Reykjavík Grapevine - 06.12.2013, Síða 12

Economics | Overload!
The basics
Framsóknarf lokkurinn (“The Progres-
sive Party,” PP) promised to carry out
a debt jubilee if elected in the latest
general elections. They were. And they
formed a coalition government with
Sjálfstæðisf lokkurinn (“The Indepen-
dence Party,” IP).
As the IP did not agree with the PP’s
idea of simply cancelling the debt, the
outcome is a mix of both parties’ ideas:
80 billion ISK (roughly 400 million GBP)
of household debt will be outright can-
celled, and an additional 70 billion ISK
will become available to people who use
their third pillar pension savings in the
next three years to pay down their house-
hold debts.
So what's the crack?
Icelandic households will get 150 bil-
lion ISK (750 million GBP) of their
household debt "cancelled" over a four-
year period. I say "cancelled" because
they are in fact paying down 70 billion
ISK of it themselves with the tax-free
pension savings.
The rest, 80 billion ISK, will be out-
right cancelled in four annual instal-
ments, although the borrower will im-
mediately feel the positive impact on his
or her monthly payment burden. Each
household that has an indexed mortgage
specifically declared to buy property for
its own use (buy-to-let mortgages are ex-
cluded!) will get a maximum 4 million
ISK of the debt written off. Non-indexed
loans get no write-off, but the tax-free
pension savings can be used to pay addi-
tionally onto the principal in the future.
The tax-free pension savings can also be
saved and later used to buy a f lat. This is
why they say that even current tenants
will benefit from the measures.
But how are they
paying for all this?
Right, that's a bit hazy. The short answer
on the list of FAQs on the Prime Minis-
ter's Office website is classic nonsense:
Q: How is the debt relief financed?
A: “The Treasury will collect increased
revenues in the next four years to cover
the cost of additional state expenditure
resulting from these actions. The ac-
tions will therefore neither be financed
by additional Treasury borrowing nor
with the granting of state guarantees.”
Right, so the no-bullshit answer of is
they’re going to increase taxes!
Where are they going to "collect in-
creased revenues”? Specifically, they are
going to tax the estates of the old banks,
i.e. the banks that went bankrupt in
2008. Their liquidation process is going
veeeery slowly, to a large extent due to
capital controls, which are holding back
the process. Yet the estates have to be liq-
uidated before we can abolish the capital
controls. It’s like being a driver with two
back seat drivers, one demanding you
drive faster and the other demanding
that you slow down. Which one are you
going to make unhappy?
The government is going to make
the old banks unhappy. Besides outright
taxing them to pay for a debt jubilee for
households, they are considering chang-
ing laws that would force them to speed
up the liquidation process.
I have two immediate concerns
about this.
First, those are two birds in the bush,
but not one in the hand. Are we definite-
ly sure that they can tax the old banks?
This sentence alone from the Prime
Minister’s slides says it all: "The com-
mittee [behind the debt jubilee] assumes
that the measures will be fully funded
over a period of four years.”
Great going, guys. I do this all the
time, too. I just book my vacation to
French Polynesia and assume that I can
finance it! 80 billion ISK!? Pennies mate,
I'll pick them up off the f loor one day!
And even if they can tax the old banks
specifically (there are some concerns
about whether it would be constitution-
ally possible or not), won't the old banks,
which are the main owners of Arion and
Íslandsbanki banks, not just pass at least
part of the cost onto their customers?
Competition in the banking industry in
Iceland isn't great you know.
Second: OK, if we can tax the old
banks to get cash for a debt jubilee,
couldn't we have used the money for
something else? Like the Icelandic pub-
lic radio, which we’re practically shut-
ting down? Or using it to pay decent
wages to doctors and nurses? I'm not
putting myself up against the debt relief
as a principle, just pointing out that we
didn't have to spend all the cash on it.
Or maybe we can tax them even
more and spend that tax income on
something nice!?
In sum
Now, there are some good things about
this measure.
