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 1st of
January 2011. On 1st 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 1st January 2012 but 105,000 krona. But of course, you only
got 100,000 krona from the bank.
Let’s assume now that on 1st January 2012 you
repay 10,000 krona plus interest. That means that you owe the bank 95,000 krona
after the repayment on 1st January 2012. Now the inflation between 1st
January 2012 and 1st 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 1st 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.
