Friday, 10 January 2014

An Icelandic "Fisher Moment"?

Irving Fisher is one of those economists that many know. At least, many economists know his work, and some of his work is better known, and acknowledged, than other. Fisher is the guy who brought us The Fisher Equation (real interest rates, nominal interest rates and inflation), the Quantity Theory of Money (PY=MV) and the International Fisher Effect (closely related to Interest Rate Parity between currencies).

He also (in)famously had the opinion, only a few days before the 1929 stock crash, that stock prices in the US had reached a "permanently high plateau". That was truly a "whoops!" moment.

But he had the guts to admit it to himself that he had been wrong. He sat down and came up with the Debt Deflation Theory, which not only is a sensible theory where private debts matter for the overall economy and where one's debt is not simply another's asset, therefore netting out on the whole, but it is also rather the opposite of what he had been doing before.

The reason why I'm shortly reviewing this is that we may just have had a "Fisher Moment" - when somebody sits down and produces a work which is contrary to what he had done before - amongst the Icelandic academics in economics. And the candidate: Fridrik Mar Baldursson, Professor of Economics at Reykjavik University. He's working with Richard Portes of London Business School.

Baldursson and Portes: post-crash
Baldursson and Portes just had a piece on vox.eu where they point out that the Icelandic banks had "gambled for their resurrection". Today, "everybody" in Iceland "knows" this but nobody had put the effort into showing it properly with data, except maybe the Special Investigation Committee that looked into the banks and many, many, many other things after the crash. Too bad their 3,000 page report was only written in Icelandic (besides some excerpts) and never translated into a language, such as English, that would open it better for academic and other types of use outside of Iceland.

Anyway, Baldursson and Portes have an interesting piece on vox.eu which is worth reading. They focus on the banks' attempts to save themselves by practically falsifying their share prices: buy the shares themselves and just before they cross the 5% mark of total holdings, which demands a public notification to the stock exchange with all the possible and impossible repercussions to their businesses if the general public actually learns that they are buying themselves, they unload their own stock onto somebody who is willing to take out a loan, at the bank itself, and buy the stocks. Of course, the only collateral is the stock itself. This the banks did repeatedly and Baldursson and Portes even hint at that this was the practice all the way back in 2005, whole three years before the music stopped.

Furthermore, the banks (or their managers, for "banks" do not take any decisions) focused on bailing out the owners of the banks before anybody else (check out the presentation for examples). What did William K. Black say again: "The best way to rob a bank is to own one." Well, touché, or what? The FSA in Iceland also gets a deserved piece of the action: "These numbers immediately raise the question of how – or even whether – the Financial Services Authority monitored lending to enforce rules on large exposures."

Baldursson's and Portes's article is most welcome. They use data from the report from the special investigation committee which, I believe, haven't been seen in English before. They also take time to point out how notoriously, even criminally, the banks were eschewing the market and bailing out their friends before anybody else. Well done!

But I'd like to point out at least two issues. And I should say immediately that I put the former point, here below, forward with only an access to the vox article and not the CEPR version, which is longer and more detailed. Slides can be found on CBI's website.

ONLY the banks?
Baldursson and Portes seem to have the opinion that it was only, or at least mainly, the banks that were gambling for their resurrection.

But that's not true! Everybody that were calling the shots were gambling for their resurrection!

Just an example: the Central Bank of Iceland. Besides the hard-currency loans to Glitnir and Kaupthing at the height of the storm in September 2008 the Central Bank of Iceland was desperately trying to keep the banks afloat. A mere glimpse at the outstanding REPO agreements between the CBI and the banks is enough to see the scramble for anything, just anything at all, that had any credit-clearing power whatsoever! The scramble for cash was so severe that the pool of all secure and applicable collateral was long depleted. To try and keep the banks afloat - "gamble for their resurrection" - the CBI expanded, or its managers to be exact, their definition of applicable collateral: financial institutions' own notes and bonds were made REPOable. And although the banks couldn't use their own notes and bonds that was easy to work around simply by adding another third bank, say a small bank or a savings bank (lets not get into any names...), and pay it a small fee for getting the cash from the CBI, using a note from the original bank, and then channel the cash straight to the note-issuing bank. And 'hocus pocus' the bank now has liquidity!

