Sunday, February 19, 2012

Iceland and the Banks

Recent news on Iceland is that the ratings agency Fitch has now determined that Icelandic debt is safe:
Fitch raised Iceland's sovereign rating by one notch, to BBB- from BB+, meaning that the country's debt is now "investment grade".

Iceland's economy imploded under a mountain of debt in 2008, forcing an International Monetary Fund bailout.
Since then, the debts of its neighbours have sparked a crisis in the eurozone.

Fitch said the decision "reflects the progress that has been made in restoring macroeconomic stability, pushing ahead with structural reform and rebuilding sovereign creditworthiness".

In 2008, its three banks failed under their enormous foreign debt, which at one point was larger than the Icelandic economy.

The value of the Icelandic krona plunged, which made its exports more competitive. The new government of 2009 was allowed to carry on borrowing and spending for another year before spending cuts kicked in.
Ignoring the uselessness of the ratings agencies in general, the upgrade is a response to the positive trajectory of Iceland's economy. In 2011, the previously devastated economy grew by 3% overall, and unemployment has fallen by over 1% since 2011. I say previously devastated, as Iceland (as I am sure you will all remember) had the most almighty banking meltdown (in relation to the overall size of the economy). However, when confronted with the lunacy of the debts racked up by the banking system, Iceland did something very different to the majority of economies when confronted with bank failure; they did not bail out the banks.

The rather odd thing is that the sky did not fall upon Iceland, there was no apocalypse, and now the economy is in recovery mode. It should be remembered that, as its financial system collapsed, Iceland went to the IMF for a bailout. The purpose of the loan, was as follows (from the IMF):

The program had three objectives: to stabilize the exchange rate, put the public finances on a sustainable path, and restructure the financial system. All three of these objectives were met by the time the program expired. This was really an enormous achievement, given the severity and depth of the crisis that Iceland faced at the time.

The exchange rate had depreciated sharply in the run-up to the crisis, and there was a deep concern that it would plummet in a disorderly way. This is why capital controls were imposed.
The government had to use its balance sheet to recapitalize the banks and rebuild the financial system. This meant that public debt became very high. Therefore, public finances needed to be restored. During the past couple of years, the government has taken a number of fiscal measures that have put the country’s finances back on a sustainable path.

Finally, restructuring the banking system was obviously a huge challenge. The size of the banking system was equivalent to about 1,000 percent of GDP before the crisis. It now stands at 200 percent of GDP, so there has been an enormous downsizing. The core banking system has been recapitalized and is fully functioning, a significant achievement for the authorities.
In light of the financial meltdown, the ISK took a battering, and one of the key objectives of the IMF was to stabilise the currency the central banks raised interest rates to a whopping 18% and implemented currency controls:

Severe currency controls were imposed in November after the Central Bank attempted unsuccessfully for two days to peg the krona against the euro. The controls involved daily currency auctions for imports of certain necessities, but these failed to prevent the krona from weakening further. A new currency regime in early December supported by the first tranche of the IMF stand-by agreement led to the value of the krona rising by 25% in the three days to December 9th. Since then, however, the currency has retreated, losing most of these earlier gains. A law restricting all currency flows related to capital-account transactions and requiring exporters to deposit all foreign currency with domestic banks was passed in late November. The legislation will prevent foreign investors that hold more than Ikr500bn of krona-denominated assets from exporting these assets for up to two years.
Perhaps most interestingly, this is the fiscal position moving out of the crisis:

The 2009 central government budget that was presented to the Althingi (parliament) in mid-December already provides for substantial expenditure cuts on both current and capital spending, as well as an increase of 1 percentage point in personal income tax rates. These cuts will make the deepening economic recession, including an expected fall of 20% in domestic demand, even worse, but are considered necessary by the government. The deficit on the public finances in 2009 is forecast by the government to be just over 10% of GDP, which the IMF has accepted, deeming any further expenditure cuts as likely to cause possibly irreparable damage to the economy. However, the IMF will be expecting further fiscal consolidation measures in order to reduce the deficit from 2010. We expect the deficit to be slightly higher than the government's estimate, at around 11-12% of GDP, but also that any reduction achieved in 2010 will be fairly modest.
It is rather surprising, but I was unable to find much detail on the spending cuts, despite looking as some Icelandic websites (probably a poor search term?). However, I did find some detail from a rather unusual source, which is the World Socialist Website:
On June 26, a comprehensive agreement was announced between Iceland’s government, trade unions and employers’ organisations, containing plans for sharp public spending cuts and tax hikes. The “stability pact” had been under negotiation for several weeks and is in response to pressure from the International Monetary Fund (IMF) for the government to seek a balanced budget by 2013.

