Should we adopt a foreign currency?

After the collapse in 2008, the hunt for a scapegoat began almost immediately in Iceland. The list was endless: the bankers, the politicians, the business moguls, the endless consumerism, the Central Bank, the corruption and so on. On that list was the Icelandic krona.

Now of course, most of the usual suspects were on the list of scapegoats for a reason. Yes, political corruption - in the form of "I know a guy who knows a guy who could do this for us" and "ahh, you're a member of that political party, well, then you'll get the job!" - is high and the level of debt-infused consumption was astronomical! And yes, the fact that Iceland tried to carry out an independent monetary policy with, at that time, the smallest free-floating currency in the world, is partially to blame for the crisis. We messed up big time (in my opinion, mostly by relying on bad economics).

Today, the "necessity" to adopt a foreign currency is very prominent in the general discussion in Iceland. And the foreign-currency vs. krona discussion is stark and heated. I think it's safe to say that not a week goes by without somebody, in a newspaper article or on a widely read news website, making the case that Iceland should or should not adopt another currency. Some economists, and of course politicians and others, thank the devaluation of the krona for the "rebound" in economic activity since the collapse. Paul Krugman has made this case. Others blame the krona for the high interest rates compared to our main trading partners and for the high inflation. In response to Krugman, Jon Danielsson, at the London School of Economics, said that Krugman deserved an F.

The politics in the discussion are almost too obvious as well. And since there is a tradition for hung parliaments in Iceland, the politics in the currency question can become a bit funny as well. As an example, today's government is a coalition between Social Democrats and Left-Greens. The Social Democrats want to join the EU. They blame the krona for every economic misfortune of Iceland and they want to adopt the euro (given an EU membership). The Left-Greens don't want to join the EU and the Minister of Finance, who is a Left-Green, has thanked the flexibility of the krona for the rebound in economic activity. Blatantly, this is absurd! I would love to be a fly on the wall during government meetings whenever EU and euro vs. krona are on the agenda.

The almost certain inevitability of mixing politics into the foreign currency vs. krona discussion makes the subject both flammable and, since it's natural for so many people never to give back an inch on their political convictions, open for tunnel vision of rather high degree. As an example of that, the president of Icelandic Confederation of Labour, Gylfi Arnbjornsson, recently said, during a conference he spoke at, that "we [Icelanders] shouldn't let the short term problems of dollar, yen and euro block our sight. The euro is like a rock in the sea compared to the Icelandic krona." The Icelandic Confederation of Labour want to adopt a foreign currency, preferably the euro. They blame the krona for high inflation in Iceland.

Now, no offence to Gylfi but I wouldn't call the lack of economical and political coordination in the Eurozone a "short term problem." In my opinion, this is an example of economic tunnel vision: OK, let's adopt the euro. But what next? Pay into the EFSF fund? It would possibly make some sense to adopt the dollar, we do trade somewhat in USD-denominated goods in international markts. But the yen? We hardly trade with Japan, why not the Australian dollar then?

I admit it freely that I don't know whether it would be beneficial for Iceland to adopt a foreign currency. Quite frankly, I think the fundamental problem of the economy of Iceland is not the currency or what currency we use. Yes, there is a moral hazard problem associated with using an independent monetary policy with free flow of capital and free-floating currency. The nation, especially the banks and the government, can go on a spending spree and let the currency take the hit later in order to rebalance the economy (this has been the normal course of events in Iceland). But at the same time, if a nation is using a foreign currency and there is a real exogenous shock (natural disaster, collapse of international markets with its main exports, etc.) it can be more easily met with an independent monetary policy through devaluation of the currency. And for a small "city state" like Iceland, population 320,000, nobody would care if we would run a "beggar-thy-neighbour" monetary policy for the rest of the universe's life.

So for a small state like Iceland, running an independent monetary policy is like getting a full coverage on your car. You'll get any cracks and scratches repaired. But will you have the discipline to drive carefully as well, given that you have full coverage? Historically, we certainly haven't, we've "gone Greek" for decades. And quite frankly I think we wouldn't resist the temptation to drive carelessly, even if we hadn't full coverage, i.e.if we used a foreign currency. Backed up by that pessimistic view, I sometimes think Jefferson was right: banking institutions are more dangerous than standing armies.

So one of the economic problems of Iceland is not the currency we use. It's the banking and financial system. If we had that under control, we could use whatever currency we wanted. It would be like putting a stone under the accelerator of our car: we couldn't drive carelessly.

Zombie borrowers and/or zombie banks?

According to those news (in Icelandic) the economy is shoulders-deep in a balance sheet recession. Apparently, the economy also seems to be under the influences of zombie-banking at the same time.