This merry-go-round was of course such a serious gamble of resurrection on behalf of the CBI that the banks' notes and bonds were nicknamed "Love Letters" (i. ástarbréf). When the tempestuousness was at its highest point the total "Collateral Loans" to financial institutions were just shy of the ISK 500 billion mark. And I'd like to remind you that ISK 500 billion is back in 2008 roughly 1/3 of GDP: this isn't just some notes and coins! Would you like to compare that ratio to e.g. TARP or QE1/2/3? I'm sure that would be a fascinating comparison.

For some reason Blogger does not seem to allow me to upload the graph. So I'm making a link to it instead, straight to CBI's website
:
CBI's outstanding "Collateral Loans" to financial institutions, millions of ISK

And on this topic: Gudrun Johnsen, a lecturer at University of Iceland's Business School, has recently stepped forward saying that she had tried to warn the FSA, the Central Bank and the Ministry of Finance back in 2005 about the troubled waters the Icelandic banking system was wading into. Nobody listened for "it would have been a political suicide to stop the party".

Reminded me of Prince's words: "As long as the music is playing, you've got to get up and dance."

Baldursson and Portes: pre-crash
Times change and people, and their opinions, thankfully, with it. Baldursson and Portes seem e.g to have changed their opinions on the Icelandic banks since 2007.

In 2007 Baldursson and Portes wrote a report for the Icelandic Chamber of Commerce. The name of the report was The Internationalisation of Iceland's Financial Sector. There we can see them applaud the Icelandic banks and their strengths, short chain of command, their unusual yet profitable business model and responses to the 2006 mini crisis. Let's look at some excerpts, with some bold-font adjustments made by me:

There are macroeconomic imbalances, but their reflection in the external accounts is exaggerated. Despite problems with monetary policy and its effectiveness, the imbalances are being corrected, and the demonstrated, exceptional flexibility of the economy gives cause for optimism. We find that their effective response to the shock of early 2006 has made the banks much better placed now to cope with domestic macroeconomic shocks, credit events, and external liquidity constraints. They are well-managed, and their business models are strong.
We consider, therefore, that the current market premium on Icelandic banks is excessive relative to their risk exposure and in comparison with their Nordic peers. If this is in fact a country risk premium, we think it is not justified by Iceland’s economic situation. 
 ...
Considering that all three banks have relatively high capital ratios to compensate for this different nature of their business model, the returns are even more acceptable. In addition, a high proportion of salaries in Icelandic banks are based on performance [with rather obvious incentives for the staff to take increased risks], indicating that the cost ratios would be much lower with simpler and less profitable operations. Taking that into consideration, the effect of the re-estimation on returns with no return on equities is rather modest
... 
After the initial shock [in 2006, the Geyser crisis], the Icelandic financial sector responded quickly and decisively:
  • deposit ratios are higher 
  • market funding has longer and more dispersed maturities
  • cross-holdings have been mainly eliminated
  • there is much greater transparency and information dissemination about the banks’ 
  • structure and activities.
On the same criteria, Icelandic banks come out well in a comparison with Nordic peers – and their overall and core profitability is higher. That is despite the high CAD and Tier 1 ratios with which they counterbalance their equity exposure. They are well hedged against volatility in the krona. Stress tests by the FSA indicate that the banks can withstand quite extreme movements in market variables specific to Iceland. The banks have negligible exposure to the US subprime market, structured finance products, and related financial vehicles that have hit many financial institutions hard recently. Most fundamental, the banks exploit strong competitive advantage, arising from their entrepreneurial management, flat management structures, and unusual business models
Yet in spite of their strong performance, Icelandic banks have lower ratings than their Nordic peers, and a much higher risk premium is being placed on their debt during the present turmoil. We see no justification for this in their risk exposure. This suggests that either the markets are not fully aware of their situation or markets place a country premium on the banks.