Speaking at the signing of the agreement, Prime Minister and Social Democrat (SDA) leader Johanna Sigurðurdóttir commented, “Now we have a map showing the route that employers and workers in both the private and public sector, together with the state and municipalities, have agreed we should follow.”

Presented as an agreement for “shared sacrifice,” it will facilitate the bail-out of the financial elite at the expense of the working class. Such an approach has been endorsed fully by the Left Greens, the junior partners in the governing coalition. Finance Minister and party leader Steingrimur J. Sigfússon insisted that, given the economic climate, “this is a hard choice but unavoidable.” [my comment; see below]

The government has given way entirely to the dictates of the IMF. In total, the government will save 70 billion kronur (€390 million) through spending cutbacks and reorganisation over the next three years, while at the same time increasing income taxes and charges on everyday items such as soft drinks to meet a budget gap of 170 billion kronur over the next four years. The planned tax hikes will account for up to 58 billion kronur.
Essentially, what we see in the case of Iceland is a tempory backstop from the IMF, combined with deep reform of the economy. The IMF originally insisted on bailing out the losses taken from Icesave, but referendums prevented this:

Yet, while the U.S. and the rest of Europe were busy with the unpopular business of propping up failed banks with taxpayer dollars, Iceland headed in the opposite direction. It guaranteed the deposits of citizens, but refused to pay off many foreign investors. And even when the government tried to pass a bill that would pave the way for the repayment of some US$8 billion worth of deposits that angry U.K. and Dutch governments had covered for their citizens, Grímsson stepped in—not once, but twice—so that the deal could be put to a referendum. He later said the decision was an effort to reaffirm the importance of democracy and civil society in Iceland. “There were a lot of people who predicted it would be the downfall of Iceland, that we would be isolated in the world and become the Cuba of the North,” he told CBC Radio in a recent interview. “But the fact of the matter is, the people of Iceland twice were able to exercise their democratic will, and now Iceland is coming out of this crisis and establishing recovery earlier and more effectively than other European countries.”

In short, the IMF loan bought time to allow a restructuring of the economy to make it more competive, and to effectively ensure that the country 'lived within its means'. Some have argued that this picture is too rosy, and I will therefore let the critic have their say:

Though Arnason agrees with the government’s general response to the crisis, he argues that many foreign observers have conveniently ignored key details when they marvel at Iceland’s “recovery.” In particular, he says a decision to prolong strict capital controls, used to stabilize the country’s plummeting currency by preventing money from leaving the country (Icelanders who move away need permission to take their financial assets with them), now threatens the country’s key industries—the same ones that are supposed to lead Iceland back to economic health. “Basically, the currency controls distort economic prices and prevent Iceland’s budding export industries from developing,” he says.
As regular readers would guess, I would not have favoured capital controls over an extended period (although could just about accept them as a brief emergency measure). The major advantage that Iceland had was that the country did not follow the bailout route, and this makes an interesting comparison with Ireland. The comparison between Ireland and Iceland has not gone without comment with this from the Irish Indendent (also see this from Reuters):

Here, we search for weaker countries with which to compare ourselves and suck up to the bureaucrats. Our leaders first picked on Iceland. We're not like Iceland, they trumpeted. We're not militant like those silly Icelanders who voted to reject a deal that would have forced them to pay the debts of reckless bankers.
Tell us what to do and we'll do it, our leaders said. We're submissive Ireland, not aggressive Iceland. To austerity and beyond!

How did that work out? Both countries took a hiding, as they were bound to in a world dominated by bankers and their political friends.

