A plea to the future government of Iceland

Statistics Iceland released new figures on the labour market recently. According to them, the unemployment rate in Iceland continues to go down. It has reached 5.7% after having reached almost 8% in early 2011.

The unemployment in Iceland is slowly improving. I guess some nations would not complain too much about the rate of unemployment around 6%. 

But here is the catch: even though the rate of unemployment is coming down, the labour market is not improving much.

Next graph shows my point. We can see that during the boom years, the total working hours (estimated by multiplying number of people at work multiplied with the average working hours) increased sharply. This is to be expected as the real capital investments at the time (housing and dam construction to name just two) demanded a lot of labour. This demand for labour was answered by importing workers from e.g. Eastern Europe and China. 

Then came the crash and the total working hours collapsed along with the real capital investments. But so did the average working hours per individual in the workforce!

Despite the improvement in the rate of unemployment, the labour market does not show any other prominent signs of returning to normal levels. 

One reason why is the fact that not all of the foreign workers went back home. They stuck around, got an Icelandic passport, have assimilated into the Icelandic culture and have become Icelanders. Good for them!

The other more prominent reason is the fact that investment is all but gone! Investment as a proportion of the gross domestic product has never been at lower levels than now. I estimate that in order to get up to the more normal 20% ratio of investment to GDP, we need to expand real capital investments in Iceland by almost half: we currently invest around 245 billion ISK annually but we need 120 billion ISK more.

The level of investment in Iceland is puny compared to the level it should be at. We need roughly 120 billion ISK more to get up to the 20% ratio where we can expect the economy to be neither in an investment bubble a la 2005-2007 nor in a serious slump. 

The normal response of politicians in Iceland to too low level of investment has been to promise a new heavy industry project. An aluminium smelter is the classic!

But the track record of heavy industry investment in Iceland hasn't been that great. The energy is sold at too low prices (that was politics) and the negative environmental effects are affecting the more Thirlwall's Law friendly tourism sector. Basically, in the long run, the positive economic (and environmental) effects are more prominent in other major industries in Iceland. The classic "lets build a new smelter!" is a cheap get-out-of-jail card and shouldn't be used, again, if the long term prospects of the economy are to be held in high regards.

Rather, what is needed, is investment carried out by small companies, especially if they are domestically owned and operating in the export industry (as it would generate a much needed foreign currency income into the economy).

Tourism is an obvious choice, especially as it would generate a lot of long-term jobs (which the construction of yet another smelter does not). The long-term growth prospects of tourism are also excellent as the number of middle-income people, which can afford and want to travel, grows tremendously as the Chinese, Indian and other Asian economies grow (Thirlwall's Law kicks in).

Investing in more energy independence would also boost the long term prospects of Iceland tremendously! We have plenty of energy that can be used to fuel the car fleet of Iceland instead of running aluminium smelters. The net savings of foreign currency (less imports of oil-based fuels) and the consequential easing on the balance of payments constraint would be most welcome.

Other industries are waiting to expand and their expansion would be very beneficial for both the level of employment and the balance of payments: beer and alcohol brewing; computer games and other IT industries; and product development in food stuffs, especially fish and sea food, just to name a few.

But small industries need low level of uncertainty and access to cheap but steady supply of financial capital. And given the high level of uncertainty that is caused by the amount of capital that wants to get out of the economy ASAP, thereby killing the exchange rate and all cost-plans associated with real capital investments but only held back by the capital controls, we cannot be surprised that the level of investment is so low. What has killed investment in Iceland is uncertainty and that uncertainty is caused by the fact that still today, five years after the collapse in 2008, we do not know what will happen to the leftovers of the Icelandic pre-2008 boom. Those leftovers - financial capital - are waiting to get out but held back only by the capital controls.

There are general elections in Iceland tomorrow, Saturday. The most prominent problem of the post-elections government will be to fix the underlying problem of financial capital that awaits its chance to get out of the economy. While that problem is left on the table, employment, investment and the standard of living will not improve.

And beware, there are no easy ways out. Cheating on the problem by either pretending that it does not exist or by assuming that building another smelter - as some politicians unfortunately want to - will fix it will in fact not as what is needed is a long-term sustainable solution where other economically and environmentally friendly industries can maintain the level of investment; building a smelter without fixing the overhang of capital waiting to get out would be like putting a band-aid on a gunshot wound.

So I only have one plea to make to the future government of Iceland: fix the overhang of capital waiting to get out of the economy, get the level of uncertainty down and support small industries in their investment projects. Do this and you will probably be re-elected.

An interview with Exame

The following interview was with Jorge Rodriques, journalist of Exame in Portugal. This is the English version - plus some additions on the Minsky moment - but the Portuguese version is due later in the week. 

The original source is here. Jorge added some very informative and good details on the general economy and the ongoing criminal cases as well so please refer to his site for further info.

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Q: Analysts and economists all over Europe praised a lot the “Iceland miracle” of last decades. Until the Great Recession came. Iceland was in the 2000s the extreme example of the financialisation of the economy and the society, worse than the US, Ireland and Spain? 
A: It depends on how you look at it. Financialisation in the sense of just trading financial instruments in between the more or less same market participants was certainly more prominent in the case of say the US than in the case of Iceland. However, at the height of the bubble, the Icelandic financial industry share of GDP topped at 9.4% in 2005 and 2006. That’s a higher ratio than even in the US. That fact becomes even more shocking when one realises that in 1997 the share of the financial industry of the GDP was 4.6%. So in less than 10 years, the finance industry more than doubled its share of the GDP and reached higher levels than even in the case of US. So yes, from that point of view the financialisation of the Icelandic economy was probably even more extreme than in the case of many other countries.

Q: Another aspect of the “miracle” that is intriguing. What was behind the so-called “entrepreneurial neo-Vikings” and the entrepreneurial economy of last decades? 
A: Credit! Credit created out of thin air by the banking system, simple as that. We of course fooled ourselves into thinking that it had something to do with the Icelandic Viking spirit, the energy of the young (and inexperienced) leaders of the leading companies, the free-market movement of the 1990s, and even the rugged and “therefore” hardening Icelandic natural environment. But there was in essence no secret formula about the temporary prominent status of the Icelandic entrepreneurial Viking. He had credit, created by nothing by either a foreign bank he managed to fool into his scheme or the newly privatised Icelandic banks that sometimes he himself or his friends had a controlling share in. And, that was that.

