The non-indexed mistake of the Icelandic government

"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens."
- John Maynard Keynes

I've mentioned before (here and here) that indexation in Iceland is a peculiar beast. In the first post on the indexation I mentioned that the main issuer of indexed (to the Consumer Price Index) securities in Iceland is not the government but households. In most countries, households wouldn't even think of taking a CPI-indexed loan but for a long time there was nothing else offered in Iceland. Normally, it is the government which issues the indexed bonds. We have e.g. the TIPS in the US, the indexed Gilts in UK and many others (see a Wikipedia list here).

We do things differently in Iceland. Off the CPI-indexed bonds registered in the Icelandic Stock Exchange, 83% of them (based on market value) are Housing Financing Funds bonds which are used to finance the mortgages to households through the HFF. The HFF has a government insurance behind it in case of lack of liquidity or equity, but the HFF is nothing else than an intermediary of indexed debt which the households are effectively issuing. And it is the households which have to carry the first part of the burden in case of problems. HFF can e.g. increase the interest rate mark-up and repossess one's house if the indexed mortgage is not repaid before the government's coffers are opened up to bail the bankrupt HFF out of trouble - which has happened recently and will only happen again given the awful financial cold the fund is suffering.

The market value of debt securities in the Icelandic Stock Exchange. The predominant issuer of indexed marketable securities is the household sector through the indexed HFF bonds.

This misallocation of the burdens of indexation creates a perverted incentive for the government and a massive problem in the wake of that which only hits the government itself in the back of its head.

As its debt is predominantly non-indexed to the rate of inflation, the government has limited reason to make sure that price increases are not excessive. Possibly, it might even want to "inflate" its debt away by allowing inflation to be just a bit higher than it would have if the incentive to "inflate away" wasn't there. But of course, too much inflation would lay waste to the balance sheet of households and that is, unfortunately, somewhat what has happened.

Let's take an example. The bailout money the government raised by issuing bonds to investors was, as one can see by glancing on the graph above, almost entirely in non-indexed bonds (this does not include the foreign-currency bailout money we got from the Scandinavian nations, the IMF etc.) The total market value of non-indexed government bonds, partly because of a lower rate of interest but mainly due to new issuances, increased by a spectacular 539 per cent between year end 2007 and year end 2010 when all the savings-bank bailouts were passed and the reconstruction of the financial system was, for the time being, finished. (Not included in this increase is the bond which was issued to strengthen the equity base of the Central Bank of Iceland after it became technically bankrupt (negative or too low equity) for that bond is simply kept in the Central Bank and not on the market.)

Why was the bailout money not raised in the form of indexed government bonds? Was it because the government did not want to carry the full cost of the bailout and instead throw it on the shoulders of households whose debts are to a large extent indexed?

Who knows! But what we do know is that the government has been raising taxes since the collapse to raise money for the bailout. Tax increases, especially VAT and excise taxes, raise the CPI (although they have nothing to with actual inflation!) and that increases the cost of CPI-indexed bonds. "Luckily" for the government, that cost is not in place for it since the debt it has issued in the recent years is, as already highlighted, mainly non-indexed.

But of course, the CPI increases, caused e.g. by higher taxes and possible pet-projects of perverse politicians, affect the indexation of households' debt. So the indexation-cost comes on top of the increased tax burden for households, adding insult to injury. Of course, this all ends up with a record number of delinquencies and defaults, which again means that the HFF suffers losses as well. Those losses are first borne by the households but when they cannot continue paying, the government, originally trying to reasonably inflate its debt away, has to step in and boost the equity foundations of the HFF. Recently, 13 billion ISK of government money were earmarked for the fund. That amount will only grow in the future.

Chart III-7 in the 2012/2 Financial Stability Report by the Central Bank of Iceland

So the government, by issuing almost only non-indexed debt after the collapse, tried to sway away from an important incentive it should face to help keeping inflation at bay. Instead, the government created, intentionally or not, a reason for itself to allow inflation to increase and inflate its debt burden away: the CPI has increased by 25% since October 2008.

But at the same time, increased inflation only increases the debt burden of indexed mortgages and bankrupts the household sector. Then, "what goes around, comes around" and the government experiences unpleasant but repeated visits from the Housing Financing Fund as the bankruptcies of households ruin its balance sheet and it needs more and more equity injections.

Maybe the government should have stopped fooling around long time ago and issue indexed debt contracts instead, thereby joining the anti-inflation team instead of boosting the ranks of the other team? Luckily, it's not too late yet to switch sides!

Icelandic CPI and the money supply

New data on inflation in Iceland were published today. The verdict: 4.5% over the last 12 months.

In some sense, this high (rather mellow on Icelandic standards) rate of inflation is a collateral damage incurred after the bust of the bubble. The money that was created en masse before and during the fantastic bubble formation before the crash is simply still sloshing around, catching too few goods with inflation as a rather expected result.

Basically, we can interpret it as the classic quantity theory of money doing its work - with a bit of lag as one can really expect (I hope nobody truly beliefs that the rational expectations theory applies: even if the money supply is expanded by x% in time period t, it is impossible to realistically expect that people will boost their price expectations immediately, resulting in a full inflation-feedback within time period t as well. However, over a longer time period, maybe a few years, we can expect the price level to slowly respond in more accordance to the MV=PY theory.)

We can throw the data up graphically to understand them a bit better. Here is the rate of inflation and the relative expansion of M3 over a 5-year-period (instead of the annual measure) since 1886 in Iceland.

