although the impact may be short lived (see more why below). The tax-free pension part of it all also makes perfect sense and simply boils down to the fact that it is not smart to save on 2-3% rate of interest when you owe debt bearing 4-5% rate of interest.

But I do have to admit that I have concerns, besides the obvious ones like the taxation issue (which may well enough not be so important). There are a few reasons why.

First, the primary loan, or the new loan, that the borrower has to pay off will still be indexed, just like the original loan that now is being partially written off. We will therefore still have all the negative effects of indexing mortgages in Iceland, including more volatile inflation, higher inflation, higher rate of interest, lesser effectiveness of the monetary policy and the risk of having to have another debt jubilee in 10 years time or so.

Second, and closely related to my first concern: although there is no direct increment in money supply because of the measures we can, I believe safely, assume that not only will we have some potential demand-pulled inflation immediately in the wake of all the jubilee but increased credit demand as well (especially if we have an increase in moral hazard due to all this: will people take on more debt because they anticipate another debt jubilee in the future?). As the increased credit demand will be met with new loans that increase the money supply we will end up with further inflation pressures. And because the principal of indexed debts will grow with more inflation we will get some, or even all, of the "jubileed" debt back. The Central Bank will also respond with an interest hike to try to hold credit demand back. That will hit the borrowers with non-indexed loans as their interest rates are potentially readjusted upwards. (More effective and sensible way of limiting credit growth and inflation would be to impose direct credit controls and connect them to the banks' own net holdings of liquidity in foreign currencies. But I doubt the Central Bank will go down that road: you can't teach old dogs how to sit).

Why, oh, why did they not make it compulsory to change the new primary loan into a normal non-indexed loan? A golden opportunity to get rid of this pest that indexed mortgages are has been wasted!

Third, although the net assets of the old bankrupt banks will contract (assuming everything goes according to plan) we will still have "considerable" pressure on the balance of payments because of increased consumption and demand. Now, of course, part of the reason for those measures is to revive household consumption. But if we will get into even further riskier waters with the balance of payments than we are in, doesn't that just signal that the exchange rate is too strong? And imagine what will happen when and if the exchange rate goes down: inflation goes up, principal of debt grows back, we're back on square one.

So again: why, oh, why did they not abolish indexation parallel to those measures?!

Fourth, and this is perhaps my most serious concern. We haven't fixed the institutional drawbacks of the Icelandic economy. Besides still having the indexation on mortgages, we still have a high self-imposed rate of interest stemming from the pension system. (It is regulatory required to get a real rate of return of 3.5% and it controls assets equal to about 120-130% of GDP. What do you think will happen to the long term rate of interest with such gigantic buyer of financial liabilities who demands a high minimum rate of interest. Has anybody heard of monopsony?). We also still have high short-term rates, to a large extent because of the indexation.

So I fear that the net effects of this debt jubilee will not be significant in the long run. At least from an economic point of view. Politically, this may fuel some fires, even in other countries where over-indebted populations may be nudged to demand jubilee there as well. In some cases those potential jubilees might make sense. The taboo of debt relief has just been delivered a blow. Maybe we can actually discuss it in a more sensible manner from now on and not with cries coming from both sides.

That is all well and square, but when it comes to the Icelandic economy, I fear we will only have short spurts of economic bounce back. It is not enough to cut the leaves of the weed, we need to dig out the roots as well.

UK & Iceland GDP comparison

After the recent GDP figures from ONS, the general reaction was rather pessimistic. FT had e.g. this tweet and article:

True, this doesn't look good. In fact, after the revisions, UK GDP volume is now further below its top before the financial crisis than Iceland's GDP is. The following graph is based on data from ONS and Statistics Iceland. The top is given the value 100 (3Q07 for Iceland but 1Q08 for the UK). Chained volume measurement, seasonally adjusted (yes, the Icelandic data are SA although they don't look like it).

Back on track: Iceland is edging closer to its GDP volume top before the crisis. The momentum is also stronger.

Iceland's GDP is now 0.4% closer to its top before the crisis than UK's GDP compared to its top. Then again, Iceland had its top two quarters ahead of the UK.

But - there is always a "but" - this is a volume measurement. And although economics teach us to think in volumes and real measurements, we arguably do not rely on barter (and never did) in our commerce. We use money and money is different between economies: try paying with Queen's money in Iceland and you'll be a laughing stock (I've tried, the guy just grinned at me) just as you will be if you try using the ISK in the UK.

So what happens if we price the volume produced in the same currency, say the GBP. That comparison makes sense: we could be producing the same volume as before the crisis but is it worth the same?

The UK volume is already priced in pounds so no need to handle that in a special way. But the Icelandic volume measure uses the ISK as a measurement stick and that measurement stick has changed significantly since before the crisis. If we measure both of the volumes in GBP, the following graph is the result.

