Thursday, 6 December 2012

Households' expenditures in Iceland

Statistics Iceland issued a survey on households' expenditures for 2011 today. Their press release notes that:

"Average household expenditure 2009-2011 is 443 thousand ISK a month and has increased by 0.4% from the 2008-2010 survey. The CPI rose by 4.0% between 2010 and 2011, hence the real household expenditure declined by 3.5%" Take note that this includes all expenditures, including housing and housing costs and not only consumption.

Here are the data from Statistics Iceland. We can see that the households are contracting their expenditures, based on these data, en masse since 2007. In monetary terms, they've only levelled off despite a 38% increase in the CPI from 2007 to 2011.

Households' total average expenditures in nominal and real (2011 prices) terms. Data from Statistics Iceland.


Now, there have been speculations that the households are consuming too much in Iceland. The overdrafts borrowing and the liquidation of private pension fund assets are taken as a sign of this conspicuous consumption, even though it should be obvious, given the shock from the financial crisis, that households should getting their financial situation in order, not binge borrowing more! As an example of this view, the newspaper Morgunbladid  had an article on 21 November where two commentators (one of them my former teacher and boss at Kaupthing Research, Dr. Asgeir Jonsson) expressed this view.

One of them, Gustaf Steingrimsson at the research department of Landsbanki, noted that households had liquidated 75 billion ISK of their pension assets since March 2009. Jonsson in the meanwhile applied the permanent income hypothesis and said that after the temporary blow to income in 2008, households were back to prior (unrealistic) consumption levels, borrowing or liquidating their wealth to fund their consumption and trusting that they would be able to find income in the future to pay the whole lot back.

Well, no! Not according to the data! In real terms, household expenditures are back down way below their 2003 levels and almost a fifth less than they were in 2007 when the borrowing binge was admittedly conspicuous! In the meanwhile, the 2011 expenditures are also way below the average households' expenditures over the period of 2002-2011. We can hardly say that households are guilty of continuing the pre-2008 gluttony!

Households' expenditures are nearly a fifth lower than in 2007 and 9% less than in 2003.


Even a clearer picture is given when we take housing cost away from households' total expenditures. 

What I've done in the graph below is to deduct the "housing, water, electricity, gas and other fuels" part from the total expenditures. What should be left is then mainly consumptive items and services. The idea is to try and focus on that sum specifically and consequently try to judge whether households' consumption, not total expenditures, are of the outrageous sort.

Indices of households' expenditures, based on CPI corrected nominal terms. Notice that the drop in expenditures leaving housing aside is relatively more than in total expenditures.

This graph tells us two things:
1) The growth in consumption before the crash was large but not the main contributor to the fact that households' expenditures grew so quickly and exorbitantly. Yes, there is a great increase from 2003 to 2007 but the main increase in expenditures is, seemingly, due to the fantastic increase in housing cost.
2) The contraction in consumption is greater than in the total expenditures of households which, on top of consumption, take the cost of housing into the account. Since 2002, expenditures due to consumption has dropped nearly 18% while total expenditures, including housing costs, have only gone down by 11%. 

Based on all this, no one can rightfully say that households are not contracting their consumption. The liquidation of pension assets is consequently not to finance irrational consumption but rather to finance the cost of housing, there included interests and repayments of principal. And as expected, housing cost has increased significantly since 2002, both in real terms but especially as a percentage of households' total expenditures.

Housing has increased its prominence as a share of total households' expenditures. Today, households spend more money on housing than food, non-alcoholic beverages, recreation and culture combined.


Sorry folks, Icelandic households are hardly lacking in effort to decrease unnecessary consumption. They are rather fighting to repay their mortgage debts.

Too bad the indexation keeps renewing them.

Friday, 30 November 2012

An Interview with Rás 2 Radio

RUV (the Icelandic equivalent of BBC) interviewed me Wednesday on the cul-de-sac that the Housing Financing Fund is stuck in.

