Reykjavík Grapevine - 15.07.2011, Blaðsíða 12

12
The Reykjavík Grapevine
Issue 10 — 2011 Magnús Sveinn Helgason is a historian. He most recently authored
addendum five to the SIC Report, and is currently working on a book
about 'financial bubbles'.
It is curious, when one considers
how obvious it now seems that the
Icelandic financial miracle was a
giant bubble, that this idea has re-
ally not received any attention from
academic economists. In fact there
are no academic studies that ad-
dress the question whether or not
the Icelandic financial miracle was
a bubble—or if it was, when it be-
came one. This is all the stranger
because of the centrality of finance
in the Icelandic economy during
the past decade—one would have
assumed that Icelandic economists
would have taken up this question.
After all, it is one of the reoccurring
themes of financial economics and
financial history.
Perhaps all the economists were too
busy engineering derivatives or work-
ing at complex deals for the banks to
spend time on idle research? Perhaps
the question didn‘t seem important?
Perhaps the answer was too obvi-
ous and the existence of a bubble too
glaring to warrant any research? Why
spend time studying something and
proving the existence of something that
is apparent to any casual observer?
Or, perhaps, the question was too
controversial. After all, it might have
caused a bit of alarm had an Icelandic
economist—as opposed to some for-
eigner “who doesn’t understand Ice-
land and the Icelandic economy”—had
pointed out the obvious: That the ‘fi-
nancial miracle’ was nothing more than
a bubble.
Whatever the reason, this is a
strange omission in Icelandic econom-
ics scholarship. An omission that prob-
ably tells us something about the state
of the economics profession in Iceland.
A BUBBLE OF HISTORICAL PRO-
PORTIONS
One measurement of bubbles is the
size of the price increases while the
bubble is inflating, and then the size of
the fall as it comes crashing down. If
we employ these measures the Icelan-
dic financial bubble does, in fact, seem
rather enormous. During the great bull
market of the 1920s, between 1921 and
September of ’29, the Dow Jones index
rose by 490%. In the internet bubble of
the ‘90s, NASDAQ gained an impres-
sive 570% between 1995 and March
2000. The Icelandic Financial Miracle,
however, outdid both, as the Icelandic
market grew by a staggering 680% be-
tween 2002 and July 2007, when the
market peaked.
The Icelandic crash
was similarly spectacu-
lar. When the internet
bubble burst, NASDAQ
dropped by 78% in two
and a half years, be-
tween March 2000 and
October 2002. In the
‘Great Crash’ of ’29—
which actually lasted for
nearly three years, be-
tween September 1929
and July 1932—the Dow Jones lost 91%
of its value. During the Icelandic crash,
which lasted a little over a year, the Ice-
landic market lost 95% of its value. This
is actually a world record for a stock
market crash!
So, it was no ordinary bubble. It was
a bubble of historical proportions. The
only viable alternative is that ‘some-
thing remarkable’ happened in Ice-
land around the turn of the century,
something so amazing that it suddenly
made Icelandic assets far more valu-
able than they had been, triggering a
680% ‘price correction,’ only to be fol-
lowed by another equally drastic 95%
‘price correction,’ caused by a sudden
unforeseeable change in the underly-
ing fundamentals.
HOW TO DENY A BUBBLE
This latter scenario would be the basic
model of any paper that followed the
‘efficient market hypothesis,’ the idea
that market participants are rational
and that stock markets are efficient—
that they always incorporate all avail-
able information, making prices a cor-
rect reflection of underlying economic
realities. The rise could not have been
caused by the madness of crowds, an
irrational exuberance of investors who
were picking and choosing what infor-
mation to act on, over-hyping positive
news and ignoring warning signs. No,
if prices rise spectacularly, it must be
because the underlying fundamentals
warrant such a rise. When they fall, it
is because the underlying fundamen-
tals have changed. And if the fall is very
sudden, it must be because the change
was unforeseeable and the information
about these changing underlying fun-
damentals arrived very suddenly.
How would one go about making
this argument? Well, one simply goes
back to the boosters of the bubble and
assumes their arguments were cor-
rect—or rather, that there was no way to
know, at the time, that they were any-
thing but rock solid. Financial econo-
mists can also use all kinds of statisti-
cal tools to show that market indicators
were all ‘normal,’ that even the most
advanced statistical tools could not
have predicted the collapse and so on
and so forth. But since we don’t have
such statistical tools at hand, and since
such statistical exercises are dreadfully
boring anyway, I suggest we explore
the former route, assuming that people
were right when they observed the
bubble inflating, proclaiming to them-
selves, “this time it’s different.”
HOW WAS IT DIFFERENT?