Q: You are writing a book about Bad Economics and the impact in the Iceland economy. Iceland was the typical example of an economy that was ruled by bad economics? 
A: Yes, and it still is! But I must be absolutely clear on the point of the “bad economists”. I do not believe that any of the leading economists were or are “bad” in any sense of that word. I believe all of them were acting in absolutely good faith, trying to improve the economy and society. But intentions are not enough if you don’t have the tools.

Q: Which theories and schools of Economic thought must be blamed? 
A: The tool that failed spectacularly was the neoclassical school of economics. Only a small handful of economists did not rely on this, unfortunately, globally ruling way of doing economics. They were the only ones that were not blinded by neoclassical theories when the bubble began to expand beyond point of no-return. But when they tried to warn the community about what was happening the neoclassical economists ridiculed them, not because they were “bad” but because they were blinded by their faith in neoclassical economics.

HIGHLIGHTS
«I must say that the Icelandic case was a quintessential example of the Minskyian theory»

Q: Can we say there were signals of a “Minsky moment” – from the name of the North-American economist Hyman Minsky that from early 1980s talked about a systemic financial process risking a new big Recession like the Great Depression of the 1930s – coming for Iceland in the end of the 2000s?
A: It’s always tough to pinpoint accurately when the exact Minsky moment arrives. But Minsky “Financial Instability Hypothesis” was certainly proved to be the most accurate economic thesis in existence when the Icelandic boom-and-bust cycle took place. I must say that the Icelandic case was a quintessential example of the Minskyian theory.

Q: How?
A: [The way up was very much like Minsky predicted. The atmosphere was euphoric, everybody wanted to make a quick buck! After a very short contraction period in 2002 the economy bounced back. Confidence grew again and when the banks were privatised in 2003 the economy boomed, driven by credit creation by the banks and people's confidence. When the credit sparked asset price inflation, all the Johns and Joneses jumped on the bandwagon and used credit to buy existing assets. An asset boom developed hand in hand with the foreign direct investment flow that was due to construction of aluminium smelter and a hydro dam in the east part of the country. Everybody forgot the lessons of 2000 and 2001 when the credit boom that took place then fuelled a stock speculation boom in Decode Genetics. That exploded fantastically! A short sober moment arrived in 2006 but the self-delusion was too strong and people reinforced their beliefs in the Icelandic miracle after the 2006 doubts had been wiped out. Foreign currency loans took over the indexed ISK loans as the main credit device fuelling the boom. Then finally, the asset price inflation slowed down and the Ponzi-positions began to lose out. Liquidity squeeze shortly followed.]

When it comes to the downturn especially we can, e.g. notice that the stock index topped above 9000 points during the summer of 2007 before finally collapsing below 500 in 2008. The liquidity shortage was also very much as Minsky predicted and the margin calls became more and more prominent. In 2008 the Central Bank stepped in and tried to supply liquidity into the market, but it didn’t suffice to stop the avalanche.

HIGHLIGHTS
« Yes, there is growth again in Iceland, but there is unfortunately not much behind it.»

Q: As you know today Iceland is a near-myth again because the island is returning to “broad based growth,” said the IMF mission chief to the Icelandic program. Are we assisting to an adjustment “miracle” praised by the IMF? 
A: Yes, there is growth, but there is unfortunately not much behind it. The reason I say this is that when we dig deeper into the national account figures they kind of lose their surface charm. Gross investment is, e.g. still meagre 12-15% of GDP, which is hardly enough to maintain the base of productive capital in the economy. The present 4.7% unemployment rate [from a peak of 9.3 percent two years ago] does not include those who have given up on looking for a job and have either moved out of the country [in 2011, Census reported that 8% of population migrated mainly to Norway] or decided to go back to school, sometimes just to do something. As a signal of the stagnant labour market, the average number of worked hour per individual in the working force has been stagnant since 2009. And, interest rates are still too high, which is an especially poisonous goblet when the indexation of mortgages is mixed with it. Also, the banks and the State sponsored Housing Financing Fund (HHF) are not very eager to liquefy their stock of empty houses and flats, due to their fright of crashing the housing market by doing so. As a clear sign of that, the HFF repossessed 501 flats and houses during the first six months of 2012, but sold only 58 flats at the same time. Finally, the number of individuals with severely delayed repayments of their debts is still rising.

Q: But there’s no reason for optimism, more than in Ireland or Portugal, the so-called “good pupils” of the troika medicines?
A: There is growth, but it is froth. I do not see much reason for any spectacular optimism about the long-term future of the Icelandic economy. The structural deficits that got us into the hole we’re still trying to dig us out of are still there and that is what makes the long-term difference. We have to fix those if we are ever to have a stable economy.

Q: What you mean by “structural” problems?
A: The structural problems that I have in mind are specifically the indexation of mortgages and the pension system, which not only has a huge funding hole but influences the financial market strongly due to its size. The effects of those problems push up the rate of interest and introduce structural financial instability into the economy, instability that does not have to be there and is not caused by anything else. Fixing those structural problems would strengthen the financial stability in Iceland to a significant and notable extent. But work is going too slowly in that field, those problems are still around.

Q: In Iceland there was not TBTF (too big to fail) banks and TBTJ (too big to jail) banksters or government officials? 
A: I cannot comment much on the TBTJ, the Special Prosecutor is investigating the cases that end up on his table and we must be patient and allow him to do his job. He has landed some victories though, such as the conviction of the ex-finance ministry undersecretary Baldur Gudlaugsson [This was the first time an insider dealing case has ever been tried at the Supreme Court of Iceland. Baldur was found guilty by the Reykjavík District Court on 7th of April 2011 and sentenced to two years behind bars. An appeal against that decision fails in Supreme Court in February 2012] and the “Exista case” [Exista is a financial services firm founded in 2001 by a consortium of Icelandic savings banks as a vehicle to hold shares in Icelandic Kaupthing Bank. A controlling shareholding in the firm was sold to a holding of the brothers Ágúst and Lýdur Gudmundsson in 2002. An IPO went on 2006 in Iceland Stock Exchange for €2.6 billion, the biggest IPO in the country's history. By October 2008, Kaupthing Bank was forced into government receivership, it was nationalized de facto. In July 2009 Wikileaks exposed a confidential 210 page document listing Kaupthing's exposure to loans. The bank had loaned billions of euros to its major shareholders, including a total of €1.43 billion to Exista and its subsidiaries which own 23% of the bank. In January 2010 law enforcement agents from Britain and Iceland searched the premises of Exista in a probe related to the trading of shares in other companies].

