The new GDP figures

Statistics Iceland issued new figures on GDP growth three days ago. As I've been flat chat in finishing my PhD I haven't had the time to dig into them properly until now. They tell us pretty much the same as the last figures: the economy is fragile and a wolf would not have to huff and puff much to blow it down.

First of all, the GDP growth of first six months of 2012 was estimated to have been 2.4%. The previously posted 3.1% growth of 2011 was reevaluated downwards to 2.6% - there goes any reason for the central bank to up the policy rates further! GDP per person is still way below what it was before the crash happened: five years later we are still only getting 91% of the GDP per person we had.

Still long way to go! Although the economy is slowly bouncing back the GDP levels per person are still meagre 91% of what they were 5 years ago.

Furthermore, and what is most important, the investment levels are still laughable in historical context. Total investment has still not gone up above 15% of GDP when the normal ratio should be close to 19-20% or thereabouts. Industry investment is only slowly coughing its way upwards when in fact a lot more investment is exactly what the economy needs! But no need to be surprised about that: the offshore krona problem is still around and interest rates are too high. Is it any wonder that the economy is not bouncing back properly!

A very severe problem is in fact arising due to the low investment levels: we are not keeping up with amortisation! The machines we use to produce whatever we are producing are breaking down faster than we can replace and fix them. To expect a proper economic recovery with reducing capital stock is like expecting to be able to run faster when you're 80 years old than when you were 25.

Investment, especially industrial investment, is still only a shadow of itself. Categorised figures only stretch back to 1997 but next graph shows how slowly total investment is recovering.

Total investment (blue line) is still insufficient. Investment is in fact so low in fact that we are not managing to keep up with the amortisation of capital with the obvious consequence that the stock of capital is reducing (red line, right axis). How exactly are we going to improve productivity for the longer run if investment is not even enough to keep up with the amortisation? Red dot is 1H2012.

As expected, when investment is low the level of employment is as well. A break in the correlation between total investment and unemployment seems to be visible after the 2008 crash. The effects of emigration on the employment figures should not be taken lightly. Employment will not bounce back until the level of investment recovers.

A structural break seems to be present in the data on unemployment and investment levels after 2008. A likely explanation is the emigration to e.g. Norway and other popular post crisis destinations of the Icelandic worker. 

A reposted figure from Unemployment in Iceland. Don't expect the total number of worked hours per worker to grow much while the level of investment is as low as it is. The GDP growth is a froth! 

The Shortage of FX in Iceland

Iceland has strict capital controls at the moment. A permission is needed from the Central Bank to move money out of the country. And if you're in the exporting business, you have to sell your foreign currency income to the Central Bank.

All this is done to preserve the foreign exchange reserves of Iceland, reserves that are almost completely borrowed from the IMF, Scandinavian countries and others. However, there is a great shortage of FX in the country as is rather blatant by the existence of the capital controls.

Andri Gudmundsson, CEO of H.F. Verdbref ("H.F. Securities"), said that the problem was that Icelanders spent too much on imported goods. This is quite fantastically right! And the lack of FX will end up with the krona falling in value. But how are we managing to spend so much on imported goods? Where is the spending power, in ISK, coming from in the first place?

The source of that spending power has traditionally been the banking system. When the banks extend loans they create the borrowed money out of thin air. The extra money in the economy is then spent on goods, including imported goods of all kinds (investment and consumer goods). When we've borrowed a lot and spent the lot on imported goods we realise we're in FX problems. The krona then falls in value when the market sobers up. The fall in the value of the krona defers people from spending their money on imports and helps exports to gain foothold.

The story is always the same in Iceland: the krona has never fallen in value unless there is expansion of bank loans in the years before. Using the data from Statistics Iceland, that's rather blatant.

Four distinctive periods are very obvious in the economic history of Iceland when it comes to expansion of bank loans and the subsequent fall in the value of the krona. 

After the bank-loan expansion that fuelled and funded the bubble that collapsed in 2008 the external balance of the macroeconomy was in ruins; we had more than 20% current account deficit in 2006 after massive imports of all kinds of consumer and investment goods. Then the krona finally collapsed.

The krona-collapse in 2008 was not enough. It's somewhat like the exchange rate collapse in 1950; ten years and some bank-loan expansion later we had another and more severe devaluation. There is still too much of kronas in the economy in comparison to the FX reserves, which is of course why we have the capital controls in the first place. And despite all the devaluation of the krona, we are still running the current account deficit in the negative territory. One reason for that is the fact that the banks are lending out money again, now in the form of unindexed mortgages. And all that money is fresh off the banks' conveyor belt.