And their recommendations were nothing related to the banks, but rather "adopt-the-euro-and-collect-more-data-and-the-CBI-should-do-something-else-than-encourage-the-carry-trade" sort of a general advice. Some of them make perfect sense (such as decreasing the use of indexation) but those recommendations would hardly have saved the banks or stopped them from collapsing:

The possibility remains, however, of unilateral adoption of the euro as legal tender – ‘euroisation’. Euroisation would have potential advantages. In the ‘euroised’ economy, speculative attacks are no longer possible, so there is no currency risk, and domestic interest rates no longer incorporate that premium. There are typically lower transaction costs and greater transparency in policy. Using a stable foreign currency may itself implant or reinforce a ‘stability culture’. 
 ...
The CBI is on an inflation target of 2.5%. Inflation driven by housing prices has however remained above the target for some time. The CBI has not had an easy task given the strong demand growth in Iceland in the last few years. And fiscal policy has not been supportive of monetary policy. Yet the policy rate of the CBI is very high compared with trading partners of Iceland, and monetary policy appears to be ineffective. There are several underlying reasons. First, the Housing Financing Fund is a major obstacle to the transmission of monetary policy. We agree with many other commentators, including the IMF, that the HFF’s role should be changed so that it no longer competes with banks in mortgage markets. Second, price indexation of financial contracts is widespread and tends to weaken monetary policy. Third, the CBI has undermined its own policy by linking its decisions to exchange rate developments. The high policy rate leads to distortions in the financial system, such as the large carry trade. If only for that reason, we urge the CBI to reconsider its strategy.  
We strongly recommend efforts to improve the collection of data to account better for the balance of international income and the international investment position.

Now, people make mistakes. And that's fine, and quite frankly even necessary if one wants to learn the real gist of things. So maybe Baldursson and Portes are learning, just like Fisher did after he had spoken about the "permanently high plateau". Baldursson and Portes made a mistake back in 2007 and now it seems as if their eyes have, at least partially, opened. They even mention their 2007 report in the presentation as being "too uncritical".

Well done guys! Seriously, it takes guts to admit one was wrong!

Monday, 2 December 2013

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.

Wednesday, 30 October 2013

Household debt and house prices

Steve Keen has an article on household debt and house prices in multiple countries, using BIS data. Since Iceland is not on the list - and we arguably had a housing bubble - I sat down and did the same (or at least similar) analysis on Icelandic data. Sources are the Central Bank of Iceland, Registers Iceland and Statistics Iceland.

First, the real (CPI deflated) house prices.

Real house prices in Iceland, monthly data.

Now let's see what happens when we add the household debt data.

Keen uses the acceleration in household debt and the change in house prices. The idea is that acceleration of household debt, which is mainly mortgages, should be like a jolt of energy into the housing market. More mortgages (increased acceleration) means more purchasing power and more purchasing power means more demand which should push up house prices. So the acceleration in the level of household debt should be correlated with the change in house prices. If the correlation is high it is a sign that changes in house prices are primarily driven by new mortgages rather than "fundamentals" of any kind.

In the case of Iceland we've got data back to 1997, limited by quarterly national accounts. We can stretch the data back to 1994 when the index for house prices is first published but I'm using quarterly data here.

Icelandic household debt acceleration and change in house prices

The second graph here above makes perfect sense until about 1Q 2008. Then we can see a great divergence between the two series and after October 2008 there is all sorts of nonsense going on.

The likely reason for the apparent non-correlation after October 2008 is that the data is all messed up. When the new banks were established they got a free book-value haircut on the existing debt of up to 30% or even more. The great profits of the banks since the collapse is to a large extent due to the banks clawing back this haircut in their books: a credit contract worth 10,000,000 ISK (nominal value) was booked, when the banks were established, at 6,000,000 ISK and then revalued, in steps, up to e.g. 9,000,000 ISK, creating a nice 3,000,000 ISK profit in the books.

It's the October 2008 haircut which is the reason for the massive drop in debt acceleration around that time. The second drop in 2010 is probably due to the fact that FX-indexed loans were deemed illegal and the banks had to write them down to a large extent. Meanwhile, the divergence in early 2008 is at least partially explained with the fact that by that time the ISK was collapsing and FX-indexed loans, the same which were later found to be illegal, were rocketing up in nominal value.

So data problems are probably the reason why the correlation doesn't make any sense after 2008. Until 3Q 2008 the correlation is as we would have expected it from Keen's idea. And the value: 0.56. If we want to be selective and skip the last three quarters of 2008 when the ISK was collapsing at the fastest pace the correlation goes up to 0.74. That's high but still lower than some of the coefficients that Keen has in the case of other countries.

