The Icelandic Debt Relief

The hottest story coming from Iceland now is the one about the government-initiated debt relief to households. Here is my take on it, focused only on handful of all the questions and issues related to the act itself and, perhaps more importantly, the potential economic development in the future. Especially on that front we have a sea of unanswered questions. Is this going to be inflationary? What about economic growth, unemployment, investment levels, etc.? The balance of payments? Will this help or hinder the abolishment of capital controls?

First some useful links (in English) that I found. They are unfortunately not many... classic Icelandic lack of communication problem... (if you've got some others, please leave a comment):
FAQ on the website of the Prime Minister's Office
The news itself on the same website
Bloomberg - Creditors in Iceland Banks Face Pressure to Speed Up Settlement (by an Icelandic journalist).

The basics
Framsóknarflokkurinn (e. The Progressive Party, PP - they are conservative) promised to carry out a debt jubilee if it would be elected into power in the last general elections. They were. The other half of the coalition is Sjálfstæðisflokkurinn (e. The Independence Party, IP - conservative).

Those two parties did not agree on how the debt should be cancelled. The PP wanted to straightforward cancel it. They were talking about up to ISK 300 billion just before the elections, the actual amount turned out to be half that. The IP thought that cancellation would be impossible since it would either be simply illegal on the grounds of property rights and / or too expensive for the State in case the State was going to foot the bill for cancelling the debt of households. Their take was to use the tax system and create incentives for people to use the 3rd pillar of the pension system - the private pension holdings - to get tax-free additional income to be spent on paying down debt and only to pay down debt.

The outcome is a mix of both. ISK 80bn. (roughly GBP 400 million) of household debt will be outright cancelled. Additional ISK 70bn. are to become available via allowing people to use their 3rd pillar pension savings in the next three years, to pay down their household debts.

So what's the crack? 
Icelandic households will get ISK 150bn. (GBP 750 million) of their household "cancelled", spread over a four year period. I say "cancelled" because they are in fact paying down ISK 70bn. of it themselves, the only thing is that they get to use tax-free pension savings to pay down that part. And that makes perfect sense by the way: why save in an illiquid form at 2-3% real interest when you have debt to pay that charges a 4-5% rate of interest.

The rest, ISK 80bn., will be outright cancelled in four annual instalments although the borrower will feel the positive impact on his monthly payment burden immediately. Each household that has an indexed mortgage, partially or wholly, (check this link to see how indexation of Icelandic mortgages works), specifically declared to buy a property for own use (buy-to-let mortgages are excluded!) will get a maximum of ISK 4 million of the debt written off. Non-indexed loans get no write-off but the tax-free pension savings can be used to pay additionally onto the principal in the future. The tax-free pension savings can also be saved and later used to buy a flat. This is why they say that even current tenants will benefit from the measures. If the household got its debt cancelled via e.g. the 110% measure this will be accounted for and the current write-off will consequently decrease.

The following is a copy-paste from the slides about the measures. The way you should read this is the following. The x-axis is the time when an ISK 15 million mortgage was taken out. The graph (grey area) shows the nominal amount of that debt today (Remember, the principal of indexed Icelandic loans INCREASES in value parallel with the CPI. That's the reason why an ISK 15 million mortgage taken out in e.g. September 2001 would amount to about ISK 25 million today according to the graph). The blue area is the debt after the debt has been cancelled and the light brown (beige??) area is the amount of the mortgage once a 3 year private pension pay-down has been accounted for. So the decrease is read vertically and depends on when the loan was taken out. Click to enlarge.

The principal of an ISK 15 million mortgage and how it is affected by the jubilee, depending on when it is originally taken out

Now, most of the questions, and some answers, about how and why and what for and all that can be found in the FAQs from the Prime Minister's Office. So head over there to read further on how the whole thing is carried out. I would rather spend time on some other issues, such as:

Is this significant?
That depends on how you look at it I suppose. This jubilee is not gigantic in comparison to the debt that has already been cancelled since 2008. On that note, I honestly think this nice info-graphic, which is circulating on Facebook from a group that is politically, well, not keen on the current government, says it all. To give the current government some rightful credit (pun intended): their measures are more significant, by a mile, than the previous government's measures (because they had nothing to do with the pink part of the left column).

Comparison of how much household debt has been cancelled in Iceland since The Crash.

The headline ("heimsmetið") is a reference to the prime minister who said that his government's jubilee was a "world record". The left column is debt that was cancelled during the coalition rule of last government. The colours represent the following: purple (12bn) - special interest benefits, pink (155bn) - correction due to illegal FX-indexed loans (this came through the justice system and had nothing to do with the former government), orange (8bn) - special debt measures, yellow (48bn) - the 110% way (any debt above 110% of your property value was written off), grey (15bn) - increased interest benefits, blue (70bn., the IP's campaign colour) - Tax-free pension savings, green (80bn., the PP's campaign colour) - debt jubilee.

So in comparison to the previous write-off of debt in Iceland, governmentally initiated or not, the current jubilee is not so huge.

However, it is significant from the point of view of proving that this is politically possible! And that's something for other nations to learn from! Jubilees do not need to be a thing of biblical times! (But of course, that does not mean that they are always a smart move!)

But how are they paying for all this?
Right, that's a bit hazy to be honest. The short answer on the list of FAQs on the website of the prime minister's office is a classic nonsense answer that doesn't add any value:

"How is the debt relief financed? The Treasury will collect increased revenues in the next four years to cover the cost of additional state expenditure resulting from these actions. The actions will therefore neither be financed by additional Treasury borrowing nor with the granting of state guarantees."

Right, so the no-bullshit answer is that you're going to increase taxes - or "collect increased revenues..." Then just say it!

Where are they going to "collect increased revenues"? From the old banks. Through taxation. Specifically, they are going to tax the estates of the old banks, i.e. the bankrupt banks since 2008. Their liquidation process is going veeeery slowly, to a large extent because of the capital controls and the tug of war between them and the liquidation process of the old banks: the capital controls hold it back but the estates have to be liquidated in the end before we can abolish the capital controls. Well, that's a nice one: like being a driver with two back seat drivers, one demanding you drive faster and the other demanding that you slow down. Which one are you going to make unhappy?

The government is going to make the old banks unhappy. Besides outright taxation on the them to pay for a debt jubilee for households, they are considering changing laws that would force them to speed up the liquidation process.

I've got two immediate concerns about this.

First, those are two birds in the bush but not one in the hand. Are we definitely sure that they can tax the old banks? This sentence alone from the slides says it all (slide 56): "The committee [behind the debt jubilee] assumes that the measures will be fully funded over a period of four years" (i. "hópurinn gefur sér þá forsendu að aðgerðin verði fullfjármögnuð á fjórum árum.").

Great going guys, I do this all the time as well! I always just book my vacation to French Polynesia and just assume that I can finance it! ISK 80 billion!? Pennies mate, I'll pick them up off the floor one day!

And even if they can tax the old banks specifically (there are some concerns about whether it would be constitutionally possible or not), won't the old banks, which are the main owners of Arion and Islandsbanki, not just pass at least part of the cost onto their customers? Competition in the banking industry in Iceland isn't great you know.

Second: OK, if we can tax the old banks to get cash for a debt jubilee, couldn't we have used the money for something else? Like not practically shutting down the Icelandic public radio? Or pay decent wages to doctors, nurses etc.? Not putting myself up against the debt relief as a principle, just pointing out that we didn't have to spend all the cash on it.

Or maybe we can tax them even more and spend that tax income on something nice!?

But how do they actually do this?
1. The mortgages are split up into "primary" and "secondary" parts.

2. The primary part (about 87% of the mortgage to be written down) is the new debt of the borrower. This loan has the same loan stipulates as the original loan, i.e. same rate of interest, indexed to CPI, etc.

3. The secondary part is interest and indexation free. There are no payments of that debt. Both of the loans are on the balance sheet of the borrower and the financial institution that owns the original loan. The total payment burden therefore contracts immediately and not over four years.

5. Annually, the State buys back 25% of the original amount of the secondary loan from the financial institution (hence the fact that this will take four years to finish). This is roughly ISK 20 billion annually, hence the total ISK 80 billion write off. The debt is then written off. The income to fund this is meant to come from the estates of the old banks themselves.