The plan and the aim is to abolish the capital controls in 2015. That plan will fail at the pace of the recent progress. We need to get serious.

Unemployment in Iceland

Two weeks ago, the Minister of Economy, Business and Industry (yes, he's all three!) Mr. Steingrimur J. Sigfusson wrote an article with the headline (translated) "Unemployment dropping fast". The reason: registered unemployment in Iceland had dropped down to 4.8%. That's pretty fine for an economy whose banking system collapsed in less than a week four years ago! Well done guys!

Not so fast! Sorry, but I'm constantly the pessimistic guy digging a bit deeper than just repeating what the headline data told us.

OK, so three weeks ago the registered unemployment rate in Iceland registered at 4.8%. That was the data for June. This column graph is copy-pasted from the monthly report by Directorate of Labour. "Atvinnuleysi" is "unemployment" in Icelandic. Click to enlarge.

The DoL data is based on how many people receive unemployment benefits. That can be pretty limited if a) the rules regarding unemployment benefits do not apply to those who want the benefits, b) there are people who have given up on looking for a job and left the labour market and e.g. went studying, c) people have left the country or d) people want to work more but cannot because there isn't a job available.

Another data source for unemployment is the data bank of Statistics Iceland. The monthly data there tell a bit different story than the ones from the DoL. They are after all better, yet not truly adequately, defined than data from the DoL. Important definitions by the Statistics Iceland include:

Employed. People are classified as working (employed) if they worked one hour or more in the reference week or were absent from the work they usually carry out. Individuals on birth leave are considered absent from work if they went on leave from a paid job, even if they have no intentions of returning to the same job.

Unemployment. Persons are classified as unemployed who have no employment and satisfy one of the following criteria:
1. Have been seeking work for the previous four weeks and are ready to start working within two weeks from when the survey is conducted
2. Have found a job which will begin within three months but could start working within two weeks. (Until 2002 the criterion was that it sufficed for the job to start within four weeks without it being investigated whether the person involved could begin within two weeks.)
3. Await being called to work and are able to start working within two weeks
4. Have given up seeking work but wish to work and could start working within two weeks.
Students, including those looking for an apprenticeship in a trade, are only considered unemployed if they have been seeking a job along with their studies or a permanent job for the past four weeks and are available to start work within two weeks of the surveys occurrence.

Outside the work force. People are termed outside the work force if they are neither employed nor fulfil the conditions for being unemployed. The labour force is considered to consist of employed and unemployed persons.

The graph below shows the unemployment according to the Statistics Iceland data. The data has been smoothed with a 12 month moving average. 

OK, so unemployment is coming down. But is that enough?

No, it isn't. What counts must be the total hours worked in the economy. And that dropped like a stone in the crash and isn't coming back up, at least not seriously.

Total weekly worked hours in the Icelandic economy. Although unemployment is slowly coming down, total worked hours isn't steaming upwards.

We can use these data on total worked hours and divide them on the total number of people in working age and the total labour force.

Total worked hours has dropped significantly as previous graph showed, down to 2004 levels. But since the labour and man force have grown since 2004, the average working hours per individual in the workforce has taken a considerable dive. And on the bottom it stays.

Suddenly, the 4.8% unemployment according to the unemployment benefits estimate isn't that impressive anymore. Weekly worked hours per individual in the labour force is damn stagnant and has in fact dropped significantly after the October 2008 crash and stayed down. Realise that if weekly worked hours drop by around 4.6 hours, as they have done, the total monthly worked hours drop by around 19.8 hours.

Give yourself that the average person earns perhaps 10-15 pounds per hour (2000 - 3000 ISK or so) and the total lost monthly wage income is around 200-300 pounds. That's around 38,000 - 57,000 ISK per month if the pound is 190 krona.

So what happened? Why is the unemployment coming down?
We can see on the two first graphs above that the unemployment, even according to the Statistic Iceland methodology, is coming down. Yet, the total worked hours per person is lingering at levels that can hardly be present in an economy that is returning from a bust. So what happened?

Emigration happened. And despair about getting a job, resulting in a huge number of people outside the labour force, happened.

First, emigration was quite noticeable after the collapse. Droves of people, both immigrated travel workers that moved to Iceland during the boom years and Icelanders, left the country. Of course, they are then neither registered as unemployed nor are they in the man or labour force. That drives down the rate of unemployment. Many of those people left simply because they couldn't get a job.

Immigrated minus emigrated people, in thousands. After the collapse in 2008, a noticeable part of the workforce has simply left the country. That has had positive impact on the data on unemployment.

