Distributed Economics

Over in the land of the rising Volcano,  the first full report on a banking system collapse has just been released.

Interestingly, even with a report that goes into a fair amount of detail on the extraordinarily contrived web of lending and borrowing between a small circle of Icelandic  businessmen, the main Icelandic banks, and their overseas Creditors, there seems to have been relatively little attention paid to the problems in the underlying monetary mechanics that allowed it to happen. In particular, the  approximately ten times expansion in the money supply that accompanied the businessmen’s sleight of loan practices, appears to have been overlooked.

Money supply figures for Iceland are available from the Icelandic Central Bank. The following analysis is based on the “Monetary Aggregate” (Peningamagn og tengdir liðir) spreadsheet which is the only statistical series that appears to have been updated since the collapse in September 2008. It labels figures since Sept 2008 as ‘provisional’.

This series covers M1, M2 and M3 statistics up until 2009. As previously discussed, the M series monetary statistics are not an entirely pure measure of the total amount of money in any given monetary system, as they can include some forms of debt instruments. In the Icelandic case, two adjustments need to be made to get a quantitative estimate purely of Icelandic Krona: the removal of Money market accounts from M3 which eventually amount to about 10%, and also foreign currency accounts which are included as part of M2. Foreign currency savings accounts incidentally, as a percentage of krona denominated M2, vary between 15-43% of total M2 over this period – which suggests there are other potential stability issues, especially for small currencies, lurking in the background connected to the fractional reserve banking system.  Iceland’s banking and currency system has never been a haven of price stability.

The issue illustrated here is both scientifically fascinating, and utterly appalling in its eventual effects. Iceland deregulated its banking system in 2001. Two of the banks, Kaupthing [nee Búnaðarbanki] and Landesbanki, were sold to private businessmen, who in at least one case used money borrowed from one bank, to purchase shares in the other. Now let’s think about that for a moment, in the context of fractional reserve banking. You borrow money from one bank, and use it to buy control in another. How does that borrowed money get treated? If – and it seems to have been the case – that money is put into Equity Capital holdings at the second bank, then the total amount  the second bank  can lend, and thereby increase the overall money supply by, has just increased. As a result of a debt somewhere else in the banking system. It’s a feedback loop entirely within the commercial banking system, increasing the money and debt supply, independent of any control by the central bank.

The statistics are divided into two series, with considerably less detail available from the earlier period. We can see from the first series below, that quantitatively the currency was relatively stable up until 1997 when M3 began to diverge from the other measures. Unfortunately, there is no detail in the first series to suggest exactly why.

The second series is over a shorter time period, slightly over 6 years. Although the most dramatic behaviour of the currency is in 2007-8, what happens before then shouldn’t be overlooked. Between September and October 2003 for example, M1 and M2 double.

Iceland is a very small country, of approximately 300,000 people, which is why these effects are so obvious. M2 as shown here is the total amount of bank deposits in the country, aside from longer term time deposits which are counted as part of M3. Iceland, as elsewhere, stores its currency electronically – physical notes are printed as needed. But the size of the country, and the electronic nature of its storage, doesn’t change the quantitative nature of what happened in September 2003.

Looking rather closely at those two months, it looks like there was approximately an 100,000 M.Kr. increase in bank deposits. At a guess, and that’s all it is, the proximate cause of the increase was probably the first payments by the Icelandic banks of the money being lent for the Icelandic Power Companies then latest venture into Aluminium production, to the tune of  $20 million in locally sourced loans. This at some level just represents how fractional reserve banking works, and if nothing else, demonstrates the dangers of making big loans within a small currency base. In terms of nuts and bolts economics, the production of things, the support of livelihoods, and general improvements in living standards,  the loan certainly made sense, in increasing total electrical power available to the economy. It’s the monetary side effects, inflation as a result of a loan, and then presumably deflation as it’s repaid -  although it seems that’s an increasingly old fashioned concept these days  -  resulting purely from the mechanics of the underlying system where the loans are created, that don’t.