What about the economy?
The government estimates that with all this they will manage to get household debt below 100% of GDP. Such a debt level is still quite high and may still be a barrier to economic growth and financial stability, especially since interest levels in Iceland are stupefyingly high in comparison to other economies.

Nevertheless, this should help. Analytica, a consulting company back home, reckons the effects of the jubilee will be the following for 2014 only:
- economic growth: +0.1%
- inflation: +0.1%
- current account balance: -0.2%
- consumption: +0.4%
- investment in new properties: +2.0%

My take in short
Now, there are some good things about this measure.

First of all, they did it! Jubilee is here, well done guys! You proved this is politically possible and economically this does not seem to be an absolute nonsense. So this opens up the possibility of doing this in other countries. Whether that would make economic sense has to be discussed for each economy. Some very indebted households will feel quite relieved and this will have positive impact on the economy although the impact may be short lived (see more why below). The tax-free pension part of it all also makes perfect sense and simply boils down to the fact that it is not smart to save on 2-3% rate of interest when you owe debt bearing 4-5% rate of interest.

But I do have to admit that I have concerns, besides the obvious ones like the taxation issue (which may well enough not be so important). There are a few reasons why.

First, the primary loan, or the new loan, that the borrower has to pay off will still be indexed, just like the original loan that now is being partially written off. We will therefore still have all the negative effects of indexing mortgages in Iceland, including more volatile inflation, higher inflation, higher rate of interest, lesser effectiveness of the monetary policy and the risk of having to have another debt jubilee in 10 years time or so.

Second, and closely related to my first concern: although there is no direct increment in money supply because of the measures we can, I believe safely, assume that not only will we have some potential demand-pulled inflation immediately in the wake of all the jubilee but increased credit demand as well (especially if we have an increase in moral hazard due to all this: will people take on more debt because they anticipate another debt jubilee in the future?). As the increased credit demand will be met with new loans that increase the money supply we will end up with further inflation pressures. And because the principal of indexed debts will grow with more inflation we will get some, or even all, of the "jubileed" debt back. The Central Bank will also respond with an interest hike to try to hold credit demand back. That will hit the borrowers with non-indexed loans as their interest rates are potentially readjusted upwards. (More effective and sensible way of limiting credit growth and inflation would be to impose direct credit controls and connect them to the banks' own net holdings of liquidity in foreign currencies. But I doubt the Central Bank will go down that road: you can't teach old dogs how to sit).

Why, oh, why did they not make it compulsory to change the new primary loan into a normal non-indexed loan? A golden opportunity to get rid of this pest that indexed mortgages are has been wasted!

Third, although the net assets of the old bankrupt banks will contract (assuming everything goes according to plan) we will still have "considerable" pressure on the balance of payments because of increased consumption and demand. Now, of course, part of the reason for those measures is to revive household consumption. But if we will get into even further riskier waters with the balance of payments than we are in, doesn't that just signal that the exchange rate is too strong? And imagine what will happen when and if the exchange rate goes down: inflation goes up, principal of debt grows back, we're back on square one.

So again: why, oh, why did they not abolish indexation parallel to those measures?!

Fourth, and this is perhaps my most serious concern. We haven't fixed the institutional drawbacks of the Icelandic economy. Besides still having the indexation on mortgages, we still have a high self-imposed rate of interest stemming from the pension system. (It is regulatory required to get a real rate of return of 3.5% and it controls assets equal to about 120-130% of GDP. What do you think will happen to the long term rate of interest with such gigantic buyer of financial liabilities who demands a high minimum rate of interest. Has anybody heard of monopsony?). We also still have high short-term rates, to a large extent because of the indexation.

So I fear that the net effects of this debt jubilee will not be significant in the long run. At least from an economic point of view. Politically, this may fuel some fires, even in other countries where over-indebted populations may be nudged to demand jubilee there as well. In some cases those potential jubilees might make sense. The taboo of debt relief has just been delivered a blow. Maybe we can actually discuss it in a more sensible manner from now on and not with cries coming from both sides.

That is all well and square, but when it comes to the Icelandic economy, I fear we will only have short spurts of economic bounce back. It is not enough to cut the leaves of the weed, we need to dig out the roots as well.

The Prophetical Talents of the Central Bank of Iceland

The Central Bank of Iceland upped its policy rates by 25 points yesterday to 6.0%. Quite frankly, I think they made a bad situation worse by doing so when it comes to the outflow of capital out of the economy and the exchange rate of the krona. But that's another story that I'm going to analyse later.

For now, I'm only going to update the graph that I first posted in The Predictability of Inflation Forecasts. Again, we can see that the inflation forecasts issued by the Central Bank of Iceland are still the same: take the current inflation rate and slowly diminish it towards the inflation target, i.e. 2.5%. No matter the rate of inflation today, it will always be down to the inflation target, or thereabouts, in 6-8 quarters (a phenomenon first pointed out by Fridrik Mar Baldursson at the University of Reykjavik). You seriously couldn't make this thing up!

The Quarterly Macroeconomic Model of the Central Bank of Iceland always predicts that the rate of inflation will move towards the inflation target in 8 quarters or so, no matter the current rate of inflation. The different lines are the inflation forecasts from different Monetary Bulletins of the CBI. The red line is the inflation target, 2.5%.

And has the Central Bank been accurate when it forecasts inflation? Not particularly so. But the inflation forecast of 3Q 2011 seems quite accurate, beside the fact that it's totally off in the beginning. Too bad they've changed their minds too often since then to really appreciate the accuracy of that forecast.

Forecasted inflation according to each Monetary Bulletin and the real measured value

As an example of a seriously flawed forecast, take a look at 2Q12 which came out in May 2012. At that time, they expected annual inflation to be 6.1% and 5.7% in end of 2Q12 and 3Q12 respectively. Notice that they are forecasting inflation for the same quarter (2Q12) as they are issuing it in. The measured annual rate of inflation was 5.4% in June 2012 and 4.3% in September 2012, way off of what was expected. Of course, once they had fed their forecasting model with the updated figures, the forecast was lowered.

Blatantly, nobody can take a forecast model which always expects inflation to go down to a predetermined figure seriously. All this is even funnier in the light of the Central Bank's self-praise in the "Post-crisis economic development and Central Bank forecasts" box in the newest Monetary Bulletin, pages 10-11. There, the Central Bank praises its November 2008 output growth (contraction really) forecast and says it was "virtually spot-on." This GDP forecast comes from the same model as the inflation forecasts.

Sure, the November 2008 forecast was too bad when it came to GDP growth. But I don't think the Bank is ever going to write the same sort of an egocentric self-praise when it comes to the July 2008 forecast where it foresaw that GDP growth would be -2.0% and -1.9% in 2009 and 2010 respectively. In reality, it was -6.6% and -4.0%. Well done boys and girls, you were so close!!

Furthermore, was the November 2008 forecast "virtually spot-on" when it came to inflation. Maybe it was as the model was accurate when it came to GDP growth. But I'm sorry, it was way off!

Not exactly the same accuracy in the inflation forecast of November 2008 as in the case of GDP growth. Notice that the model expects inflation to drop down to the inflation target in 7 quarters as it always does, no matter the current rate of inflation! 

Decoding the Current Account of Iceland

I've gotten some comments from different people regarding the current account (deficit) of Iceland. That issue isn't simple, there is a lot more to it than meets the eye. In short, if you're going to use the data for research or to make a case for something, my advice is: don't take the data at face value!

The problem is that the public data aren't representing what they in reality should. The Current Account is meant to measure the net flow of money into the economy originating from net balances of goods, services and factor income (and current transfers, i.e. gifts, donations etc.). The problem is that the CA figures for Iceland are not measuring the flow, they are, to a very large extent, merely guesstimating it! And the reason: the old bankrupt banks.

Let's first look at the official figures. The green line below is the four quarter running average of the OECD figures for Iceland. The blue line is the official non-amended figures from the Central Bank of Iceland (four quarter running average as well). Obviously, those are pretty much the same figures, leading us to trust the CBI figures pre 1997 (OECD figures only extend to 1997).