Second, people lost hope. They simply left the labour market. Both the University of Reykjavik and University of Iceland said that record number of new students had been admitted into the universities. One can only speculate how many of those people got back in the classroom because they couldn't find anything else to do.

This actually shows in the data. A record number of people have left the labour force, simply because they cannot find anything to do. There are no jobs around, they lose hope about getting a job, stop looking and they are therefore unregistered from the labour force according to the Statistics Iceland methodology. And people outside the labour force are not unemployed according to the data - although in reality they may well be!

When the collapse in 2008 happened, the trend of people leaving the labour force had been going on for around a year already. After the October 2008 collapse, the trend has been all but upwards. At the same time, record number of people have registered themselves in tertiary education, quite likely because they have nothing else to do. 

Checking the number of people outside the labour force as a percentage of the total man force does not make much difference.

The lack of employment has pushed record number of people out of the labour market, no matter if one looks at the number itself or the ratio of labour force leavers to total man force. 

So I'm very very sorry. Although measured unemployment is coming down, the main reasons for it are not increased employment or increased number of employment opportunities - that would show itself in increased number of worked hours per individual in the labour force - but people giving up on looking for a job. They leave the labour force either by educating themselves or by leaving the country. Of those active in the labour force, the average income is in the meanwhile perhaps 200-300 pounds lower than it was in 2008.

Unemployment in Iceland is not 4.8%. That's lies, damned lies and statistics.

Icelandic public pension zombies

I promised some time ago to get into the Icelandic pension system now that the Financial Supervisory Authority in Iceland has published its annual report on the system, taking into the account the figures as they were at year end 2011.

Few things you have to know about the system before we continue.

It's a classic three-pillar system. The State takes care of the basic social security. That pillar is a normal defined benefits system in the sense that this part is paid for with taxes.

The second pillar is a messy mix of defined benefits and defined contribution system. The second pillar is one part public but the other is private. The public part is backed up by the State and its benefits are predefined. The contributions are as well but the contributions fall way short of covering the benefits as we will see later in this post. This means that the defined benefits must be fulfilled with the State's money. And that's a lot as we will see later as well! In fact, it is so much that I believe the public part of the second pillar of the Icelandic pension system is as good as bankrupt. At least technically.

The private part of the second pillar are the private pension funds. They are messy as well because laws no. 129 from 1997 define the benefits they must fulfil. In the case of old-age pension the funds must pay out the equivalent of 56% of average wages during the working life of the pensioner, given 40 years of working life.

The contributions are also "half-defined". There is a clause in the law that states that the funds can define the contribution needed to back up the clearly defined benefits but the mess is that they all follow the same basic contribution ratio: 12% of wages, up from 10% in 2005. The trick is that there is another clause - clause no. 39 -  that states that the private pension funds must "redefine" the pension assets of their members if the actuarial position is negative by 10% or negative by 5% for five years in a row (yep, the pension funds in Iceland are allowed to constantly be in the negative territory with their actuarial position!). The redefinition of pension rights normally means to simply write them down by whatever figure is necessary to get the actuarial position back into not-as-negative territory. However, the public part of the second pillar never writes down any pension rights since they are backed up by the State.

Right, this is some of the basics you need to understand what will follow. What follows scopes outs only the public part of the second pillar. My argument is that it is as good as bankrupt. You'll see why in a bit.

The bankrupt public pension system in Iceland
Again, the public pension system in Iceland is backed up by the State.

There were 668 billion ISK (5.5 billion USD) missing on the actuarial position of the whole second pillar of the Icelandic pension system in Iceland at year end 2011. The public pension funds were responsible for 547 billion (4.5 billion USD) of those 668 billion, the private funds the rest (121 billion ISK).

This might not sound serious but remember that the GDP of Iceland was around 13.4 billion USD in 2011. The total income of the State - federal and states - was 679 billion ISK (5.6 billion USD) in 2011. So the hole on the public pension system amounts to roughly one third of annual GDP or 80% of the income of the State. And don't forget, the State is the guarantor of the public pension system. A system which hole on the balance sheet is now 80% of the annual gross income of the guarantor.

Something missing on the State's balance sheet?
So there is a massive hole on the balance sheet of the public pension funds which the State is the guarantor for. This means that the money missing in the public pension funds should show up on the balance sheet of the Icelandic State, right?

Apparently not! Booked pension liabilities of the State - federal and states - are 163 billion less than the total hole in the actuarial position of the public pension funds.

There is something missing on the balance sheet of the State in Iceland. The guarantee on the public pension system seems not to be fully accounted for. Amounts in billion ISK.