The money supply continues to increase over the next 3 years. It’s masked to some extent by the rather dramatic increases in 2007, but M1 doubles by the end of 2006, M2 increases by about 1.8 times, and M3 by a factor of 1.6. CPI Inflation rises from 2% in 2004, to 8% in 2006, and this causes other problems. Icelandic krona loans are index linked, something that was introduced to deal with a previous bout of severe inflation – in fact, i’d guarantee that historically Iceland got severe inflation anytime their power company decided to expand their electricity supply, and borrowed money to finance it. Fractional reserve banking is far from problem free even when it’s not being deliberately exploited.  The increase in the last decade though, had another cause.  In the background of the Icelandic economy, a small cabal of Icelandic businessmen had effectively turned their businesses, in conjunction with their relationships with the owner’s of the three main Icelandic banks, into what appears to have been a co-ordinated exploit of the Equity Capital loophole.

As a result of this, the Icelandic money supply measures double again in the year between January 2007 and September 2008, when the collapse of Lehman Brothers intervenes, and turns Iceland into, were anyone paying any attention to the actual systemic issues behind the credit crises of the early 21st century, the canary in the goldmine.

Doubling the money supply in slightly over a year, is by any standards extraordinary. As is having it increase by an order of magnitude in  7 years. It’s not Weimar levels of increase, but neither is it something that should just be occurring without any comment. It also makes any and all economic statistics for that period from Iceland highly suspect. Money is used as an economic measurement. If the quantity of money is changing, and this isn’t corrected for, it’s akin to trying to measure with an elastic band.

Quantitative changes in the ratio’s between currencies don’t necessarily play themselves out in immediate adjustments to currency trading, the relationships themselves seem to be quite sticky with sudden, abrupt changes. The Icelandic Krona’s exchange rate was relatively stable up until the crisis hit in 2008 in an 80-100 band. The high interest rates being paid because of central bank attempts to control the monetary expansion acted to attract foreign investment, and damp down the quantitative impacts of the increase.  In Iceland as elsewhere, a lot of the quantitative increase in the money supply is essentially getting trapped within the monetary system, which limits the impact on general inflation. Iceland did experience a severe housing bubble though, and there as elsewhere, the shells of uncompleted luxury condominium projects litter the countryside.  What is clear today, is that anybody holding Icelandic Krona at the 2008 rate of 90 to the Euro, has lost about half of their purchasing power with the current, capital control protected rate of 172.

The total quantity of Icelandic M1 and M2 in circulation over the 2003-2009 period in fact increased by about 10 times. Measurements of M2 can’t be compared exactly between countries, because they aren’t consistently defined, but driven by similar systemic factors, US M2 doubled in roughly the same time frame, and the Euro increases by about 50%. This would counterbalance the Icelandic increase to some extent, and any increased production would also have had a counterbalancing deflationary effect.  While it’s also certainly not the case that all currency is local, neither is all currency available for foreign currency trading.

Although the Icelandic Central Bank has been heavily and rightly criticised for its role in this, it has a  simple defense on the behaviour of the monetary mechanics. It followed the Economics textbook. It raised interest rates, to try and control the money supply expansion being created by a business culture that had devolved to simply making as many loans as possible, and extricating the proceeds abroad. All this achieved though, was to attract more foreign currency into the economy in pursuit of higher interest rates. Enabling increased expansion, and more loans, rather than the careful control and regulation suggested by Economics theory.  The Economics textbook is wrong at a very basic level, but since its false assumptions are so embedded and central to the discussion itself, it seems impossible to break its hold on the debate.

But perhaps we can start with a simple question.  In Economics’ textbooks, control of the money supply is consistently described as being solely the responsibility of the Central Bank, and for very good reason. Changes in the total supply of money effect everybody, double the money supply, halve the value of people’s savings. Weimar was just the extreme case.  So perhaps somebody could ask the Icelandic Central bank if they deliberately increased their money supply by ten times over the last 7 years?

And if they didn’t, who did?

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