Living standards in Iceland: Collapse or not?

The international press has been rather predominantly positive when it comes to judging the extent of the economic recovery of Iceland. The 4.2% GPD growth (1Q11 to 1Q12) is prominent and the fact that unemployment is not measured in double digits, and actually even slowly coming down, is something that amazes the international press.

I've raised my concerns regarding this rosy picture before. This post however is to check if another "eye-brow raiser" from Iceland, Heidar Mar Gudjonsson who has amongst other things supported the idea of Iceland adopting the Canadian Loonie, is right or not.

Basically, Gudjonsson said that "living standards" (i. lífskjör, according to this source, I haven't read the original one) had moved back 20 years due to the collapse of the krona. We can argue what is meant by "living standards" but based on this opinion of his he said that the Central Bank of Iceland was basically not correct when it claimed that recovery was back and sound. Einarsson and Sigurdsson, two economists at the Central Bank, replied saying that although living standards had dropped in the crisis they had never gone down as far as Gudjonsson estimated. They claimed living standards in Iceland were back down to 2004 levels.

A month ago, I wrote on a similar topic. The data I used there were on a quarterly basis so they weren't really usable here. So I dug into the data bank of Statistics Iceland and OECD and came out with the figures below.

Basically, Icelandic GDP measured in SDR and deflated with the G7 inflation index that the OECD publishes - this is an estimate of the true SDR inflation, I know! - has collapsed from almost 170 in 2007 down to 100 in 2010 (data was missing for 2011). In the meantime, GDP measured in ISK (deflated with the Icelandic consumer price index) topped in 2008 and is beginning to come back up again, hence the 4.2% GDP growth figures.

GDP in Iceland. The idea of "The Icelandic Miracle" is based on GDP measured in the domestic currency. Data from OECD and Statistics Iceland. My estimates.

However, Gudjonsson on one hand and Einarsson and Sigurdsson at the Central Bank on the other were more referring to wages rather than GDP. And when it comes to Icelandic wages measured in deflated SDR, the data is rather clear: the purchasing power of Icelandic wages abroad bottomed out in 1993 and we were pretty close to reaching that bottom again in 2009. So Gudjonsson is very right when it comes to living standards measured in the foreign purchasing power of Icelandic wages: they have crashed!

Data shows that wages in Iceland measured in deflated SDRs are back down to 1997 levels or thereabouts. Gudjohnsson estimated they were back down to 1993 levels, probably using another currency basket than the SDRs. In the meanwhile, the wage index measured in deflated ISK is slowly making its way up again, just as the economists of the Central Bank of Iceland claim. 

So now we can start arguing which one is a better measurement of the living standards in Iceland, or in fact any other country: the domestic-CPI deflated purchasing power of domestic wages measured in the domestic currency or the foreign-CPI deflated purchasing power of domestic wages measured in the foreign currency?

And for pity's sake, is this really a wise definition: "the recession is over if GDP growth measured in CPI-deflated domestic currency is not negative for two consecutive quarters"?

Austerity and Interest Rates

In light of Spain's toughening of austerity measures, it's worth doing a bit of data cracking and comparisons on budget deficits and government bond interest rates.

First, this is how the projected budget deficit of Spain compares to other economies. Data comes from the newest issue of The Economist (Iceland's budget deficit figure is full year 2011). According to the WSJ, the aim is to get Spain's deficit down to 6.3% this year (instead of previous target of 5.3%) and 4.5% in 2013. By 2014, the deficit is to dip back under the 3% Maastricht line: 2.8%.

Projected budget deficits for 2012. Data from The Economist

The aim of the game is to get the interest rates down so Spain (and the EZ as a whole) doesn't collapse. That makes sense, looking at this scatter plot below: an obvious negative correlation between budget balances and interest rates, meaning that if a country is suffering increased budget imbalances, the interest rates on its government bonds tend to go up.