Koo (Holy Grail of Macroeconomics) showed how the demand for loans was the main reason for the lost decade in Japan. He also made the case that the same problem had been prominent during The Great Depression in US and in Germany during 2000-2005. Other notable economists, such as Roubini, have also mentioned this.

Rough translation of the news is:

"Birna Einarsdottir, CEO of Islandsbanki, says that low demand for loans is the main reason for low growth of credit within the financial system. This was one of the points the made during a financial conference organised by the Islandsbanki.

Birna said that the loan-and-risk committee of Islandsbanki had agreed on the lion's share of loan applications they had received in 2011. About 74% of applications were agreed upon immediately but only 3% denied downright. Birna also said that those figures were a testament of firms adopting to higher standards set up by banks.

Loan applications in 2011 mirror the state of the economy according to Birna."

Teaser (Rates)

Iceland's economy is a high-interest rates economy. Keynes, when he was influencing debt management for HM Treasury, always emphasised that high interest rates were the "economic problem." He first focused on the short rates but later he turned his attention to the longer rates.

Surely, one can only imagine what Keynes would have said about the "economic problem" of Iceland had he seen this graph.

Long term interest rates in Iceland and the Euro area (OECD figures)

Essentially, this sums up the economic problem of Iceland in one single graph. Iceland is killing itself with high interest rates! And the Icelandic economy is more indebted than most, if not all, Euro countries. So the debt burden is awesome! 

Of course, there have been many attempts to explain this huge interest rate difference. The most common ones are:

- Iceland uses the krona as a legal currency and due to lack of liquidity on international FX markets, the interest rate differential between the Icelandic economy and other economies is high (it's a liquidity mark-up)

- Icelanders are big spenders and not much for saving. Using the "loanable funds" theory (supply and demand analysis) one then sees immediately that interest rates are and should be high compared to other economies where people are saving.

Personally, I think both of those are explanations are lightweight. In fact, I think the second one is straightforward wrong: the second you introduce a fractional reserve banking system into the economy the loanable funds theory is useless. The majority of this interest rate differential, something that I would like to claim that Keynes would have called THE economic problem of Iceland, is explained differently than most people think. 

The major influencers are the Icelandic pension system and the mortgage system of Iceland. 

Those are the structural deficits that are the major reasons for why Iceland collapsed. And they are still in place. Therefore, the crash is still ongoing and the economy not on "a path of recovery" - at least not for the long run -  as the Governor of Central Bank of Iceland seems to think.

More on this later.

Why Am I Blogging?

Some people would call me young. When I was even younger, I was studying BSc economics at the University of Iceland. I graduated in May 2008. My final work was a 25k word dissertation about the comparisons between the Icelandic banks and the Scandinavians. My final conclusion: despite some possible liquidity problems, the Icelandic banks seemed fine in comparison with their Nordic peers. Six months later I, and many other people, was proven awesomely wrong. What I had learned in my undergrad studies crashed in front of me and left me with a feeling of being completely lost. Something wasn't right.

I left to England in September 2008 to study masters in Money & Banking at the University of Exeter. I continued directly into a PhD in economics, emphasising financial instability and foreign direct investment. During the academic year 2009-2010 I read Kindleberger's Manias, Panic, and Crashes. Everything remotely connected to the topic of financial crises ended on my night table. When I read Cooper's The Origin of Financial Crises I came across the name of Minsky. Naturally, I ended up reading Minsky's Stabilising an Unstable Economy. That was a complete eye-opener and from there I realised that something was seriously wrong with my undergraduate courses. I drowned myself in books and papers by authors such as Minsky, Keynes, Schumpeter and Keen. 

The knowledge I gained from reading those authors instead of mainstream economics made me certain that the crash of the financial and economic system back home in Iceland wasn't a coincidence or collateral damage from the global financial crisis. There were structural deficits in the Icelandic economy that made it even more prone to crises than the common fractional reserve banking systems of other countries. No matter if the global crisis would have happened or not, the Icelandic economy would have crashed anyway. The timing was just a coincidence.

I started blogging in Icelandic in April 2010 about diverse economic matters ranging from pointing out what I considered structural economic madness to contemporary matters such as the Icesave dispute. To some people I seemed to make sense and I got emails from people that thanked me for putting their own thoughts down in a more concrete way than they thought they could do themselves. Others said I was being ridiculous and just "one of those bloggers" who thought they knew what they were talking about. Somewhat as expected, most of the negative comments I got were from other economists or people that had in some part built up or maintained the system that I was accusing of being the root of the whole economic problem.

So here I am, starting a blog about what happened in Iceland during and before 2008 and why the crash was inevitable given the structure of the economy that is in place in Iceland. I hope some people will find this informative and interesting. More importantly, I hope people will learn from this blog not to do "Icelandic economics." Because they're "neat, plausible and wrong."