“Iceland, a Tiny Dynamo, Loses Steam”

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This article in the New York Times states that Iceland is experiencing an economic bust. Its currency has declined sharply, and inflation rates are over 8% (for the second time in two years). They, as well as the Icelandic government, assert that the cause is due to evil hedge fund speculators, and the inability of Icelandic banks to access funds.

And now, the REAL story:

In absence of sudden wars or famines and the like, there is never an economic bust which is not the result of government economic policies. The Icelandic government, which has in fact led a largely free market economy, has been printing a lot of money. A credit crunch, and the inability for banks themselves to obtain funds, is an expected and ever-recurring result of the previous printing of money, in the form of the expanding of credit by a country’s central banks to its member banks, and by the member banks to individual businesses.

The creation of credit which is not backed by real savings competes with real savings for the same limited assets and investments. The result is that businesses are fooled by artificially low interest rates and the seeming availability of savings at these low prices. They borrow this new fake money, which looks like the other money that is backed by savings. They then invest it in projects which seem profitable in the beginning only because of the false and distorted market signals caused by the credit expansion, but which really are not profitable. Many of these investments taken on should not have been, and once the credit expansion comes to an end or even simply slows, these improper investments representing the misallocation of scarce resources is revealed. The shoring up of these malinvestments by the abandoning of bad projects and the unloading of improper workforces is the necessary and healthy healing process we call a recession. The capital which is lost in these investments, and the subsequent failure to replay loads to banks, results in the credit crisis - credit was there, but it has been wasted and lost.

The balance sheet of the Icelandic Reserve Bank (central bank) shows a dramatic increase in the money supply in recent years, which is clearly the fuel for the recent economic boom, and is certainly the cause of current high prices and a devaluing currency. When more money is printed and added to an economy, there becomes more money chasing the same amount of goods. This results in higher prices for each good. If the amount of new money grows faster in one country than in another, that country’s currency falls against that of the other(s) country(s).

Annual credit expansion in Iceland was over 30% per year in 2005 and 2006, which is considerably higher than its 15-year average of 15%. It is true that hedge funds have poured a lot of money into this small country, which could even be the cause of much of the increase in the money supply (in which case we would have to blame the central banks of other countries such as ours for printing money).

But a deeper look shows us that the central bank itself is responsible for an overwhelming increase in the supply of money in Iceland. In order to create new money, the central bank has to purchase government debt securities. It pays for these debt securities by means of crediting the bank account of the entity which sold the central bank the bonds, with the value of the purchase price of the bonds. It does this by simply keying in that particular dollar figure on a computer keyboard. The bank credits the account with money which does not exist - until those keystrokes are complete.

The central banks’ balance sheet shows that the dollar amount of debt securities it held as of 2001 was just over 67 million krona. By the end of 2004 that number had reached over 200 million krona. Today it stands at almost 450 million. This 571% increase in government debt held by the central bank means that new checking accounts were created at a multiple of more than 10 times this growth rate. This is because banks are entitled to lend out approximately 90% of the new deposits they receive from the central bank. When the first bank lends out 90% it becomes a deposit in a new bank, which keeps only 10% and loans out the other 90%. The same goes for the third bank and so on. The end result is the creation of 10 times the amount of the original new money that was created by the central bank.  The value of checking deposits member banks held at the central bank also increase dramatically, as shown in Fig. 1. The subsequent decrease shows the amount of credit contraction which has taken place and caused the bust.

Whether the boom was created domestically or internationally, the cause is ultimately the expansion of money in the economy by one government or another. Adding new money to an economy does not help create real economic growth, which is the production of more goods and services. But printing this money does cause inflation, raise asset prices, cause a distortion of the production structure resulting in economic booms and busts, redistributes wealth from lenders to borrowers and from savers to spenders and from the poor to the rich, and destroys large amounts of real savings and capital. All of these events serve to reduce the real standard of living for most citizens in each country.

Kel Kelly @ April 21, 2008