Inflation, Debt and the Icelandic krona

Just a little something, worked out from the OECD and Iceland Statistics data on M3 and Consumer Price Index in Iceland. Notice how high the correlation is and that the inflation is lagged by five quarters.

Growth in the money supply (M3) and change in the CPI over three year period (for smoothing). Notice that M3 growth leads. I haven't done the Granger-causality test but I find it highly unlikely that M3 growth does not cause inflation, at least if one looks at the graph.

It is also worth reposting this graph from The Icelandic krona and the Icelandic debt:

Growth of macroeconomic debt (in the ownership of the banking system) and the annual change in the USDISK cross.

 This I have done the Granger-causality test on:


Equation 1: GrossDebt
Heteroskedasticity-robust standard errors, variant HC1

                coefficient   std. error   t-ratio   p-value
  -----------------------------------------------------------
  const          0.0426658    0.0286018     1.492    0.1456
  GrossDebt_1    1.02175      0.175881      5.809    1.89e-06 ***
  USDISK_1      -0.318946     0.219615     -1.452    0.1562

Mean dependent var   0.315019   S.D. dependent var   0.231991
Sum squared resid    0.733335   S.E. of regression   0.151383
R-squared            0.599242   Adjusted R-squared   0.574195
F(2, 32)             33.95636   P-value(F)           1.23e-08
rho                 -0.218167   Durbin-Watson        2.411990



Equation 2: USDISK
Heteroskedasticity-robust standard errors, variant HC1

                coefficient   std. error   t-ratio   p-value
  -----------------------------------------------------------
  const          -0.141294    0.0387644    -3.645    0.0009   ***
  GrossDebt_1     1.00756     0.150647      6.688    1.50e-07 ***
  USDISK_1       -0.148002    0.206466     -0.7168   0.4787

Mean dependent var   0.153163   S.D. dependent var   0.250120
Sum squared resid    0.693631   S.E. of regression   0.147228
R-squared            0.673898   Adjusted R-squared   0.653517
F(2, 32)             32.08670   P-value(F)           2.26e-08
rho                  0.050441   Durbin-Watson        1.822156


For those of you who don't have a clue what the Granger-causality test is about it is to evaluate the causality between two (or more) variables.

The print-outs here above basically say that gross debt in the ownership of the banking system expands first and then the krona falls in value. In fact, the trade-off (the coefficient) is almost exactly 1:1. Equally as important, the causality does not run the other way, i.e. from devaluation to expansion of debt.

So the "common truth" regarding the krona being a useless currency "because it is always falling in value and it needs capital controls to survive" is simply straightforward incorrect. It is the creation and expansion of debt  in the banking system, simultaneously creating money which leads to inflation, that devalues the krona.

The devaluations of the krona have nothing to do with it being a "useless currency" but everything to do with the creation of debt by the banking system. The capital controls are of the same origin; they have nothing to do with the krona being a "useless currency" but everything to do with the creation of debt by the banking system.