HIGHLIGHTS
«The whole Icelandic financial system went down the drain, but the payment system was maintained thanks to tremendous efforts by the staff of the Central Bank.»

Q: And regarding the TBTF banks?
A: The question of TBTF banks is very interesting in the case of Iceland, however, and I think it deserves more attention than it has gotten. The definition of a TBTF bank is that it is too systematically important to be allowed to fail since otherwise the financial system would collapse, general commerce in the wake of that and consequently the whole economy. But that didn’t happen. Yes, the whole financial system went down the drain, but the payment system was maintained thanks to tremendous efforts by the staff of the Central Bank. And, since the payment system was kept intact, commerce kept on and the economy did not crumble entirely. We could still buy our pints of milk and bakeries still baked their breads. And, they kept on accepting card payments.

Q: How it happened the “miracle”? 
A: The reason for why the payment system did not collapse was that it is centralised entirely through the Central Bank itself. That means that the Central Bank can allow a bank, no matter how big it is, to go under since it isn’t a clearing bank for any of the general every day commerce that everybody expects to be able to do. This is not the case in many countries, such as the UK. This structure of the payment system – the Central Bank is the only clearing bank of the whole payment system of everyday commerce – was the essence of why the payment system did not collapse even though 90% of the banking system, by assets, went bankrupt in a time span of only a week. This is the fundamental lesson for other nations: channel the whole payment system through the Central Bank and no bank is too big to fail when it comes to every day commerce.

Q: What kind of fiscal austerity measures were adopted that permitted the fiscal deficit cut from near 14pc of GDP at the end of 2008 to 5.7pc for 2011?
A: Well, the 13.8% fiscal deficit in the last quarter of 2008 was a one-off cost: it includes the new equity injection into the Central Bank (yes, the equity of the Central Bank of Iceland was wiped out in October 2008 – the Central Bank went bankrupt!). So let’s make sure not to think that the politicians have managed to cut the deficit from 14% of GDP to 5.7% by austerity alone. The austerity measures in Iceland were in fact not as severe as in say Spain, Portugal or Greece. The welfare system was more or less maintained, beside extensive cuts in health care to such a level that they have had to use sticker tape to temporally fix some of the cancer treating equipment in the main hospital in Reykjavik. Health service outside the capital has also been guillotined quite severely. Taxes were raised as well. A special net-wealth tax was adopted, VAT was raised, now commonly 25.5% though lower steps exist as well, and the tax rate on wages was increased. Same goes for taxes on capital gains, now 20% instead of 10% before. Personal tax return for individuals was increase as well however, having the effect that most of the increased tax burden was carried by the richer part of the population.

HIGHLIGHTS
«But the currency crash – the depreciation of the krona – also caused inflation and that led to higher principals of our debts, debts that many people will never be able to repay.»

Q: The depreciation of the krona was the main tool for the adjustment? 
A: Yes, the crash of the krona was the main tool of the external adjustment. It however, lead to even further internal imbalance since the crash of the exchange rate lead to increased inflation and that increased the principal of the inflation-indexed mortgages and many other debt instruments. This imbalance is still being dealt with and it will take a while.

Q: Can you explain better that downside risk? 
A: Yes, this needs some explanation. The mortgage system in Iceland is such that the monetary value of the principal increases hand in hand with the inflation. So if one borrows say 100,000 kronas mortgage and the inflation rate is 5% over next year, the debt increases up to 105,000 kronas. Then, the repayments are made, but the repayment of the increase of the principal is spread out over the whole remaining loan period. The currency crash therefore had the effects of increasing the competitiveness of Icelandic goods, thereby allowing us to rebuild the economy on the basis of exports and tourism. But the currency crash also caused inflation and that led to higher principals of our debts, debts that many people will never be able to repay.

Q: It would be better if Iceland defaulted in its sovereign debt and implemented a full restructuring debt process?
A: No, it would not. It would, however, be a good idea to carry out some sort of debt jubilee for the private individuals and enterprises in the economy. And, that can be done, the only thing that is needed is the political will to do so. But if the State defaults on its debts we would probably have even more serious problems on our hands. Yes, national States have defaulted on their debts before and later arisen out of their economic ashes like the phoenix, but it is a high risk and absolute last resort measure. But in some cases, for example some present economies in the Eurozone, such last resort measures are exactly the ones that are needed. But the finances of the Icelandic State are not, yet that serious. So sovereign default is probably not a good idea for Iceland, at least not yet.

Q: Would you refer specific “growth policies” pursued by the government? 
A: Not in particularly anything else than those that aimed at lessening the hit of the financial crisis immediately after it happened. The fight against IMF-demanded austerity should be highlighted though. There is a plan to get government funded investment going during the years of 2013-2015. Included in that plan is, e.g. general road network maintenance and increased subsidies to high-tech and technology development funds, etc. The financing of this plan is meant to come from road tolls and fees on fish catches, born by the fishing industry. This may not become realised, however, as there are general elections next spring.

HIGHLIGHTS
«The question about who are the real owners of the Icelandic banks is very good: we do not know! People have speculated a lot about this. Foreign shark hedge funds are one theory, the old domestic “entrepreneurial Vikings” is another and on the theories go.»