"Don't spend your money or we'll charge you extra high interest rates"

But oops, that's not what it seems to be when we look at countries with their own currencies and not the euro. They seem to be able to spend all they want without fearing higher nominal rate of interest. Yes, I know the 1970s and 1980s stories. But in times of dull economic activities, as is the case nowadays, it seems quite all right for the government to spend all it wants as long as the economy is using its own currency.

"You can spend your money all you want, as long as you can create it yourself"

Both scatter plots above have outliers that could possibly be bending the fundamental relationship. So if we skip some notable outliers (Iceland, Norway [who has positive budget balance amounting to 13% of GDP anyway?], Greece, Spain, Italy) we get the following scatter plot.

"Please borrow and spend, we'll charge you lower rate of interest if you do so!"

Two things to notice about this final plot:
- it seems the relationship between budget balance and the rate of interest on government bonds is positive, completely contrary to neoclassical theory: if the state increases its budget balance, it will be charged higher rate of interest.
- all the EZ economies, except Germany, are above the trendline. Denmark is of course pegged to the euro, we can argue whether we should put it with the EZ economies or not.

So those fiscal-neoclassicals (commonly but incorrectly known as "Keynesians") out there might be right but maybe only half-right: we can end this depression now if we use the public finances to increase monetary demand in the economy and give people a chance to repay their debts, but only if the economies in question have their own currencies; the EZ economies would find this spend-and-survive strategy "a bit more" difficult.

Good luck Spain on cutting down the deficit, get unemployment down to humane levels and end this depression. You're going to need it!

Interest Rates and Indexation

Back in February, I highlighted the fact that contrary to what the (neoclassical) economists held while defending widespread indexation of loans, and in particular mortgages, the interest rates on indexed loans were not lower than on normal CPI-non-indexed loans but on the contrary higher.

This is important: one of the foremost defences of the indexation of mortgages in Iceland is that it, following Fisher's Theory of Interest Rates, should lower the rate of interest compared to non-indexed loans. Therefore, abolishing the indexation would only backfire and borrowers of indexed loans should be happy with their indexation; due to it, they are getting lower rate of interest than otherwise.

Too bad the data does not back that up (a recurrent problem in neoclassical economics)! The updated version of the graphs I posted in February - and some - are here below.

General nominal rate of interest of indexed and non-indexed loans in Iceland. The development from February continues: nominal rate of non-indexed loans is still lower than that of indexed loans. The two circles highlight on one hand the period of überhigh policy rates during the credit boom times and the now-longer period of economic contraction after the collapse.

General real (CPI deflated) rate of interest of indexed and non-indexed loans. 

To figure out whether it is cheaper to borrow money in the form of an indexed loan or non-indexed one, simple compounded interest calculations can be done. Note that according to the Fisher theory and the defenders of indexation, the indexed loan should, for the longer term, be cheaper, i.e. the compounded indexed-principal should be lower than the non-indexed one.

Again, that is not backed up by the data.

100kr. that grows with compound nominal rate of interest. The non-indexed loan is, contrary to what neoclassicals say it should be, cheaper!

So I'm sorry, but for those of you Icelanders who have borrowed money via an indexed loan believing that you were getting a better deal: you're being conned! (But you've probably figured that out already.)

I was in fact asked to explain why this was to be expected as I had expressed my view was. The nudge came from Asgeir Danielsson, head of Department of Research & Forecasting at the Central Bank of Iceland. My reply was posted online on the website of The Icelandic Journal of Business and Economic Matters - Verðtrygging og vextir. My explanation was post-Keynesian and Minskyian in nature: the presumed abolishment of uncertainty in the loan contract was outweighed by the facts that CPI measurements are wrong - a well-known but largely ignored problem in CPI-indexed contracts - and cash flows were distorted by the way the indexation was carried out, leading to higher accepted rate of interest and widespread Minskyian speculation and Ponzi finances.

When Danielsson's reply came, I was very disappointed: he circumvents completely the question why the data is contrary to what neoclassical theory expects and focuses instead on my criticism on the ergodicity assumed in the Central Bank's (Danielsson and his team) economic model, which is a rather unimportant matter (that I admittedly should have skipped in my own article) when it comes to discussing indexation and the rate of interest.