Current Account balance as a % of GDP. I don't think any Western economy has ever managed to run its current account deficit as far down as Iceland did in 2007 and 2008. Figures from OECD and Central Bank of Iceland.

Iceland's current account (% of GDP) since 1946 to 2007. By 2004 we were already close to setting historical record CA deficit that should have worried most sober economists (we managed to fool us into thinking those were financed with capital inflows from private parties). The party continued for four more years, then reality knocked. Source: Statistics Iceland and Central Bank of Iceland.

Now here comes the trick: since 2008, we cannot trust the publicly announced CA figures. Since 2008, the public CA figures are not showing the actual flow that the CA figures should show.

The reason is the fact that the old banks are in receivership. The receivers of the banks are liquidating their assets and paying them out to the claimants of the old banks, normally the owners of the bonds etc. issued by the old banks. This process takes however many years and the flow of payments to the claimants, which no one knows who is (they are effectively the owners of the new banks because the new banks are, mainly, in the ownership of the receiver of the old bankrupt banks), is not constant nor can it be accurately estimated many years before it actually happens.

But due to international rules about national accounts, the Central Bank, as the accountant of the current account, must estimate what the claimants will in the end get paid. This puts the Central Bank up against the wall: how is it meant to know how much and when the claimants of the banks, which are foreign, will get?

Imagine e.g. that the assets in the receivership of Kaupthing amounts to, say, 1000 billion ISK. Those assets still earn interest and their price fluctuates while they are being liquidated. Lets imagine that the calculated interest - not flow but an estimate of the flow! - of those 1000 billion ISK are 50 billion in one quarter. This amount must be booked as negative factor income in the current account, even though no flow actually happened. The liquidation process can take years and in the meanwhile, the Central Bank must estimate the interest earned on the asset as that is accounted for as (negative) net factor income, not having the slightest clue how much worth the asset will finally be. But those estimates end up dragging the Current Account down, as it is presented, although there has been no actual flow behind the estimated interest income on the assets in the receivership. The Current Account figures of Iceland, since 2008, do not represent actual flow of money as they are meant to!

Furthermore, nobody knows how much will actually be paid out. The assets of the receiverships are fluctuating in value as they are being liquidated and once they are sold and finally paid out to the claimants, the Central Bank may have over- or underestimated the actual net factor income. Finally, we don't know when the liquidated assets will be paid out to the claimants - i.e. when they finally become an actual flow! - which is when they will, at least to some extent, register on the FX market. In short, this is a total mess!

To estimate the flow itself that is meant to be represented by the CA figures, the Central Bank has issued another quasi-public CA estimate. This estimate cuts out entirely the effects of the receiverships of the banks, and in comparison to the public figures - those issued to the OECD - they look quite different!

Once the old bankrupt banks have been cut out of the Current Account figures, they become considerably better looking. 

But of course, this methodology of the Central Bank - to cut out entirely the effects of the old bankrupt banks - isn't strictly correct either. Cutting out all the effects of the receiverships of the banks ignores the flow that actually takes place due to the liquidation of banks' assets and payments to claimants.

In effect, the "true" current account deficit of Iceland is somewhere in between the two extremes. It is somewhere between -8% and -1.2%. Where exactly? No chance to know!

Hopefully, this explains some of the reasons why Iceland, according to public data from e.g. OECD and other international data banks, is still running a CA deficit amounting to such ridiculous levels that it challenges common economic sense. The situation is bad but it's not as scandalously bad as the OECD figures imply. But the CA figures of Iceland are in fact very interesting for another fact: they show extremely well the effects of bank loans on the Current Account, something I'll get into detail later.

Should Iceland adopt the EUR?

Some time ago, I sent my answer to this question to the European Web - a quasi-official website which has the purpose of answering questions about the EU admission process of Iceland and other general EU considerations. What follows is a rough English translation of the answer, originally posted here: Ættu Íslendingar að taka upp evruna?

The timing of the posting of the answer was in fact quite fitting since the Central Bank just issued a tome - a 600+ page report - on whether Icelanders should adopt the euro or not. Their conclusion: they weren't sure. So am I, except I reach that conclusion in about one A4 page.

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Should Icelanders adopt the euro?

Each and everyone has to answer this question on their own. The reason is that adopting the euro or keeping the krona is to a large extent a question of how risk averse Icelanders are at the time of their answering. Economics will not be able to answer which of the two currencies are "better".

The Eurozone is based on the theory of Optimum Currency Area. In very short, that theory states that if different local economies are alike enough, such as in terms of culture, language and trade cycle, and they have a significant level of trade in between them, then it would be beneficial for those two local economies to adopt the same currency, first and foremost to decrease the cost of commerce (such as due to the need to exchange currencies all the time). 

The upside of this (hoped for) decrease in cost of commerce should outweigh the fact that if this common currency is adopted then the local economies are forfeiting their independent monetary policy. That in fact can sometimes be the aim since independent monetary policy is sometimes so fantastically badly conducted that it does the economy more bad than good. Adopting a foreign currency should therefore not only decrease the cost of commerce but also boost the credibility of the ruling monetary policy, thereby increasing general economic wellbeing.

It is here though where individuals' own risk aversion plays part. The author has sometimes drawn up the metaphor that keeping your own national currency, which is not pegged to another, is like buying a full insurance on your car. If you however choose to give up the independent monetary policy, then you are choosing to go for a very limited insurance on your car.

The metaphor is the following: a full insurance on one's car can cost a pretty penny. If, however, the owner of the car has an accident, which he had nothing to do with, the insurance company will pay the cost of repairing the car - minus the self-coverage. The owner knows this however so he becomes subject to moral hazard: him knowing that he will get most of the cost of repairment from the insurance company certainly does not encourage him to drive more carefully. If he's not careful, the chances of him actually having an accident increase.

A car owner which does not buy a full insurance does not become subject to moral hazard. The owner will have to pay the full price of repairing the car in such instances and therefore the limited insurance car owner has the incentive to drive more carefully. He can however still have an accident which he could not avoid no matter what. He can also still have an accident because he drove like an idiot, even if he hadn't bought the full insurance. 

The Icelandic krona and the euro are represented by the full and limited insurances here above. The car is the economy and the driver behind the steering wheel is the people in the economy, most importantly the policy makers - and banks. If the economy ends up in troubles, the "full-insurance" will kick in in the form of devaluing the currency. The self-coverage is higher inflation in case of massive devaluation and lack of foreign purchasing power. But the economy will be "repaired" with the devaluation. However, the "get out of jail card", which what the devaluation of the currency really is, also does not give the Icelandic people much encouragement to drive carefully. So keeping the independent currency can in fact introduce fluctuations into the economy, fluctuations that do not need to be there. Nevertheless, it is still possible, even if you drive carefully, to have an accident. And nothing stops you from driving like an idiot even if you don't have an full insurance. And when the accident happens, there will be no independent currency to devalue if you have the euro.

So the question which of the two currencies is "better" for the Icelandic economy is not only about whether Iceland is a part of the optimum currency area that Eurozone is meant to be - which in fact can be argued against, hence the euro crisis. The answer is also whether the Icelandic nation is risk averse enough to forfeit the "full insurance" that the independent currency is.

It can easily be argue that holding dearly onto a currency which has lost 99.95% of its value versus the Danish krona since 1939 is not the wisest thing to do. If the euro is adopted the handling of the economy must become much stricter. In that case, we are not only talking about fulfilling the Maastricht treaty on fiscal deficit and fiscal debts but we must consider the debt levels and debt issuance of private parties as well. The economic problems of the periphery countries are not only explained with reckless federal spending, such as in the cases of Italy and Greece, but with the expansion of private debt, such as in the cases of Spain and Ireland.

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My point: Iceland can still end up in dire economic straits due to private debts, even if we would adopt the euro.

An interview with Exame

The following interview was with Jorge Rodriques, journalist of Exame in Portugal. This is the English version - plus some additions on the Minsky moment - but the Portuguese version is due later in the week. 

The original source is here. Jorge added some very informative and good details on the general economy and the ongoing criminal cases as well so please refer to his site for further info.

