Jekyll and Hyde

There were a couple of bits of good news from Kreppaland this week. Firstly, the assets of Kaupþing banki h.f. are reckoned to be enough to pay off German depositors in Kaupthing Edge. The Kaupthing Edge accounts in Germany were operated under the disastrous "branch" model chosen by Landsbanki for its Icesave accounts, rather than the more conservative "subsidiary" model that Kaupþing chose for most of its overseas retail markets. The news from Kaupþing's Icelandic administrators is equivalent to €1.2 billion that the Icelandic state will not now have to take on in short term loans: Prime Minister Jóhanna Sigurðardóttir was justifiably pleased at last week's annual meeting of the Central Bank.

A second piece of good news came from the United Kingdom. The administrators of Landsbanki's Scottish subsidiary Heritable Bank plc reckon that uninsured depositors (mostly UK local councils) will get 70–80% of their money back. As a spokesman for Kent County Council put it, they'd have lost more money had they invested their reserves on the London Stock Exchange.

The news about Heritable Bank didn't cause many ripples in Reykjavík, for reasons I'll come to in a moment. However Iceland's finance minister and tireless promoter of relations with Norway, Steingrímur J. Sigfússon, was ready with a comment: "It is very positive that there are valuables at hand but it does matter how they are disbursed of the interest of the nation."

The problem for Steingrímur Jóhann is that these "valuables" are not available to be disbursed "of the interest of the nation". Heritable Bank was a subsidiary of Landsbanki h.f., or to put it another way, Landsbanki was Heritable's shareholder. Shareholders are always the last to get paid in a liquidation and, if depositors are only getting 70–80%, it seems very unlikely there will be anything left afterwards. As a Scottish company, Heritable Bank was a full member of the UK Financial Services Compensation Scheme, which picked up the £500 million deposit insurance bill but which will also be reimbursed at "70–80%". The only benefit to Iceland is a bit of good press, and a reminder that the banks had (and have) assets as well as debts, but even that is welcome these days with all sorts of ludicrous claims being exchanged in multiple fora.

Now Steingrímur Jóhann is a geologist, not a lawyer, but one would hope that he understands the principle of limited liability corporations, especially given his current job. Icelandic Wikipedia doesn't have an article on them, but I found this one in Nynorsk if it helps him at all… After all, it's hardly the first time he's put his foot in it in less than three months as finance minister, a job that one would think is pretty important (not to say hellishly difficult) in today's Iceland.

On the other hand, like the character from the Robert Louis Stevenson novella, Steingrímur Jóhann has another side to his (political) personality. As well as being finance minister, he is also minister of fisheries and agriculture, a subject dear to puffins!

Steingrímur Jóhann's party, the Vinstrihreyfingin–grænt framboð (Left–Green Movement) were long ridiculed by "those who decide[d]" for Iceland: until, that is, the kreppa came and people started to realise that the old decisions were not as sensible as had been claimed. Steingrímur Jóhann was born on a sheep farm in Northeast Iceland, and already had experience as agriculture minister (1988–91), but was still taking on one of the more conservative sectors of any society from the position of leader of the "loony left". And, despite all the anxiety which surrounded his appointment, he has done remarkably well at the helm.

His predecessor in the fisheries ministry left a poisoned chalice in the form of a controversial set of fishing quotas, especially for the section devoted to commercial whaling. Steingrímur Jóhann sensibly decided not to take on the powerful fishing lobbies in a head-to-head, saying that there were probably more important things for the nation to be arguing about, but neither did he simply dodge the argument. In one of his last acts before tomorrow's election, he has commissioned a study of the contribution of whaling to the Icelandic economy, which many believe to be zero if not negative. He has calmly cooperated with the European Commission in their review of the EU Common Fisheries Policy – possibly a far more effective way to insure the future of 8% of the Icelandic workforce than any hypothetical hardball negotiation.

The last opinion polls suggest a clear victory for the parties of the current coalition government, and hence a clear break with the hegemony of Sjálfstæðisflokkurinn (Independence Party). But as Heilög Jóhanna prepares her new government, she will still have to take account of grubby little demands like "another job for one of ours!" or "the best job for me!" I can only hope that she manages to place as many ministers as possible with portfolios that they will do well. That means removing finance from Steingrímur Jóhann, but keeping him as fisheries and agriculture minister. The next few days will really show the commitment of Iceland's political class to move ahead together for the good of the country – or not as the case may be.