This mismatch is something which generational accounting would fix. That has of course never been implemented although it seems pretty sensible. But hey, who knows! Maybe we get lucky and just accidentally trip over 163 billion ISK somewhere? I kind of doubt it however. Who cares anyway, 163 billion is only around one fourth of annual gross income of the State in Iceland.

Maybe they  can just monetise the whole thing by asking the Central Bank to print the whole lot for them! Too bad that might be inflationary and the pension rights are indexed to inflation. Wonder who would win that race, the dog or the tail.

The nutshell
The public pension system in Iceland is missing 547 billion ISK on its actuarial position. That deficit will in the end be borne by the State finances but they nevertheless seem not to be accounted for fully on the balance sheet of the State. The State is therefore seemingly so hiding a liability amounting to around 10% of GDP. Hiding public liabilities is an interesting sport.

But the public part of the second pillar of the Icelandic pension system is essentially not that interesting. It is technically bankrupt, needs to be restructured and I'm not going to spend too much time on it. The only question is when the public system comes down crashing and we all know that self deception can go on for a long time before the "sudden realisation" dawns upon everybody.

The more interesting part is the private part of the second pillar. We'll get into that part later.

Does The Teaching of Economics Take The Markets into Account?

A post I wrote for the Inomics Blog and was published yesterday. 

I'm working on writing up my thesis at the moment, will continue posting more on the Icelandic pension system after I've finished that or when I find time to!

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“I write to you from a disgraced profession” were the words of James K. Galbraith, the son of one of the most successful bestsellers of books on economic and financial matters. “Economic theory… failed miserably to understand the forces behind the financial crisis.”

For those of us who know or have studied mainstream economics theory, this sounds pretty much correct: despite the thousands of pages of economic theory we studied in our undergraduate programs, we had essentially no idea what the heck was going on when the crash belatedly arrived. What baffles most is that senior economists – including those who were teaching the undergrads – did not seem to have much of an idea either. Respect for economists collapsed parallel to world economic activity and one startling but clear observation dawned upon many: the market did not fit the description made of it in the textbooks!

That, to say the least, must be a problem. Mainstream economic theory assumes this and that to reach its conclusions about whatever the subject at hand might be. Included in those assumptions are quite a few quirks about the market(s) that seem to defy reality. Those assumptions are that the markets are “efficient”, where the e-word does not seem to mean the same thing as in everyday life, and that there are no cheaters, which the Ponzis and Maddoffs of the world and the “Lie-bor” scandal have taught us, again, is not the case. Also, everybody is “rational” or at least “rational up to (fixed) boundaries” but, again, rational in economics does not mean the same thing as in everyday life. Isn’t that a problem on its own that one has to keep different definitions of words in mind depending on whether one is on the subject of economics or speaking to one’s spouse?

The truth is that mainstream economics, especially the higher degree of it, is as good as useless when it comes to the market place. I will soon finish my PhD degree in economics and some potential non-academic employers that I’ve met ask me immediately how much market experience I have. I’ve got some and it calms them down but I did not understand vividly until recently why they were so focused on asking me the market-experience question right after they heard that I was earning a PhD in economics.

The reason is that many PhD students in economics are doing the type of economics that could never be applied to the markets! The stuff they are doing is mathematically proving the existence (not the size!) of some obscure factor in an even obscurer model of an economy that has not, does not and will not ever exist. Some employers have told me that they have had to “de-educate” newly graduated PhD students in economics for them to be valuable employees. Their mind had simply been trained in thinking about economics of a non-existent economy and not the one they were living in. Is it any wonder that most PhD students in economics are not immediately grabbed by the financial market – unless they know how to program in Matlab, R, C++ and SQL – and instead linger on in academia, sometimes just to find a job that pays the bills?

Teaching economics: what is it good for?
Economics teaching has to change! Economics as it is taught today is not producing highly skilled labour that can be a valuable input in the manic-and-panic markets that exist in the real world but not in the textbooks. Keynes was in fact quite close to being absolutely right: “the master-economist must possess a rare combination of gifts… He must be mathematician, historian, statesman, philosopher…”

Today, the trained economist is mainly a mathematician but the other four traits are forgotten or secondary at best. Worse than that, the trained economists is not a mathematician in the mathematics of real-life markets, full of chaos, uncertainty and feedback loops, but of orderly markets and rational behaving firms and individuals that never cheat and are never subject to influencing each other.

The trained economist is therefore trained in the mathematics of something that does not exist. He holds none of the traits that Keynes thought were necessary for the master-economist. If this is not changed respect for economics and economists will continue to dwindle and the potentials for wide affluence that the not-yet-science could deliver will never be delivered.