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Q: Analysts and economists all over Europe praised a lot the “Iceland miracle” of last decades. Until the Great Recession came. Iceland was in the 2000s the extreme example of the financialisation of the economy and the society, worse than the US, Ireland and Spain? 
A: It depends on how you look at it. Financialisation in the sense of just trading financial instruments in between the more or less same market participants was certainly more prominent in the case of say the US than in the case of Iceland. However, at the height of the bubble, the Icelandic financial industry share of GDP topped at 9.4% in 2005 and 2006. That’s a higher ratio than even in the US. That fact becomes even more shocking when one realises that in 1997 the share of the financial industry of the GDP was 4.6%. So in less than 10 years, the finance industry more than doubled its share of the GDP and reached higher levels than even in the case of US. So yes, from that point of view the financialisation of the Icelandic economy was probably even more extreme than in the case of many other countries.

Q: Another aspect of the “miracle” that is intriguing. What was behind the so-called “entrepreneurial neo-Vikings” and the entrepreneurial economy of last decades? 
A: Credit! Credit created out of thin air by the banking system, simple as that. We of course fooled ourselves into thinking that it had something to do with the Icelandic Viking spirit, the energy of the young (and inexperienced) leaders of the leading companies, the free-market movement of the 1990s, and even the rugged and “therefore” hardening Icelandic natural environment. But there was in essence no secret formula about the temporary prominent status of the Icelandic entrepreneurial Viking. He had credit, created by nothing by either a foreign bank he managed to fool into his scheme or the newly privatised Icelandic banks that sometimes he himself or his friends had a controlling share in. And, that was that.

Q: You are writing a book about Bad Economics and the impact in the Iceland economy. Iceland was the typical example of an economy that was ruled by bad economics? 
A: Yes, and it still is! But I must be absolutely clear on the point of the “bad economists”. I do not believe that any of the leading economists were or are “bad” in any sense of that word. I believe all of them were acting in absolutely good faith, trying to improve the economy and society. But intentions are not enough if you don’t have the tools.

Q: Which theories and schools of Economic thought must be blamed? 
A: The tool that failed spectacularly was the neoclassical school of economics. Only a small handful of economists did not rely on this, unfortunately, globally ruling way of doing economics. They were the only ones that were not blinded by neoclassical theories when the bubble began to expand beyond point of no-return. But when they tried to warn the community about what was happening the neoclassical economists ridiculed them, not because they were “bad” but because they were blinded by their faith in neoclassical economics.

HIGHLIGHTS
«I must say that the Icelandic case was a quintessential example of the Minskyian theory»

Q: Can we say there were signals of a “Minsky moment” – from the name of the North-American economist Hyman Minsky that from early 1980s talked about a systemic financial process risking a new big Recession like the Great Depression of the 1930s – coming for Iceland in the end of the 2000s?
A: It’s always tough to pinpoint accurately when the exact Minsky moment arrives. But Minsky “Financial Instability Hypothesis” was certainly proved to be the most accurate economic thesis in existence when the Icelandic boom-and-bust cycle took place. I must say that the Icelandic case was a quintessential example of the Minskyian theory.

Q: How?
A: [The way up was very much like Minsky predicted. The atmosphere was euphoric, everybody wanted to make a quick buck! After a very short contraction period in 2002 the economy bounced back. Confidence grew again and when the banks were privatised in 2003 the economy boomed, driven by credit creation by the banks and people's confidence. When the credit sparked asset price inflation, all the Johns and Joneses jumped on the bandwagon and used credit to buy existing assets. An asset boom developed hand in hand with the foreign direct investment flow that was due to construction of aluminium smelter and a hydro dam in the east part of the country. Everybody forgot the lessons of 2000 and 2001 when the credit boom that took place then fuelled a stock speculation boom in Decode Genetics. That exploded fantastically! A short sober moment arrived in 2006 but the self-delusion was too strong and people reinforced their beliefs in the Icelandic miracle after the 2006 doubts had been wiped out. Foreign currency loans took over the indexed ISK loans as the main credit device fuelling the boom. Then finally, the asset price inflation slowed down and the Ponzi-positions began to lose out. Liquidity squeeze shortly followed.]

When it comes to the downturn especially we can, e.g. notice that the stock index topped above 9000 points during the summer of 2007 before finally collapsing below 500 in 2008. The liquidity shortage was also very much as Minsky predicted and the margin calls became more and more prominent. In 2008 the Central Bank stepped in and tried to supply liquidity into the market, but it didn’t suffice to stop the avalanche.

HIGHLIGHTS
« Yes, there is growth again in Iceland, but there is unfortunately not much behind it.»

Q: As you know today Iceland is a near-myth again because the island is returning to “broad based growth,” said the IMF mission chief to the Icelandic program. Are we assisting to an adjustment “miracle” praised by the IMF? 
A: Yes, there is growth, but there is unfortunately not much behind it. The reason I say this is that when we dig deeper into the national account figures they kind of lose their surface charm. Gross investment is, e.g. still meagre 12-15% of GDP, which is hardly enough to maintain the base of productive capital in the economy. The present 4.7% unemployment rate [from a peak of 9.3 percent two years ago] does not include those who have given up on looking for a job and have either moved out of the country [in 2011, Census reported that 8% of population migrated mainly to Norway] or decided to go back to school, sometimes just to do something. As a signal of the stagnant labour market, the average number of worked hour per individual in the working force has been stagnant since 2009. And, interest rates are still too high, which is an especially poisonous goblet when the indexation of mortgages is mixed with it. Also, the banks and the State sponsored Housing Financing Fund (HHF) are not very eager to liquefy their stock of empty houses and flats, due to their fright of crashing the housing market by doing so. As a clear sign of that, the HFF repossessed 501 flats and houses during the first six months of 2012, but sold only 58 flats at the same time. Finally, the number of individuals with severely delayed repayments of their debts is still rising.

Q: But there’s no reason for optimism, more than in Ireland or Portugal, the so-called “good pupils” of the troika medicines?
A: There is growth, but it is froth. I do not see much reason for any spectacular optimism about the long-term future of the Icelandic economy. The structural deficits that got us into the hole we’re still trying to dig us out of are still there and that is what makes the long-term difference. We have to fix those if we are ever to have a stable economy.

Q: What you mean by “structural” problems?
A: The structural problems that I have in mind are specifically the indexation of mortgages and the pension system, which not only has a huge funding hole but influences the financial market strongly due to its size. The effects of those problems push up the rate of interest and introduce structural financial instability into the economy, instability that does not have to be there and is not caused by anything else. Fixing those structural problems would strengthen the financial stability in Iceland to a significant and notable extent. But work is going too slowly in that field, those problems are still around.

Q: In Iceland there was not TBTF (too big to fail) banks and TBTJ (too big to jail) banksters or government officials? 
A: I cannot comment much on the TBTJ, the Special Prosecutor is investigating the cases that end up on his table and we must be patient and allow him to do his job. He has landed some victories though, such as the conviction of the ex-finance ministry undersecretary Baldur Gudlaugsson [This was the first time an insider dealing case has ever been tried at the Supreme Court of Iceland. Baldur was found guilty by the Reykjavík District Court on 7th of April 2011 and sentenced to two years behind bars. An appeal against that decision fails in Supreme Court in February 2012] and the “Exista case” [Exista is a financial services firm founded in 2001 by a consortium of Icelandic savings banks as a vehicle to hold shares in Icelandic Kaupthing Bank. A controlling shareholding in the firm was sold to a holding of the brothers Ágúst and Lýdur Gudmundsson in 2002. An IPO went on 2006 in Iceland Stock Exchange for €2.6 billion, the biggest IPO in the country's history. By October 2008, Kaupthing Bank was forced into government receivership, it was nationalized de facto. In July 2009 Wikileaks exposed a confidential 210 page document listing Kaupthing's exposure to loans. The bank had loaned billions of euros to its major shareholders, including a total of €1.43 billion to Exista and its subsidiaries which own 23% of the bank. In January 2010 law enforcement agents from Britain and Iceland searched the premises of Exista in a probe related to the trading of shares in other companies].

HIGHLIGHTS
«The whole Icelandic financial system went down the drain, but the payment system was maintained thanks to tremendous efforts by the staff of the Central Bank.»

