Daily Mail and House Prices in Iceland

In light of the Daily Mail's post regarding the surprise winner of Iceland in the house prices competition, I am going to repost the following graph, based on data from the Central Bank of Iceland.

The fundamental reason for the surge in house prices in Iceland is not the economic recovery but the expansion of new mortgages, i.e. debt. Those new mortgages spur the economic growth since the debt creation becomes somebody's income (first the seller's and then who ever gets the money from him as he spends it). In the meanwhile, investment is lagging and furthermore, 60,000 households (40% of the total, year end 2010) are in negative equity on their balance sheet. None of those 60,000 households are thinking of speculating in the property market in at the moment, I presume, since they are busy paying down their debts.

The speculators are more likely to be high net-financial-wealth holders, looking for income and yield on their financial assets. The nominal yield on the rental market is around 7-9%, depending on which part of Reykjavik we're talking about. Unindexed mortgages carry 5-7% interest rates. If you have the net-cash to cover the need for equity, leveraging it up with a mortgage only "makes sense".The money that is spurring the growth of the Icelandic economy is therefore not coming from investment in capital assets and the subsequent production of goods and services, but speculation with properties.

Newly created mortgages are driving the property market in Iceland, as they do in other countries. The resulting income from debt-creation is what is then spurring economic growth, but not investment in real capital. Data including January 2012. Central Bank of Iceland.

The Daily Mail article is here: "UK property market..."

Iceland vs. Ireland

Ever since the "what's the difference between Iceland and Ireland?" joke, the comparison between the two economies has been frequent. I'm going to jump on the bandwagon and at the same time offer a rather pessimistic long-term view on Iceland, at least in comparison to Ireland.

First, the facts. GDP growth in Iceland has picked up and Iceland Statistics famously reported growth of 3.7% over the first three quarters of 2011 compared to same period the year before. The Central Bank of Iceland (not that I expect that institution to be right all the time) expects economic growth to be 3.0% in 2011 and 2.5% in 2012. Iceland is back on track!

Or so it seems at least. I'll get to it later why the optimistic view of the future is a misconception (I touch on it as well in this post: Money and Debt in Iceland and the New Prosperity) but first, let me show you the track record of Iceland's economy compared to Ireland (and Spain and Greece).

Volume of GDP indices, seasonally adjusted and rebased to top=100. OECD figures. Economic growth in Iceland has always been volatile. Celebrating victory in "the race against the Irish" is therefore quite ill-timed and not only because of that reason. 

The romantic view on Iceland
There is one misunderstanding apparent when Iceland and Ireland are compared. People seem to sometimes think that Icelandic people said "Oh, hell no! We're not going to save your arses, you just have to go bankrupt and that's the end of it" to the banks. Some people make a gesture to Icesave referendum to justify that point of view. Furthermore, the "splendid" 110% debt write-off that was passed by the parliament is considered to a fantastic success and shows on top of that the will of the people to simply get the banks to understand that debts that cannot or should not be repaid, won't be repaid.

Sorry, there is a bit of romanticism in this story.

First, the Icelandic government tried absolutely everything it could possibly do in 2008 to save the banks. It was Iceland's "fool's luck" to have allowed the banks to grow up to 1,000% of GDP that made the government rescue impossible. There was no other choice than to let the banks go bankrupt, even though it has been painted in the foreign media as "Iceland chose to let the banks go bankrupt instead of shoring up their broken pieces."

Second, the Icesave agreement was forcibly passed through the parliament by the government. It was the president that stopped the bill to become a law after the world of bloggers had been on fire for months while the public anger against the government ascended day by day. More importantly, the Icesave dispute had nothing to do with Icelandic "banksters" as they were called by that time. It was and is an international quarrel regarding how to interpret the EU/EEA treaty concerning deposit insurance schemes and passport-banking within the EU. Icesave wasn't and isn't a question of bailing out the banks.

Third, the 110% debt write-off that was introduced by the government hasn't been that successful and certainly not very influencing in the overall scheme of things.