Q: If the sovereign debt skyrocketed after 2008 can we say it was for a good reason, for the relief of the households and corporations debt? Or the so-called debt forgiveness is another myth? 
A: The severe increment of government debt after the 2008 was first and foremost due to the rescue of the Central Bank of Iceland which lost the equivalent of about 20% of GDP when it lent money to the banks against lousy collateral. When the banks went bankrupt, so did the Central Bank. The cost of injecting new equity into ended on the shoulders of the taxpayer. That cost was around 400 billion ISK according to The Icelandic National Audit Office. The so-called debt forgiveness of household and corporate debt did not cause any severe, if any when everything is taken into account, cost for the State. The banks bore all the “cost” but it effectively did not impair their equity at all. The reason for that is that when the new banks were established on the foundations of the fallen ones, the assets were booked in the new banks at about 40% discount. A 100,000 krona loan became a 60,000 krona loan on the books of the new banks. This magic did not, however, continue to the borrower himself, he still owed the bank 100,000 krona. It was this discount that was used to cancel the majority of the debt that was actually cancelled. In February, the households had been forgiven 196 billion ISK (12% of GDP) but that was pretty much all outweighed by the indexation of mortgages, so the net cancellation was rather limited. Firms got a lot more cancelled, around 550 billion ISK. And, of course, not everybody got the equal amount cancelled. Eight firms got cancelled the total of 205 billion ISK. In fact, most of the firms that got debt cancelled were asset holding firms, many of them totally empty of assets after the collapse. So their debts would have had to be cancelled anyway, simply due to the liquidity process behind their bankrupt itself.

Q: After the banking restructuring, who benefited most from it? Who are the real owners of the Icelandic banks today? 
A: I think this must have been the most indebted firms that benefited the most, simply because they got the most of the debt cancellation. And, the question about who are the real owners of the Icelandic banks is very good: we do not know! People have speculated a lot about this. Foreign shark hedge funds are one theory, the old domestic “entrepreneurial Vikings” is another and on the theories go. But quite frankly, we simply do not know.

DIFFERENCES WITH THE TROIKA EUROZONE BAIL-OUTS

«If the austerity had been as unforgiving as the one that is in mainland Europe the Icelandic economy would not have been given the breathing space to recover from the shock.»

Q: What are in your view the main differences of the Icelandic strategy relative to the adjustment programs adopted by the so-called troika EU/ECB/IMF in the Eurozone?
A: The Icelandic austerity was not as severe and the increment in taxation was more directed towards the richer end of the populace. I believe that was the right thing to do, if the austerity had been as unforgiving as the one that is in mainland Europe the economy would not have been given the breathing space to recover from the shock. Socially, it was probably healthier as well to let the rich carry most of the austerity burden, otherwise we could have had general riots and another “pots and pans” revolution. Another important difference was that we were capable of allowing the currency to devalue and that helped although the homemade structural deficits of indexing debt to the level of consumer price probably just switched out the problem of external imbalance with an internal one. Being able to allow the banks to go under while maintaining the payment system was a huge advantage as well.

Q: That is one of the “lessons” that you think universal…
A: Yes. The Troika could learn tremendously of the Icelandic experience in that case, it would save them the problem of having to save the whole banking system repeatedly. Banks should, as any other firms, be allowed to go bust! Finally, there were some debt cancellations although they were more or less just to wind down part of the indexation problem when it comes to the households in particular. But debt cancellations are doable; one just has to find the political courage to carry them out.

Q: How did Iceland deal with the IMF? 
A: IMF did propose more austerity and did for example propose more severe cuts in the welfare system. That was refrained and probably for the good. The adjustment process, especially the cut in fiscal deficit, was slowed down in comparison to the IMF proposal.

Q: Will Iceland abandon the krona and adopt the Euro, or it will choose a different strategy searching a non-European currency? 
A: I cannot say. The official stance is to gain entry into the EU and adopt the Euro. But to fulfil the Maastricht guidelines on Euro could take us as long as a decade and the EU will have transformed significantly in as short time as half that. So to adopt the Euro will probably take us a while, given that there will be political will after the 2013 elections to finish the EU entry process.

The new GDP figures

Statistics Iceland issued new figures on GDP growth three days ago. As I've been flat chat in finishing my PhD I haven't had the time to dig into them properly until now. They tell us pretty much the same as the last figures: the economy is fragile and a wolf would not have to huff and puff much to blow it down.

First of all, the GDP growth of first six months of 2012 was estimated to have been 2.4%. The previously posted 3.1% growth of 2011 was reevaluated downwards to 2.6% - there goes any reason for the central bank to up the policy rates further! GDP per person is still way below what it was before the crash happened: five years later we are still only getting 91% of the GDP per person we had.

Still long way to go! Although the economy is slowly bouncing back the GDP levels per person are still meagre 91% of what they were 5 years ago.

Furthermore, and what is most important, the investment levels are still laughable in historical context. Total investment has still not gone up above 15% of GDP when the normal ratio should be close to 19-20% or thereabouts. Industry investment is only slowly coughing its way upwards when in fact a lot more investment is exactly what the economy needs! But no need to be surprised about that: the offshore krona problem is still around and interest rates are too high. Is it any wonder that the economy is not bouncing back properly!

A very severe problem is in fact arising due to the low investment levels: we are not keeping up with amortisation! The machines we use to produce whatever we are producing are breaking down faster than we can replace and fix them. To expect a proper economic recovery with reducing capital stock is like expecting to be able to run faster when you're 80 years old than when you were 25.

Investment, especially industrial investment, is still only a shadow of itself. Categorised figures only stretch back to 1997 but next graph shows how slowly total investment is recovering.

Total investment (blue line) is still insufficient. Investment is in fact so low in fact that we are not managing to keep up with the amortisation of capital with the obvious consequence that the stock of capital is reducing (red line, right axis). How exactly are we going to improve productivity for the longer run if investment is not even enough to keep up with the amortisation? Red dot is 1H2012.

As expected, when investment is low the level of employment is as well. A break in the correlation between total investment and unemployment seems to be visible after the 2008 crash. The effects of emigration on the employment figures should not be taken lightly. Employment will not bounce back until the level of investment recovers.

A structural break seems to be present in the data on unemployment and investment levels after 2008. A likely explanation is the emigration to e.g. Norway and other popular post crisis destinations of the Icelandic worker. 