Q: And regarding the TBTF banks?
A: The question of TBTF banks is very interesting in the case of Iceland, however, and I think it deserves more attention than it has gotten. The definition of a TBTF bank is that it is too systematically important to be allowed to fail since otherwise the financial system would collapse, general commerce in the wake of that and consequently the whole economy. But that didn’t happen. Yes, the whole financial system went down the drain, but the payment system was maintained thanks to tremendous efforts by the staff of the Central Bank. And, since the payment system was kept intact, commerce kept on and the economy did not crumble entirely. We could still buy our pints of milk and bakeries still baked their breads. And, they kept on accepting card payments.

Q: How it happened the “miracle”? 
A: The reason for why the payment system did not collapse was that it is centralised entirely through the Central Bank itself. That means that the Central Bank can allow a bank, no matter how big it is, to go under since it isn’t a clearing bank for any of the general every day commerce that everybody expects to be able to do. This is not the case in many countries, such as the UK. This structure of the payment system – the Central Bank is the only clearing bank of the whole payment system of everyday commerce – was the essence of why the payment system did not collapse even though 90% of the banking system, by assets, went bankrupt in a time span of only a week. This is the fundamental lesson for other nations: channel the whole payment system through the Central Bank and no bank is too big to fail when it comes to every day commerce.

Q: What kind of fiscal austerity measures were adopted that permitted the fiscal deficit cut from near 14pc of GDP at the end of 2008 to 5.7pc for 2011?
A: Well, the 13.8% fiscal deficit in the last quarter of 2008 was a one-off cost: it includes the new equity injection into the Central Bank (yes, the equity of the Central Bank of Iceland was wiped out in October 2008 – the Central Bank went bankrupt!). So let’s make sure not to think that the politicians have managed to cut the deficit from 14% of GDP to 5.7% by austerity alone. The austerity measures in Iceland were in fact not as severe as in say Spain, Portugal or Greece. The welfare system was more or less maintained, beside extensive cuts in health care to such a level that they have had to use sticker tape to temporally fix some of the cancer treating equipment in the main hospital in Reykjavik. Health service outside the capital has also been guillotined quite severely. Taxes were raised as well. A special net-wealth tax was adopted, VAT was raised, now commonly 25.5% though lower steps exist as well, and the tax rate on wages was increased. Same goes for taxes on capital gains, now 20% instead of 10% before. Personal tax return for individuals was increase as well however, having the effect that most of the increased tax burden was carried by the richer part of the population.

HIGHLIGHTS
«But the currency crash – the depreciation of the krona – also caused inflation and that led to higher principals of our debts, debts that many people will never be able to repay.»

Q: The depreciation of the krona was the main tool for the adjustment? 
A: Yes, the crash of the krona was the main tool of the external adjustment. It however, lead to even further internal imbalance since the crash of the exchange rate lead to increased inflation and that increased the principal of the inflation-indexed mortgages and many other debt instruments. This imbalance is still being dealt with and it will take a while.

Q: Can you explain better that downside risk? 
A: Yes, this needs some explanation. The mortgage system in Iceland is such that the monetary value of the principal increases hand in hand with the inflation. So if one borrows say 100,000 kronas mortgage and the inflation rate is 5% over next year, the debt increases up to 105,000 kronas. Then, the repayments are made, but the repayment of the increase of the principal is spread out over the whole remaining loan period. The currency crash therefore had the effects of increasing the competitiveness of Icelandic goods, thereby allowing us to rebuild the economy on the basis of exports and tourism. But the currency crash also caused inflation and that led to higher principals of our debts, debts that many people will never be able to repay.

Q: It would be better if Iceland defaulted in its sovereign debt and implemented a full restructuring debt process?
A: No, it would not. It would, however, be a good idea to carry out some sort of debt jubilee for the private individuals and enterprises in the economy. And, that can be done, the only thing that is needed is the political will to do so. But if the State defaults on its debts we would probably have even more serious problems on our hands. Yes, national States have defaulted on their debts before and later arisen out of their economic ashes like the phoenix, but it is a high risk and absolute last resort measure. But in some cases, for example some present economies in the Eurozone, such last resort measures are exactly the ones that are needed. But the finances of the Icelandic State are not, yet that serious. So sovereign default is probably not a good idea for Iceland, at least not yet.

Q: Would you refer specific “growth policies” pursued by the government? 
A: Not in particularly anything else than those that aimed at lessening the hit of the financial crisis immediately after it happened. The fight against IMF-demanded austerity should be highlighted though. There is a plan to get government funded investment going during the years of 2013-2015. Included in that plan is, e.g. general road network maintenance and increased subsidies to high-tech and technology development funds, etc. The financing of this plan is meant to come from road tolls and fees on fish catches, born by the fishing industry. This may not become realised, however, as there are general elections next spring.

HIGHLIGHTS
«The question about who are the real owners of the Icelandic banks is very good: we do not know! People have speculated a lot about this. Foreign shark hedge funds are one theory, the old domestic “entrepreneurial Vikings” is another and on the theories go.»

Q: If the sovereign debt skyrocketed after 2008 can we say it was for a good reason, for the relief of the households and corporations debt? Or the so-called debt forgiveness is another myth? 
A: The severe increment of government debt after the 2008 was first and foremost due to the rescue of the Central Bank of Iceland which lost the equivalent of about 20% of GDP when it lent money to the banks against lousy collateral. When the banks went bankrupt, so did the Central Bank. The cost of injecting new equity into ended on the shoulders of the taxpayer. That cost was around 400 billion ISK according to The Icelandic National Audit Office. The so-called debt forgiveness of household and corporate debt did not cause any severe, if any when everything is taken into account, cost for the State. The banks bore all the “cost” but it effectively did not impair their equity at all. The reason for that is that when the new banks were established on the foundations of the fallen ones, the assets were booked in the new banks at about 40% discount. A 100,000 krona loan became a 60,000 krona loan on the books of the new banks. This magic did not, however, continue to the borrower himself, he still owed the bank 100,000 krona. It was this discount that was used to cancel the majority of the debt that was actually cancelled. In February, the households had been forgiven 196 billion ISK (12% of GDP) but that was pretty much all outweighed by the indexation of mortgages, so the net cancellation was rather limited. Firms got a lot more cancelled, around 550 billion ISK. And, of course, not everybody got the equal amount cancelled. Eight firms got cancelled the total of 205 billion ISK. In fact, most of the firms that got debt cancelled were asset holding firms, many of them totally empty of assets after the collapse. So their debts would have had to be cancelled anyway, simply due to the liquidity process behind their bankrupt itself.

Q: After the banking restructuring, who benefited most from it? Who are the real owners of the Icelandic banks today? 
A: I think this must have been the most indebted firms that benefited the most, simply because they got the most of the debt cancellation. And, the question about who are the real owners of the Icelandic banks is very good: we do not know! People have speculated a lot about this. Foreign shark hedge funds are one theory, the old domestic “entrepreneurial Vikings” is another and on the theories go. But quite frankly, we simply do not know.

DIFFERENCES WITH THE TROIKA EUROZONE BAIL-OUTS

«If the austerity had been as unforgiving as the one that is in mainland Europe the Icelandic economy would not have been given the breathing space to recover from the shock.»

Q: What are in your view the main differences of the Icelandic strategy relative to the adjustment programs adopted by the so-called troika EU/ECB/IMF in the Eurozone?
A: The Icelandic austerity was not as severe and the increment in taxation was more directed towards the richer end of the populace. I believe that was the right thing to do, if the austerity had been as unforgiving as the one that is in mainland Europe the economy would not have been given the breathing space to recover from the shock. Socially, it was probably healthier as well to let the rich carry most of the austerity burden, otherwise we could have had general riots and another “pots and pans” revolution. Another important difference was that we were capable of allowing the currency to devalue and that helped although the homemade structural deficits of indexing debt to the level of consumer price probably just switched out the problem of external imbalance with an internal one. Being able to allow the banks to go under while maintaining the payment system was a huge advantage as well.

