Did Icelandic households receive a major debt forgiveness?

"tkn" asked me in a comment to How to create a housing bubble? whether it was true that the Icelandic households had had their debt forgiven in any major amount. This is, unfortunately, not true. The short answer is that Icelandic households had 196.3 billion ISK (about 1.0 billion pounds) "forgiven" of their debts. That's about 12% of GDP.

But that's not really it. According to the "Icelandic Broadcasting Company" (IBC instead of BBC) the write-offs consisted of:

• 43.6 billion ISK due to the 110% act: if your mortgage was worth more than 110% of the market value of your property you could apply for, but not necessarily get, debt forgiveness to the point where the rest of your debt would be 110% of the market value. This, along with the next point, was organised and, of course, hailed by the government as a "significant" act to lessen the debt burden of households.
• "Abstract debt relief" provided for 6.2 billion ISK of the total 196.3 billion. This part was for individuals and couples that were in "serious" debt difficulties.

Those two points above were public initiatives. The next two were incidental!

• According to Act no. 38/2001, linking the principal of debt to the exchange rate was illegal. This was nevertheless done. Nearly every single "foreign currency loan" (they weren't really loans in foreign currencies, they were merely loans in Icelandic krona where the principal fluctuated with the exchange rate of the krona) to households was illegal. When it was finally ruled, by the Supreme Court, that this was illegal, the banks had to recalculate the nominal value of the "foreign currency loans". The Central Bank provided the rules how to but those rules were disputable to say the least since they were retroactive! Roughly 108 billion ISK of mortgage debt was "written off" due to this but using that phrase is deceiving since the loans were illegal in the first place. In fact, two months ago a ruling was passed by the Supreme Court that touched on those loans and the result of the ruling was negative for the banks. But the banks, two months later, have not amended their debt collection methods accordingly. And people are getting frustrated. 
• The recalculation of illegal exchange-rate-linked car loans, similar to the illegal mortgages, caused households debt to be lowered by 38.5 billion ISK.

Total: 196.3 billion ISK.

So this is the debt relief that Icelandic households received. However, due to the peculiar way of indexing the nominal value of mortgages to the Consumer Price Index, the inflation in Iceland has caused the principal of those indexed loans to grow. How much exactly, I do not know, but back-of-the-envelope calculations yield roughly 360 billion ISK since September 2008.

But it's maybe unfair of me to set this figure right next to the write-offs of 196 billion that the households got, incidentally or not. After all, this 360 billion figure is just a representative of how mad the mortgage system is in Iceland.

So I am afraid I must shatter the hopes of anti-debt activists and their ideas of Iceland. Unfortunately, the debt of Icelandic households is still around and it probably amounts to roughly as much, as a share of GDP, as it did before the collapse of October 2008.

How To Create a Housing Market Bubble

You allow the banks to lend out as much as they want. Graphically, that would be something like this:

New loans to households in millions of krona (we use . instead of , to represent ,000s). In August 2004 the banks entered the mortgage market with at-that-time revolutionary type of mortgages: 25 or 40 years and 4.2% real interest rates (the principal was indexed to the CPI) which later were lowered to 4.15% due to fierce competition in getting people to borrow money. The result was a housing boom of extraordinary heights (see next graph) which is being corrected through inflation, although the recent spur of mortgage growth is halting that much needed correction. Many thanks to Thorvardur Olafsson and Karen Vignisdottir at the Central Bank of Iceland for the data.

What do the colours mean? Blue: mortgages in ISK, red: mortgages indexed to the value of foreign currencies (loans in ISK where the principal fluctuates with the value of ISK in foreign currencies), green: car loans in ISK, yellow: car loans in ISK but indexed to the value of foreign currencies. The indexation to foreign currencies was later (2011) ruled out to be illegal according to law from 2001 (a long story but rather representative of the scandalous workings of the Icelandic financial system).

Here is the house prices saga in Iceland:

House prices in Iceland according to Thjodskra

And people seriously say that we had a financial crisis because of the collapse of Lehman and other problems in international markets?! Please, this was a home-made problem, and we still haven't solved it!

Banks: intermediaries or money-creators?

Peter Radford has a comment about whether banks are intermediaries or not on the Real World Economics blog, answering my comment where I say Krugman is disastrously wrong in his Banking Mysticism post. His comment is:

"I have just returned from depositing some cash in my local bank. An insignificant amount to be sure, but not the result of my being loaned to by that bank.

So.

Was that deposit a loanable funds sum? Is my bank an intermediary? Or is my deposit simply a recycled amount originating, way back, from a loan? If so, are the decisions of depositors like me completely irrelevant to an understanding of banking? Is that cash not really mine after all, and merely part of a giant flow from one bank to another? Did my decision have no macroeconomic effect?