A reposted figure from Unemployment in Iceland. Don't expect the total number of worked hours per worker to grow much while the level of investment is as low as it is. The GDP growth is a froth! 

Unemployment in Iceland

Two weeks ago, the Minister of Economy, Business and Industry (yes, he's all three!) Mr. Steingrimur J. Sigfusson wrote an article with the headline (translated) "Unemployment dropping fast". The reason: registered unemployment in Iceland had dropped down to 4.8%. That's pretty fine for an economy whose banking system collapsed in less than a week four years ago! Well done guys!

Not so fast! Sorry, but I'm constantly the pessimistic guy digging a bit deeper than just repeating what the headline data told us.

OK, so three weeks ago the registered unemployment rate in Iceland registered at 4.8%. That was the data for June. This column graph is copy-pasted from the monthly report by Directorate of Labour. "Atvinnuleysi" is "unemployment" in Icelandic. Click to enlarge.

The DoL data is based on how many people receive unemployment benefits. That can be pretty limited if a) the rules regarding unemployment benefits do not apply to those who want the benefits, b) there are people who have given up on looking for a job and left the labour market and e.g. went studying, c) people have left the country or d) people want to work more but cannot because there isn't a job available.

Another data source for unemployment is the data bank of Statistics Iceland. The monthly data there tell a bit different story than the ones from the DoL. They are after all better, yet not truly adequately, defined than data from the DoL. Important definitions by the Statistics Iceland include:

Employed. People are classified as working (employed) if they worked one hour or more in the reference week or were absent from the work they usually carry out. Individuals on birth leave are considered absent from work if they went on leave from a paid job, even if they have no intentions of returning to the same job.

Unemployment. Persons are classified as unemployed who have no employment and satisfy one of the following criteria:
1. Have been seeking work for the previous four weeks and are ready to start working within two weeks from when the survey is conducted
2. Have found a job which will begin within three months but could start working within two weeks. (Until 2002 the criterion was that it sufficed for the job to start within four weeks without it being investigated whether the person involved could begin within two weeks.)
3. Await being called to work and are able to start working within two weeks
4. Have given up seeking work but wish to work and could start working within two weeks.
Students, including those looking for an apprenticeship in a trade, are only considered unemployed if they have been seeking a job along with their studies or a permanent job for the past four weeks and are available to start work within two weeks of the surveys occurrence.

Outside the work force. People are termed outside the work force if they are neither employed nor fulfil the conditions for being unemployed. The labour force is considered to consist of employed and unemployed persons.

The graph below shows the unemployment according to the Statistics Iceland data. The data has been smoothed with a 12 month moving average. 

OK, so unemployment is coming down. But is that enough?

No, it isn't. What counts must be the total hours worked in the economy. And that dropped like a stone in the crash and isn't coming back up, at least not seriously.

Total weekly worked hours in the Icelandic economy. Although unemployment is slowly coming down, total worked hours isn't steaming upwards.

We can use these data on total worked hours and divide them on the total number of people in working age and the total labour force.

Total worked hours has dropped significantly as previous graph showed, down to 2004 levels. But since the labour and man force have grown since 2004, the average working hours per individual in the workforce has taken a considerable dive. And on the bottom it stays.

Suddenly, the 4.8% unemployment according to the unemployment benefits estimate isn't that impressive anymore. Weekly worked hours per individual in the labour force is damn stagnant and has in fact dropped significantly after the October 2008 crash and stayed down. Realise that if weekly worked hours drop by around 4.6 hours, as they have done, the total monthly worked hours drop by around 19.8 hours.

Give yourself that the average person earns perhaps 10-15 pounds per hour (2000 - 3000 ISK or so) and the total lost monthly wage income is around 200-300 pounds. That's around 38,000 - 57,000 ISK per month if the pound is 190 krona.

So what happened? Why is the unemployment coming down?
We can see on the two first graphs above that the unemployment, even according to the Statistic Iceland methodology, is coming down. Yet, the total worked hours per person is lingering at levels that can hardly be present in an economy that is returning from a bust. So what happened?

Emigration happened. And despair about getting a job, resulting in a huge number of people outside the labour force, happened.

First, emigration was quite noticeable after the collapse. Droves of people, both immigrated travel workers that moved to Iceland during the boom years and Icelanders, left the country. Of course, they are then neither registered as unemployed nor are they in the man or labour force. That drives down the rate of unemployment. Many of those people left simply because they couldn't get a job.

Immigrated minus emigrated people, in thousands. After the collapse in 2008, a noticeable part of the workforce has simply left the country. That has had positive impact on the data on unemployment.

Second, people lost hope. They simply left the labour market. Both the University of Reykjavik and University of Iceland said that record number of new students had been admitted into the universities. One can only speculate how many of those people got back in the classroom because they couldn't find anything else to do.

This actually shows in the data. A record number of people have left the labour force, simply because they cannot find anything to do. There are no jobs around, they lose hope about getting a job, stop looking and they are therefore unregistered from the labour force according to the Statistics Iceland methodology. And people outside the labour force are not unemployed according to the data - although in reality they may well be!

When the collapse in 2008 happened, the trend of people leaving the labour force had been going on for around a year already. After the October 2008 collapse, the trend has been all but upwards. At the same time, record number of people have registered themselves in tertiary education, quite likely because they have nothing else to do. 

Checking the number of people outside the labour force as a percentage of the total man force does not make much difference.

The lack of employment has pushed record number of people out of the labour market, no matter if one looks at the number itself or the ratio of labour force leavers to total man force. 

So I'm very very sorry. Although measured unemployment is coming down, the main reasons for it are not increased employment or increased number of employment opportunities - that would show itself in increased number of worked hours per individual in the labour force - but people giving up on looking for a job. They leave the labour force either by educating themselves or by leaving the country. Of those active in the labour force, the average income is in the meanwhile perhaps 200-300 pounds lower than it was in 2008.

Unemployment in Iceland is not 4.8%. That's lies, damned lies and statistics.

A bit more on the living standards

A very quick note on the living standards in Iceland and the question of how far they collapsed in 2008.

I implied that the answer to the question depends on whether one measures the wages in Iceland in foreign currencies (SDRs) or in the Icelandic krona. The ISK-denominated wages haven't crashed anything close to the SDR-denominated wages. So the question is: which one is a better measurement?