First of all, they did it! Jubilee is here,
well done guys! You proved that this is
politically possible and economically
that it doesn’t have to be absolute non-
sense. Some very indebted households
will feel quite relieved and this will
have a positive impact on the economy
although the impact may be short lived.
The tax-free pension part of it also
makes perfect sense and simply boils
down to the fact that it is not a smart to
save with a 2–3% interest when you owe
debt bearing 4–5% interest.
But I do have to admit that I have con-
cerns, besides the obvious ones like the
taxation issue.
First, the primary loan, or the new
loan, which the borrower has to pay off,
will still be indexed, just like the original
loan that is now being partially written
off. We will therefore still have all the
negative effects of indexing mortgages
in Iceland, including more volatile and
higher inflation, higher interest rates,
a less effective monetary policy and the
risk of having to have another debt jubi-
lee in 10 years time or so.
Second, and closely related to my
first concern, although there is no di-
rect increment in money supply because
of the measures, I believe we can safely
assume that not only will we have some
potential demand-pulled inflation im-
mediately in the wake of the jubilee, but
also increased credit demand as well (es-
pecially if we have an increase in moral
hazard due to all this: will people take on
more debt because they anticipate an-
other debt jubilee in the future?).
As the increased credit demand will
be met with new loans that increase the
money supply, we will end up with fur-
ther inflation pressures. And because
the principal of indexed debts will grow
with more inflation, we will get some, or
even all, of the "jubileed" debt back.
The Central Bank will also respond
with an interest hike to try to hold credit
demand back. That will hit the borrow-
ers with non-indexed loans, as their
interest rates are potentially readjusted
upwards. (A more effective and sensible
way of limiting credit growth and infla-
tion would be to impose direct credit
controls and connect them to the banks'
own net holdings of liquidity in foreign
currencies. But I doubt the Central Bank
will go down that road: you can't teach
old dogs new tricks.)
Third, although the net assets of
the old bankrupt banks will contract
(assuming everything goes according
to plan), we will still have "consider-
able" pressure on the balance of pay-
ments because of increased consump-
tion and demand. Now, of course, part
of the reason for those measures is to
revive household consumption, but if
it takes us into even riskier waters with
the balance of payments than we are
in, doesn't that just signal that the ex-
change rate is too strong? And imagine
what will happen if and when the ex-
change rate goes down: inf lation goes
up, principal of debt grows back and
we're back to square one.
So again: why, oh why did they not
abolish indexation parallel to those
measures?!
Fourth, and this is perhaps my most
serious concern. We haven't fixed the
institutional drawbacks of the Icelandic
economy. Besides still having the in-
dexation on mortgages, we still have a
high self-imposed rate of interest stem-
ming from the pension system (which
is required to get a real rate of return
of 3.5% and it controls assets equal to
about 120–130% of GDP). What do you
think will happen to the long-term rate
of interest with such a gigantic buyer of
financial liabilities that demands a high
minimum rate of interest? Has anybody
heard of monopsony?
Although politically this may fuel
some fires, even in other countries
where over-indebted populations may be
nudged to demand jubilee, I fear that the
net effects of this particular debt jubilee
will not be significant in the long run,
at least from an economic point of view.
When it comes to the Icelandic economy,
I fear we will only have short spurts of
economic bounce back. It is not enough
to cut the leaves of the weeds, we need to
dig out the roots as well.
An extended version of this piece originally
appeared on Ólafur’s blog: http://icelandi-
cecon.blogspot.com
The hottest story coming from Iceland now is the one
about the government-initiated debt relief to house-
holds. Here is my take on it, focused only on a hand-
ful of the issues related to the act itself and, perhaps
more importantly, its potential economic impact.
12The Reykjavík Grapevine Issue 18 — 2013
The Great Icelandic Jubilee
Making sense of the debt relief
— Ólafur Margeirsson
A dinner or lunch at the elevated fourth floor of Harpa concert hall is a destination
in itself. Relax and enjoy fine Italian cuisine complemented with a spectacular
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Reservations
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ð
Ólafur is a Ph.D.
student in econo-
mics at the Uni-
versity of Exeter,
emphasizing FDI
and financial
stability.
Sigtryggur Ari