I've mentioned how I think the Icelandic way of indexation is doing more harm than good in Iceland but I've never actually explained how it works. So here goes. This post is not going to touch on the disastrous effects of Icelandic indexation but merely am I going to draw a rough picture of how it works in practice.
Naturally, and as expected, the idea with indexation of debt contracts in Iceland is to preserve the purchasing power of the borrowed funds. The classic analogy in Iceland is that if you lend a horse, you're meant to get a horse back. If people want to think about interests as well, the lender is meant to get the horse back and a pony. Likewise, if a bank in Iceland lends out 1,000,000 ISK the indexation to the Consumer Price Index (CPI) is meant to preserve the purchasing power of the 1,000,000 until repayment. And since the bank is lending out the savers' money (which isn't true but let's skip that detail for the time being) the savers get their lent-out purchasing power back when the loan is indexed. Simple, basic stuff.
Now, of course, this is done in many countries, most notably on federal bonds. Sweden, USA, France, Iceland and plenty of other federal states index their bonds - or at least a part of them - to the CPI. This is all fine, issuing indexed treasury bonds hinders the State from being able to print itself out of debt problem and increases the fate of investors in State's finances. Also, one can argue that issuing indexed treasury bonds is cheaper for the State since real rates are, at least in theory, lower on such contracts compared to where the rates are nominal.
The way indexation is done in Iceland isn't that different from other countries...
To readmore check out Olafur Margeirsson
's blog at http://icelandicecon.blogspot.com/
Olafur is the author of the forthcoming book ''Bad Economics'' (Searching Finance 2012)