The fact of the matter is that it must be a personal matter. A family of four living in Iceland who never travels to foreign countries does not feel the pain of the krona collapse as much as the one who goes to Spain every summer.

And as almost always, there are politics behind which measurements you want to use. If you want to claim that living standards in Iceland have collapsed due to e.g. the wrong government policies, you pick the SDR-denominated wages. If not, you use the other figures. If you want to say that unemployment in Iceland is low at the moment, you compare it to Spain. If you want to say that unemployment in Iceland is high at the moment, you compare it to the historical average.

Anyway, I was looking for data for my PhD and came up with this comparison shown in the graph below. I must admit that I find it quite remarkable how the Gross National Product plummeted in the crash while the Gross Domestic Product only dipped a bit more than slightly.* And here comes another weird question: why is it so that US statistics use GNP so often while European stats use the GDP? Why isn't GDP or GNP used in all countries? Which one is "righter"?

GNP of Iceland dipped considerably more than the GDP. Which one is a better measurement of nation's living standards?

Then it is the comparison matter. How is Iceland doing in comparison to other economies? According to the Better Life Index by OECD we seem to be doing all right. Life in Iceland is not all too bad really, at least if you compare it to other countries. But if you want to say that life is horrible, you don't compare it other countries. You compare today's life with the credit-fuelled good times of 2007.

A screen shot from the Better Life Index website of OECD. Check out Iceland's figures here.

So what are we talking about again? How much living standards fell or how to define living standards?

Back to work, have to finish this thesis one day!

*For those of you who do not know: Gross National Product is the sum of value of all products and services made by the citizens of a country, no matter where they are in the world. Gross Domestic Product is however the sum of value of all products and services made within the borders of the country.

A car made in France by a German company is therefore a part of the GNP of Germany but part of the GDP of France.

Is Iceland OK now? Economic figures comparison

I have been silent for a while here, apologies for that, as I'm on a vacation in France and working on the last draft of my PhD thesis on the sideline. Some exciting updates - from a nerdy point of view - coming up though and once the thesis is out of the way I'll get into proper research for the book I'm (supposedly) writing on the Icelandic economy.

Anyway, the hottest buzz on and about Iceland nowadays is that it's out of the recession.Gylfi Zoega, one of the foremost professors of economics at the University of Iceland, and a member of the monetary policy committee at the central bank of Iceland, said the recession was over. Krugman, who seems very fond of Iceland (come on over again and spend your dollars, we need them!) said that the country had broken all the rules, contrary to Ireland, "and things are not too bad."

Not too bad indeed: 4.2% GDP growth between 1Q12 and 1Q11. Iceland is back on track! How about "une petite coupe de champagne?"

Anyways, I've got my (usual) doubts and I've expressed them repeatedly (such as here, here and here). So as I was paging through the newest issue of The Economist I decided to use the figures at the back there to throw up this comparison of economic figures from all over the world.

Figures from the newest issue of The Economist. Iceland's figure are from Statistics Iceland or calculated by myself. The CA/GDP figures are estimates for 2012, same goes for the Budget Balance figures. In the case of Iceland, I use the total CA/GDP figures (-7.0%) but some want to exclude the old banks from those figures since they are in receivership. If skipped, the figure drops down to -0.1%. Click to enlarge.

This table can be fuzzy to read on its own to judge between the economic health of the economies in question. So I used the figures there to construct the following simple comparison table.

The following table does nothing but to give "points" to countries according to their relevant position to the other ones. As an example, the GDP growth in Greece is worst, so Greece gets 1 point for GDP growth. China is on the top, so they get 18 points for GDP growth. Likewise, only Iceland has worse current account deficit than Greece so the Mediterraneans get 2 points for that comparison. The total points of all the countries are then summed up in the right most column.

Looking at this table, Iceland's 4.2% GDP growth isn't so impressive any more. Like I said almost a month ago "well, yes, there is growth" but unfortunately, there seems to be not much  more. Iceland's "not too bad" economic performance is still pretty damn bad.

The comparative rankings of economic figures, using the data in the previous table. Norway wins (98 points) followed by Germany (82) and Sweden (80). Greece loses (23 points), Spain gets 29 points and Italy 34. Iceland is next (35 points).

The "economic points" of each nation (same data as in the table). Well done Iceland, you're in league with the best!

P.S. When are we going to start talking about the budget imbalances of Netherlands? Is 5.1% budget deficit just a-OK because Spain is rocking it at 6.5%?

(edit: 21:50) Initial calculations were wrong on the budget deficit comparison. That has now been corrected.

The New GDP Figures

Statistics Iceland issued a new set of quarterly GDP figures for Iceland just before the weekend. The results: 4.2% real growth (seasonally adjusted) between 1Q11 and 1Q12. The Minister of Economic Affairs - or his assistant as the Minister of Economic Affairs is also the Minister of Agriculture and the Minister of Fisheries - immediately wrote an article in the most read newspaper, saying that "the [economic] improvement had been thoroughly confirmed."

Well, yes, there is growth! But not because the government is doing anything about it - it's always easy to have a comparatively better economic situation than during an outright economic collapse - and rather simply because Koo's balance sheet recession bounce-back is in play.

I wrote about in December: the Icelandic economy was in a "Lehman Brothers shock" where the actual bankruptcy effects and the sheer collapse of the financial system had been the main contributor for the collapse in GDP. But once the financial panic cleared out of the system the GDP growth came back, automatically, as the economy calmed down. In the meanwhile, balance sheet recession was inevitable since too much corporate and household debt made it impossible for the economy to grow at a rate that was even close to what it had been growing at before.

I might be fooling myself and under the spell of Galbraith ("faced with the choice between changing one's mind and proving that there is no need to do so, almost everyone gets busy on the proof") but I'm going to stick to that case: the Icelandic GDP growth is due to an automatic bounce-back from the financial collapse and panic and the "thoroughly confirmed" economic improvement is in reality an economy that is burdened with a balance sheet recession.