On the problem of CPI measurements being incorrect, he shuns it completely: "A small deviation in the measurement of price indices - a deviation that is furthermore pretty well known [italics added] - does not change that conclusion [that long-term loans with fixed nominal rate of interest would have to carry very high uncertainty premium if they were going to have fixed rate of interest; ergo: indexation is needed!]

I cannot for the life of me agree with Danielsson! First of all, if Danielsson wants me to take him seriously, he needs to answer my concerns about the increased prominence of Minskyian speculation and Ponzi finances in the indexed environment. Furthermore, regarding the miscalculations in the consumer price index, nobody knows the exact deviation in the measurement. And since loan contracts - beside the pension rights! - amounting to roughly 110% of GDP (yep!) are indexed to the CPI I must admit that I find it important to know exactly how much the deviation is. One percentage point off - a deviation not uncommon in bigger economies - and the beneficiary (the lender) is being handed 18 billion krona per year on a silver plate! Merci beaucoup!


Can Danielsson please refer to any one source where I can find the estimate of the deviation? How exact is it? And if the deviation is "pretty well known" why is it not corrected for in CPI-indexed financial contracts?

This failure of indexation to deliver lower rate of interest needs to be explained! There is no reason to stick to indexing mortgages and other loan contracts if it is not delivering what its proponents are saying it should!

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.

High rates or not?

I translated (and expanded) the post about Iceland prepaying the crisis-money ahead of schedule into Icelandic and posted it on my blog back home. In the wake of it, I got some comments and nudges such as:
- the coupon on the bond isn't 6.0% but "3.something" and then the market adjusts the price to whatever it thinks is appropriate
- 6.0% isn't too bad compared to other countries (I reckon with similar credit rating)
- USD isn't the currency of Iceland, therefore it's only normal that the risk on this USD bond is high

OK, so I went to the Bloomberg terminal here in Exeter (one of the few British universities that has an access to a Blooomberg terminal) and spent an hour looking up international bonds issued by other sovereign countries. This table summarises what I found:

Examples of USD bonds issued by sovereign states and maturing roughly in the same year as the Icelandic bond issued in May. Click to enlarge.

I tried to find sovereigns with similar credit rating and followed Moody's on that - I noted S&P's and Fitch's ratings as well. If I didn't find a bond maturing in 2022 I went for the one closest to that year. All bonds are in USD.

So what is this comparison telling us:
- of the Baa3 rated countries, only Croatia is getting a worse deal than Iceland. The yield on the Hungarian bond is higher than that of Iceland but it receives speculation grade.
- there are three Ba1 (speculation grade) countries that seem to get a better deal than Iceland. Notice especially Uruguay but that bond is sinkable so they should be getting a better deal.
- the yield on the Philippine bond is half the yield on the Icelandic bond, despite the fact that the Philippine bond is two credit notches worse
- many countries with float, managed or not, are getting a considerably better deal than Iceland. So can we really conclude that not having the USD currency as a legal tender is such an important factor?
- apparently, being pegged to the USD isn't so great: Panama is charged higher rates than Peru, Colombia and Indonesia which all have floating currencies. Same goes for the comparison between El Salvador (USD peg) and Philippines (float).
- Go Colombia! Callable (in 2020 if I remember correctly, was foolish enough not to note it down) but all the same getting 2.8%. I wonder why they seem such a good Baa3 borrower, they must be getting the dollar-flow from somewhere to justify that...

I stand by what I said: this bond issuance of Iceland is a badly done job and absolutely not "successful" like the Ministry of Finance held. Iceland shouldn't be paying 6.0% rates if we compare it to other sovereigns. 3-4% is certainly possible, especially if we go for a sinkable bond a la Uruguay.

And by the way, the coupon on the Icelandic bond is 5.875%, which is of course why there was quadruple over subscription. I reckon the underwriters took some fee so the rates in the end were equivalent to 6.0% like the Ministry of Finance announced.