Q: That is one of the “lessons” that you think universal…
A: Yes. The Troika could learn tremendously of the Icelandic experience in that case, it would save them the problem of having to save the whole banking system repeatedly. Banks should, as any other firms, be allowed to go bust! Finally, there were some debt cancellations although they were more or less just to wind down part of the indexation problem when it comes to the households in particular. But debt cancellations are doable; one just has to find the political courage to carry them out.

Q: How did Iceland deal with the IMF? 
A: IMF did propose more austerity and did for example propose more severe cuts in the welfare system. That was refrained and probably for the good. The adjustment process, especially the cut in fiscal deficit, was slowed down in comparison to the IMF proposal.

Q: Will Iceland abandon the krona and adopt the Euro, or it will choose a different strategy searching a non-European currency? 
A: I cannot say. The official stance is to gain entry into the EU and adopt the Euro. But to fulfil the Maastricht guidelines on Euro could take us as long as a decade and the EU will have transformed significantly in as short time as half that. So to adopt the Euro will probably take us a while, given that there will be political will after the 2013 elections to finish the EU entry process.

Q&A on Iceland

The Spanish radio station Colectivo Burbuja interviewed me on Iceland and the ongoing development of the economy amongst other things. The posted interview is here but the original text in English is below.

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- What were the main reasons of the 2008 Icelandic crisis?

Debt! Private debt in particular! We went completely ahead of ourselves and borrowed massive amount of money. Most of the money went into consumption and buying up existing assets. We had massive housing and stock bubbles at the same time which came down crashing at the same time as well.

It is important to realise that the money we borrowed did not only come from abroad but was simply created out of thin air by the domestic banking system. This newly created money was then spent on stocks, houses, imports and extravagancies; we surely and literally lived on credit. And this credit was mostly created out of nothing by the domestic banking system. But when the creation of new debt slowed down and repayments of outstanding debts failed, the whole house of credit tumbled down and crashed.

-Which were the policies and the strategy of the government to try to dig out Iceland from the hole?

The government and other public bodies tried everything they could to keep the banks alive. A year or so before the crash the Central Bank expanded the allegeable base for repurchasing agreements, basically allowing the banks to come to the central bank and borrow money from it for whatever collateral they could find or create themselves!

The rules became so loose that Bank A could issue a bond, sell it to Bank B which took it to the Central Bank and used it as collateral for borrowed money from there. Bank B would then do whatever it wanted to with the money, e.g. lend it to Bank A if Bank A needed more cash. Bank A could also do the same thing for Bank B. This policy effectively made possible for any bank, as long as it had an accomplice, to borrow money from the Central Bank with a bond issued by itself! Those bonds were later, due to how fragile they were as collateral for loans at the Central Bank, called “love letters”.

When the perfect storm arrived in September and October 2008 the Government, and not only the Central Bank, tried everything it could to catch the falling banks. The major issue was to find foreign cash as the banks needed first and foremost euros and dollars to keep their businesses going. The government and the Central Bank went all over the world, including to Russia, to try to find bailout money for the banks. But the sheer size of the banking system made it impossible as they dwarfed the economy as a whole: at its top, the assets of the Icelandic banking system amounted to roughly 10 times the annual GDP. The British banking system is roughly 4.5 times the GDP of the United Kingdom in comparison.

In the end, the banking system collapsed because its relative size to the economy made it impossible to rescue. Iceland did not “allow” the banks to go bankrupt; we tried everything we could to save them but we could not.

-Should the Icelandic way to deal with the crisis become a model for the rest of countries with problems (Spain,Portugal...) ?

That depends on the structure of the payment system! One admittedly great feat accomplished in October 2008 was to keep the domestic payment system going although 90% of the banking system collapsed in matter of days. On this front, the Central Bank did well and fantastically!

The payment system in Iceland is rather special: everything goes through the same clearing bank, i.e. the Central Bank. In Britain for example, the clearing banks are independent banks, such as Barclays and HBOS.

This means that if Barclays or HBOS go bankrupt, a large part of the payment system in Britain becomes dysfunctional and shuts down! That would be the spark of the utmost chaos as people were not able to use their debit cards or transfer money to and from bank accounts. Commerce would collapse and with it the economy.

In Iceland however, everything goes through the Central Bank: a special entity which is a part of the Central Bank (called “Reiknistofa Bankanna” or literally “The Banks’ Calculation Office”) handles all the electronic payments such as online and debit and credit card transfers.

This structure of the payment system was a very important part of why we managed to keep the system going although 90% of the banking system collapsed in an instant. I do not know the organisation of the payment systems in e.g. Spain or Portugal but if the big banks such as Santander or Banco Espírito Santo are acting as clearing banks in the banking system, “The Icelandic Way” of “allowing” the banks to go bankrupt would be difficult to carry out.

So it depends to a large extent on the structure of the payment system whether banks can be allowed to go bust or not. In case of Spain and Portugal, I cannot say.

-Jón Asgeir Johannesson and Björgólfur Guðmundsson have been usually blamed as some of the main people who helped to cause the crisis, are they still influential in the economy and the politics?  

Yes and no. Johannesson allegedly still controls the biggest media corporation (his wife, Ingibjorg Palmadottir, is registered for 90% of its stock). Johannesson himself is not so prominent any more however. He probably does not want to, especially as he is being sued by the bankrupt estate of Glitnir Bank which he was a stakeholder in. The bankrupt estate is accusing him of practically using the bank to extend massive amount of credit to himself without any credible business plan behind the act. He himself personally owed the Icelandic banks 126 billion krona at the time of their collapse (remember this figure when the so-called debt forgiveness is discussed below) according to the research report of the Parliament.

Gudmundsson was one of the few major players that were actually declared bankrupt as many of them dodged legal action by holding their debts and assets in separate asset holding companies, thereby freeing themselves personally of any bankruptcy claims. Gudmundsson has all but disappeared from the scene although his son, Bjorgolfur Thor, is still in the news every now and then.

- Did somebody ring the alarms about the dangerous position Icelandic banks were in during the boom years before the financial system implosion? If so, why those voices were not heard?

Yes, multiple persons, banks and rating agencies did. In fact, the “mini crisis” of 2006 was sparked by sober foreign analysts, such as those of Danske Bank, pointing out that the expansion of debt that was taking place in Iceland had to stop one day. In Iceland, one of the most memorable persons who questioned the boom was an unknown doctor of psychiatry, Dr. Andres Magnusson. His analysis was basic, economics based and built on national account figures that everybody could find online.

Those voices were heard but ridiculed, both by politicians and the banks. The then Minister of Education, Thorgerdur Katrin Gunnarsdottir, famously said that one of the foreign analysts, Richard Thomas at Merril Lynch, “was in need of re-education” after having expressed his pessimistic view of the then Icelandic miracle. And as an example of how closely knit together business and politics in Iceland are, it should be mentioned that Gunnarsdottir’s husband, ex-handball star Kristjan Arason, was the CEO of Retail Banking at Kaupthing Bank. They dodged bankruptcy by moving their liabilities into an asset holding company called “7 Right” in February 2008, eight months before Kaupthing Bank went bankrupt.

A massive PR campaign was started after the mini crisis in 2006 to strengthen the idea of the entrepreneurial Vikings from Iceland. Even the president – now just newly elected for his fifth consecutive 4-year term – participated in the PR. Many have and never will forgive him for being that cheerleader.

The reasons why people were so blind and unwilling to accept the fragility of the economic boom are one of the enigmas behind all booms-and-busts. “This Time Is Different” and “We Are Special Because of...” were phrases that everybody heard repeatedly, just as in any other credit fuelled boom in the past in other economies. The self deception was almost flawless. It did not help that the media in Iceland was, and is, owned by the business moguls themselves.

-Most journalists (for example Roger Bowles) point at the Icelandic Central Bank as one of the main causes of the crisis, What was the Seðlabanki role lead by Davíð Oddsson during the pre-crisis years? What could it have been done better to avoid the crash?

Personally, I don’t think it mattered much that Oddsson – a lawyer and an ex-prime minister who pretty much had his successor appoint him as the governor of the Central Bank – was in charge at the Central Bank. Oddsson had an army of economists under his control that should have known what was going on but they were all blind to the impacts of the debt build-up.