IgNobel nominations (3)

(continued from this morning's post)


Mr. Sigurður Einarsson, former Chairman of Kaupþing banki h.f., Reykjavík, Mr. Björgólfur Guðmundsson, former Chairman of Landsbanki h.f., Reykjavík, and Mr. Þorsteinn Már Baldvinsson, former Chairman of Glitnir banki h.f., Reykjavík, for their studies on high-leverage banking in a small economy.

This nomination is for a long-term study whose pertinence is only now becoming apparent. It began around 2003, with the deregulation of the Icelandic banking sector under the government of Davíð Oddsson (see separate nomination). It is useful to recall some “vital statistics” from that period:

• Bank lending to the domestic sector: ISK 698.3bn
• Credit system total lending: ISK 1,970.9bn
• Króna M3: ISK 393.6bn
• Central Bank of Iceland policy rate: 5.8%
• Króna exchange rate index: 126.6
• Estimated labor force: 154,600

The small size of Iceland’s economy was an obvious handicap to the three commercial banks in their plans for expansion. All three decided that would have to set up operations in places where there were more people if they ever wanted to earn more money (and who doesn’t?). But, for the very same reason that they wanted to expand abroad, they didn’t have the money to do so: so they borrowed it.

The three banks set up, bought or maintained operations in at least ten jurisdictions of the European Economic Area, as well as in Switzerland, the Isle of Man, Guernsey, Canada, the USA and Japan. These operated either as branches or as subsidiaries, and offered the normal range of banking services, especially (but far from exclusively) to Icelandic companies. However the range of lending opportunities was somewhat limited in these mature banking markets, so much of the money was lent instead in the ‘captive’ Icelandic market, as can be seen from the “vital statistics” at the end of 2007:

• Bank lending to the domestic sector: ISK 3,004.5bn
• Credit system total lending: ISK 5,386.4bn
• Króna M3: ISK 1,145.2bn
• Central Bank of Iceland policy rate: 13.75%
• Króna exchange rate index: 121.8
• Estimated labor force: 169,600

Such a business strategy creates obvious exchange rate risks – the banks were buying króna assets (loans) with liabilities in euros and dollars. Fortunately the banks were able to use two devices that they did not themselves invent: lending at index-linked interest rates and lending in foreign currencies. The latter obviously transfers the entire exchange rate risk to the bank’s client. To understand the former, it is sufficient to note that the Icelandic consumer price index is approximately half-composed of imported products: hence, in this case, half the exchange rate risk is transferred to the client. It should also be mentioned that the króna remained strong throughout most of the study, thanks to the high nominal interest rates imposed by the central bank in an attempt to stem the inflation caused by the commercial banks’ lending.

Nevertheless, the commercial banks felt obliged, from 2006 onwards, to seek alternative funding sources, and so started taking deposits in their overseas markets. Again, they were helped in this by the high nominal interest rates in Iceland that they themselves were maintaining by their business strategy. The Icelandic banks could offer extremely competitive interest rates to depositors in the rest of Europe because they were using the money to lend in Iceland. At the end of 2007, the three commercial banks had deposits of ISK 3,465bn and borrowings of ISK 5,198bn: these figures are 268% and 402% (respectively) of Iceland’s 2007 gross domestic product.

As the interbank lending market dried up in 2008, the banks found it increasing difficult to roll over their borrowings. They continued to expand their overseas deposit-taking operations – the last such operation was set up by Landsbanki in Austria on September 4th, 2008 – but were increasingly dependent on the fickle confidence of their overseas clients. The króna as well seemed to lose the confidence of international investors, along with 35% of its value, between January and September 2008. Our final snapshot of the “vital statistics” is from just before the collapse of the Icelandic economy:

• Bank lending to the domestic sector: ISK 4,827.4bn
• Credit system total lending: ISK 6,731.4bn
• Króna M3: ISK 1,230.3bn
• Central Bank of Iceland policy rate: 15.5%
• Króna exchange rate index: 151.8
• Estimated labor force: 148,600

All three commercial banks collapsed within the space of less than a week in early October 2008. Their Icelandic operations were ring-fenced off in an attempt to preserve some semblance of a domestic banking system: the domestic assets (ie, loans) of the banks exceeded their domestic liabilities (ie, deposits) by at least ISK 3,714bn, or 287% of Iceland’s 2007 GDP. The new banks were forced to provision against the non-repayment of between half and two-thirds of the value of these loans. All the same, the Icelandic government has had to supply capital equivalent to 30% of GDP, while the new (state-owned) banks start life with liabilities to their predecessors’ (mostly foreign) creditors of 90% of GDP. Deposit insurance liabilities in the UK, the Netherlands and Germany are estimated at €3.8bn: given the current uncertain value of the Icelandic króna, it is impossible to express this figure as a proportion of GDP, but it is at least half Iceland’s 2007 output. Another €2bn is trapped in “glacier bonds” – private, króna-denominated debt sold to offshore investors attracted by the high nominal interest rates – waiting for currency controls to be relaxed.