I've got some points to argue why:

1. GDP growth is considerably lower now than it was before, even measured in ISK. Notice how comparable the quarterly GDP growth figures are to Koo's "Lehman Shock" theory (see next set of figures).

Growth in GDP, measured in ISK, is still below what may be considered as historically normal. The sluggish growth is a sign of a balance sheet recession where debt and debt deflation are holding the economy back.

2. The above GDP growth figures are in the domestic currency. Icelandic GDP measured in Special Drawing Rights (SDRs) is merely the shadow of itself - a 65% shadow of itself to be exact since the value of Icelandic GDP has collapsed by 35% since its top in 2007. Admittedly, this is better than the horrendous 45% collapse straight after and during the collapse but again, that is an automatic bounce-back from the panic and not genuine "thoroughly confirmed" return of economic health.

Icelandic GDP measured in non-CPI deflated SDRs (billions of SDR per quarter). Compare the Iceland's GDP growth figures to Exhibit 16 from Koo's paper

3. Investment is still not coming back, causing historically very high unemployment. I know +7% unemployment may not sound much in the ears of a young unemployed Spanish person but for Iceland, that's pretty high. Those are, as far as I can figure out, numbers that are more or less comparable to U-3 unemployment (no U-6 unemployment figures are available).

Investment as a share of GDP, four-quarter moving average. Investment has hardly bleeped above 15% of GDP while it needs to be much closer to the 20% value to be considered "normal".

4. The debt deflation is quite simply so obvious in the the new Central Bank's data on financial stability that we need not discuss the matter any further. The Icelandic economy is in full-swing debt deflation! And contrary to what the Central Bank might think, raising the interest rates is not the right thing to do in such a situation!!

Debt of Icelandic households, % of GDP. Blue = indexed; purple = FX linked; orange = nonindexed loans, comparable to normal mortgages in Europe; green = overdraft; dark blue = leasing contracts

Number of individuals on list of deferred payments (red line: number of bankruptcies and unsuccessful attached properties)

Debt of non-financial corporates as % of GDP. Blue = CPI indexed; purple = nonindexed, normal loans; orange = FX linked (great idea, lets mostly indebt us in foreign currencies!!)

Debt of non-financial corporates, European comparison (% of GDP). Does anybody know the Icelandic word for "debt deflation"?

So I'm afraid I'm just as bearish as before: the Icelandic economy is in the fastest debt deflation process that I've ever seen. 

The main thing that makes this possible is the around 40% discount the Icelandic banks received as their "birth gift" when they were established in 2008: the loan portfolio was transferred from the old banks into the new ones at a 40% discount which was not forwarded to the borrowers who saw their debts, in many cases, grow in monetary terms due to indexation of mortgages. 

As long as the banks are milking out the discount they received in 2008, the economy will not collapse entirely again. But that's only for the short term. If the debts are not gotten rid off, the problem will persist. And the intrinsic systemic factors lead to ever growing value of debts, due to high interest rates and indexation on mortgages. The financial system has to be reformed bottom up - pension funds and indexation are on the top of the list and close thereafter is the monetary policy - simply because it will not stand the test of time in its current form. The Icelandic financial system is built to collapse, just as it was before 2008.

The Rate of Interest and the Nominal Monetary Target

Jeffrey Frankel's article "The Death of Inflation Targeting" and my comment on a Facebook link of a friend to it are the soil of this post. In the comment I said that it was a shame people did not understand that the classical/neoclassical/Austrian theory of rate of interest being the price of waiting to spend your money was wrong. I was asked to clarify better what (the Hell!) I meant and how it was connected to the Death of Inflation Targeting. 

The classical theory of rate of interest
Most of us and all of us who went for Econ 101 know this theory. Higher interest rates spur people to save higher part of their income and at the same time those same rates cause investment, which is funded with the savings of people (savings must come first, investment follows... also incorrect but that matter is somewhat out of the reach of this post), to decrease as rates becomes higher. In "equilibrium" the savings and investment schedules meet and that is where the rate of interest and amount of savings and investment is decided.

The well-known supply-demand diagram of how interest rates are decided according to the amount of savings and investment in the economy.



This is the static theory of rate of interest: rates get higher and people will save more, no questions asked. This is of course nonsense, otherwise how would one explain situations like this one?

A question in a survey I asked people to participate in. Higher rates don't seem that interesting if you cannot access your money. Obviously, the number of responds might not be significant enough, but you get the point: higher rates don't necessarily mean that people jump automatically on that bandwagon as the static theory of rate of interest implies. 

 

The classical dynamic version is that people ask for the rate of interest because they are willing to wait for that price (rate of interest) for their chance to spend their money. The longer you wait the higher rates you will get. Interest rates are the price of time according to this theory. This seems like the most accepted view of most economists and it’s an old one. It is essentially built on the idea that interest rates are decided on where the marginal disutility of waiting to consume (save) is equal to the marginal productivity of capital (I’m not going to get into how flawed the terms “marginal disutility of savings” and “marginal productivity of capital” are).

Hayek (Austrian) held that interest rates reflected the collective (market) preference of individuals to consume now rather than later. If people wanted to consume now, interest rates would have to be high in order to get them to save part of their income until they could use it and the accrued interests for consumption later.

Mises (Austrian) was of the same opinion: “Interest is the difference in the valuation of present goods and future goods; it is the discount in the valuation of future goods as against that of present goods” and “The greater the fund of means of subsistence in a community, the lower the rate of interest.”

Hicks (neo-Keynesian, the one who thought he grasped Keynes’s General Theory in the IS-LM model but apologised for his faults later): “There are other instruments of economic policy which can attain the same objective as a rise in interest rates; and some of these may well be less destructive instruments. But we should not forget that in these days of scarcity time is short; and the rate of interest is the price of time.” (1947, ‘World Recovery After War – A Theoretical Analysis’ my emphasis).

Marshall (neoclassical): “Interest, being the price paid for the use of capital in any market, tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming at that rate”.

So the rate of interest is the price of waiting according to the classical/neoclassical/Austrian theory. A rather convenient corollary of this – note especially the latter quote from Mises – seems to be that the only thing needed to decrease the rate of interest in the economy is to get the public to save more: if the public increases its savings, the supply of investment-funds increases and, given the same investment schedule, the rate of interest lowers and investment increases exactly by the same amount of increased savings.