Just as in all other cases of irrational
exuberance, those who claimed things
were somehow different could, at the
time, point to some pretty compelling
arguments to bolster their case. All epi-
sodes financial historians have identi-
fied as bubbles begin as reasonable
price increases, a strong bull market,
based on some sound fundamentals,
a price correction triggered by some
dramatic economic change which justi-
fies increased optimism. At some point,
however, prices simply lose their moor-
ings to these underlying fundamentals
and start heading toward the strato-
sphere.
The Icelandic economy had under-
gone a dramatic transformation in the
1990s, due in part to massive free mar-
ket reforms. At the same time all cur-
rency controls had been lifted, opening
the financial system up to global mar-
kets. All of this seemed to have un-
leashed tremendous energy—pundits
and politicians were particularly fond
of pointing to the foreign investments
of the banks and allied Icelandic busi-
ness Vikings as proof of this explosive
energy.
During the earliest phases of the
Icelandic asset bubble, rising prices
were explained with increased effi-
ciency due to mergers
and restructuring of
existing firms made pos-
sible by the creation of
a stock market and the
transformation of the
banking system. When
the opportunities for
mergers and takeovers
in Iceland had dwindled
and the banks and busi-
ness Vikings had turned
their eyes outward, the
rising stock prices were explained by
the potential and profitability of foreign
expansion.
At first glance this reasoning
seemed, and still seems, pretty con-
vincing.
CIRCULAR LOGIC
The rule of thumb measures used to
judge stock prices similarly appeared
to justify higher prices. The price-earn-
ings ratios of the Icelandic market were
relatively low in international compari-
son, leading Kaup!ing to suggest in
April 2007 that market valuations were
relatively low in international compari-
son (a price-earnings ratio, or a P/E
ratio, is the number of years of current
profits it would take a company to jus-
tify its market price). The P/E ratios of
the investment companies which domi-
nated the Icelandic stock market and
which led the ballooning asset bubble
appeared especially reasonable. In July
2007, the price-earning ratio of FL-
Group was 9,4—which is not at all that
outrageous—the historical average P/E
ratio of firms in the S&P 500, a broad
measure of the US stock market, was
around 15.
Since the P in the P/E ratio was as-
tronomically high (the market value of
FL Group was over 400 billion ISK in
July 2007, or some 6,7 billion dollars.
To put that in perspective—Twitter was
recently valued at 7 billion dollars), the
P/E ratio could only be reasonable if the
E of the equation was equally high. And
of course it was—all these firms were
making record profits. The profit of FL
Group during the first six months of
2007 was 23 billion ISK. But since as-
sets were booked at their current mar-
ket price, rising asset prices showed
up as profits on the books, meaning
the massive profits of these compa-
nies were largely the result of a rising
market, which in turn generated even
larger profits.
This circular logic was constantly
used to justify ever higher prices, and
surprisingly few people pointed out
how absurd this really was. A edito-
rial in the business section of Morgun-
bla"i" made a note of this in July 2004,
remarking that this logic was made
worse by the cross-ownership of finan-
cial firms and that it could work both
ways: a drop in stock prices would lead
to a chain reaction of losses and falling
prices.
But the market apparently shrugged
off these concerns. And, strangely
enough, nobody made any attempt to
explain why exactly it was reasonable
to expect FL Group or any of these
companies to maintain astronomical
profits for a decade. Especially since
such profits could only be maintained
if asset prices continued their upward
march unstopped, it seems odd to as-
sume that they would continue to grow
at the same rate as they had.
How on Earth was this supposed
to work? The absurdity of these ex-
pectations is especially glaring when
we consider the banks. Their stock
prices rose by 444% (Glitnir), 536%
(Landsbankinn) and 661% (Kaup!ing)
between January 2004 and July 2007,
thanks to handsome profits caused
by profitable investment banking op-
erations at home and abroad. But their
high stock prices could only be justi-
fied if they continued to grow. And
who could seriously expect the banks
to continue to expand their balance
sheets? Between 2004 and 2007 the
banks grew their books sevenfold—at
the end of 2007, their assets were 870%
of Iceland’s GDP. The FDIC, which reg-
ulates deposit institutions in the US,
considers annual growth that exceeds
25% a red flag—indicating that the in-
stitution in question has taken on too
much risk. The Icelandic banks would
have raised a whole lot of red flags at
the FDIC.
Finance | Bubbles
Playing The Game Of ‘This Time It’s Different’
How Iceland almost became ‘a global finance centre’—ha ha ha
“When the internet bubble burst, NASDAQ dropped by
78% in two and a half years, between March 2000 and
October 2002. In the ‘Great Crash’ of ’29—which actually
lasted for nearly three years, between September 1929 and
July 1932—the Dow Jones lost 91% of its value. During
the Icelandic crash, which lasted a little over a year, the
Icelandic market lost 95% of its value. That is actually a
world record for a stock market crash!”
Continues on page 44
Words
Magnús Sveinn Helgason