The 110% debt write-off was simply a measure that was offered to over-indebted households. It was very simple on the surface: if your mortgage was higher than 110% of the estimated market value of the property, you could have the debt written off down to the 110% mark.

The total debt that was written off based on this jubilee was 43.6 billion krona. On top of that came 6.2 billion due to "special measures". In comparison, the debt that was written off due to illegal foreign-exchange-linked loans was 146.5 billion krona. In September 2008 (the last point in time where it is known how high the face value of household debt was) the debt of households was 1,890 billion krona (128% of GDP). The government induced debt write-off has been roughly 2.5% of the total debt of households. Is that meant to be a huge turning point? Give me a break! The indexed debt of households has in the meanwhile risen by a rough estimation of 200 billion ISK due to rise in consumer prices since 2008. This is not a typo.

Longer term view
The debt dynamics in the Icelandic economy are scary! The mortgage and financial system is built to collapse, it is an unmissable feature of the organisation of the system. Real rates on debt that is founded on money traded in the secondary market (after the money has been created by the banking system) have a legal floor of 3.5% due to the legal structure of the pension system and its sheer size within the economy. The 3.5% floor has only been broken recently due to the capital controls locking in the money in the economy. When they are lifted, whenever that will be, the bubble on the bond market will implode and the yield rocket up to the floor once more when pension funds and other investors get out of the economy in search for higher yield, even if that will cost bearing higher risk in the form of investing in international stock markets.

In the meanwhile, most mortgages are indexed to the Consumer Price Index. The key to the long-term instability in the organisation is that the nominal interest rates are not what is indexed to changes in the CPI but the actual principal of the loan is indexed to the value of the CPI itself. This effectively means that every time there is a rise in the CPI, the borrower "gets" an automatic loan from the lending institution in the form of the fact that he doesn't have to pay the cost of the indexation at that point in time. One of the rationale behind why this mad system is meant to work is that borrowers are supposed to be forward looking and anticipate today that they have to pay their increased debts due to higher nominal value of their indexed mortgage in 20 years time. Give me another break!

No, Ireland and Iceland are not the same. Iceland may have the upper hand now because the GDP growth figures of 2011 and perhaps 2012 are and will be more favourable in the case of Iceland. But Ireland does not have to fight as mad mortgage and financial system as the Icelandic one and that is what will chain Iceland down in the longer run.

Plus, Ireland has Guinness! And leprechauns!

Do those graphs seriously give the impression that the Icelandic economy is healthier than the Irish one? Data from European Mortgage Federation. Author's calculations on the interest rates in case of Iceland's economy.

Money and Debt in Iceland and the New Prosperity

The collapse of the money supply in Iceland has been turned around, at least for the moment. That would support the view that the economy is not in the deadlock deflationary spiral it was in in 2010.

Money supply (M3) in Iceland, its 12 month change and the its acceleration. The turnaround is quite frankly amazing, and now the money supply growth has reached the level of the mid 1990s. 

Borrowers have returned to the banks: the growth of the money supply is propelled by the growth of new debt by banks. That has had the consequences of housing prices to rise again.

New mortgages and housing prices. The growth in new mortgages is mainly from banks. The good part of that story is that most of the new mortgages are non-indexed, i.e. what most other nations would consider normal. Not only does that strengthen the interest rate policy of the Central Bank considerably but the non-indexed debt is, contrary to what one might think from the Fisher hypothesis, with lower real interest rate on average.

House prices follow the growth of mortgages in Iceland as in any other country. The capital controls lock the funds of wealthy individuals in the economy as well, pushing them to invest in houses to rent instead of putting their funds into low-yielding bank accounts or bonds. The result is another speculation bubble in housing.

The momentum in the Icelandic economy is picking up. However, that momentum is quite unevenly spread out and quite worryingly based on housing speculation and the presence of the capital controls. Not only have the capital controls infused a bubble in the bond market but the money is finding its way into housing as well, pushing up both the rental price and the cost of buying. In the meanwhile, investments are still minimal.

The bottom line is that the new economic growth in Iceland and the ascent of housing prices aren't supported by fundamental economic activity but debt, capital controls and speculation. The momentum is good but the way forward is winding. Lifting the capital controls without shocking the economy won't be easy if investment does not return soon. In fact, if investment does not return soon, the economy is a goner.