And today? Well, the banks began offering non-indexed mortgages (majority of mortgages in Iceland is indexed to the CPI) in 2009 and they really took off in 4Q 2009 according to data from the CBI. A large share of new mortgages is now non-indexed but their share is fluctuating somewhat. As far as I'm aware of no official data series exists which shows their share at all times.

We could check out the correlation between household debt acceleration and house prices from e.g. October 2008 or December 2009 but we would still have to deal with the rather bizarre drop in the data in 2010, probably caused by the FX-indexed being found illegal. If we however check the correlation only from 4Q 2010 we get this:

Household debt acceleration and change in house prices since 4Q 2010. Correlation: 0.85


Now, this is guesswork and should be taken with a pinch of salt! I do not know when exactly the banks book their losses due to the illegal FX loans, I'm guessing, from the data itself, that it's before 4Q 2010. Furthermore, this is less than three years of data so we should be careful in trusting that the correlation will stay there forever. Also, since the CPI includes house prices and the CPI affects the nominal value of indexed mortgages we should expect to see correlation through that link as well. Finally, correlation is not causation and all that - and this applies to the previous graph as well.

All the same, this feels intuitively too comfortable to outright deny it. It at least seems that the current housing market in Iceland is driven first and foremost by new credit being created by the banking system. I wonder how important fundamentals, such as wages, really are.

Oh, well! Back to work!

Tuesday, 16 July 2013

Icelandic Pension System: Only 700 billion missing

The FSA in Iceland recently posted a new set of figures regarding the pension system back home. The bottom line: only 674 billion ISK missing (i.e. the total actuarial position is negative by 674 billion). That translates into just over 39% of GDP which is an improvement from the 2009 figure when the gap was a considerably worse 50% of GDP. So even if the current situation is bad - good luck finding money nearly equal to the whole government's, local and state, income for a whole year! - it isn't as bad as four years ago.

Or is it?

The Icelandic pension system is often held up high as one of the best ones in the world (at least in Iceland). Again, looking at other pension systems, I suppose this is true but that's not because the Icelandic system is so great but rather because most other systems are so bad! At least Iceland had the wits to store some of the pension-tax that is collected from its citizens, creating somewhat of a buffer for the public finances once the baby-boomers retired and their grandchildren entered the tax... sorry... labour force. Consequently, we have assets in the system worth around 129% of GDP (which, taking the deficit into the account, means that we, and our unborn children, have promised ourselves to pay ourselves pension worth 168% of GDP... we just don't have the money to do so... yet... but that's a problem for future generations, right?)

Not doing too bad in comparison to many others. Bankrupt by 700 billion ISK all the same.

Seemingly slowly recovering

The second graph above might give the impression that the system is recovering after the 2008 crash. What it doesn't show however is that the funds cut down the benefits of their clients by 130 billion already by year end 2011. So the majority of the improvement in their actuarial position comes from these cuts. The 2012 improvement is certainly helped by a convenient increase in domestic stock prices at the end of the year.

What's wrong?

The fundamental problem of the Icelandic pension system is that it implicitly promises a rate of return that is impossible to get in the long run. This rate of return is around 3.5%. Nobody in fact knows it for sure for it hinges on the development of factors such as wages and expected longevity. And since nobody knows for sure how exactly those factors will change, the only thing we can do is to estimate the needed rate of return to fulfil the pension promises. And the best estimate: 3.5% real rate of return per annum. Consequently, this figure is in the actuarial accounting for the pension system to try and keep balance between the future cash flows that will affect the asset side of their balance sheet on one hand and the liabilities side on the other.

But think about this: in an economy with limited resources and in fact where the annual GDP growth is already below 3% on average, is it realistic to promise a 3.5% rate of return on your pension assets?

If the impossibility of this promise doesn't immediately pop up in front of your eyes, think of it this way: would you trust a person who promises to pay you a 3.5% real rate of return on the funds you are going to lend to her when you expect that this person will only earn 3.0% real rate of return on her investments?

If I would show up at the bank with such an investment plan, I should be rightfully laughed at and tossed out!