5-year inflation and 5-year relative expansion of the money supply (M3). Notice that the axes are the same. Correlation: 0.88. Data constructed from various sources. (OECD, Statistics Iceland, Central Bank of Iceland).

We can see that the bump in 1994-2012 (October value) seems a bit out of place since there is a lack of response in the Consumer Price Index. The same applies to the early 20th century bump and the WW2 spike.

The early 20th century bump can be explained with the fact that the banking system was truly developing fast back then and the proper allocation of money brought supply-side improvements, therefore the CPI did not chase the expansion of the money supply as much. Data might be the reason why as well, we never know with data looking so far into the past. The WW2 spike can be explained by the massive inflow of capital from abroad which did not really enter the circulation but was stacked up in the Central Bank in the form of foreign reserves. They were promptly spent - every pound of them! - after the war on the "second industrialisation" in Iceland when the agriculture and fishing industries were modernised with tractors and trawlers. Of course, we went a bit over our head in that episode and the over-investment was, with the benefit of hindsight, monstrous! But at least that over-investment, despite leading to a currency crash in the early 1950s, left us with tractors and trawlers. Not entirely useless!

But that leaves the early 21st century bulge in M3 without corresponding reaction in the CPI. Lets zoom down onto the last 18 years.

Same as above but zoomed down onto the 1994-2012 period. Notice that the axes are now not the same (inflation is on the right axis). 

Now, all of the sudden the rather close (judging from the earlier graph) relationship between 5-year change in money supply and 5-year change in CPI brakes down. So what happened to all that extra money? Well, it's still there. It's just not buying goods... yet. In this respect, it is interesting to look at the ratio between money supply and the monetary value of GDP, i.e. the M/PY ratio (the inverse of the velocity of money).

The ratio between the money supply and the monetary value of total production. Will this ratio fall back down to normal heights through a deletion of money (some people want to "go German" in Iceland and adopt a "New Krona" a la Germany in 1948 when they basically wiped out a large part of the money supply to stop hyperinflation from happening - the "Wirtschaftswunder" happened somewhat as a result of that), through higher nominal prices (inflation) or through more production (GDP growth)?

So what will happen? Will the money just "hang around" there doing nothing or will the monetary value of total production increase? And if it does, will the monetary value of total production increase through higher nominal price level - i.e. will inflation happen - or will it happen through more stuff being manufactured - i.e. will GPD growth happen?

Maybe it wasn't such a good idea to allow the banks to create all that money in the early 2000s!

The Prophetical Talents of the Central Bank of Iceland

The Central Bank of Iceland upped its policy rates by 25 points yesterday to 6.0%. Quite frankly, I think they made a bad situation worse by doing so when it comes to the outflow of capital out of the economy and the exchange rate of the krona. But that's another story that I'm going to analyse later.

For now, I'm only going to update the graph that I first posted in The Predictability of Inflation Forecasts. Again, we can see that the inflation forecasts issued by the Central Bank of Iceland are still the same: take the current inflation rate and slowly diminish it towards the inflation target, i.e. 2.5%. No matter the rate of inflation today, it will always be down to the inflation target, or thereabouts, in 6-8 quarters (a phenomenon first pointed out by Fridrik Mar Baldursson at the University of Reykjavik). You seriously couldn't make this thing up!

The Quarterly Macroeconomic Model of the Central Bank of Iceland always predicts that the rate of inflation will move towards the inflation target in 8 quarters or so, no matter the current rate of inflation. The different lines are the inflation forecasts from different Monetary Bulletins of the CBI. The red line is the inflation target, 2.5%.

And has the Central Bank been accurate when it forecasts inflation? Not particularly so. But the inflation forecast of 3Q 2011 seems quite accurate, beside the fact that it's totally off in the beginning. Too bad they've changed their minds too often since then to really appreciate the accuracy of that forecast.

Forecasted inflation according to each Monetary Bulletin and the real measured value

As an example of a seriously flawed forecast, take a look at 2Q12 which came out in May 2012. At that time, they expected annual inflation to be 6.1% and 5.7% in end of 2Q12 and 3Q12 respectively. Notice that they are forecasting inflation for the same quarter (2Q12) as they are issuing it in. The measured annual rate of inflation was 5.4% in June 2012 and 4.3% in September 2012, way off of what was expected. Of course, once they had fed their forecasting model with the updated figures, the forecast was lowered.

Blatantly, nobody can take a forecast model which always expects inflation to go down to a predetermined figure seriously. All this is even funnier in the light of the Central Bank's self-praise in the "Post-crisis economic development and Central Bank forecasts" box in the newest Monetary Bulletin, pages 10-11. There, the Central Bank praises its November 2008 output growth (contraction really) forecast and says it was "virtually spot-on." This GDP forecast comes from the same model as the inflation forecasts.

Sure, the November 2008 forecast was too bad when it came to GDP growth. But I don't think the Bank is ever going to write the same sort of an egocentric self-praise when it comes to the July 2008 forecast where it foresaw that GDP growth would be -2.0% and -1.9% in 2009 and 2010 respectively. In reality, it was -6.6% and -4.0%. Well done boys and girls, you were so close!!

Furthermore, was the November 2008 forecast "virtually spot-on" when it came to inflation. Maybe it was as the model was accurate when it came to GDP growth. But I'm sorry, it was way off!

Not exactly the same accuracy in the inflation forecast of November 2008 as in the case of GDP growth. Notice that the model expects inflation to drop down to the inflation target in 7 quarters as it always does, no matter the current rate of inflation!