But here's another couple of numbers. End of 2010, unemployment in Ireland, 13.9 per cent. And in Iceland, 7.7 per cent.
Of course, another key difference between Iceland and Ireland is that Iceland has its own currency, and the devaluation of an overvalued currency (the country was pre-crisis a miracle economy) saw the economy become more competitive in respect to its real wealth generating industries (e.g. aluminium, fishing, tourism).

It is odd, is it not, that the necessity to bail out the banks in other countries was shouted from so many rooftops, that we were deafened with the sound of the wailing to save the banks. In light of this, perhaps the most odd discussion comes from an article I quoted from earlier:

But some question whether the response to Iceland’s collapse would work elsewhere, or whether anyone would actually want to try. Take, for example, the decision not to bail out the banks. Most agree Iceland simply didn’t have any choice. The sector’s debts, mostly in foreign currencies, were so great compared to the tiny country’s economy that guaranteeing them would have only made things worse. Iceland also benefited by not being part of the eurozone (though it now wants to join). The krona dropped like an anchor and gave export and tourism industries a boost, helping to offset some of the decimation of the financial sector.
So choosing to bail out the banks was a good idea, just because it was possible? This does not seem to be an argument at all. If Iceland had caved into bailing out the banks, we can only speculate how the economy might now look with the cost of the bailouts sitting on the government balance sheet. My own view is that the country would still be in deep troubles.

Note: The IMF lending to the country will, of itself, give an artificial boost to GDP and employment. However, the government is using the time given by the loan to transition the economy. This is very different from the rather sad example of so-called 'austerity' in the UK, where the borrowing is through bond issuance, but where the borrowing hides the underlying structural weakness of the economy. My guess is that, when coming off the IMF drip, Iceland may see a dip or period of stagnation in the economy, but I am guessing that they have made most of the adjustment necessary to reflect their real wealth generating capacity. With the UK, there has been no real adjustment yet. Perhaps it will take a dose of IMF imposed austerity to make the transition?

Note 2: Apologies for any spelling mistakes. I am not sure that the Blogger spell-checker is working, and it is sometimes difficult to spot your own (sometimes glaring) mistakes.

Note 3: I forgot to mention for newer readers; I was opposed to the bank bailouts at the time the crisis broke. Take a look through the archives, and you will find that I did not have anything good to say about them whatsoever.

Note 4: Some responses to comments on the last post...

Lemming: Yes, you are correct that some of the savings are likely to be somewhat questionable! With regards to UK debts being backed by assets such as housing (your 2nd comment), yes the argument is dubious - as the asset prices will reflect the erzats size of the economy. Let's say that the UK's real size without borrowing is 20% smaller than it appears (I calculated roughly this figure for the US economy if you remember the post, but cannot recall the number for the UK); would house prices really remain at current levels (in real terms)?

Anonymous: Thanks for the link on the necessity for Europeans to live within their means! It is a long standing theme of the blog.

Jonny: Your comment requires a much longer response, so apologies for not replying. However, good questions.....

General: As always, thanks for all of the comments, which are (as ever) well considered. Sorry I cannot respond to all, but time is limited.

Thursday, February 9, 2012

The Gambler's Roll of the Dice

The news of the day is the latest bout of quantitative easing (printing money) by the Bank of England (BoE). The BoE has the following to say:

The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%. The Committee also voted to increase the size of its asset purchase programme, financed by the issuance of central bank reserves, by £50 billion to a total of £325 billion.

In the United Kingdom, the underlying pace of recovery slowed during 2011, with activity falling slightly during the final quarter. Some recent business surveys have painted a more positive picture and asset prices have risen. But the pace of expansion in the United Kingdom’s main export markets has also slowed and concerns remain about the indebtedness and competitiveness of some euro-area countries. A gradual strengthening of output growth later this year should be supported by a gentle recovery in household real incomes as inflation falls, together with the continued stimulus from monetary policy. But the drag from tight credit conditions and the fiscal consolidation together present a headwind. The correspondingly weak outlook for near-term output growth means that a significant margin of economic slack is likely to persist.