It could be said that any Ig Nobel Prize should be shared more widely. Perhaps an Ig Nobel Special Mention could go to the anonymous managers at Glitnir who allegedly engineered an unauthorized loan of €47 million for their bank from the Norwegian government; or the anonymous manager at Landsbanki who allegedly transferred €695,000 into his personal account in order to “save deposits”: but these cases are currently before the courts where they belong. I could nominate Mr. Geir H. Haarde, Prime Minister of Iceland 2006–2009 and finance minister 1998–2005; Mr. Björgvin G. Sigurðsson, minister of “business affairs” (with responsibility for banking) from 2007 until January 2009 or his predecessor Mr. Jón Sigurðsson… but an Ig Nobel Prize is traditionally reserved for “achievements”, and so it seems inappropriate to honor these people for simple inactivity, no matter how essential that inactivity was to the pursuit of the studies in question.

I shall rest my case, believing that I have shown that the nominees have indeed made “achievements that cannot or should not be reproduced” in their field (even if the exact field were not their chosen one) and hoping that the Distinguished Members and the random passer-by will agree with me.

(data from the Central Bank of Iceland, the International Monetary Fund and the 2007 Annual Reports of Kaupþing banki h.f., Landsbanki h.f. and Glitnir banki h.f.)

IgNobel nominations (2)

(continued from yesterday's post)


Mr. Davíð Oddsson, former Chairman of the Board of Governors of the Central Bank of Iceland, former Prime Minister of Iceland, for his study of the effects of increasing money supply while keeping interest rates high.

The Central Bank of Iceland, like many central banks in Europe, operates its monetary policy by inflation targeting. The target rate for Icelandic inflation is 2.5%: since Davíð took over the helm of the CBI in October 2005, the target has only been met in 2 months out of 29 (it was met in 37 out of the previous 55 months). As is normal in such circumstances, and according to the Taylor rule, the central bank has steadily increased interest rates in an attempt to control inflation, up to 15.5% in September 2008.

However high interest rates tend to restrain economic activity, and so are unpopular with politicians such as Davíð. In order to support the Icelandic economy, the Central Bank of Iceland decided to increase the number of krónur in circulation. It did this by lending money to Icelandic banks on the basis of “newly-issued uncovered securities”, the financial equivalent of IOU notes. (see para. 19 of Iceland's Letter of Intent to the IMF)

In classical economic theory, the effects of an increasing money supply and of high interest rates should cancel each other out. However Davíð discovered that, if the money supply is increased sufficiently – the Icelandic króna M3 increased by 52.7% in the twelve months to September 2008, compared to a GDP growth of 5.0% – it will outweigh the effects of high interest rates. At such levels, the study shows, one finds the classical economic response to “printing money”: that is, inflation, currency devaluation and, eventually, systemic economic collapse.

The study has now been halted at the request of the International Monetary Fund, as there are already sufficient data to include in the new editions of undergraduate economics textbooks.

(data from Statistics Iceland, Central Bank of Iceland)

(to be continued)

Video from the Wall Street Journal

This video is 21 minutes long: I won't pretend to agree with all of it, but it's one of the better (and more balanced) free videos I've found.

IgNobel nominations (1)

To the Distinguished Members of the Ig Nobel Board of Governors, and the random passer-by who is traditionally invited to assist them in their deliberations.

Distinguished Members, random passer-by,

Each year since 1991, the Ig Nobel Prizes have honored research that cannot or should not be repeated. It is something of a tradition that one of the Prizes should be awarded for achievements in the field of economics.

In the past, the Distinguished Members and the random passer-by have chosen to honor the Vatican (2004, for outsourcing prayers to India), Karl Schwärzler and the nation of Liechtenstein (2003, for making it possible to rent the entire country for corporate conventions, weddings, bar mitzvahs, and other gatherings) and of course the team of economists from the University of New Mexico, USA, for discovering that professional lap dancers earn higher tips when they are ovulating.

They have also chosen to honor Enron and 27 other financial companies for adapting the mathematical concept of imaginary numbers for use in the business world (2002), Nick Leeson for using the calculus of derivatives to demonstrate that every financial institution has its limits (1995) and Juan Pablo Dávila for managing to lose 0.5% of Chile’s gross national product by typing “buy” instead of “sell” (1993). It is in the spirit of these latter awards that I wish to make two nominations for the 18th First Annual Ig Nobel Prizes, for achievements in the field of economics whose transcendence was not fully apparent at the date of last year’s awards ceremony on October 2nd.