Still long way to go: measured in GBP, the Icelandic GDP volume does not seem to be edging must closer to its previous height

Notice the drop in the Iceland data in 2006. This is the "Geyser crisis", a short wake up call to the fact that we were in a bubble. But it did not last long; politicians and prominent businessmen claimed everything was peachy, the housing bubble restarted (held up with exchange-rate linked loans which have now been deemed illegal) and the banks kept on growing. Then, finally, the party ended.

To my British friends I say: sure, you're not in the best of situations. But if it makes you feel better, you're not in the worst.

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.

Firms' cash flows

3rd draft of the thesis is done! My supervisor is reading it over and I hope he will be all right with it. Will meet him in two weeks or so, until then, it's time I revive this blog a bit!

Statistics Iceland issued, not long time ago, new data covering the cash inflows of Icelandic firms, based on their VAT reports. The bottom line: the nominal value is back up above pre-crisis levels in 2008 but the real value is still lingering below. There is a steep spike in the real cash flows however so the firms-part of the economy is picking up pace.

This is the nominal value of firms' cash flows. The sample is smoothed out with a running average. Notice the stagnant period in 2001-2003 when nominal cash flows were hardly or not growing at all. That compares to the 10% drop in nominal cash flows in 2009. 

Firms' nominal cash flows

This real cash flows story is another one a bit more frightening. Suddenly, the drop in 2009 has stopped being violent and has turned into a battle for existence!

Firms' real cash flows, 2012 price level

What is curious is to see where the drop comes from. And the answer: from the burst of the housing bubble. On the graph below we can see how industries have rocketed upwards as a share of the firms' total cash flows. At the same time, cars and car repairs have trended downwards for a long time. Most notably however, we can see that after the housing bubble burst, the "construction" has basically disappeared.

Graph shows how firms' total cash flows are split based on what they're doing. The burst of the housing bubble is rather obvious

The burst of the housing bubble is even more blatant in the next graph. Since 1970, the construction of residential housing has never been as low. That is so even if Icelanders are now 319,000 compared to 204,000 in 1970.

Number of square meters in new residential houses and flats, begun and finished, in each year. If you're a carpenter looking for a job, don't come to Iceland!

Of course, we can see on the sectoral cash flow graph that it is the Industries (manufacturing) that have kept the economy alive since the implosion in 2008: total value sold of manufactured goods doubled between 2007 and 2011 (reaching 727 billion ISK in 2011). Most of this comes from manufacture of basic metals (the smelters) but food products and beverages (the fishing industry, we've also become producers of many different brands of beers!) have done their parts as well.

I don't think anyone will deny that the utter collapse in the value of the krona helped industries keeping the economy alive. At the same time, the strengthening of the krona during 2002-2007 can be blamed at least partially for the deterioration of those same industries in that period. In the meanwhile, the housing bubble and the credit mania kept the economy going while the krona was too strong.

Maybe next time I'll check out the data for e.g. France and Spain but both economies had/have a housing bubble (don't tell me Parisian house prices are sustainable!) and then an economic slowdown, Spain in particular of course. Ireland would be a nice comparison as well. Have industries in Spain, Ireland and even France refuelled the economy to the same extent as has been the case in Iceland after the implosion in the housing market? Based on the prominent discussion about the growing current account deficit in France, I'm going to doubt it in case of her - at least until I see the data.

Should Iceland adopt the EUR?

Some time ago, I sent my answer to this question to the European Web - a quasi-official website which has the purpose of answering questions about the EU admission process of Iceland and other general EU considerations. What follows is a rough English translation of the answer, originally posted here: Ættu Íslendingar að taka upp evruna?

The timing of the posting of the answer was in fact quite fitting since the Central Bank just issued a tome - a 600+ page report - on whether Icelanders should adopt the euro or not. Their conclusion: they weren't sure. So am I, except I reach that conclusion in about one A4 page.

--------

Should Icelanders adopt the euro?

Each and everyone has to answer this question on their own. The reason is that adopting the euro or keeping the krona is to a large extent a question of how risk averse Icelanders are at the time of their answering. Economics will not be able to answer which of the two currencies are "better".

The Eurozone is based on the theory of Optimum Currency Area. In very short, that theory states that if different local economies are alike enough, such as in terms of culture, language and trade cycle, and they have a significant level of trade in between them, then it would be beneficial for those two local economies to adopt the same currency, first and foremost to decrease the cost of commerce (such as due to the need to exchange currencies all the time). 

The upside of this (hoped for) decrease in cost of commerce should outweigh the fact that if this common currency is adopted then the local economies are forfeiting their independent monetary policy. That in fact can sometimes be the aim since independent monetary policy is sometimes so fantastically badly conducted that it does the economy more bad than good. Adopting a foreign currency should therefore not only decrease the cost of commerce but also boost the credibility of the ruling monetary policy, thereby increasing general economic wellbeing.