The beauty however of macroeconomics is that we can run such an unrealistic system for quite a while by racking up gross debt - owed by the households themselves, firms and the state - in the early stages of the system. The newly created debt will act as somebody's income and spur increases in asset prices, consequently improving the balance sheets of those who hold the assets in question. So while the debt increases, the system will report a rate of return higher than the growth of GDP. In the end however, the debt burden brings the system down and it collapses. This is why I've repeatedly called the Icelandic pension system a Ponzi scheme.

That is the essential problem of the Icelandic pension system: it promises more than it can deliver. On top of that comes the very important side effects of pushing the rate of interest in the Icelandic economy upwards. This happens due to the funds' gigantic size in the economy while they demand such a high rate of return on whatever they buy: to fund an investment project, it is not unlikely that at least some of the money will come, one way or the other, from the Icelandic funds which demand a 3.5% rate of return. Consequently, the rate of interest is pushed upwards, killing the economic recovery.

I only realised this in 2010 and went public (e.g. here, here, and here) with this rather blatant truth once one just stops and thinks about it. Already in 2010 I repeatedly warned that the system needed reform to lower the dreaded 3.5% minimum rate of return. I also warned that if the pension system would not be reformed, the rate of interest would stay too high and kill off any gross investment in the economy. It wasn't done and, as expected, the level of gross investment in the economy hit a historical low! The high rate of interest, pushed upwards by the pension system, was one of the culprits.

We would have had a proper recovery if the pension system had been reformed

The Icelandic Pension Fund Association publicly replied and said I was wrong. One of the foremost specialists on the system, Bjarni Thordarson (who has now passed away), claimed my stating of the case a "nonsense" (i. dómadagsrugl). The president of the Icelandic Confederation of Labour, Gylfi Arnbjornsson, thought that my "misunderstanding" about how the system worked was becoming "awkward".

Now, finally, we have news that they are going to do something about it: the system is being reformed although it seems as if they are mainly going to reform it such that the government-backed up part and the private part will be coordinated with each other. They are going to jack up the pension age from today's 67 years though. Overall, reports are still hazy and the final plan has not been formalised.

Let's wait and see and hope that they will actually improve the system but not just reform it.

Thursday, 27 June 2013

UK & Iceland GDP comparison

After the recent GDP figures from ONS, the general reaction was rather pessimistic. FT had e.g. this tweet and article:


True, this doesn't look good. In fact, after the revisions, UK GDP volume is now further below its top before the financial crisis than Iceland's GDP is. The following graph is based on data from ONS and Statistics Iceland. The top is given the value 100 (3Q07 for Iceland but 1Q08 for the UK). Chained volume measurement, seasonally adjusted (yes, the Icelandic data are SA although they don't look like it).

Back on track: Iceland is edging closer to its GDP volume top before the crisis. The momentum is also stronger.

Iceland's GDP is now 0.4% closer to its top before the crisis than UK's GDP compared to its top. Then again, Iceland had its top two quarters ahead of the UK.

But - there is always a "but" - this is a volume measurement. And although economics teach us to think in volumes and real measurements, we arguably do not rely on barter (and never did) in our commerce. We use money and money is different between economies: try paying with Queen's money in Iceland and you'll be a laughing stock (I've tried, the guy just grinned at me) just as you will be if you try using the ISK in the UK.

So what happens if we price the volume produced in the same currency, say the GBP. That comparison makes sense: we could be producing the same volume as before the crisis but is it worth the same?

The UK volume is already priced in pounds so no need to handle that in a special way. But the Icelandic volume measure uses the ISK as a measurement stick and that measurement stick has changed significantly since before the crisis. If we measure both of the volumes in GBP, the following graph is the result.

Still long way to go: measured in GBP, the Icelandic GDP volume does not seem to be edging must closer to its previous height

Notice the drop in the Iceland data in 2006. This is the "Geyser crisis", a short wake up call to the fact that we were in a bubble. But it did not last long; politicians and prominent businessmen claimed everything was peachy, the housing bubble restarted (held up with exchange-rate linked loans which have now been deemed illegal) and the banks kept on growing. Then, finally, the party ended.

To my British friends I say: sure, you're not in the best of situations. But if it makes you feel better, you're not in the worst.