CPI inflation has fallen back from its September peak, declining to 4.2% in December. Inflation should continue to fall sharply in the near term, as the increase in VAT in January 2011 drops out of the twelve-month comparison. Inflation is then likely to decline further as the contribution of energy and import prices diminishes, while downward pressure from unemployment and spare capacity continues to restrain domestically generated inflation.

In the light of its most recent economic projections, the Committee judged that the weak near-term growth outlook and associated downward pressure from economic slack meant that, without further monetary stimulus, it was more likely than not that inflation would undershoot the 2% target in the medium term. The Committee therefore voted to increase the size of its programme of asset purchases, financed by the issuance of central bank reserves, by £50 billion to a total of £325 billion. The Committee also voted to maintain Bank Rate at 0.5%. The Committee expects the announced programme of asset purchases to take three months to complete. The scale of the programme will be kept under review.
We are now in a situation in which we can see the following; record lows of interest rates over a sustained period, record government deficit spending and bout after bout of money printing:


For money printing, I cannot find a graphical representation to illustrate the scale, but you can find an interactive chart here. In summary, macro-economic tools have been deployed in unprecedented ways to support the UK economy. But....and here is the rub, they are just not working. The end result of this macro-economic stimuli?

Inflation, bouts of recession, a current account balance firmly in the red, and the highest rate of unemployment for 17 years.

Labour Force Estimates

So, all of the macroeconomic measures are really working? The picture overall is pretty clear. The UK has relatively high inflation, rising unemployment, a struggling economy and relatively high unemployment. In any normal world, this might suggest that the policy that has been enacted is just plain wrong. However, like a gambler who is on a losing streak, the policy makers just keep on throwing the dice in the hope that the situation will turn around. Maybe one more big bet, and I'll make up for the losses......

And the latest bout of QE hits the pensioners who have been sensible enough to save:

Further QE is likely to spell bad news for people set to retire this year as annuity rates plummet, leaving pensioners facing high living costs and low returns on their savings.

Research from financial services company Hargreaves Lansdown found that a 65-year-old man with £100,000 could have bought a level income of £7,855 in July 2008, but someone in the same situation today would only receive an income of £5,923, a drop of just under 25pc.

Dr Ros Altmann, director-general of Saga, said the "short-term stimulus" of QE has "very dangerous long-term consequences".

She said: "Buying gilts is not the best way to stimulate growth - it does, of course, help the banks, but it actually has side-effects that directly damage the economic outlook.

"Having more and more poorer pensioners and forcing companies to put money into their pension schemes, rather than their business operations, is a drag on growth, not a boost."

She said tumbling annuity rates mean that "over a million pensioners will be permanently poorer for the rest of their lives, as they have bought an annuity at rates that have been artificially depressed by the Bank of England".
"The impact of QE on pensions and pensioners will lead to lower growth, so we urge the Bank to consider different ways of using newly created money to try to boost the economy."
Of course, it is not just pensions that are being hit by this latest bout of QE, but savers in general have been hit by high inflation and low interest rates. On the other side of the balance sheet, the debtors and profligate are given an easy ride, with high inflation eroding the value of debt, and low interest rates allowing lower repayment rates.What we have in current policy is a major failure. It is built upon an assumption that stimulating consumer demand through reduction in debt servicing costs and providing low interest rates to companies to allow for expansion will actually help the economy recover. It is apparent that it is not working. In fact, consumers and non-financial companies are reluctant to take on more debt (from Steve Keen):

And consumers are still saving:

Note from the first chart consumer debt remains relatively stable over the last few years, after a period of sustained growth. Consumers are not significantly de-leveraging, but they are not significantly growing their debts. In the second chart, the savings rate soars, but then declines before climbing again. What we are seeing is the conflict between the uncertainty about the future, and policy which is punitive to savers and encouraging debt accumulation.

The most interesting thing about the charts is that it shows that in order for the UK to return to so-called growth, it is necessary for consumers to stop saving and recommence debt growth. Of course, this is not real growth, but might be described as Ersatz growth. Returning to the balance of trade chart, we can see the nature of this Ersatz growth. Consumer debt growth saw a corresponding expansion of the deficit in the current account.What the current punitive policy seeks to do is to increase consumer debt levels, in order to import and distribute more goods and services, with the distribution of the imported goods and services seen as economic growth. Fortunately, so far, consumers have been reluctant to play ball, albeit that debt levels are still relatively high and remain relatively stable.

