Icelandic Indexation, Part II

In my first entry about Icelandic indexation of debt and credit, predominantly mortgages, I touched on how the cost of inflation is added onto the principal of the mortgage instead of being in the form of higher nominal rates as is the case in most other countries. The feedback I got from one of my readers was “I still don’t understand how this thing works, it looks nuts the way you describe it and it can’t be right.”

I’m sorry, but it is. But admittedly, I didn’t explain in enough detail how the principal first grows and then contracts only much later in the loan period. Second, I didn’t explain how or why the monthly payments are growing exponentially in nominal terms as the loan closes in on its terminal date. So I hope this post clarifies some of the grey zones that I left in the first part about Icelandic indexation.

An example

The best way to explain the functionality of anything is, in my humble opinion, always to take an example. To make things more coherent between this part of the story and the first I’m going to use the same loan and the same given figures. They were: an indexed mortgage of 20.000.000 ISK for 40 years at 5.0% real (NOT nominal) interest rates. Payments are monthly and calculated on an annuity basis, i.e. every single monthly payment (monthly payment = repayment of principal + interests) should be equal given a certain principal that is repaid over the loan period and fixed interest rates. Average inflation is 2.5% (which is the inflation target of Central Bank of Iceland).

The following screen shot from Excel shows how this mortgage would develop in the beginning, i.e. the first year of 40. Notice that the borrower does not owe “remainder of original nominal principal” but “remainder of inflation-compensated principal after payment” once he has dutifully paid the monthly payment. And that amount grows spectacularly in the beginning of the loan period.

Table 1: The development of an indexed mortgage in Iceland. Notice that the "remainder of the inflation-compensated principal after payment" grows even though payment has been carried out (click to enlarge).

In fact, it continues to grow, in the case of only 2.5% inflation, until month 212 (for almost 18 years!) when it finally tops in 24,055,720 ISK. Notice that at that time, the original nominal principal has shrunk down to 15,487,314 ISK. But again, that’s not what the borrower owes. He owes 24,055,720 ISK after having paid dutifully of the mortgage for 17 years and 8 months. And the original amount borrowed was 20,000,000 ISK.

Table 2: The principal owed does not begin to shrink in nominal terms until after almost 18 years in case of the mortgage listed in table 1 (click to enlarge).

But 2.5% inflation is low in Iceland. If we put more historically reasonable inflation rate of 5% (average annual inflation from 1990 to 2010 was 5.2%) the inflation-compensated principal doesn’t begin to shrink until after – hold your breath – 25 years and 11 months. By that time, the nominal amount owed has in fact more than doubled!

Table 3: 5% inflation is historically lot more realistic in Iceland than 2.5%. In that case, the amount owed more than doubles before it begins to finally shrink after almost 26 years (only 14 years left of the loan period, click to enlarge).

For a more detailed comparison, the graph below shows the development of the principal owed in the case of 2.5% annual inflation on one hand but 5% inflation on the other.

Graph 1: The development of the amount owed (ISK) on the mortgage in tables 1-3, given 5% annual inflation or 2.5%.

An enlightening graph is also the development of the monthly payments (payment = monthly repayment of [inflation compensated] principal + interests) in the cases of 2.5% and 5% inflation. The graph below shows the monthly total payments. In the case of 5% annual inflation over the whole loan period – remember the average annual inflation for the last 20 years is 5.2% - the monthly repayment grows by a factor 7. This is not a joke! From this graph one can also estimate that a person who borrowed money with an indexed 40 year mortgage 20 years ago is paying today about 2.5 times more than in the beginning of the loan period. Anyone who wants to bet this person to be bankrupt in 10 years? And does anyone want to think about the feedback between inflation and necessary nominal wages-after-tax? We’ll come to that in later posts.

Graph 2: The monthly total repayments grow exponentially. The higher the inflation is, the higher is the exponential growth. Notice that in the case of 5% inflation, the borrower will in the end pay 7 times higher nominal amount than he did in the beginning of the loan period.

But why does the principal not shrink?

Because the cost of inflation – the indexation – is added onto the principal instead of being included in higher nominal interest rates as is the case of almost every single mortgage system in the world (apparently Chile and Israel, of all countries, do something similar to this but I’ve never found the necessary data to do a complete comparison between the systems. The Central Bank of Iceland loves to make reference to those economies whenever it is challenged on whether the Icelandic system is clever or not. If somebody can tell me anything about the indexation of mortgages in Israel and Chile, please contact me, it would be most appreciated!)

I hope this explains somewhat better the madness of the Icelandic indexation. If you’ve got a feeling that this system cannot work out you’re most profoundly right! But the rabbit hole goes deep and we are getting closer on being able to discover it properly now that, I hope, the functionality of the indexation is somewhat clearer.

