Lessons in international
finance from Iceland
Metaphors for economic disaster
By Jon Fernquest
You have a dog, and I have a cat. We agree that
they are each worth a billion dollars. You sell me the dog for a
billion, and I sell you the cat for a billion. Now we are no longer pet
owners, but Icelandic banks, with a billion dollars in new assets.
Iceland has been called the "perfect bubble."
Even a new word was coined: De[b]tonation = debt + detonation.
Emeritus professor of economics at the University of Chicago Robert Aliber famously responded to a question during the Q&A session after a talk at the University of Iceland in May 2008:
“I give you nine months.
Your banks are dead. Your bankers are either stupid or greedy. And I’ll bet
they are on planes trying to sell their assets right now.”
As finance specialist Burton Malkiel observes: ‘Greed run amok has been an essential feature of every spectacular boom in history.’”
(Photo on right of spectacular Dettifoss waterfall in Iceland, the most powerful waterfall in Europe)
Speculative bubbles and crashes, nothing new
Robert Aliber is has been rewriting the economics book that first described the history of speculative bubbles, Charles Kindleberger’s 1978 classic work Manias, Panics, and Crashes. This time Iceland will be one of the examples in the book.The book uses a model of economist Marvin Minsky to describe the typical pattern of a speculative bubble. The steps in the Minsky model run as follows:
1. New profit opportunities are
created by some fundamental
change in the economy or politics:
"It
may be the outbreak
or end of a war, a bumper
harvest or crop failure,
the widespread adoption of an invention with pervasive effects --
canals, railroad, the automobile -- some political event or surprising
financial success...an unanticipated
change of monetary policy."
In Iceland's case the most fundamental change was the reorganization of Iceland's fishing industry in the 1970s. This created billionaires with large amounts of capital to invest.
Overfishing in Icelandic fisheries became a big problem in the early 1970s (Read H. Scott Gordon's 1954 paper on overfishing). This tragedy of the commons problem was fixed by assigning limited property rights over the yearly fish catch:
Iceland’s big change began
in the early 1970s, after a couple of years
when the fish catch was terrible. The best fishermen returned for a
second year in a row without their usual haul of cod and haddock, so
the Icelandic government took radical action: they privatized the fish.
Each fisherman was assigned a quota, based roughly on his historical
catches. If you were a big-time Icelandic fisherman you got this piece
of paper that entitled you to, say, 1 percent of the total catch
allowed to be pulled from Iceland’s waters that season. Before each
season the scientists at the Marine Research Institute would determine
the total number of cod or haddock that could be caught without
damaging the long-term health of the fish population; from year to
year, the numbers of fish you could catch changed. But your percentage
of the annual haul was fixed, and this piece of paper entitled you to
it in perpetuity. ..
Even better, if you didn’t want to fish you could sell your quota to someone who did. The quotas thus drifted into the hands of the people to whom they were of the greatest value, the best fishermen, who could extract the fish from the sea with maximum efficiency. You could also take your quota to the bank and borrow against it, and the bank had no trouble assigning a dollar value to your share of the cod pulled, without competition, from the richest cod-fishing grounds on earth. The fish had not only been privatized, they had been securitized. It was horribly unfair: a public resource—all the fish in the Icelandic sea—was simply turned over to a handful of lucky Icelanders. Overnight, Iceland had its first billionaires, and they were all fishermen. But as social policy it was ingenious: in a single stroke the fish became a source of real, sustainable wealth rather than shaky sustenance. Fewer people were spending less effort catching more or less precisely the right number of fish to maximize the long-term value of Iceland’s fishing grounds (Source: Michael Lewis, Vanity Fair)
Even better, if you didn’t want to fish you could sell your quota to someone who did. The quotas thus drifted into the hands of the people to whom they were of the greatest value, the best fishermen, who could extract the fish from the sea with maximum efficiency. You could also take your quota to the bank and borrow against it, and the bank had no trouble assigning a dollar value to your share of the cod pulled, without competition, from the richest cod-fishing grounds on earth. The fish had not only been privatized, they had been securitized. It was horribly unfair: a public resource—all the fish in the Icelandic sea—was simply turned over to a handful of lucky Icelanders. Overnight, Iceland had its first billionaires, and they were all fishermen. But as social policy it was ingenious: in a single stroke the fish became a source of real, sustainable wealth rather than shaky sustenance. Fewer people were spending less effort catching more or less precisely the right number of fish to maximize the long-term value of Iceland’s fishing grounds (Source: Michael Lewis, Vanity Fair)
2. Credit expands in many different ways.
This includes the "formation of new banks, the development of new credit instruments, and the expansion of personal credit outside of banks." While Iceland's speculative bubble was expanding foreign capital flowed into Iceland:
German banks put $21
billion into Icelandic banks.
The Netherlands gave them $305 million, and Sweden kicked in $400
million. U.K. investors, lured by the eye-popping 14 percent annual
returns, forked over $30 billion—$28 billion from companies and
individuals and the rest from pension funds, hospitals, universities,
and other public institutions. Oxford University alone lost $50
million.
The so-called carry trade was a major factor behind Iceland's massive expansion in credit. The carry trade consists of borrowing one currency that charges a low interest rate like the British Pound and purchasing a different currency with a high interest rate like the Icelandic Krona.
Using this magic households in Iceland took out low interest home loans in Euros not in the local Icelandic currency. After the local currency devalued people had to pay a lot more every month for their homes. Defaults on home loans became more likely. Ultimately, Iceland may end up using the Euro.
3. A speculative mania and bubble is created by expanding credit.
Speculators earn a lot of money quickly on their investments and invest more, new investors are drawn into the market: "new investment leads to increases in income that stimulate further investment and further income increases" (positive feedback loop) .