Some of the points I raised:

- HFF has a government guarantee (some concerns have been raised if it is truly bound into law) and therefore, a non-payment of its debt can be considered a default of the Icelandic State
- since the net interest differential has become negative due to mortgage repayments and the Fund's inability to repay its own debts at its own will (the HFF bonds are irredeemable), the Fund has practically become a leech on the State's finances: every 2-3 years, the government has to pump new equity into the fund
- this need to pump new equity into the Fund impairs the prospects of abolishing the capital controls in Iceland as the Central Bank is of the opinion that the public finances must be balanced before capital controls are lifted
- but due to the capital controls, the interest rates in the Icelandic economy as pushed downwards. This gives households the incentive to refinance their mortgages, which they have begun to do (especially with non-indexed loans from the banks)
- this again creates the "leeching" situation of the Housing Financing Fund due to the fact that its bonds are irredeemable. Ergo: we have a potential vicious cycle
- if a non-payment of HFF debt is considered to be a government default, we cannot do much about the bonds which have issued so far. We can however stop issuing more of them! The Chairman of the Housing Financing Fund was asked later the same day about this proposal of mine and he said that although it had not been made official, the HFF's board had already decided to stop issuing more HFF irredeemable bonds. That comment was later watered down by a statement from the HFF board itself.
- the debt rating of the Icelandic State is hampered by the fact that the State guarantee amounts to 950 billion ISK (roughly double the gross tax income of the Icelandic federal government).
- increasing interest rates will not solve the problem of the negative interest rate differential since if interest rates are raised, borrowers will simply default instead, leading to equity problems all the same

The interview can be found here (in Icelandic)

"The Mirror" on Rás 2

Wednesday, 28 November 2012

Icelandic CPI and the money supply

New data on inflation in Iceland were published today. The verdict: 4.5% over the last 12 months.

In some sense, this high (rather mellow on Icelandic standards) rate of inflation is a collateral damage incurred after the bust of the bubble. The money that was created en masse before and during the fantastic bubble formation before the crash is simply still sloshing around, catching too few goods with inflation as a rather expected result.

Basically, we can interpret it as the classic quantity theory of money doing its work - with a bit of lag as one can really expect (I hope nobody truly beliefs that the rational expectations theory applies: even if the money supply is expanded by x% in time period t, it is impossible to realistically expect that people will boost their price expectations immediately, resulting in a full inflation-feedback within time period t as well. However, over a longer time period, maybe a few years, we can expect the price level to slowly respond in more accordance to the MV=PY theory.)

We can throw the data up graphically to understand them a bit better. Here is the rate of inflation and the relative expansion of M3 over a 5-year-period (instead of the annual measure) since 1886 in Iceland.

5-year inflation and 5-year relative expansion of the money supply (M3). Notice that the axes are the same. Correlation: 0.88. Data constructed from various sources. (OECD, Statistics Iceland, Central Bank of Iceland).

We can see that the bump in 1994-2012 (October value) seems a bit out of place since there is a lack of response in the Consumer Price Index. The same applies to the early 20th century bump and the WW2 spike.

The early 20th century bump can be explained with the fact that the banking system was truly developing fast back then and the proper allocation of money brought supply-side improvements, therefore the CPI did not chase the expansion of the money supply as much. Data might be the reason why as well, we never know with data looking so far into the past. The WW2 spike can be explained by the massive inflow of capital from abroad which did not really enter the circulation but was stacked up in the Central Bank in the form of foreign reserves. They were promptly spent - every pound of them! - after the war on the "second industrialisation" in Iceland when the agriculture and fishing industries were modernised with tractors and trawlers. Of course, we went a bit over our head in that episode and the over-investment was, with the benefit of hindsight, monstrous! But at least that over-investment, despite leading to a currency crash in the early 1950s, left us with tractors and trawlers. Not entirely useless!

But that leaves the early 21st century bulge in M3 without corresponding reaction in the CPI. Lets zoom down onto the last 18 years.

Same as above but zoomed down onto the 1994-2012 period. Notice that the axes are now not the same (inflation is on the right axis). 

Now, all of the sudden the rather close (judging from the earlier graph) relationship between 5-year change in money supply and 5-year change in CPI brakes down. So what happened to all that extra money? Well, it's still there. It's just not buying goods... yet. In this respect, it is interesting to look at the ratio between money supply and the monetary value of GDP, i.e. the M/PY ratio (the inverse of the velocity of money).