If there are any questions that are still left unanswered or you’ve got any other comments, leave them in the comment box and I’ll do my best to answer them. If there are a lot of troubling matters still left to be dealt with – beside the sheer shock of thinking men that some nation thought it might be a good idea to organise its mortgages in such a spectacularly mad way – I’ll try to clarify them further in later post(s).

But surely, I haven’t even begun introducing you to the madness of Icelandic economics. Wait until I explain the pension system!

Uncertain Future

Just to let everybody know that posting will be sporadic at best for the next few days as travels are coming up.

In other news, almost finished with Steve Keen's doctoral thesis, "Economic Growth and Financial Instability". It's brilliant! Minsky comes alive right in front of the reader's eyes, just by using a bit of nonlinear dynamic modelling.

Highly recommended text. You can find it, along with some other important macroeconomic and banking goodies, at Steve's website.

Iceland, The Euro, And High Interest Rates

An acquaintance of mine and me were discussing a newspaper article arguing for the adoption of the Canadian dollar in Iceland. Without getting into too much detail, the author of the article said the adoption of CAD beneficial for Iceland due to the fact that both economies were rich in energy and raw commodities (if you know Icelandic, the article is here). Furthermore, the Canadian banking system is one of the safest one in the world - which is true - and the currency is stable - which is also true, probably because the banking system is sound. One can of course make the same case about the Norwegian krona and the similarities between the economies of Norway and Iceland but anyway, adopting the CAD was meant to be beneficial.

I would like to stress that I don't have a clue whether Iceland should adopt a foreign currency or not, let it be the CAD, NOK, USD or whatever else. And the reason is simple: I, like everybody else, do not know which will be better because there is massive uncertainty in the decision ("unknown unknowns"). Furthermore, it hinges on the personal risk appetite of everybody.

My favourite analogy to explain this is that of the car insurance: if you buy a full-cover car insurance (you have an independent currency which you can devalue if the economy runs into trouble) you are tempted to drive faster (take risky economic decisions). But if you decide to turn down the car insurance (use a foreign currency which cannot be devalued if the macroeconomy runs into trouble) you'll have the incentive to drive more carefully. But of course, nothing says you will, you still might drive like a maniac or hit black ice and crash the car. And I trust Icelanders well to drive like maniacs - by soaking up private debt - even if we used a foreign currency.

We can endlessly, because of different risk appetites and the impossibility of quantifying them for a sensible mathematical model, argue which is better, to buy the insurance or skip it. And everybody would be "right". So quite frankly, I think the currency quarrel is rather futile, especially because it is not the fundamental problem of the Icelandic, or any other, economy. Discussing private debt and debt creation should come first, currency regime second. But that's never even thought of amongst neoclassical economists who don't know Minsky and the real-Keynes and still consider the market to be efficient and people rational. Please, give me a break!

Useless ideologies
But the quarrel is there, no matter how futile it may be. But in all honesty, this is not a quarrel anymore. The truth is that there is an ideological tug-of-war regarding the currency and the monetary question in Iceland where politics and extremism are rampant. There are roughly three camps: the ISK supporters, the EUR supporters and the smallest "lets adopt whatever" group, predominantly making the case for CAD, NOK or USD.


Customary to Icelandic public discussion - not that it's only Icelandic unfortunately - some people, from all camps, deny to accept the reasonable argument the other camps make. The ISK supporters mitigate or even deny the krona’s role in bankrupting the economy while highlighting the ongoing EUR debt crisis and the positive effects the ISK devaluation had on the current account. The EUR supporters mitigate or deny the fact that the devaluation of the ISK is assisting the economy to get back on its feet while ignoring the EUR debt crisis and highlighting the cases of Estonia and Finland who adopted the EUR and are doing fine.

All the groups have something worth noting. The problem is that the idealists either ignore their currency-opponents or answer them in empty phrases. Those zealots are a small part of all the groups but they are unfortunately quite eye-catching and distort the necessary discussion that has to take place regarding the future of the Icelandic monetary system. The end result will be, many fear, that no progress takes place in building up the Icelandic economy on principles that everybody can agree to are reasonable and wise.

I have to admit that the insistence of the EUR supporters is what strikes me most, no offence meant. Many of them are so utterly blind on what's going on in the Euro zone and the obvious need for a monetary reform that it amazes me! The official aim is to adopt the EUR through EU admission. Hopefully, we'll have a referendum about EU admission in 2013 or 2014. If the answer out of that referendum will be yes (I have personally not made up my mind), Iceland would enter the EUR "waiting room" (the  ERM2), peg the ISK to EUR with 15% band while trying to fulfil the Maastricht criteria. That would take us another 5 years at least, given how seriously far away we are from fulfilling the 60% public gross debt to GDP mark. So earliest adoption of the euro would be around 2020 or thereabouts (and no, you cannot hide behind the expectation theory of interest, making the case that if Iceland enters the ERM2, it would "effectively" mean that the EUR is the legal tender). And does anyone want to wonder what has happened to the Euro zone in 2020? Why apply to something today which is obvious to have changed significantly by the time we would finally be accepted?