Money printing is just one element in the arsenal that has been deployed to 'rescue' the economy. The Bank of England just does not seem to understand that this can only lead to further inflation and a corresponding decline in disposable income for pensioners. However, it is not just pensioners that are seeing their disposable income declining, as wages are not keeping up with inflation.

I am afraid that I do not have a link, but I have previously noted that even the BoE accepts that their printing of money was a contributor to inflation, and the BoE has also acknowledged that disposable income has been squeezed between low wage increases and inflation. So why do they persist in the policy of printing money? Even on its own terms, the policy is counter-productive. The answer is that it is a means of keeping government borrowing costs down. As long as there is even a possibility of QE, the market for UK government debt is indirectly supported and when QE takes place that support becomes direct. In this case (yet again), the QE is taking place at a time of high inflation, and despite the requirement of the BoE to keep inflation rates within target. Once again, the QE is being enacted with a promise of a fall in inflation just around the corner. If you look at the chart for inflation and follow the link to the chart for QE, you will see that this is a pattern. In each case, the justification is that a fall in the rate of inflation is just around the corner, and the BoE claims that it is acting to prevent deflation.

It is also notable that as each bout takes place, the justification has come to increasingly include elements that fall outside of the BoE remit; the BoE increasingly justifies its actions on the basis of the general economic situation. The inflation story is increasingly threadbare, so the BoE shifts attention to other justifications.

However, there is a fundamental point here, and I return to my earlier discussion. Does all of this macro-economic stimulus look like it is working? However you might look at it, high inflation, squeezed disposable income, high and growing unemployment, sky-rocketing government debt, and a current account deficit does not appear to be sensible economic policy. It is very clear that the policy is not working. Of course, some would argue for even more QE, even more government expenditure is necessary. This is exactly the approach of the losing gambler. The bets become larger and larger in the hope that the losses from the previous bets can be made good.

There are two elements that are missing from the macroeconomic picture over the last few years. The first missing element is genuine austerity. For all the talk, it is simply non-existent. The government continues to gorge on debt even as the economy remains in dire straits. As I have argued in previous posts, implementation of austerity is necessary, but will see a dramatic shrinkage in GDP. The second missing element is real reform of the structure of the UK economy. I followed the tinkering of benefits reform with considerable interest. It was interesting to see how difficult it was to even tinker with with the system by putting a cap on benefits (e.g. see here). Although there are many ways of measuring average income, the measure just aimed to cap benefits at something approximating average earnings for a working person. Nevertheless, the controversy has raged around the measure (see here for my proposed benefits reform, which is now probably too late to enact).

In other words, the macroeconomic policy is one of continuing to roll the dice, and placing the bets that (somehow) it will all work out. I use this analogy because the whole point of betting is to get rewards without having to really work for them. It is counting on luck, not hard work to achieve a living and/or wealth. This appears to be the underlying approach of government; just keep on betting that there is a solution with no cost, and one that does not involve actually reforming to place the emphasis on the UK earning income. The solutions are not working, but more bets are placed that luck will come in and change everything, despite the evidence to the contrary.

My argument is simple; stop betting higher and higher and get out of the gambling game. Instead, address the underlying problem of the UK's lack of ability to earn the income to which it aspires. It is very simple. The structure of the UK economy is the problem.

Note 1: Sorry for a somewhat rambling post. It was a post that developed as it went along, but I hope that it 'hangs together'.

Note 2: The UK National Statistics used to be a great source of data and charts. A while back they changed the format of their data presentation, and it now takes dogged determination to find anything of value in the site. You have to dig, and dig and dig to find anything. It makes me wonder whether the easy access of data was considered to be problematic......? Curiously, government debt seems to be exclusively expressed in terms of % of GDP, with the OBR in particular preferring to use this presentation. I am sure that with enough time and effort, it would be possible to find the information, but it is very odd how it has become so difficult.

In light of this, I have used a variety of sources for charts, and apologise for not using 'official' charts. Of particular note is the Economics Help site, which provides a wealth of useful charts.