This view of the origin of rate of interest has never been proven to apply in practice. And it is of course very very flawed once one takes a step back and thinks about it.

“This is a nonsense theory”
Keynes declined the classical theory out of the simple observation that it was inconsistent with the assumptions it rested on:

The independent variables of the classical theory of the rate of interest are the demand curve for capital and the influence of the rate of interest on the amount saved out of a given income; and when (e.g.) the demand curve for capital shifts, the new rate of interest, according to this theory, is given by the point of intersection between the new demand curve for capital and the curve relating the rate of interest to the amounts which will be saved out of the given income. The classical theory of the rate of interest seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down. (from the General Theory, Chapter 14, my underlining)

So Keynes had to come up with another theory since he realised the classical theory was useless for the simple fact that one cannot both eat the cake and keep it.

Keynes’s Liquidity Preference Theory of Rate of Interest
Keynes’s LPT was based on the sober observation that savings could be kept in many different forms. It wasn’t the amount of savings that decided the rate of interest, as in the classical/neoclassical/Austrian theory, but the form which the savings were kept in. 1,000 euros kept in cash are just as much of savings as 1,000 euros kept in corporate bonds. If people were willing to shift from one form to the other, interest rates would change. How people saved mattered, not the amount they saved.

A simple way to show the subtle difference is hopefully the following. A man has 1,000 euros in after-tax income. He spends 900 of them in living expenses (consumption) and the rest is savings.

Now the question he must ask himself is the following: “will I possibly need the 100 euros I’ve saved this month in case something happens in the near future that calls for unexpected expenditures that I cannot meet with my regular after-tax income? If so, I need to keep the savings in a form which I can easily access to meet the unexpected expenditures. If not, I can keep the savings in a form that could possibly take me days or years to access.”

If the man thinks he needs the cash in near future, he will keep it in liquid form, such as cash, which yields no rate of interst, or a demand-deposit bank account which he can withdraw the money from any time he wants. But at the same time, the demand-deposit account has very low rate of interest.

If the man thinks he doesn’t need the cash, he’s OK with keeping it in illiquid form that takes him days to get into the type of wealth he can spend on consumption, i.e. cash. One such form is time-deposit bank account which he cannot withdraw the money from until sometime later. This is beneficial for him as the time-deposit account has very high rate of interest in comparison to the demand-deposit account.

Notice the very subtle difference: no matter how he decides to keep his savings (20 euros in the demand-deposit bank account and 80 in the time-deposit account or 50 in each...) he will always save the same amount! The rate of interest does not influence the amount he saves but only how he saves it – how much goes into the immediately accessible but low interest rate demand-deposit bank account in comparison to the ill-accessible but high interest rate time-deposit account.

So the rate of interest is not the price of waiting to consume (to save) but the price of our willingness to depart with the ability to use our money in case something unexpected happens. Interest rates are, as Skidelsky called it, the price we are willing to accept for losing our “instant command over sums of money.”

A wonderful corollary to this fact is that the Central Bank can, and should, influence not only the short term rate of interest downwards but the long-term rates as well. It does this by securing full liquidity in the market for public-debt instruments of all maturities. Doing so, the public can be as liquid as it wants and the rate of interest will decrease.

The Future Nominal Monetary Target?
It is here where the “Death of the Inflation Target” plays its part. The inflation target was built on the classical, and wrong, theory of the origin of the rate of interest. More importantly, the majority of central bank theorists have not accepted what market makers have been knowledgeable about for a very long time: money is endogenously created at the same time as credit is but not exogenously (the textbook helicopter model): money does not come first and then credit but credit-demand first and then credit-creation and money-creation at the same time. And it is the Endogeneity of money that creates the asset boom-and-bust cycle.

Blatantly, as the Austrians realised (although they used the wrong theory of interest to reach that conclusion) and Keynes as well, if the rate of interest is lower than the marginal efficiency of capital, a bank credit-driven investment boom and bubble will commence. But at the same time, the rate of interest must be kept low in order to fuel investment demand and thereby labour demand. High interest rates kill off productive investment that would have otherwise lowered the unemployment and increased production in the economy. Low enough interest rates – as low or lower than the marginal efficiency of capital – would almost definitely secure full employment in the economy, permanently.

The problem that arises from a situation where interest rates are lower than the marginal efficiency of capital is the threat of a credit boom with all the accompanying money creation and demand that will hit supply-constraints resulting in the inevitable: high inflation.

But the remedy against this is to keep the endogenous nature of money on a short leash. Money in a modern economy is created by the banking system sidelong the creation of credit and debt. If the credit creation capabilities of the banking system are kept under control, not with high rates of interest – for dear money does not automatically mean that money will not be easy – but with direct control of how much credit it can give, the credit boom problem is solved. If those limitations are put into place, there is no chance that credit-driven investment bubble can form with the resulting inflation unless the funds come from abroad.

But foreign inflow of funds into an economy means that the nominal exchange rate of the currency will strengthen. Stronger exchange rate means lower exports and shift from domestically manufactured goods to imports, resulting in a decrease in employment. Full employment in an economy where the Endogeneity of money is kept on a short leash does not go along with too strong exchange rate. At the same time, too low exchange rate means imports-inflation.

Somewhere, there is a wonderful but ever-changing balance in the exchange rate which is weak enough to secure full employment but not so weak that it causes overinvestment, credit-fuelled expansion of money supply and imports-inflation.

The future monetary target should be to keep interest rates low at all times with full liquidity provision of the central bank, fulfilling the public’s demand for liquidity – i.e. full access to their wealth – at all times. At the same time, in order to stop bank-credit fuelled investment booms-and-busts from forming, the credit creation capabilities of the banking system should be limited in such a way that the limitations are directly influencing the banking system to reach full employment and low inflation at the same time through balancing the exchange rate.

Nota bene: this exchange rate would be a free-market solution restrained only by the rules the central bank puts into place regarding credit creation. At the same time, the central bank influences the rate of interest downwards in order to reach the rather socially and economically well acceptable target of full employment through private investment projects.