The ratio between the money supply and the monetary value of total production. Will this ratio fall back down to normal heights through a deletion of money (some people want to "go German" in Iceland and adopt a "New Krona" a la Germany in 1948 when they basically wiped out a large part of the money supply to stop hyperinflation from happening - the "Wirtschaftswunder" happened somewhat as a result of that), through higher nominal prices (inflation) or through more production (GDP growth)?



So what will happen? Will the money just "hang around" there doing nothing or will the monetary value of total production increase? And if it does, will the monetary value of total production increase through higher nominal price level - i.e. will inflation happen - or will it happen through more stuff being manufactured - i.e. will GPD growth happen?

Maybe it wasn't such a good idea to allow the banks to create all that money in the early 2000s!

Thursday, 22 November 2012

The Upcoming Problems of Housing Financing Fund

The Housing Financing Fund (HFF) in Iceland is a government sponsored entity that raises money on the capital markets and lends it onwards to Icelandic households in the form of mortgages. The total government guarantee on this fund is 950 billion ISK (58% of GDP and almost two times annual income of the State).

The problem is: the HFF is bleeding, slowly but securely. Consequently, it is a massive threat for the public finances because the government has to bridge the gap whenever its equity position runs down. And today, that position is only 1.4% of total assets.

HFF's accumulated losses since 2008 are 46.7 billion ISK. Its equity is supposed to be above 5% but as already mentioned, it is 1.4% now - down from 2.3% in June.

The government has already pumped 33 billion in new equity into the fund (in 2010) but that was swallowed whole in the fund's participation in the 110% act (you had part of your debt cancelled if your mortgage was 110% of the market value of the property). The fund has also tried to increase its net interest rate premium as we can see on the graph below. All the same, the fund now needs 12-13 extra billion ISK from the government.

The interest rate premium of HFF has increased slowly but securely since 2009. The red line is the fund's interest rate cost (the rate on HFF 44 which matures in 2044), the blue line is the rate it offers its borrowers and the green line the difference there between. The black line is 12 month moving average. 


The reasons for its demise: lack of common sense

The first reason for HFF's troubles is the fact that it is offering a rate of interest which households cannot pay in the long run!

You may have noticed on the graph above that the blue line stands at just above 4%. It stands at 4.2% to be exact. This however is not nominal rate of interest but real rate of interest!

All the mortgages from HFF are indexed - and if you want to know in more detail how Icelandic indexation on mortgages works, check this out - and carry therefore the real rate of interest. The most brilliant thing about the indexation of mortgages in Iceland is that it is not the nominal rate of interest which is upped parallel to the changes in the rate of inflation, but the principal of the loan is changed according to the annual rate of inflation.

So if you have a mortgage from HFF of, say, 1,000,000 ISK you will get it with 4.2% rate of interest. Assume that this is in November 2012. In November 2013 the annual inflation turns out to be 5%. That means that you now owe the HFF a mortgage amounting to 1,050,000 ISK which still carries the 4.2% rate of interest. You do not owe 1,000,000 at 9.2% rate of interest.

The Icelandic indexation basically postpones the full cost of the monthly payment. Instead of demanding that you as the borrower pay the original amount at 9.2% nominal rate of interest, you get a loan, automatically, amounting to 50,000 ISK and are asked to repay it later. This of course happens repeatedly, every single month to be exact (the amount changes of course depending on the rate of inflation).

Now, the trick is that this may not be so bad if the borrower can in reality pay back the loan. But that means the borrower has to find money to repay the original principal and the automatic loans as well which are so conveniently extended to him.

That is going to be a bit problematic for the average household. For even though the real rate of interest on HFF loans are 4.2%, the real wages in Iceland are not growing by that number. They are only growing by 1.1% per annum (since 1989).

So if you look at the households as a whole and consider their debts, which carry the real rate of 4.2%, and their wages, which grow by 1.1% per year, is it not likely that the ratio debt/wages will grow year by year?

Well, yes it is! And so they have! This happens not only because of new non-automatic borrowing but also because the households are given an automatic loan every single time there is inflation: inflation basically funds itself! This really smells a bit like a Ponzi-financed inflation. And that is truly what indexation, in its current form, of mortgages in Iceland is. Some day, a large chunk of this mortgage debt will have to be either refinanced at a rate of interest well below what it is today or simply straight forward cancelled. This is not sustainable!