I agree Krugman ignores – apparently – endogenous money creation. But banks gather deposits as fast as they can? Why? If they can simply create money why would I, as a banker, ever waste my time building branches to attract deposits? Why would I raise or lower interest rates to “attract deposits” if I never needed to?

Chick, in her book “Macroeconomics After Keynes”, pages 236-240, describes a difference between a “banking system” and an older, less sophisticated “bank”. She argues that the notion of being a ‘savings conduit’ (i.e. an intermediary) is outmoded once banking becomes so intertwined it can be called a system. She tries to make a great deal of this.

The issue, it appears is causation: does savings drive investment; or does investment drive savings? Chick sits squarely in the latter camp because of her Keynesian view, while Krugman seems muddled and appears to tend towards the former.

My life as a banker for 20 years would have been a whole lot more simple had I known that I was not running an intermediary. At least in part.

It appears to me – naively obviously – that banking is more complicated than either side in the Keen – Krugman discussion implies. Banks clearly create money. They recycle it too. And that recycling is called intermediation. Which, in turn, can be called being a conduit for savings.

Is this another case of two tribes not wanting to concede that there may be a middle ground?"

There is no middle ground
I am going to argue that there is no middle ground: banks are creators of money, in all instances.

First, transforming cash into bank deposit has, effectively, no effect on your net holdings of money-type assets. Cash is money just as bank deposit is accepted as such. However, there  is a great difference in cash-money and deposits-money in the sense that one of them is vulnerable for sudden lack of trust when depositors don't believe anymore to be able to use the bank deposit as money. That is when we see a classic bank run: people are despairingly trying to SELL their bank deposit to the bank itself and BUY cash instead. And the price therebetween is 1:1.

But that's exactly what you do when you take your cash-money to the bank, just the other way around. You sell it to the bank and instead the bank gives you a bank deposit, which is usable as money, and you get tiny rate of interest on it as well. As long as you think you can access your bank deposit whenever you want to use it as money, you're ok with that deal.

Note also that the rate of interest on the deposit is (should) be lower than the policy rates, which is the price of liquidity assistance from the central bank. The bank will be happy to buy the cash from you and sell you low interest deposit instead, not to lend the cash out (intermediary) but to fulfil either regulatory minimums or bank-specific needs regarding liquid assets. Those liquid assets can be the cash itself (the Austrian dream of 100% reserve requirement ratio) or the bank can sell the cash you just brought in to another bank or even the central bank itself and get liquid (central bank or other bank) deposit instead.

The question each economic unit has to ask himself is how liquid he wants to be. Cash is the utmost liquid asset and you can, as Keynes realised and built his Liquidity-Preference theory on, use it to store your wealth if you do not trust any other assets to hold your wealth in or if you want to make a speculative move on the price of other assets (you standing in the bank-run queue is essentially a speculation on your behalf: you think your bank-deposit asset will collapse in value and therefore you are trying to sell it to get more liquid asset, cash, instead in which you prefer at that moment to store your wealth in).

So when you brought the cash-money into the bank, you indeed had macroeconomic effect: you lowered the rate of interest (by obviously such a low amount it wasn't noticed but I hope you get my point) as you accepted an asset (bank deposit) that is not as liquid as cash. You selling your cash to the bank is a sign of your liquidity-preference being lower than when you held the cash.

My point is that banks are not intermediaries: you are not depositing your cash-money in the bank for it to lend it out to another person, you are selling your highly-liquid cash-money to the bank for not-as-liquid bank-deposit. The bank may well sell the cash you sold to it to the central bank for a liquid central-bank deposit or buy a much more illiquid CDS contract or whatever not, it hinges on the liquidity preference of the bank you just sold the cash to. And since this is a question of liquidity-preference of units but not intermediary process, the banks will ALWAYS create deposits parallel to creating bank-loans. Those deposits are then spent on other assets, both financial and non-financial, but they are always somebody's financial-liability in the system, no matter how you store that wealth, i.e. purchasing power.

An obvious problem that arises from this is "when is a financial asset money?" How the newly created deposit is spent makes a difference on how much "money" ends up in the system. Do you spend it on a savings account (thereby moving a time-deposit, which is M1, into M3)? Or do you spend it on Treasuries? Or corporate bonds? Or stocks?

This was a problem that Keynes realised in the GT but he, as far as my knowledge goes, never addressed it properly but simply said (in footnote no. 66): "...we can draw the line between "money" and "debts" at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for "three months" one month or three days or three hours or any other period; or we can exclude from money whatever is not legal tender on the spot. It is often convenient in practice to include in money time-deposits with banks and, occasionally, even such instruments as (e.g.) treasury bills."