The return of economic growth in Iceland is not supported by fundamentals such as investment in real capital. The foundations of it are therefore weak and mostly speculation and debt driven. Lifting the capital controls in such an environment will not be easy.

Icelandic Indexation and Real Rates

One of the major arguments for indexing the mortgages in Iceland to the rate of inflation is to terminate the risk that arises due to inflation in the loan agreement. After all, the economy is not governed by nominal variables - as the neoclassicals maintain - and so, indexation to the CPI must be a good idea to mitigate the risk in the loan contract. Doing so, the lender is supposed to be willing to lend at lower interest rates than if the rates are nominal and fluctuate with the inflation. The borrower and the economy as a whole will then benefit from lower interest rates.

Friedman was a supporter of this idea (to heterodox economists, that would probably be argument against indexation!) and it is considered to be an unshakable truth in Iceland. As an example, the minister of business in 2004 said that it would be a bad idea to abolish the indexation of mortgages since unindexed loans had "2-3%" higher real rates than indexed ones. Asgeir Danielsson, an economist at the Central Bank of Iceland, said in March 2009 that if people were risk averse, one should expect real interest rates of indexed loans to be lower than on unindexed loans (to clarify, "unindexed loans" are normal loans where you would pay interest rates every month and the principal would shrink in nominal terms as you paid it down every month)

This is disputable, to say the least. I believe this should be exactly the other way around: unindexed loans should have lower real rate of interests than indexed ones. Also, the economy should be more stable if the loan contracts would be unindexed to the price level. When I got my hands on data that I hadn't seen before, posted in obvious view by the Central Bank itself, I got firmer in that belief.

Graph 1 shows the development of nominal interest rates of indexed and unindexed loans. There are three periods that are especially important and they have been circled. Circles 1 and 2 are periods when the CBI was trying everything it could to cool down the economy but because the indexation of mortgages defends the borrowers from the nominal interest rates hikes by the CBI, nothing happened and the punch bowl stayed on the table.

When the punch bowl had finally been emptied and dropped to the floor in 2008, the CBI tried to get the economy going again by lowering its policy rates. But the same problem persisted, this way the other way around: because of the indexation, households' available cash-on-hand after having paid the monthly repayment and interests was hardly or not at all influenced by the CBI dropping interest rates down from record 18%. So the economy never recovered. In the meanwhile, the indexed debt just kept ballooning out as the price level rose.

Graph 1 The nominal rates of unindexed and indexed loans in Iceland

Graph 2 The real rates of unindexed and indexed loans in Iceland

So this is what happens. Because of the indexation of an overwhelming majority of mortgage debt, the interest rate setting mechanism of the Central Bank of Iceland fails. The consequence is that effective interest rates can, as in 2005 and 2007, be too low when they need to be much higher to cool down the economy. Likewise, as in 2009 and 2010, it can happen that effective interest rates are too high when the economy needs it most to get a slacking monetary policy.

Therefore, contrary to the neoclassical belief, it turns out that the economy in Iceland isn't helped at all by the indexation of mortgages and loans, not even in lowering the interest rates as the neoclassicals believe. In fact, the common belief that the economy of Iceland is so unstable because of the Icelandic krona, and therefore needs indexation of mortgages and other loans, is quite likely wrong entirely: the economy of Iceland and the Icelandic krona are unstable because of the indexation of mortgages and loans, not the other way around.

Steve Keen on Iceland's Financial System

Steve Keen was interviewed by Iceland Television 1 last Sunday. He was first and foremost talking about why the neoclassical economics was all wrong and how it was nonsense that "No one saw the crisis coming." He also mentioned why debt jubilee was basically needed in order to keep social peace and fascist powers at bay.

Regarding Iceland especially, he said: "What horrifies me is that you've got a financial system designed by neoclassical economists." 

Ain't that right!!

You can see the interview here (in English, introduction in Icelandic to 0:30min):

Steve Keen interviewed by Iceland Television 1