So quite frankly, the official aim of adopting the EUR through EU membership is, well, not that smart. The only other possibility would be to adopt EUR unilaterally. But that wouldn't really be  a good idea either; to adopt a currency from an economy that's in a debt crisis? No thanks, CAD or NOK are obvious choices instead if we are going to adopt another currency anyway.


Any scapegoat will do
But the currency isn't the economic problem of Iceland. It's the debt and the high interest rates. Fix the debt and interest rates problem and the currency problem will be non-existent, no matter which tender is the legal one. But a lot of people think the ISK is to blame for the high interest rates, and consequently high debts, of household, firms and the State in Iceland. 


The classic argument is that since the ISK is so small there is a high liquidity premium on financial assets denominated in Icelandic krona in the form of high interest rates. And high rates, and Icelandic indexation, lead to higher debt. Some people honestly think this premium to be somewhere between 1.5% to 3.0%. Seriously, think about this: 150 - 300 points, the liquidity premium only! Two loans to the same borrower which are exactly the same except one is denominated in ISK and the other in EUR. The interest rate differential would be 150 - 300 points due to liquidity premium alone.

Not likely! But it's true, long term interest rates in Iceland have been 1.5-3.0% higher than in other major equally developed economies. And this is absolutely the major economic problem of Iceland. So why not blame one of the smallest currencies in the world and its lack of liquidity?


I'm sorry, but it's nonsense. The long term interest rate differential is not high because of lack of liquidity with the legal tender but because of a bizarre legal framework that a certain system is built on, a system that many Icelanders are quite proud of, possibly because they've been told it's one of the best ones in the world: the pension system.


More on that later.

The EFSF Explained In Plain English

In light of the newest argument about the EFSF being a Ponzi scheme or not (see Telegraph and Reuters), I remembered seeing this video not long ago. This must be one of the best non-economic explanation for the European Financial Stability Facility (EFSF). Kudos to the man/woman who thought up this joke.

But seriously, where are they're going to get the 1,000bn. euros from?

The Private Debt Problem In Europe

The real-world economics blog posted this graph today. It shows well that the euro zone crisis isn't really a public debt crisis, it's private. To see the indebtedness of Spanish and Portuguese companies at the top and the Greek firms at the bottom, given that they are not cooking their books too much, is revealing. Like Minsky always emphasised: private gross and net debt levels matter!

Non-financials' net debt to earnings (EBIT) ratio by country

Of course, from an Icelandic perspective, this isn't that interesting until we put the Icelandic data in there as well. And since the Central Bank of Iceland only just yesterday - what are the odds! - posted, for the first time, aggregated financial accounts for households and firms in Iceland, we can construct the same data.

Icelandic firms' net financial debt to earnings (EBIT). Net financial debt is estimated with Gross Debt - Total Deposits. 

Here is also another graph showing the other side of non-financial debt, i.e. household debt. All three countries experienced the same: a massive private debt bubble!

Household debt as % of GDP

So the difference isn't that great between Spain, Portugal and Iceland. We're all fighting a private debt crisis. The public debt crisis is then bred by the private debt crisis: too much private debt is stopping private investors from getting investment and spending started again, leaving the States stripped of tax income from private economic activity.

Due to this, the public debt crisis is perhaps more severe in Portugal and Iceland since private parties are more indebted in those countries compared to Spain. Also, the State is more indebted in Portugal and Iceland as well (public debt closing onto 90% of GDP in both countries while around 60% in Spain).

But the foundations of the debt crises in Spain, Portugal and Iceland is private debt. In Greece and Italy, it's arguably public debt however. But no matter where the fundamental problem is, while the debt levels remain high in those economies, economic activity will be low. And while economic activity will be low, the public and private debt crises will just keep on growing, especially if nominal economic growth won't be higher than the interest rate on the debts of public and private parties.

Spanish, Portuguese and Icelandic private and public parties need to deleverage their balance sheets, just as private parties had to in Japan during the 90s after the "Swinging 80s" in Japanese stocks and houses. That deleveraging rushed in the Lost Decade: a decade of weak economic growth, low or negative inflation, ultra-low interest rates and high unemployment compared to the years before.

It is not unlikely that some sort of similar economic hardship will hit the three economies here discussed. And when Spain and Portugal end up in such situation, they will drag the rest of the euro zone down with them. Christine Lagarde is probably right: there is a serious threat of an European Lost Decade.