Household debt in Iceland as a ratio of spendable income. The drop in 2011 can be explained to some extent by the illegal foreign-currency loans and the households' endeavour to use pension savings to repay debt.


The other reason for HFF's bleeding wound is the fact that it cannot pay its debts in advance: the bonds it issues have a no-early-payment clause.

This means that if households decide they want to refinance their HFF mortgages with another one, from e.g. a bank, the HFF will end up with a stack of cash it has no idea what to do with. That stack of cash will of course only yield 0-1% real rate of interest, if that, which is quite problematic for HFF because its issued bonds (the HFF 14, HFF 24, HFF 34, HFF 44 bonds) are irremediable and carry a 3.75% coupon rate.

Blatantly then, the HFF will slowly bleed out. Whatever money the government throws at it will practically be nothing else than a temporary bandage on the negative-net-interest wound which it slowly bleeds equity out of.

Truth is that the Icelandic Housing Financing Fund is in a Wile E. Coyote moment: there is nothing behind it other than the air and the Icelandic government's guarantee. The problem is that HFF cannot be allowed to go bankrupt for if it does it can be interpreted as a payment default of the Icelandic state.

It will be fun to be an Icelandic tax payer in the future! Also, if a condition for abolishing the capital controls is a deficit-free budget, good luck with that with HFF hanging around.

(Icelandic version first published on Pressan.is)

Thursday, 15 November 2012

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! 

Wednesday, 14 November 2012

Firms' cash flows

3rd draft of the thesis is done! My supervisor is reading it over and I hope he will be all right with it. Will meet him in two weeks or so, until then, it's time I revive this blog a bit!

Statistics Iceland issued, not long time ago, new data covering the cash inflows of Icelandic firms, based on their VAT reports. The bottom line: the nominal value is back up above pre-crisis levels in 2008 but the real value is still lingering below. There is a steep spike in the real cash flows however so the firms-part of the economy is picking up pace.

This is the nominal value of firms' cash flows. The sample is smoothed out with a running average. Notice the stagnant period in 2001-2003 when nominal cash flows were hardly or not growing at all. That compares to the 10% drop in nominal cash flows in 2009. 

Firms' nominal cash flows

This real cash flows story is another one a bit more frightening. Suddenly, the drop in 2009 has stopped being violent and has turned into a battle for existence!

Firms' real cash flows, 2012 price level

What is curious is to see where the drop comes from. And the answer: from the burst of the housing bubble. On the graph below we can see how industries have rocketed upwards as a share of the firms' total cash flows. At the same time, cars and car repairs have trended downwards for a long time. Most notably however, we can see that after the housing bubble burst, the "construction" has basically disappeared.

Graph shows how firms' total cash flows are split based on what they're doing. The burst of the housing bubble is rather obvious

The burst of the housing bubble is even more blatant in the next graph. Since 1970, the construction of residential housing has never been as low. That is so even if Icelanders are now 319,000 compared to 204,000 in 1970.

Number of square meters in new residential houses and flats, begun and finished, in each year. If you're a carpenter looking for a job, don't come to Iceland!

Of course, we can see on the sectoral cash flow graph that it is the Industries (manufacturing) that have kept the economy alive since the implosion in 2008: total value sold of manufactured goods doubled between 2007 and 2011 (reaching 727 billion ISK in 2011). Most of this comes from manufacture of basic metals (the smelters) but food products and beverages (the fishing industry, we've also become producers of many different brands of beers!) have done their parts as well.

I don't think anyone will deny that the utter collapse in the value of the krona helped industries keeping the economy alive. At the same time, the strengthening of the krona during 2002-2007 can be blamed at least partially for the deterioration of those same industries in that period. In the meanwhile, the housing bubble and the credit mania kept the economy going while the krona was too strong.

Maybe next time I'll check out the data for e.g. France and Spain but both economies had/have a housing bubble (don't tell me Parisian house prices are sustainable!) and then an economic slowdown, Spain in particular of course. Ireland would be a nice comparison as well. Have industries in Spain, Ireland and even France refuelled the economy to the same extent as has been the case in Iceland after the implosion in the housing market? Based on the prominent discussion about the growing current account deficit in France, I'm going to doubt it in case of her - at least until I see the data.