The Central Bank’s role was typical: to control inflation (the inflation target in Iceland is 2.5%) and to maintain financial stability. On both of these fronts, the Bank failed miserably. Since the 2.5% inflation target was adopted in March 2001 until October 2008 there were in total 17 months (out of 92) where the target was reached. Regarding maintaining financial stability, well, I don’t think I need to stress its failures there.

The Central Bank should have stopped the debt build-up as it was the private debts that brought the economy down. But the economists at the Central Bank, as in other central banks in the world, did not realise this problem since they were all educated in neoclassical economics where private debt does not matter and banks are simply just “intermediaries” between savers and borrowers and not producers of purchasing power as they are in reality. Iceland is the typical example of an economy that was ruined by bad economics.

-You have been very critical in your articles about the future of the Icelandic pension system, why?

Ah, yes! The pension system! Our glorious pension system!

The pension system of Iceland is one of the biggest ones in the world when compared to the domestic economy. Its assets amount to around 135% of GDP. Only Holland and Switzerland are in the same league.

The problem, however, is twofold. First, even though the gross assets of the pension system amount to this gargantuan figure, there is a hole in its balance sheet amounting to 40% of GDP. This means that the pension funds have promised to pay out money to future pensioners that they do not have and will not ever have.

This problem is well-known and widespread in Europe and North America. But it is the other part of the pension system problem that worries me. A lot!

The pension funds have to get around 3.5% real return on their assets if they are going to fulfil the promises they are legally obliged to. This means that pension funds will not lend out money or buy stocks or do whatever they are doing unless they are promised a return equal to 3.5% plus the rate of inflation. That means e.g. almost 9% in nominal terms now that inflation in Iceland is 5.4%.

As a consequence of the size of the funds, they hold more than half of the financial instruments registered in the Icelandic Financial Exchange. The problem that now arises is that because the pension funds are so big and are legally required to get this high rate of interest, they effectively push the rate of interest in the economy upwards!

One of the foremost reasons for high rate of interest in Iceland is the organisation of the pension system. In other words, the government cannot sell its bonds on the market unless it promises the buyers, which are to a large extent the pension funds, very high rate of interest. As a case in point, the interest rates on 10 year government bonds are 7.2% at the moment. And as high rate of interest bring high rate of financial instability, the pension system of Iceland is a real problem.

-Is Iceland still fighting a housing bubble? How many years of net income does a family need to buy an average size house/flat?

This is a tough one for when does the “bubble” definition start to apply to a market?

Yes, house prices are going up again mainly because the banks have begun to offer non-indexed loans (normal mortgages in other Western countries) to households to buy flats and houses. This has become very popular: people are borrowing money, again, to buy houses and the banks are creating this money out of thin air as they have always done, especially before the crash in 2008. Consequently, house prices have gone up again after having dropped by 35% in real terms, a very typical figure when house bubbles burst. But the upward movement in real house prices is very limited simply because inflation is still high.

No official figures exist regarding the second half of the question. However, a comparison can be made by using data from Statistics Iceland regarding the cost of housing in different countries. That comparison is shown in the following two graphs:

(Notes: Share of housing cost is calculated as the median of the proportion of housing cost which is calculated after the proportion of housing cost in total disposable household income as been calculated for each individual.

  

If a household uses 40% or more of its disposable income in its house it is considered to have a housing cost overburden. The second graph shows the proportion of people who have housing cost overburden. See Statistics Iceland for details.)

-The most common Icelandic loans are not variable interest ones but indexed ones, something not common at all in the rest of Europe, could you explain how those indexed loans work?

OK so normal (European) mortgages work in the following way: you borrow 100,000 euros to buy a house. Let’s say that you will repay the loan back in 20 years and every payment is equal to the previous one. Let’s assume a nominal rate of interest equal to 5%. That means that every monthly payment for the next 20 years will be 660 euros. This amount will not change as long as the rate of interest does not change. Some loans are tracker loans, meaning that they e.g. follow the LIBOR rate with some premium. So the final interest rate on those loans will be LIBOR + the premium that the lender sets.

The Icelandic indexed mortgages are considerably different! Let’s assume that you borrow 100,000 krona and you are going to repay it in the same way as the EUR loan above. This is a pathetically low amount as you would need around 30 million krona to buy the median house. But for the sake of argument, let’s just stick to similar figures.

The stated rate of interest on the indexed Icelandic mortgages is not the nominal rate of interest but the real rate of interest! And on top of that real rate of interest – which is most often fixed for the whole loan period – you have to add the current rate of inflation to find out the nominal rate of interest. So if the real rate of interest on an Icelandic mortgage is e.g. 4% (the cheapest loans during the boom had 4.15% real rate of interest) you have to add the rate of inflation on top of that to find the total rate of interest. The inflation in Iceland is now 5.4%. So the total rate of interest on that mortgage is 9.4%.

The peculiarities do not stop there. The inflation part of the total rate of interest is not paid back monthly as in the case of regular European mortgages but is added on top of the principal.

This means that if the rate of inflation over one year is e.g. 5% the original borrowed amount (100,000 krona) grows by 5% before you make a repayment. So imagine you borrow 100,000 krona on 1^st of January 2011. On 1^st of January 2012 the inflation over the last year is measured to have been 5%. That means you do not owe the bank 100,000 krona on 1^st January 2012 but 105,000 krona. But of course, you only got 100,000 krona from the bank.

Let’s assume now that on 1^st January 2012 you repay 10,000 krona plus interest. That means that you owe the bank 95,000 krona after the repayment on 1^st January 2012. Now the inflation between 1^st January 2012 and 1^st January 2013 is for example 10%, which historically is not such an unlikely inflation level in Iceland. That means you owe the bank 104,500 on 1^st January 2013 (95,000 * 1.1 = 104,500). So you can see that as long as inflation is high, you kind of feel like a hamster in a wheel.

It is important to realise that the amount that is added on the top of the principal does in fact never exist. It is a simple accounting figure that happens only on the bank’s books. The bank will however profit from this accounting figure as it appears on its books as appreciation of the price of its assets and / or as interest rate income. So in Iceland, banks profit if inflation takes place. The higher the rate of inflation, the higher will the profits of the banking system be in Iceland.

Notice also that because it is the principal that grows by the rate of inflation the monthly payments slowly grow as time passes. In the example here above where 100,000 euros were borrowed at 5% nominal rate of interest, the monthly repayments were 660 euros, no matter the rate of inflation. The total amount repaid over the whole 20 years is 158,289 euros.

In Iceland, the first repayment of a 100,000 krona loan at 5% rate of interest would be 660 krona only if the rate of inflation is 0%. But if the annual inflation is e.g. 3% for the whole 20 years, the first monthly payment is not 660 krona but 662 krona because the principal has grown. The last payment, 20 years later, would be 1,192 krona or almost double the first payment. And the total repaid amount is not 158,289 krona as in the case of the normal European mortgage, but 216,241 krona. More than double the original borrowed amount. This is so because the interest rates on the loan are calculated on the original principal (100,000) plus any increments that take place due to inflation.

The argument for this system is to maintain the real purchasing power of the money that the bank lent out in the beginning, i.e. the 100,000 krona. But I have criticised those mortgages extensively and largely blame the way of indexation for why we can never have a stable economy in Iceland. There is not a shred of doubt in my mind that this indexation system destabilises the Icelandic financial system. But, according to neoclassical economics, this should not be a problem since “money is neutral” in neoclassical theory. But this is obviously a huge problem in my opinion! So again, the Icelandic economy is being turned into ruins by bad economics.

-Did the families really get a major debt forgiveness? What is the present level of debt of the families and the total Icelandic economy debt (including government, families and companies) compared to the 2007 level?

The newest figures I have seen regarding the “forgiveness” of household debt are from February 2012. By that time, households’ debt had been written down by 196.3 billion krona (1.24 billion EUR, around 12% of GDP). However, the majority of the write-offs were due to illegal foreign-currency-linked loans that the banks lent out but were later deemed illegal. So they had to write them off. The write-offs due to that factor alone were 146.5 billion.

The rest (49.8 billion ISK) was due to official expedients, such as the allowance to write off one’s mortgage down to 110% of the market value of the property used as collateral. But if your indexed mortgage had not risen above 110% of the market value of your property, you would not get any debt written off.

