Published July 21, 2010

After the Icelandic Supreme Court invalidated loans indexed to foreign currencies, the banks and regulators have struggled to determine what interest the borrowers should pay—the stated interest in the loan agreements or the much higher inflation-indexed loans typical to Icelandic contracts.

The borrowers who took out inflation-indexed loans are adamant, however, that the FX-indexed loans be adjusted to mirror their own. Although these borrowers expressed no pity when the Icelandic króna tumbled and principal of their neighbours’ FX loans doubled, they now protest that their neighbours should not reap a windfall which, they say, they will have to make up with their taxes.

Two of Iceland’s three major banks have already passed to private ownership, and all three say that they will be able to withstand the devaluation of these loans (in fact, the loans had been discounted by 50% when the banks were in receivership, so the devaluation will not have any adverse effect on the banks’ books, though I’m sure the banks would just as soon collect the full amount).

So what are the inflation-indexed borrowers so worried about? They received exactly what they bargained for. Why does it gall them so to see their neighbours beat the system for a change, especially since it seemed that the neighbours were being mercilessly mauled by the system?

The real question should be: why do Icelanders, alone in the world (to the best of my knowledge) have mortgage and car loans indexed to inflation?

In other countries, the interest charged on a large long-term personal loan like mortgages and car loans represents a gamble by the lender that the rate of inflation will remain lower than the interest rate for the term of the loan. If the rate of inflation spikes, the payments will soon be miniscule compared to the borrowers’ earnings. If the borrower took out a loan when interest rates were high, and inflation is tamed, he will then refinance at the lower rate, so the bank will not get a windfall.

Icelandic regulators should take note that the banking systems in the United States and Europe have somehow survived under this system throughout the entire industrial era, and have even managed to make a bit of a profit. In fact, it is in the banks’ interest that inflation be tamed, or they don’t get much in the way of profits.

By indexing loans to inflation, Iceland in effect guarantees the banks a profit, regardless of their competence in assessing risk. It has absolved the Central Bank from exercising more responsible control over the money supply. It also has the effect of feeding on itself. Each time the rate is adjusted to take into account the previous month’s rise, it bumps up the inflation rate a bit more, which increases the next month’s rate, etc. It’s like gambling in a casino—the house always wins.

So, instead of expending energy complaining about the FX borrowers’ sudden change in fortune, the inflation-indexed borrowers should be demanding that they be allowed to opt-in to similar deals from the banks. Instead of fighting each other, we should stand united against the bank cartel that has kept us under its thumb for too long.