Wednesday, 31 October 2012

"At Dawn" on Bylgjan Radio

The long silence here is explained by the fact that I've been working on my PhD like crazy for the last weeks. The last chapter does not write itself. It is coming to an end though, one day this will all be finished!

Was on the phone in the radio show "At Dawn" this morning at Bylgjan radio back home. The topic was the pension funds and the idea of a member of parliament, Mordur Arnason, to give people the choice to use their monthly payments into their own pension fund to pay up their mortgages. So instead of forming rights within the pension system, people would pay down their debts instead. 

I pointed out that Arnason's idea was simply based on the fact that the yield pension funds are getting, costs etc. taken into account, is only around 2.5%-3.0% (real interest rates). In the meantime, mortgages in Iceland carry 4-7% real interest rates. So why not pay back your debts first and then build up your rights within the pension system?

Thorhallur Josepsson from The Pension Fund of Commerce was in the studio. He agreed with me that Arnason's idea deserved some serious thinking. But he didn't agree with me entirely, at least not when I said my opinion on the general structure of the Icelandic pension system and when I commented on the funds' need to get 3-4% real rate of return if they were going to be able to stand by the promises they are legally obliged to.

The clip can be found in the link below (Icelandic).

Wednesday, 3 October 2012

Wages in Iceland According to the Tax Man

A Facebook friend of mine posted data on there about the gross wage income of tax payers for the last years. The data got me thinking and I came up with the two graphs below.

Explanations are in order. First, the data is gross pre-tax income in the form of wages, including wage-benefits (car sponsorships etc.) and pension payments. The gross income amount is divided by the number of those persons that posted that income to the tax man. Furthermore, the years are the years of which the income took place. The data comes from this Facebook friend of mine, Elias Petursson, and he has it from the Directorate of Internal Revenue (a very cumbersome name for the tax collector).

So in 2007, the average tax-record-maker made nearly 4.8 million ISK in pre-tax income (2011 prices). That is equivalent to 58 thousand USD (again, in USD 2011 prices).

But then came the crash. In 2008, the average gross pre-tax income had fallen down to 4.5 million ISK. The figure went on downwards, bottoming out in 2010 at 3.75 million ISK. A mighty fall of 21% in pre-tax gross income in only three years! Only last year did the pre-tax gross income increase, but it is still 18% lower than it was in 2007. And this excludes all the effects of the tax hikes!

But there is more. The collapse of the currency by 50% - you needed 64 ISK to buy 1 USD in 2007, in 2011 you needed 116 of them after having bounced back from the 124 ISK/USD low in 2009 - decreased the purchasing power of the average Icelander abroad significantly. The 58 thousands USD gross pre-tax income in 2007 turned out to have become only 33.5 thousands in 2011.

The pre-tax income of the average Icelander has decreased significantly since 2007, both in ISK and USD alike. Red is the USD figure in thousands, on right axis. Blue is ISK in millions on left scale. Both figures are detrended with the respective price index and all figures are in 2011 prices.


Now, the axis on the graph above don't add very much detail. If we however make an index out of the figures, we come up with this.

The pre-tax gross income of the average Icelander has decreased by 18.3% since 2007. Measured in USD however, the fall is 42.7% since 2007. Notice the slow upward move since 2009 though. Again: USD in red, ISK in blue (fixed prices)


So the populace of the IMF Wunderkind has had to settle for a contraction in USD-based gross pre-tax income of more than 42%. Well, we can always look at the bright sides: since the USD income bottomed out in 2009, the growth is 12.3%. Maybe there is something behind the GDP growth figures after all.

Yet, I must wonder what happens once we take the tax burden into the account.

Tuesday, 2 October 2012

The Optimistic GDP Forecasts and IMF's Turnaround

Islandsbanki published its economic forecast for the Icelandic economy late in September. Their expectations: 3.2% growth in 2012 and increasing after that.

I sat down and looked at some other forecasts in comparison to get a feeling for the realism behind them. I cannot say that any of them is realistic for 2012 except the IMF one. And funny enough, IMF is in fact turning around on its policy on Iceland and the problem we have on "offshore" kronas. IMF isn't as optimistic about its wunderkind as they used to be when they threw that "Iceland and IMF" conference one year ago.

