“Iceland, a Tiny Dynamo, Loses Steam”
Filed Under Uncategorized
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
Interesting, but expansion of the money supply actually raise nominal interest rates, it doesn’t lower them. While interest rates may appear to fall due to expansionary monetary policy, nominal interest rates rise due to the inflation premium added to loan rates by bankers. This is observed in the correlation between movements in the supply of money, and movements in the nominal interest rate; they have historically moved together. Bankers anticipate inflation when the money supply is expanding, and add the premium to compensate for a weaker dollar in the future.
1. Your analysis of multiple deposit creation is mathematically flawed. What are the true reserve requirements under the Icelandic Central Bank? And, multiple deposit creation is NEVER a direct ratio of the RR; it is the inverse of the ratio! You need to be very careful in stating cause and effect. And there is no mention whatever of the fact that expanding the monetary base (NOT the money supply, as you call it) is the central bank’s only power. The ultimate expansion of the money supply is completely out of the central bank’s power; a first-year principles student should know this. It is a function of the reserve requirement, (which is NOT 10% in Iceland, as you implied), liquidity preference, the currency ratio C/D, and banks’ preference for holding loans versus securities. Banks and other financial intermediaries make it possible for people like you to earn a return in the first place! Linking savers with borrowers enables YOU to earn interest on your investments. Do you object to that?? Please spend some time educating yourself on the science of economics before you put yourself out here (among real economists who recognize bluster when they read it) as an “expert”.
Replies to Dalton:
Re: reserve ratio:
This is a valid point. I did write implying “that if it were 10%”, and assumed the same ratio as we have in the U.S., for explanatory purposes. In fact, Iceland’s is much lower, which would lead to even more money being created.
Re: Deposit as a direct ratio of the RR:
From “The Economics of Money, Banking, and Financial Markets,” Fifth Edition by Frederic S. Mishkin p. 425: “When the Fed supplies the banking system with $1 of additional reserves, deposits increase by a multiple of this amount – a process called multiple deposit creation.” Also: p. 428: “Therefore, the total increase in deposits from the initial $100 increase in reserves will be $1000: The increase is tenfold, the reciprocal of the 0.10 reserve requirement.
I stated: “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.” And: “The end result is the creation of 10 times the amount of the original new money that was created by the central bank”.
I did not mention that deposits had been created in a direct ratio of the RR, but that they had been created as a multiple of the amount of money the central bank created.
Re: No mention of monetary base/not mentioning other facts which are outside of the central banks’ power:
My purpose here is not to explain every detail of the money creation process, as would be the case in a text book. Regardless of what direct control central banks have of ultimate money supply creation from the increase in the monetary base which they bring about, the point is still the same: money creation and inflation can only come from the central bank.
Re: Banks are intermediaries that connect savings with borrowers and allow us to receive interest:
An intermediary takes money from one party who is willingly handing it over for the purpose of loaning it to someone else. They give up the access to that money for the specified period of time. This would occur in the case of a time deposit, for example. When a bank tells you your money is available while at the same time telling someone else it’s available to them, that’s not being an intermediary. When a bank creates new money they are making money at our expense (via inflation). They are not being paid to act as an intermediary in that case; they are paying themselves at our expense.
What do you mean by interest? Do you mean loaning $100 and getting paid back $105? The primary reason interest in this form exists is because of inflation.
Actual monetary interest exists in our world primarily due to inflation – Revenues rise ahead of costs due to new money being printed, while costs were paid out in the past when things cost less. In a world with a constant supply of money, profit/interest can exist only in the form of net investment – depreciated costs (and cost of goods sold) lagging behind due to the fact that they are spread over a longer time period. This is the only way one can explain how firms, economy-wide, can take in more than they lay out for capital investment and labor (see George Reisman’s Net Investment/Net Consumption explanation in his book Capitalism).
Thanks though for your input!