(to be continued)

Central Bank translation service

Thanks to Mike the UK Nordic Analyst (whatever one of those is) over at IceNews for providing this translation of the main points from the speech of Central Bank Governor Svein Harald Øygard last Friday. It made me laugh out load, so I thought I'd share it with my readership (hi Mum!)

He said
“All efforts should be made to avoid further socialisation of private sector debt”

Which means
“If you think that the Central Bank and Government are going to help you Icelanders pay back, reschedule or even write off, your mortgages, indexed car loans or corporate debts … well you can forget it! We’ve got enough on our plate already with depositor guarantee schemes and ISK bonds due.”

He said
“The negotiation processes in the financial sector and the restructuring and recapitalisation of the banks must therefore be pursued according to plan.”

Which means
“Plan!! Plan? We’re just blundering along being told what to do. As for restructuring the banks it looks as if they will need to come to terms with their creditors. Who cares about the division between “new” and “old” banks? Our foreign bondholders certainly don’t. Let’s hope for the best!”

He said
“As part of this, the foreign exchange exposure and indexed loan exposure of the new banks must be addressed.”

Which means
“I have no idea how the banks are going to pay back their debts, especially those that need to be paid back in foreign currencies! But hell, it’s not my problem – it’s the banks!”

He said
“With declining domestic demand, there will be resources available to service the country’s accumulated debt.”

Which means
“All income from our productive output will be used to pay our foreigner creditors. So frankly we’re not going to have anything to spend on ourselves. Domestic demand? Don’t make me laugh! Bread and water if you’re lucky!”

He said
“The Central Bank also reviews selected measures that may allow the most impatient investors locked in by the capital controls to convert their holdings of ISK, in a way that does maintain the currency reserves of the Bank.”

Which means
“Impatient investors? Why are they impatient? Because their bonds have matured and they want their money back – NOW! If we did pay them it would wipe out our currency reserves. Does anyone have any ideas?”

He said
“Negotiations for bilateral loans, other negotiation processes, and the IMF review should be completed shortly.”

Which means
”The IMF et al are holding back the latest tranche. We need money. We’re descending into poverty. HELP!”

Dreamland (1)

Draumalandið ("Dreamland" in English) opened in Reykjavík a couple of weeks ago. It's not a fashion store (who'd open one of them in Iceland these days?), it's a film based on the book of the same name by Andri Snær Magnason. The book is available in English, translated by Nicholas Jones and published by Citizen Press, ISBN 978-0955136320.

Both the book and the film tell the story of the Kárahnjúkavirkjun power plant in East Iceland, a 690 MW hydroelectric power station built to serve a new aluminium smelter in Reyðarfjörður… at a huge cost. You can find English comments about the film at the Iceland Weather Report and at Economic Disaster Area. Alda in particular claims it to be "quite possibly the most important Icelandic film ever made".

So what is all the fuss about this documentary (whose subtitled trailer you can find here)? Well the project was (and is) very controversial in Iceland. It has been hailed as the biggest single civil engineering project ever attempted in the country, and lambasted as a pointless destruction of the natural environment. It is far from clear that it will ever make a single króna in profit. But also it has been claimed that it is one of the causes of the kreppa. Aluminium smelting in Iceland is a topic which deserves its own post, so I shall concentrate on the third of these points for today.

The hydroelectric plant was built with immigrant labour and foreign money. It is good for Iceland that it was built with immigrant labour: it would have cost even more had the contractors been obliged to hire Icelanders at the then-going rates! The 2005 estimate of its cost was 90 billion krónur (roughly €1 billion, at the going exchange rates of the time).

Now readers of this blog might see a sign here. 90 billion krónur is a lot of money, but it is far less than many of the sums described here. The glacier bond problem is something like 500 billion krónur; the Icesave "problem" is even larger, roughly 800 billion krónur, but hopefully less serious in the short term as there seem to be agreements not to make too much of a fuss about it.

Let's take the example of Landsbanki. At 30 June 2008, it had:

• 345 billion krónur in ISK deposits, but 1372 billion krónur in loans in Iceland;
• 989 billion krónur in sterling deposits, but only 528 billion krónur in loans in Britain and Ireland.

There are many honest and honourable reasons to object to the expansion of aluminium smelting in Iceland, but the idea that it was responsible for the kreppa is not one of them. The kreppa was created by Iceland's commercial banks sucking money into Iceland, regardless of such schemes as Kárahnjúkavirkjun. White elephants are often born during economic bubbles, and they never help, but it goes too far to accuse this one of having caused the whole financial meltdown.