GDP forecasts range from 2.4% (IMF) to 3.2% (Islandsbanki) in 2012. CBI stands for Central Bank of Iceland.


OK, so the range for 2012 is 2.4% to 3.2%. That compares to 2.4% GDP growth the first 6 months of 2012 compared to the same period the year before. That means that to reach 3.2% growth (Central Bank of Iceland (CBI) and OECD expect 3.1% growth in 2012) the economy needs to grow by 4.0% in the second half of 2012.

4.0%. Right. Well, that's not going to happen. Islandsbanki's 3.2% expectation is way off, we can immediately write their 2012 forecast off. Same really goes for CBI's and OECD's 3.1% forecast.

The most interesting forecast is IMF's. It's interesting not only because it is the most realistic one but it also signifies a turnaround on IMF's behalf when it comes to Iceland.

IMF in 2011: "We nailed it!"
In August 2011, IMF projected 3.1% GDP growth in Iceland. It expected 2.5% growth for the full year 2011, which compares to the latest estimate of 2.6%. Well done! IMF generally expected "a tentative economic recovery": the inflation was rising, the krona depreciating slowly and uncertainty was (and is) still high due to the Icesave dispute. However, "access to international capital markets [had] been regained" and "outlook was for a moderate expansion" while "concerns persist about the sources of medium-term growth." IMF constantly mentioned the growth in private consumption, an economic factor that practically caved in in 2009 and 2010.

But the most prominent IMF position was that of the handle of the crisis. A whole conference was set up in October to celebrate the good job done and famous international economists came to Iceland to check out the crisis Wunderkind. In November 2011, IMF's eyes to the possible unorthodox handling of the crisis had opened and Iceland's case suggested "alternative way out of crisis."

Iceland had basically taught IMF that atypical "we must save the creditors!" policies weren't the only one available. Good stuff, very important that IMF realised this.

IMF in 2012: "We nailed it BUT..."
Now, IMF has realised that it may have to extend even further the Icelandic case of "let the creditors drown". The reason: the offshore kronas.

The offshore kronas are funds, denominated in krona, that are stuck in the economy behind the capital controls. Their sources can be of any kind, ranging to the Glacier bonds issued during the 2004-2007 Party to normal households' savings that are eager to get out of the economy on expectations alone that the value of the krona will collapse the instant the capital controls are lifted. Estimates of the whole offshore krona amount run from 400-1,000 billion ISK (25%-60% of GDP or thereabouts).

On 28 September, IMF issued a Concluding Statement. There, we can see IMF arguing that "significant reduction (or elimination) of the “overhang” of liquid offshore krona" is one of the preconditions for lifting the capital controls. That was always known. What is a turnaround is the way IMF is now willing to do it:

"To accelerate [reducing the stock of liquid offshore krona] it is necessary to strengthen the incentives for holders of liquid offshore krona to participate in the liberalization strategy. A key step will be to curtail expectations that capital controls will be lifted soon, including by removing a reference in legislation to a terminal date for the controls. In addition, the strategy should clarify that the conditions under which liquid offshore kronas are allowed to exit will become less favorable over time

And they continue:

"Once incentives are in place, the authorities could open the next channels envisaged in their strategy—bond swaps and an exit tax. The objective of the bond swaps would be to reduce the stock of offshore krona before introducing an exit tax and ultimately lifting the controls. Swapping short-term krona-denominated assets into long-term euro-denominated bonds would distribute the pressure on the balance of payments over several years."

This is a turnaround. IMF is now accepting the not-so-unlikely possibility that in order to ever lift the capital controls in Iceland, the Icelandic authorities basically have to fry the creditors even more. IMF padded Iceland on the back for not rescuing the banks in 2008 and thereby let the creditors of the banks take the hit. Now, they are directly saying that Iceland would need to take one more step and straightforward threaten the holders of liquid offshore krona: "the strategy should clarify that the conditions under which liquid offshore kronas are allowed to exit will become less favourable over time."

IMF changing?