However, due to the peculiarity of indexing mortgages in Iceland, the 196 billion written off were weighted out with increases in the indexed principals of debt. Therefore, the bottom line is the same: households’ debt is still around 250% of disposable income, even higher than it was in 2007. As a proportion of GDP, households’ debt has decreased slightly from 120% in 2008 to 110% in year-end 2011.

Non-financial companies got a major debt relief however and that was more or less the banks’ own initiative to do so. Non-financial corporate debt as a percentage of GDP has dropped from around 325% in 2008 down to just below 200% in 2011. Most of it was simply written off but Icelandic firms are nevertheless still one of the most indebted ones in Europe.

Government debt skyrocketed during and after the crash, to a large extent to save the equity of the Central Bank which became technically bankrupt because of loses on its “love letters” (see above what the “love letters” were). In 2007, the gross federal debt was 43% of GDP. It was 115% of GDP at the end of 2011.

So the debt figures are roughly the following (in per cent of GDP, year-end 2011): households – 110%, non-financial corporations - 200%, the government – 115%.

-Who is running the Icelandic banks now?

Good question! We don’t know!

When the banks went bankrupt they went into receivership. The new banks that were established on the foundations of the old ones were partly done so with money from the government. The State holds 81% in the New Landsbanki, 13% in Arion (the New Kaupthing Bank) and 5% in Islandsbanki (the New Glitnir). The rest is owned by the old banks or their bankrupt estates to be exact.

The main owners of the new banks are therefore those who own bonds issued by the old banks as they are entitled to payments out of the bankrupt estates. The public has no idea who holds those bonds and have therefore essentially no idea who are the true owners of the Icelandic banks. There have been speculations that the principal owners are some foreign hedge funds or even some of the old Icelandic business moguls. But nobody knows for sure.

-You write frequently in your articles about the capital controls, what are the effects of those controls on the economy?

The major effects are on the exchange rate. The exchange rate of the Icelandic krona is artificially kept higher than it really should be by locking money inside the economy with the capital controls. This is in violation of the European Economic Area contract where the free flow of capital must be allowed as part of the “Four Freedoms”. But Iceland was hit by a systemic collapse so an exception is made for the time being.

-What are the consequences of the Icesave conflict? Is Iceland ready in case they lose the trial?

The consequences of the Icesave (“IceSlave” as it was nicknamed in Iceland) could be severe not only for Iceland but for the whole system of deposit insurance schemes in Europe.

Icesave is essentially an international quarrel between Iceland and the ESA (EFTA Surveillance Authority). The argument is whether or not there is a government guarantee on the bank deposit insurance scheme in an EU & EEA country. Iceland’s case is that there is no such guarantee but ESA disagrees and also withholds that the Icelandic government did not treat all depositors of the Icelandic banks equally when all deposits in Iceland, whether they were in the ownership of foreigners or not, were guaranteed but not deposits outside the Icelandic financial system.

The dispute is now on the desk of the ESA court. If Iceland wins, it could be a clear legal precedent in EU countries: all of a sudden the deposit insurance schemes in EU countries, implicitly considered to be backed up the public finances, could be deemed effectively empty or dysfunctional. Depositors’ trust in their domestic deposit insurance scheme could be severely harmed, even leading to bank runs.

If Iceland loses the possible harm for the public finances could be prominent. However, there is also doubt whether the deposit insurance was to be paid out in the currency that the deposits were in (GBP or EUR) or in the currency of which the deposit insurance was denominated in, i.e. Icelandic krona. If Iceland loses and has to pay out pounds or euros, the country is as good as bankrupt. But if Iceland loses and can pay the insurance out in Icelandic krona, the country should do alright afterwards.

-Do you think the international media fully understands the Icelandic crisis, have they described it in a too romantic way?

Yes, my feeling is that they generally have. The Icesave dispute and how it was romanticised as an uproar of the Icelandic people against the international financial powers – when it was more of an uproar against the Icelandic government who was willing to sign almost any deal whatsoever – is one case in point. The so-called debt forgiveness is another.

The newest one is regarding the fact that GDP in Iceland, measured in Icelandic krona, is growing again (4.2% GDP growth between 1Q11 and 1Q12). Sure, there is economic growth measured in Icelandic krona but the question is whether the devaluation of the krona has to be taken into the account or not. Iceland’s GDP was 20.4 billion USD in 2007 but in 2011, due to the collapse of the currency, 12.7 billion USD. So are we back on track or not?

Yes, we’re growing again but we have a long way ahead of us before we make up lost ground. And my fear is that if we do not fix the dysfunctional banking and pension systems, we will never make up that lost ground. And that has not, perhaps understandably, been picked up by the international press.

-Is Iceland going to adopt a new currency? Which one would suit the best?

I sincerely do not know if we will. The currency question in Iceland is one of the economic and political questions that we have to answer before we can move on with our lives.

One option is to continue with the krona but many dislike that option wholeheartedly since they believe that the krona will do nothing but collapse again and again. So they want a “stronger” currency. The appetite of Icelanders to adopt another currency runs from the fact that the Icelandic krona has not been very stable in the past, to say the least. The krona has in fact lost 99.95% of its value against the Danish krona since it was established on a par against that currency in 1918. Most of the devaluation happened during the 1970s and 80s and not the early 2000s though.

The official direction is to enter the European Union and adopt the euro. That plan is understandably not considered to be very tasty by many people given the economic turmoil in the EU countries.

Another rather prominent idea is to unilaterally adopt a foreign currency. The menu of possible countries runs or has run from the Canadian dollar to the euro to the Norwegian krona back to the US dollar. The Canadian dollar idea is the most prominent one at the moment but historically the support for a foreign currency has almost been an object of fashion. So who knows, maybe in one year’s time we’ll be talking about some other currency and everybody would like to adopt that one.

Which would be the best one? I cannot say. Nobody can. I can however say that the main problem of the Icelandic economy is not its currency but the organisation of the banking and financial system. The economy will never be stable for the longer term if the financial system is not fixed and that has nothing to do with our choice of which currency we choose to use as the legal tender. We have to fix the financial system on our own, changing which currency we use will not do that for us.

-Iceland population is well educated, the demography is healthy, aluminium prices, energy prices and even water prices will go up on the medium term, there's a bright future.. but what are the main threats that will have to face the country?

In the near future, it is the economic crisis in the European Union. We need income from exports and tourism to rebuild the economy and a large part of our trade is done with European countries. So if Europe falters, so will we.

But even if European leaders solve their mess – let’s hope they will – the Icelandic economy is not out of the woods. Yes, the nation is well educated and many Icelanders that go abroad, for e.g. studies or temporary work, want to move back home. We have also plenty of renewable energy, clean water and territorial waters full of fish. So what is there to stop us?

Ourselves! There are powerful pressure groups in the Icelandic economy that want to keep the status quo in the financial system, even though that would be very suboptimal. Those pressure groups run from e.g. the representatives of the banks, pension funds and the old business moguls to and through the politicians. So as long as the old politicians are still in the Parliament, doing deals behind closed doors, I have little hope for true long term recovery. The crash in 2008 taught me to be very suspicious towards politicians, especially if they have been in the Parliament for long. Gunnarsdottir and Arason are just one extreme example of too much and blatant connection between politics and business, especially banking, in Iceland. Gunnarsdottir is still an MP.

More importantly, we need to get our heads straight regarding economics. The policy makers in the financial system are unfortunately following neoclassical economic theory that has no foundations in reality. They are also advising the MPs who naturally think that the neoclassical economists know what they are talking about. But since neoclassical economics is responsible for freak systems, such as the indexation of debt, we need to correct that mistake.

Icelanders need to renew further the political leadership of all political parties. We need to drop people that are doing deals behind closed doors and effectively representing special interest groups. We need new people into the Parliament who are willing to make unpopular but necessary choices such as regarding the pension system. And we need to sway away from economic policies built on the dreamt-up foundations of neoclassical economics.

If we manage to get this done, the future is truly bright for Icelanders. But without those improvements, especially the ones on the financial and pension systems, I am not so optimistic about the nation’s long term prospects. I would at least think twice before moving back home.