It is here though where individuals' own risk aversion plays part. The author has sometimes drawn up the metaphor that keeping your own national currency, which is not pegged to another, is like buying a full insurance on your car. If you however choose to give up the independent monetary policy, then you are choosing to go for a very limited insurance on your car.

The metaphor is the following: a full insurance on one's car can cost a pretty penny. If, however, the owner of the car has an accident, which he had nothing to do with, the insurance company will pay the cost of repairing the car - minus the self-coverage. The owner knows this however so he becomes subject to moral hazard: him knowing that he will get most of the cost of repairment from the insurance company certainly does not encourage him to drive more carefully. If he's not careful, the chances of him actually having an accident increase.

A car owner which does not buy a full insurance does not become subject to moral hazard. The owner will have to pay the full price of repairing the car in such instances and therefore the limited insurance car owner has the incentive to drive more carefully. He can however still have an accident which he could not avoid no matter what. He can also still have an accident because he drove like an idiot, even if he hadn't bought the full insurance. 

The Icelandic krona and the euro are represented by the full and limited insurances here above. The car is the economy and the driver behind the steering wheel is the people in the economy, most importantly the policy makers - and banks. If the economy ends up in troubles, the "full-insurance" will kick in in the form of devaluing the currency. The self-coverage is higher inflation in case of massive devaluation and lack of foreign purchasing power. But the economy will be "repaired" with the devaluation. However, the "get out of jail card", which what the devaluation of the currency really is, also does not give the Icelandic people much encouragement to drive carefully. So keeping the independent currency can in fact introduce fluctuations into the economy, fluctuations that do not need to be there. Nevertheless, it is still possible, even if you drive carefully, to have an accident. And nothing stops you from driving like an idiot even if you don't have an full insurance. And when the accident happens, there will be no independent currency to devalue if you have the euro.

So the question which of the two currencies is "better" for the Icelandic economy is not only about whether Iceland is a part of the optimum currency area that Eurozone is meant to be - which in fact can be argued against, hence the euro crisis. The answer is also whether the Icelandic nation is risk averse enough to forfeit the "full insurance" that the independent currency is.

It can easily be argue that holding dearly onto a currency which has lost 99.95% of its value versus the Danish krona since 1939 is not the wisest thing to do. If the euro is adopted the handling of the economy must become much stricter. In that case, we are not only talking about fulfilling the Maastricht treaty on fiscal deficit and fiscal debts but we must consider the debt levels and debt issuance of private parties as well. The economic problems of the periphery countries are not only explained with reckless federal spending, such as in the cases of Italy and Greece, but with the expansion of private debt, such as in the cases of Spain and Ireland.

----------------------------

My point: Iceland can still end up in dire economic straits due to private debts, even if we would adopt the euro.

The Shortage of FX in Iceland

Iceland has strict capital controls at the moment. A permission is needed from the Central Bank to move money out of the country. And if you're in the exporting business, you have to sell your foreign currency income to the Central Bank.

All this is done to preserve the foreign exchange reserves of Iceland, reserves that are almost completely borrowed from the IMF, Scandinavian countries and others. However, there is a great shortage of FX in the country as is rather blatant by the existence of the capital controls.

Andri Gudmundsson, CEO of H.F. Verdbref ("H.F. Securities"), said that the problem was that Icelanders spent too much on imported goods. This is quite fantastically right! And the lack of FX will end up with the krona falling in value. But how are we managing to spend so much on imported goods? Where is the spending power, in ISK, coming from in the first place?

The source of that spending power has traditionally been the banking system. When the banks extend loans they create the borrowed money out of thin air. The extra money in the economy is then spent on goods, including imported goods of all kinds (investment and consumer goods). When we've borrowed a lot and spent the lot on imported goods we realise we're in FX problems. The krona then falls in value when the market sobers up. The fall in the value of the krona defers people from spending their money on imports and helps exports to gain foothold.

The story is always the same in Iceland: the krona has never fallen in value unless there is expansion of bank loans in the years before. Using the data from Statistics Iceland, that's rather blatant.

Four distinctive periods are very obvious in the economic history of Iceland when it comes to expansion of bank loans and the subsequent fall in the value of the krona. 

After the bank-loan expansion that fuelled and funded the bubble that collapsed in 2008 the external balance of the macroeconomy was in ruins; we had more than 20% current account deficit in 2006 after massive imports of all kinds of consumer and investment goods. Then the krona finally collapsed.

The krona-collapse in 2008 was not enough. It's somewhat like the exchange rate collapse in 1950; ten years and some bank-loan expansion later we had another and more severe devaluation. There is still too much of kronas in the economy in comparison to the FX reserves, which is of course why we have the capital controls in the first place. And despite all the devaluation of the krona, we are still running the current account deficit in the negative territory. One reason for that is the fact that the banks are lending out money again, now in the form of unindexed mortgages. And all that money is fresh off the banks' conveyor belt.

The plan and the aim is to abolish the capital controls in 2015. That plan will fail at the pace of the recent progress. We need to get serious.