To my knowledge, Treasury bills and Treasuries are generally not included in official money supply measurements.  But that's where bank-deposits, created parallel to bank loans, can end up if the owner of the deposit so chooses. Obviously, we can put "CDS contracts" or "stocks" or any other financial instrument in there as well according to this "definition" of money. And that is suddenly not "money" any more, even thought the debt and the deposit were created at some time in the past.

So banks are not intermediaries, not even partially so. They are simply, as Schumpeter so blatantly stated it, creators of purchasing power.

New Data on Income Distribution in Iceland

Statistics Iceland released this morning new data on disposable income in Iceland. Peeking at the info one can draw three conclusions:

First, the boom from 2004 until 2008 wasn't evenly distributed at all - not that it's surprising. The disposable income of the top 10% grew 33% in four years while the income of other groups grew 21-25% (the "80-90%" income group added 25% to its real disposable income, the bottom 10% added 21%). This had the obvious effects that the income ratios between the top 10% and the rest fell.

Second, although the Gini coefficient has gone down from 29.6 in 2004 down to 23.6 in 2011 (based on incomes of the years 2003 and 2010), the main source of the increased equality, according to the Gini, is that the top 10% have lost all their income increase. 

Third, the real disposable income of households has gone back to the level of 2004. There is basically no growth in real disposable income over 7 years! In the meanwhile, the debt of Icelandic households has grown by at least 20 percentage points if the ratio debt/GNP is examined. And the real disposable income is not adjusted for debt burden.

Graph 1: Real Disposable Income of Icelanders on fixed 2010 prices. 

Graph 2: Since most of the income growth during the boom years was in the richest group, the ratio of other groups' income to the top-income group fell; Iceland was edging closer to a Plutonomy. The ratio bounced back after the collapse, basically because the top earners lost all theirs.

Graph 3: An index of real disposable income of different groups. The growth of the Real Disposable Income that took place during the boom years is all gone. In the meanwhile, a conservative estimate of Households' debt at year end 2011 was 117% of GNP compared to 98% in 2004.

Graph 4: Debt of Icelandic households according to book-value of debt. The face value is somewhat higher, especially after the 2008 collapse. Today's Icelanders have to pay 20% higher debt with the same real disposable income they had in 2004.

Excerpts from the General Theory by Keynes

I've been reading the General Theory by Keynes due to the "policy chapter" (working title) of my PhD thesis. I had only read chapter 12 before but now that I'm working my way properly through book IV of the GT (chapters 11 to 18 on The Inducement to Invest) I realise what sort of genius Keynes was. Here are some excerpts, only from chapters 11 and 12 (I don't have much time and the number of quotes would grow quickly if I would include chapters 13-18, especially from chapter 13 where the liquidity-preference theory of rate of interest is introduced):

Chapter 11 - The Marginal Efficiency of Capital
"The most important confusion concerning the meaning and the significance of the marginal efficiency of capital has ensued on the failure to see that it depends on the prospective yield of capital, and not merely on its current yield."

"It is important to understand the dependency of the marginal efficiency of capital of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle."

"The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake in regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between today and tomorrow... The fact that assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality."

Chapter 12 - The State of Long-Term Expectations
"It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is  reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which out knowledge is vague and scanty. For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the the future, modified only to the extent that we have more or less definite reasons for expecting a change.

The state of long-term expectations, upon which our decisions are based, does not solely depend, therefore, on the most probable forecast we can make. It also depends on the confidence with which we make this forecast - on how highly we rate the likelihood of our best forecast turning out quite wrong."

"If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence."

Factor no. 4 of how we form the expectations of the future and on what they are based on deserves to be quoted at full length. Keynes's own italics are still there but my emphasises are underlined:


"(4) But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgement and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.


Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.


This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.


Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.


If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence  of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

"We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance."

And today's economic theory?
What I must admit finding amazing is that all that is written here above doesn't take a genius to write (although Keynes certainly was). I cannot help to feel that the meaning of the text here above can be agreed to be in some sense true by any commonly intelligent human being. That same human being would at the same time quite likely to be able to convey the meaning of this text to another person, maybe not using those exact words but conveying its meaning and feeling all the same. This is truly nothing more than common sense.

Nevertheless, today's economic theory is nothing of this sort. Just as an example, uncertainty about the future does not exist in today's ruling macroeconomic theory. It is disturbing how far away from the real world the ruling paradigm of economic theory is.

And is it any wonder, seeing today's ruling economics theory where the sensible economics of Keynes is completely and patently ignored with fully informed economic agents who take decisions based on "rational" expectations where there is no uncertainty about the future course of events, that we are in a world of economic mess?