Common ways of describe this sort of crowd behaviour include: "monkey see, monkey do," and "a larger and larger group of people seeks to become rich without a real understanding of the processes involved," "speculation tends to detach itself from really valuable objects and turn to delusive ones," and "There is nothing so disturbing as to one's well-being and judgement as to see a friend get rich."
In Iceland's case the speculative mania was driven by a male-dominated risk taking culture. In general, the 2001 paper Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment by authors Brad Barber and Terrance Odean found that "men not only trade more often than women but do so from a false faith in their own financial judgment. Single men traded less sensibly than married men, and married men traded less sensibly than single women: the less the female presence, the less rational the approach to trading in the markets." (Read paper)
4. Overtrading, according to Adam Smith, now occurs in three different ways:
1. Buying an asset for
pure speculation,
buying to profit from resale of the asset at a higher price, rather
than holding and receiving an income from the asset or using the asset
to produce a good,
2. Over-estimation of future returns, projecting a trend of rising asset values far into the future without end,
3. Over-leverage or over-gearing, including buying on margin and on installment payments.
2. Over-estimation of future returns, projecting a trend of rising asset values far into the future without end,
3. Over-leverage or over-gearing, including buying on margin and on installment payments.
4. Contagion occurs next as overtrading spreads from one market to another.
5. International transmission occurs when overtrading and speculation spreads internationally from country to country.
6. The "Minksy moment" occurs whe some event finally precipitates a crisis, this leads to panic and a rushed sell-off and liquidation of the overvalued asset. This event could be: 1. a large drop in the price of the asset, 2. a bankruptcy, or 3. "the revelation of a swindle."
The panic feeds on itself, just like the speculation did, until:
1. prices are so low that
people start buying the asset again,
2. trading in the asset is halted, or
3. a lender of last resort supplies enough credit to meet the demand for cash of investors liquidating the asset.
2. trading in the asset is halted, or
3. a lender of last resort supplies enough credit to meet the demand for cash of investors liquidating the asset.
Vocabulary
a metaphor - language that directly compares seemingly unrelated subjects, for example:
- All the world's a stage,
- And all the men and women merely players;
- They have their exits and their entrances; — (William Shakespeare, As You Like It, 2/7)
a bubble, a speculative bubble - when asset prices rise to unreasonably high levels beyond true asset values, investors make a lot of money, and are very enthusiastic about the market, then one day asset prices suddenly drop (the crash), investors lose a lot of money as well as their enthusiasm for the market, besides causing market instability, bubbles also have a negative effect on economies because they temporarily misallocate funds into non-optimal uses" and then quickly pull them out. (See Wikipedia) ภาวะฟองสบู่
mania - being too excited about something and doing it to excess
coin a new word - create a new word to express a meaning
detonation - causing a bomb to explode
emeritus professor - a retired professor
University of Chicago - home of the most conservative school in economics founded by Milton Friedman (See Wikipedia)
Q&A session - the time after a talk or presentation where the audience can ask questions
I give you nine months - what a doctor says to a patient who will die soon
greedy - wanting to have more of something (money, food) than is fair
run amok - acting in an uncontrolled way, acting with uncontrolled rage (See Wikipedia)
spectacular - very impressive and dramatic, surprising to watch and look at
Dettifoss waterfall - a waterfall in northern Iceland, the most powerful waterfall in Europe (See Wikipedia and Flickr)
Marvin Minksy - economist with well-known theory of financial crises (See Wikipedia)
Minksy moment - the turning point when a speculative bubble bursts and investors start losing money (See Wikipedia)
an outbreak of Y - when something unpleasant, such as violence or a disease, suddenly starts to happen
a bumper harvest - when farmers get a lot of crops from the seeds they planted
pervasive - present everywhere in an area
unanticipated change - a change that people were not expecting
tragedy of the commons - unregulated use of a common, public resource for private, personal gain will result in overexploitation and destruction of the resource (See Wikipedia and Google Definitions)
speculation - buying an asset hoping that its price will go up and you will make money, it could go down with a loss of money, assuming the risk of loss in return for the uncertain possibility of a reward (See Wikipedia)
overtrading - the polite word for speculation used by economist Adam Smith
positive feedback loop - when a system responds to change by amplifying the change, making the change even bigger
negative feedback loop - when a system responds to change by reducing or dampening the change, making the change even less
feeds on itself - makes changes even bigger (like "positive feedback loop" above)
credit instrument, financial instrument - an investment bought and sold in an organized syste, including stock shares, bonds, options, futures
personal credit - loans to individuals
the carry trade - borrowing one currency that charges a low interest rate and purchasing a different currency with a high interest rate
(See Google Definitions)
monkey see, monkey do - common saying, that compares humans to monkeys that do what ever they see someone else doing (imitate)
delusive - makes you believe in something that is not true
well-being - a person's health and happiness
leverage - borrowing part of the money needed to buy something
over-leverage, over-gearing -
buying on margin - when stocks or other assets are bought by borrowing part of the price
installment payments - regular monthly payments that pay back a loan for something
precipitates a crisis - causes the crisis
panic - a sudden intense uncontrollable fear
rushed sell-off - people are quickly selling as price falls
bankruptcy - when a business fails and stops operation
a swindle - when people deceive and cheat other people in order to get money from them
a revelation - a surprising fact or story made known to the public
revelation of a swindle - people finally find out that someone was cheating them out of their money
lender of last resort - the bank that will lend when every other bank cannot (the central bank within a country, the IMF for whole bankrupt countries)