The funny thing is that those ideas are old. One of the MPs of Iceland, Lilja Mosesdottir, has for a long time urged a more critical stance on the offshore krona issue. She has spoken about a German-1948-type adoption of a "new krona" (assets in ISK redenominated in a new currency, which's exchange rate is a function of the nominal value of the asset being redenominated, e.g. 1:1 for low amounts, wages, etc. but 10:1 for high amounts and offshore krona) and an "exit tax" if offshore krona owners want to swap them out for EUR or any other foreign currency. She in fact used to be in the government but went rogue due to what she felt was the government's softness towards IMF. 

Now, IMF has basically taken up her stance.

And why? Maybe because they are afraid that their Wunderkind isn't in the good shape they hoped to.

But maybe because they are generally accepting the fact that "debt that cannot be repaid, won't be repaid" and creditors should simply accept it. That would be the most wonderful thing if IMF finally realised that and actively applied that policy in its future bailouts.

Monday, 1 October 2012

House Prices in Spain and Mortgages

Not that it isn't something that most people already know but the house market in Spain is imploding. Awesomely! Most people of course realise that this is connected to the nuclear winter in the mortgage market in Spain: no mortgages,  no house sales and certainly no increments in house prices.

I sat down and did a bit of data cracking. The correlation between the contraction in mortgages and the implosion in the house market quite frankly startled me.

First, lets see the reduction in the number and amount of new mortgages in Spain. Data comes from Statistics Spain and EuroStat.

New gross mortgages in Spain and their number. Non-amended data.

Next, we can see that the house price index seems to follow the total gross new mortgages downwards.

New mortgages (12 month moving average) and the house price index in Spain


But what is seriously scary is the correlation between the change in house prices and the change in new mortgages. A correlation of 0.99 is practically unheard of!

The fall in the house prices is due to the utter collapse of the mortgage market. The dire deflationary spiral in the housing market in Spain is almost perfect!


Good luck turning this around with a bit of austerity!

Friday, 28 September 2012

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.

Monday, 24 September 2012

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.

Tuesday, 18 September 2012

The Icesave Dispute and European Sovereign Ratings

The Icesave legal dispute is on ESA's table at the moment. The presentation of the case is in Luxembourg today. What many people don't realise is that if Iceland loses the case, the sovereign ratings of EU countries will be likely to be seriously harmed. And here's why (the very short version).

Icesave was a branch of Landsbanki in Holland and UK. When Landsbanki went bankrupt the depository fund of Iceland had to pay out the depository insurance. However, the amount of money in the Icelandic Deposit Insurance Fund was inadequate to cover the minimum EU cover: 20,887 Euros (or GBP equivalent).

The governments of the three countries got into a lengthy negotiation and the outcomes of that negotiation were the Icesave contracts. They were nicknamed "Iceslave contracts" back home. We voted on them twice and in both cases the referendum was a clear "no".

Plenty of foreigners thought this was the Icelandic people saying "no" to paying bankers' debts. That's not true. The referendums were fortunate stop-valves on our own government that wanted to make a very expensive deal with the Dutch and the British instead of going straight to court and ask: "are we, the State of Iceland, legally committed to pay out the minimum deposit insurance in case of inadequate funds in the Deposit Insurance Fund?"

In other words: is there a sovereign insurance on Deposit Insurance Funds in Europe? The EU says it's so, we don't!

So if Iceland loses the Icesave case it means that there is a formal sovereign backup on the deposit insurance funds in all the EU countries. That means that the British, Spanish, Irish, Italian, Portuguese and German governments all insure the deposits in their banks (up to 20,667 euros) no matter where in the EU they are! Depositors in Greece can park their euros in Barclays and the government of United Kingdom solemnly swears that if Barclays goes bankrupt, the UK taxpayer will pay the euros back to the Greeks. The Spanish taxpayer will reimburse the Brit who has his or her money in Santander and so on. The important difference between a subsidiary and a bank branch becomes effectively none when it comes to deposit insurance for the depositor (Kaupthing Edge was a subsidiary of Kaupthing while Icesave was a branch).

Anybody wants to make a wild guess what happens to the sovereign ratings of those countries if they are legally required to back up the deposit insurance funds? I don't think that liability is e.g. on the books of the Spanish government. Nor is it on the Dutch books.

Thursday, 13 September 2012

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.

Monday, 10 September 2012

The new GDP figures

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

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

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


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

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

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


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


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

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


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